PORTFOLIO POINT: A change in the prices being paid for undeveloped iron ore could lead to an entirely new industry based on trading in tenements.
The biggest story in iron ore is not that prices might be 'toppish’, thanks to slowing Chinese demand, but rather a remarkable re-rating of iron ore reserves triggered by Gina Rinehart’s spectacular $1.5 billion 'Roy Hill’ deal with South Korea’s Posco, signed earlier this month.
At the stroke of a pen, Rinehart has unleashed a game-changing deal which is set to revalue iron ore in the ground – and ultimately many iron ore stocks across Australia. Put simply, undeveloped iron ore, until very recently, was valued at about $1 a tonne. Under Rinehart’s deal with Posco, the valuation is at least four times higher, at $4 a tonne.
Rinehart is not alone here. Close behind is fellow WA tycoon Kerry Stokes, who has been trading in this space through his interests in Iron Ore Holdings and iron ore junior Haoma Mining, which earlier this week penned a deal at $5.79 a tonne.
Moreover, the spectacular lift in prices for undeveloped ore bodies is not going unnoticed across the mining sector. As an example, if the $4/tonne value was applied to FMG’s last reported 7.97 billion tonnes of direct shipping ore (omitting its 2.46 billion tonnes of low-grade magnetite ore), it would put a theoretical value on the company of close to $31.9 billion, compared with its current stockmarket value of $18.3 billion.
FMG’s share price would notionally rise from $5.86 currently to around $10, boosting Forrest’s stake in the stock from $6 billion to around $10 billion.
That FMG is not trading at $10 is a result of the company being valued as an ongoing business, using conventional price-to-earnings multiples and similar mathematical tools, which do not account for the underlying value of ore in the ground.
Until now, no one has valued iron ore exploration and mining companies on an “ore-in-the-ground” basis. Indeed, all the attention has been on the prospect of softening prices for produced iron ore (to read more on this issue see today’s article by Roger Montgomery).
But once analysts pay closer attention to the rising in-ground value of undeveloped ore, it is going to boost the fortunes of many, including billionaire Kerry Stokes, who is the major shareholder in Iron Ore Holdings. The exploration company last year sold some of its undeveloped ore for $1.35 a tonne.
Over time, all iron ore stocks could benefit from changes in the way ore in the ground is being traded. ASX-listed stocks – such as Atlas Iron, BC Iron, Mt Gibson, and Aquila Resources – would be among the beneficiaries, thanks to their reserves of high-grade material.
The trigger for this different look at the industry was a throwaway line from FMG’s chief executive, Neville Power, at a media briefing on the sidelines of last week’s Mines & Money conference in Hong Kong.
What Power said, when asked about iron ore values, was that he was pleased with the value being assigned to Rinehart’s Roy Hill mine, with the clear inference being that her deals could have a beneficial effect on FMG.
At the time, Power’s one-liner was not pursued, with media questions focussing on FMG’s plans to possibly float its magnetite assets in Hong Kong, or on another Asian stockmarket, with the liberated capital being used to help meet the cost of expanding its traditional iron ore business.
“We have fully-funded our expansion and mining equipment for this current expansion, so there’s no necessity to do anything in the short-term,” Power said about the possible magnetite float.
But his reference to Roy Hill caused me to reassess how the market is valuing undeveloped iron ore deposits, which are yet to have railway and port access, versus the value of undeveloped ore in a company which has all the necessary infrastructure.
Power obviously had this in mind, because once you start looking at events in the iron ore industry over the past few years, it becomes clear that the stockmarket has not been a rational place to value ore-in-the-ground.
The first hint that the market was behaving inefficiently can be seen in the 2009 acquisition of United Minerals Corporation by BHP Billiton for around $200 million, with the prize being the undeveloped, 158 million tonne Railway iron ore deposit.
BHP Billiton paid $1.30 for each UMC share, a price which was 43% higher than the prevailing market. The acquisition was priced at $1.27 a tonne of ore, setting what can now been seen to be a low benchmark.
Last year, Iron Ore Holdings sold undeveloped iron ore deposits at a price of around $1.35 a tonne.
The two latest deals, which could cause a general uplift in values, involve Rinehart’s Roy Hill project, and the Daltons project of Atlas and Haoma Mining.
In Rinehart’s case, the little public information available indicates that Asian steel mills are buying a share of the Roy Hill project at a price equivalent to around $4 per tonne of ore.
That price can be calculated from the notional $10 billion value assigned to the project when the Korean steel maker, Posco, last year became the first outside investor in Roy Hill, paying a reported $US1.6 billion for a 15% interest. Japan’s Marubeni and Taiwan’s China Steel are also reported to be paying similar prices per tonne for smaller stakes in the project.
A value per tonne can be calculated using information on Rinehart’s website, which says Roy Hill contains a total of 2.42 billion tonnes of ore, in the categories of indicated and inferred, and divided between ore that is above 55% iron and a secondary category of ore assaying between 50%-and-55% iron.
Using the approximate value of $10 billion put on Roy Hill by Posco, and dividing it by the total of 2.42 billion tonnes of ore, leads to a value of $4.13 a tonne.
In the Atlas/Haoma deal, announced yesterday, a value of $5.79 a tonne was placed on undeveloped ore. That deal covers the residual part of a deposit called Daltons, which was co-owned by Atlas (75%) and Haoma (25%), and which Atlas plans to bring into production soon.
Under the terms of the Daltons deal, Atlas is paying Haoma $33 million ($10 million cash and $23 million in Atlas shares). Given that Daltons contains 22.8 million tonnes of ore, and Haoma is entitled to 5.7 million tonnes, that values the orebody at $5.79 a tonne.
Confirming that high value per tonne is a secondary part of the agreement – that Atlas will pay Haoma $5.50 a tonne for any ore mined above 24 million tonnes.
Not every deposit, or every company, will get the higher prices which are emerging in the iron ore industry, but the significance of the prices being paid for undeveloped material is starting to affect the way investors, and company managers, value assets.
Direct comparisons between deposits of iron ore have always been difficult because of varying qualities, such as the amount of iron in each tonne of ore, the level of impurities, and whether the orebody is close to railways and ports.
It is the isolation of some orebodies which explains the early low prices, and underlines the importance of access to infrastructure. BHP Billiton’s price for the Railway orebody of $1.27 a tonne can now be seen as a magnificent deal, as BHP Billiton is able to sell the Railway ore for more than $120/tonne.
Iron Ore Holdings, which has made selling undeveloped ore its primary business focus, could be a significant beneficiary if the Roy Hill and Daltons values flow through to its assets.
The rising values for undeveloped iron ore also explain why a syndicate of Hong Kong investors battled to acquire control of Brockman Resources, with its 1 billion tonne Marillana resource, when most Australian investors could not see the prize.
Rather than being worth its current on-market value of $355 million, Brockman is theoretically worth between $1 billion and $4 billion, using the Roy Hill and Iron Ore Holdings deals as low and high valuation tools – or more than $5 billion using the Daltons deal.
Critical to the changing nature of iron ore valuations are the differences in orebodies, with a premium price being paid for high-grade material (62% iron and above), and a heavy discount on material with high impurity levels, especially the “steel killer” elements, phosphorous and alumina.
Some poor-quality orebodies can be blended with premium material to achieve a uniform quality, such as Rio Tinto’s standard “Pilbara blend”, but other orebodies will not be developed until a way is found to lower the phosphorous content – a project on which the CSIRO has been working for 20 years.
Does what’s happening in the undeveloped ore sector change the way investors should treat the iron ore companies?
Yes, because even if the price of ore landed in China falls from its current boom-time high of around $US140 a tonne for premium material, an entirely new industry based on trading in tenements is developing and it is an industry perfectly suited to small companies, as Iron Ore Holdings has demonstrated.
Bigger miners will also benefit as the business of buying and selling undeveloped ore develops and the higher values being achieved, such as those at Roy Hill and Daltons, are factored in to the market.
There is no doubt Australia is facing some headwinds, with declining terms of trade and lower credit growth (to read more on this, see today’s article by Gerard Minack).
And though many analysts, such as Minack and Alan Kohler, are bullish on the outlook for construction and engineering companies engaged in the broader area of mining services, the point an active investor must not miss is that, in essence, Australia’s iron ore boom is far from over. If anything, it has just ratcheted up a notch thanks to the rising values being placed on ore-in-the-ground.