Is Fortescue selling out its costs advantage?

Andrew Forrest and his leadership team have taken the biggest step yet in their search for a volatility-proof balance sheet. But the asset sales risk undermining their production costs.

Fortescue Metals’ confirmation that is has a process underway for the sale of a minority interest in its Pilbara infrastructure assets is another indication of the severity of the wake-up call Twiggy Forrest received in September.

That was when the iron ore price tumbled below $US90 a tonne and Fortescue was forced into a radical re-shaping of what had been a very aggressive debt-funded expansion plan. It mothballed some of the planned increases in capacity, carved into its cost base, began selling non-core assets and refinanced its borrowings. Only a week ago Fortescue sold a 25 per cent interest in its Nullagine joint venture with BC Iron for $190 million.

The sale of an interest in The Pilbara Infrastructure entity, which owns Fortescue’s rail and port assets, would be the most significant step yet in re-shaping the group’s balance sheet, with some estimates that it could raise more than $2 billion. With a book value of more than $US6 billion it is conceivable a sale of, say, 49 per cent could raise far more than $US2 billion given that these are quite unique assets.

Despite the rebound in the iron ore price above $US120 a tonne, where it appears to be holding and, if anything, forming slightly Fortescue appears determined to get its balance sheet into a stable enough shape for it to be able to re-start its expansion plans.

The original vision was to increase production from around 85 million tonnes this financial year to 155 million tonnes a year with the development of the Kings deposit within its Solomon Hub project.

The significance of that development, along with the Firetail development that will add 20 million tonnes a year to Fortescue’s output, is that it would not only lift production to a run-rate of 155 million tonnes a year but materially lower the group’s overall production costs. Kings was shelved in order to avoid $US1.6 billion of capital expenditures.

At its last balance date Fortescue had about $US8.5 billion of debt and most analysts see its debts peaking at around $US12 billion if it debt-funds the deferred expansion to 155 million tonnes a year.

Selling non-core assets, or interests in them, to reduce the degree of leverage in the group would, given the nasty lesson about the potential volatility of iron ore prices learned in September, appear a sensible strategy.

There is, however, a delicate trade-off involved. Fortescue, despite its perceived riskiness, has been able to borrow relatively cheaply and, if it can get through to the 155 million tonnes a year target, it would be able to get its productions costs below $US50 a tonne and into the bottom quartile of producer costs.

As with the sale of a power station that it made in response to the September shock the critical issue is whether it can sell assets at prices that, relative to the cost of debt, don’t materially adversely impact its ongoing operating costs.

While there is some tolerance because of the reduced leverage and risk from a lower peak borrowing level the imperative for Fortescue is to ensure its future operating costs are in that bottom quartile to reduce its vulnerability to future iron ore price gyrations.

Fortescue and its advisers, Lazard and Macquarie, would therefore be very mindful of the need to maximise the sale price for the interest in the port and rail assets and minimise the ongoing cost of Fortescue’s access to those assets, knowing that Forrest would otherwise rekindle his affection for debt.

That Fortescue understands the trade-off and tensions was underscored by the decision it made late in September to deploy the $US900 million of headroom within the urgent refinancing it arranged after the iron ore price dived in redeeming, for $US715 million, the royalty notes it had issued to the US hedge fund Leucadia National Corp in 2006.

Lazard helped negotiate that deal, which swapped a production royalty that was costing around $US200 million a year and could have cost Fortescue something approaching $US400 million a year by 2014 for interest costs of about $35 million a year – that was a brilliant piece of opportunism from Fortescue, exploiting its own apparent stresses and the fear generated by the iron ore price crash.

The interesting question, assuming it can extract an attractive offer for the interest in its port and rail assets, is whether that’s the end of the asset sales.

There has been some interest from third parties in buying interests in some of its operating mines, which could be an option for further de-risking the group, albeit at the cost of potential upside.