Iron ore's harder times

Miners' rising earnings mask a problem: costs are rising, demand is slowing and new mines have the world awash with iron ore.

PORTFOLIO POINT: New miners, rising costs and softening demand are making life tougher in the iron ore market.

If you think iron ore will be an easy way to make money in 2012 and beyond, think again, because there are three forces bearing down on an industry that has had an easy ride on an unsustainably high commodity price.

Rising supply, slower demand and soaring costs are rubbing the gloss off iron ore, the sector that dominated last week’s profit reports from BHP Billiton and Rio Tinto, and was confirmed in the Fortescue Metals Group half-year result filed earlier today.

FMG, the only pure-play iron ore miner among those three companies, is the best example of what’s happening in the iron ore business because although it reported a notoriously impressive 15% increase in underlying earnings for the period to December 31, to $1.5 billion before interest, tax, depreciation and amortisation, it was hurt by rising costs.

Always complex because of refinancing charges and near non-stop expansion, the key to FMG’s numbers for investors were the 44% increase in ore mined, and the 30% increase in tonnes shipped (including a small contribution from third parties) – at a sharply higher cost per tonne of $US47.97 compared with $US38.84 in the previous six months, to June 30.

FMG said in its results presentation that the higher costs were caused by the foreign exchange impact (higher Australian dollar), and “increased strip ratios” – miner’s talk for the mines getting deeper, which means more overburden (waste) having to be removed to extract the ore.

Perhaps even more concerning is that two of FMG’s key metrics, cash flow from operations and operating cash flow per share, went modestly into reverse.

What the FMG half-year report shows is that profit growth, which is what keeps investors interested, is giving way to a period of increased export volumes but with little, if any, increase in earnings.

That is not an overall sell signal on all iron ore stocks, but it is a warning that the easy money has been made and now comes the much tougher job of efficiently operating the integrated mine, railway and port systems that make up a bulk commodity business.

Remember, although Fortescue is a pure play, iron ore made a big contribution to the big diversified miners – 50% of BHP Billiton’s underlying earnings before interest, tax and other charges for the half-year to December 31, and 73% of Rio Tinto’s underlying EBITDA for the year to December 31.

The first warning that the iron ore boom was coming to an end (for investors, if not employees and management) was published here almost exactly 12-months ago (see Iron ore overload).

Back then, the first signs of surging production could be seen. Today, the massive level of fresh investment is producing a tsunami of iron ore.

For sector leaders such as BHP Billiton, Rio Tinto and Fortescue, the immediate outlook for their iron ore operations is probably a steady profit result this year, with the full effects of toughening business conditions becoming more obvious from 2013 onwards.

In effect, this is a confirmation of last year’s warning that the best times are over, a point reflected in share price movements over the past 12 months with:

  • Fortescue shares falling from $6.88 to less than $5 in January, but back up to $5.61 on Tuesday amid speculation of a corporate deal with Canada’s Teck Resources, and then back to $5.50 after the release of the half-year result.
  • BHP Billiton weakening from $46.49 to $36.17, largely because of sliding profit margins in sectors other than iron ore, making the business alarmingly dependent on that one division.
  • Rio Tinto, down from $87.43 to $69.28, mainly because of losses in its aluminium division, making it even more dependent on iron ore than BHP Billiton.

What appears to be happening with the diversified miners, essentially BHP Billiton and Rio Tinto, is that they are investing heavily in the sector that is currently producing the best profit margins, iron ore.

It’s fine in theory, but the problem is that every other iron ore producer in the world is doing the same thing at the same time.

In Australia alone, the big three of iron ore are collectively investing more than $40 billion (and perhaps a lot more) in new mines, railways and ports to add about 470 million tonnes of capacity, doubling last year’s rate of exports in a frantic five-year burst of activity. Brazilian iron ore miners are also expanding exports, and new mines are being developed in Africa.

Everyone, including new “value-adding” entrants in the business which will process low-grade magnetite ore to produce a premium-quality export product, is chasing business in Asia and especially in China.

Even if the price remains at its current elevated level there are the other factors bearing down on the industry: rising supply and rising costs.

In the Pilbara region of WA, home to most of Australia’s iron ore mines, costs are soaring at both the capital and operating level thanks to heavy demand for equipment and skilled labour, with the miners forced to compete for workers and services with oil companies building LNG projects.

Pinning a precise figure on how much the iron ore miners are investing in new capacity is not easy as both are undertaking a series of rolling upgrades. There is no big bang.

However, examples of the expansion projects under way include:

  • Rio Tinto’s a $3.4 billion expansion of its Nammuldi mine, and Cape Lambert port as part of a step up from 220 million tonnes a year to 353 million tonnes by the first half of 2015.
  • BHP Billiton announcing the first spending on a new export facility called the outer harbour at Port Hedland, which could ultimately cost $14 billion. The complex of rail, ore stockpiles and four kilometre long jetty will eventually add a total of 240 million tonnes of capacity to the company’s current annual production rate of 178 million tonnes of iron ore a year.
  • FMG allocating $8.4 billion to lift its annual rate of production from 55 million tonnes to an initial 155 million tonnes, and then push towards a stretch target of 355 million tonnes a year, if it gets approval to build a new port.
  • Atlas Iron, which is producing at a much more modest annual rate of six million tonnes, is also expanding to 15 million tonnes in 2015, and then up to 46 million tonnes in 2017, and perhaps more in the future.

Increased production has not yet produced a significant fall in the price of iron ore, which is proving to be remarkably resilient, thanks in part to India imposing tight controls on exports in order to protect its domestic steel industry.

The question for investors is judging how quickly the pincer effect of a flat (or falling) iron ore price will meet rising costs which will inevitably lead to lower profits.

As an investment strategy the best way to treat the iron ore sector is to divide it by time; that is, to see that next two years of continuing strong profits (assuming no global shock), and for prices to retreat as the new supply hits the market.

A sign that now is as good as it gets for iron ore was shown in an analysis by the investment bank Goldman Sachs, of future iron ore earnings by BHP Billiton and Rio Tinto after the two companies released their half-year and full-year profits last week.

BHP Billiton, according to Goldman, should lift its profit from iron ore by a marginal 3.8% this year with an increase from $US13.328 billion to $US13.842 billion. Next year, 2013, the increase will be an even more marginal 2.5%, up to $US14.193 billion.

The profit, in raw dollars, is impressive. But it’s not rising, and perhaps even falling after allowing for inflation.

It’s a similar story with Rio Tinto with iron profits this (calendar) year tipped to reach $US12.197 billion, down fractionally on the 2011 iron ore division profit of $US12.853 billion.

As an investment class, iron ore retains its credentials, for now, with a number of potentially profitable entry points, such as Atlas, Iron Ore Holdings, and even the new magnetite ore processing stocks Gindalbie and Grange, which hope to prove that the higher price they will get for a premium product will offset their rising capital costs.

In terms of a potential trading profit, the iron ore processors are worth a look, if only because their shares have been heavily discounted over the past few years because of widespread uncertainty about their profit-making potential.

With Gindalbie trading at 68.5¢ and Grange at 59¢ there is room for a significant uplift if they can deliver on half their promise.

As an investment idea, today’s Fortescue results tell the story of rising export volumes, which is good news for employees, but with those volumes not delivering profit growth of the same magnitude as earlier years, which is not so good for investors.