KGB Interview: Fortescue's Nev Power

Fortescue Metals chief executive Nev Power tells Business Spectator's Alan Kohler, Robert Gottliebsen and Stephen Bartholomeusz:

-- A muted supply response is driving current conditions in the iron ore market

-- Cost disadvantages sustained through subsidised iron ore production in China could result in a large portion of that country's iron miners shutting down

-- Blending ores and expanding the business has been vital in reducing Fortescue's costs by more than 23 per cent in the past year

-- If the iron price continues to fall, debt repayment will remain a top priority to maintain stability, but capital expansions and dividend payments could also provide options

-- What he thinks about Gina Rinehart developing Roy Hill in the current marketplace

-- Fortescue is looking to increase inbound investment from China

-- Why the development of domestic gas supplies in Australia is so important for miners and agriculture

Alan Kohler: Now, welcome to Business Spectator and thanks for joining us.

Nev Power: Thanks, Alan. It’s good to be here.

AK: Nev, the story goes that the iron ore price has been driven down by the majors, Rio, BHP and Vale, increasing production to try to drive smaller producers out of business. Could you tell us firstly, is that right? What’s going on? And secondly, is Fortescue in on the game or what?

NP: Alan, I think what we’re seeing is all of the capacity that’s been invested in over the last couple of years coming into the market in a very short space of time. In our own case, we’ve brought on over 100 million tonnes of new capacity in the market in the past couple of years and what we’re seeing is a muted supply response to that new iron ore supply.

AK: What do you mean “muted supply response”?

NP: Well, I think the…

AK: You mean muted demand response?

NP: No. I mean that the high-cost producers that are currently in the market that are only there because the iron ore price was very high previously have not retreated out of the market as quickly as we had expected them to.

AK: Oh, I see. Right.

NP: And so the supply response, if you like, the high-cost producers exiting the market has been a lot slower. And I think one of the key reasons for that are the large stockpiles of iron ore that we currently see at the port.

AK: But is it a deliberate plan to try to drive the Chinese producers in particular out of business?

NP: No, I don’t see it as a deliberate plan. This has been a well-forecast and telegraphed plan that low-cost iron ore producers such as ourselves have been expanding capacity to fill the gap in supply that was left when Chinese demand accelerated. 

What happened when that demand took off -- and I think it surprised everybody including the Chinese -- was that there wasn’t enough supply in the market to meet that demand. So it was only marginal producers, particularly in China, that were able to expand production quickly enough to meet that.

What’s happening now is the new low-cost, seaborne supply has come into the market, but we’re seeing a delay in how quickly the high-cost production exits.

Robert Gottliebsen: Okay. Could I just put a possibility of a different way of looking at this? Back in the '60s, we had a shortage of iron ore and the price went up, and all those things. The Japanese really fostered increased production to the point that where we got a run of iron ore, the price fell. I wonder to what extent the Chinese have done exactly this -- that they’ve repeated what the Japanese did way back decades ago and fostered overproduction. 

NP: There's probably an element of that, but what I would say is that if you look at the demand side, the demand has actually been stronger than what even China itself forecast.

So contrasting that to the Japanese situation, I think the demand was overestimated. The famous J curves of the 1960s and ‘70s and ‘80s never really came to fruition. But in China, what we’re seeing is the demand for iron ore is there. We’re seeing record steel production, record iron ore demand every single day. But what has happened is supply has overrun that demand because the high marginal-cost producers are still tenaciously hanging on in the market.

Stephen Bartholomeusz: Nev, I know that when Rio and BHP look at that high-cost Chinese domestic production, so 400 million tonnes -- half their requirements -- they say most of that’s going to be there forever, and we can’t assume that because they’re high cost they’ll disappear. Is that how you look at it?

NP: I think about it in economic terms. If you think about it, for a steel mill in China -- and remember that 50 per cent of Chinese steel production is by private mills -- for a steel mill to subsidise iron ore production or for the Chinese government to subsidise iron ore production to any extent puts them at a serious cost disadvantage to the other steel producers in the world.

I think the Japanese, Korean and Taiwanese steel mills as well as the rest of the world would love to see a cost advantage over the Chinese because the Chinese have been very competitive, very productive and very low cost. Therefore they have dominated world steel markets.  If they put themselves at a cost disadvantage for anything other than a short period of time, I suspect they’ll start losing market share. What we’ll see is the Chinese steel mills being forced to pick up lower cost raw materials.

AK: It sounds like you think that the Chinese iron ore miners will close down.

NP: I do, Alan. I think it will take some time, and slower than I anticipated it would. But if we look at that 400 million tonnes of production in China, I’m sure that there is some there that is very low cost and will be there for a long period of time. 

There is some other production that is no doubt attached to steel mills and perhaps integrated in the cost structure. Certainly those in inland provinces are at a competitive advantage in terms of freight. But there’s also a large portion, I suspect, that will go out of business because they’re not competitive.

AK: How much? What’s your estimate?

NP: Some of the estimates that I’ve seen are perhaps as much as a quarter of that production. And if you look at today’s supply-demand, taking 100 million tonnes out of the supply would make a massive change to that supply-demand balance. So, it probably only needs somewhere between 50-100 million tonnes to restore that balance in the market.

SB: One hundred million tonnes would basically equate supply and demand today, but between BHP and Rio -- and they appear committed -- there’s another 35 million tonnes coming out of the Pilbara. Vale’s already got 130 million tonnes in the pipeline and it’ll be there before 2018. Anglo’s got Minas-Rio in South America. That’s another 26 million tonnes. Gina Rinehart’s got 55 million tonnes coming out of Roy Hill. So, you could take out the entire Chinese domestic production and it’s going to be replaced by seaborne production and so you’ll still have a market that’s fundamentally oversupplied. 

NP: And if that occurs, Stephen, that’s exactly what will happen, I suspect, until demand growth gradually eats away at that increased supply. The reality of this market is that the iron ore price will stay low for as long as it takes for that supply-demand balance to be restored.

AK: Given what Steve said, it could fall a lot further. It could actually head south significantly, couldn’t it?

NP: It could do, depending on where the new marginal cost producers become. But if you look at our own case, we are now delivering iron ore to China at under $US50 a tonne.

SB: That’s C1 though, isn’t it, Nev?

NP: No.  That’s all in, delivered cost into China. If you want to add interest payments and sustainable capital, interest is about $US3 a tonne, sustaining capital’s probably $US3 or $US4 a tonne on top of that. It still makes us very, very competitive compared to the two thirds or three quarters of the cost curve that are above that. Bear in mind, we are at a significant freight advantage to South American and African producers and sea freight’s at all-time lows. 

As sea freight goes up and as we start to see the Australian dollar start to come back to perhaps more sustainable long-term levels, our competitiveness only grows. So, we’re in a very good position in the Pilbara and we’re in a very good position at Fortescue for the long term because of that cost structure.

RG: We’re seeing in both Rio and BHP substantial falls in their cost structures and that reflects the fact that Pricewaterhouse said that they were some of the most inefficient miners in the world. Have you got scope to do similar things with Fortescue?

NP: Robert, we’ve brought costs down by 23 per cent in the last 12 months and the key to that has been bringing on new low-cost mines that allow us to blend our ores and make the absolute best out of the ores that we have. 

We have some very good, low-impurity ores in the Chichester, which we’re now able to blend with Brockman-style ores from our Solomon Hub to get an advantage in both mines. We’ve still got some of that process to go and, in addition to that, we get the normal advantages of being able to run the business productively and efficiently as an overall business. 

If we wind the clock back, it’s not so long ago. Fortescue’s only been in production for six years, so our oldest mine is six years old. Our youngest mine is just six months old. And when we were from a single production source, we had no choice other than to have the costs of that production source.

As we’ve developed new production sources and expanded our business, we’ve now got the ability to blend ores and to reduce our costs. So, driving greater efficiency, we’ll see our costs continue to come down, and we’ve set guidance for this year at $30-$31 a tonne C1 costs. That means we’ll exit this year below $30-a-tonne C1.

AK: I couldn’t believe it when I read the presentation from the annual report and it showed costs being reduced by 23 per cent. You’re a new mine. You’re a new business. I mean, isn’t that an indictment of the cost structure that you started out with, if so soon after you started, you’re cutting costs by more than 23 per cent?

NP: Well Alan, if we were a steady-state business, I would agree with you, but that 23 per cent has come from bringing the low-cost Solomon mine, so Firetail and Kings are very low-strip ratio efficient mines. They’re bulk ore bodies and they’re conventionally mined and their strip ratios are less than 1.5 to one and we’re using those ores to blend with the Chichester ores, which are higher cost, higher-strip ratio, but very low impurities to produce product that suits the market. So, that big cost reduction from us has come from the expansion of our mines and the implementation of our development strategy.

AK: Rio’s driving its trains from Perth. Are you doing that?

NP: No, not yet. We…

AK: Are you going to do it?

NP: We are running autonomous trucks and we have the first production installation of the Caterpillar autonomous truck system at our Solomon mine.  It’s going extremely well. We’ve got around 20 trucks operating autonomously now and they’re proving to be safer and more productive than manned trucks.

The big benefit in autonomous is not the cost of the operator, it’s the productivity gains that you get and the safety gains you get of having a computer being able to monitor the trucks.

AK: I know. I never thought you paid the truck drivers that much.

NP: In terms of trains, I guess we’ll watch and see how the industry develops around that. For us, the most important thing is being able to run those trains efficiently and productively and make sure the scheduling’s right. We’ve just implemented a new scheduling system that’s come out of GE and that scheduling system is operating to give us the fastest turnaround times that we can get out of our existing system.  It’s working very well.

SB: Nev, with hindsight, the shock you got in 2012 in September has been really positive for Fortescue and left you in a much better position than you might have been. You still have more than $US7bn of net debt. You still have costs that are higher than BHP’s and Rio’s. If the price keeps falling, do you have a contingency plan, and does the equity in the infrastructure come up for grabs again, for instance?

NP: Stephen, we do have a lot of options for us because, unlike some of our competitors, we own 100 per cent of our business, we own 100 per cent of our mines, 100 per cent of our infrastructure. 

What you see in our balance sheet is the clear, transparent picture. We also don’t have any other parts of the business that are drawing capital from our iron ore business because some of our competitors, while they might be diversified, get most of their earnings out of iron ore. It really puts us in a very good position financially. 

We have a lot of options with our balance sheet. We have nothing in the debt structure that’s due to be paid until 2017 and the US capital markets continue to run very, very strongly, which gives us lots and lots of options there. Our priority will be debt repayment. We’ve talked about that in the past, where we’ll focus on continuing paying down our debt to get us below around 40 per cent gearing and we’ll continue progressively increasing dividend policy up to a 30-40 per cent payout.  

We’ll cut our cloth going forward to suit the market and, as I’ve talked about our cost structure, we’ll also look at our capital expansions, debt payments and dividend payments in the same context, depending on what the cash flows are generated from the iron ore market.

SB: One of the things that’s puzzled me this year is that there were two prepayments. I think it was $US500m for prepayments of port access fees and $US700m for prepayments for iron ore. What does that do to your cash flows? You’ve already banked $1.2bn.

NP:  The $500m is not dependent on anything other than time, Steve, so that actually decrements down in the accounts over the next four years because it is a payment for port access for our joint venture mine at Iron Bridge. So, that’s in there and there’s no repayment required of that. 

The iron ore prepayments do need to be repaid and we’ve scheduled to do those during this financial year, which means this year we will have $700m or $800m of cash to repay those. Therefore the debt repayment will slow down during this financial year, but we’ll step up again next year because that is a one-off payment as is our tax payment in October. 

SB: That’s three-quarters of a bill for the tax payment.

NP: Yes, about $650m. There’s about $750m-$800m in prepayments. So that $1.3bn, $1.4bn is a one-off for this year that’s not repeated next year. That’s why we’ve put fairly conservative estimates on debt repayment for 2015, but increasing again during 2016.

RG: Do you think that with the benefit of hindsight, Gina would now go ahead with Roy Hill? It’s a somewhat higher cost mine coming into this market place.

NP: Yeah. Look, it’s a big investment and we of all people know what it takes to develop those assets and develop that infrastructure and I’d have to say that I’m very pleased that we had our capital expenditure when we did and I think the only regret we would have at Fortescue is we didn’t do it quicker and we didn’t do it sooner. So, in this market, I think it’s a very tough market to be developing that level of infrastructure.

RG: So, you don’t think she’d do it with the benefit of hindsight?

NP: Well, I’m not sure. I guess her drivers and Hancock’s drivers might be a little different to others in the industry because I think they’re committed to developing that mine with dedicated infrastructure. We would have been quite happy to develop the mines and use other infrastructure, but of course we were forced to develop our infrastructure because there was no other choice.

AK: Your share price has fallen 40 per cent since February. Given what you said before about the position that Fortescue’s in now, are you and the other executives seeing that as a buying opportunity?

NP: Yeah, absolutely, Alan. I think it does represent a tremendous buying opportunity.

AK: So, are you buying?

NP: When I can, I do, yes.

AK: You do. So, you are buying shares at the moment.

NP: Well, I’m not buying right at the moment.

AK: Not today.

NP: Not today, but you might have seen that I’ve just been allocated a significant portion of shares as part of my performance payment, so I’ve got to digest the tax payment on that first.

SB: Oh, so you’ll be selling shares.

AK: You’re selling to pay the tax, right.

AK: Now, you made a presentation in Chinese last week. Was that to investors or to customers?

NP: What we quite often do is translate presentations that we make here for both investors and customers and translate that into Chinese. So, obviously we’ve very focussed on China as our customer base and we would like to also increase China as a source for inbound investment. I think that there is opportunity in the future to get more investment from China.

AK: Is there much investment from China in Fortescue now that you’re aware of?

NP: Well, we have obviously the Hunan Valin group as a major shareholder with 15 per cent. And we’re not aware of any other major blocks, but I suspect that the sovereign wealth funds and other investment funds out of China are investing in there, and of course a lot of investment is channelled through Hong Kong, so it’s a little hard to see with any great degree of detail where exactly it comes from.

RG: Nev, personally you’ve got a major stake in agriculture. What do you think is required to make Australia an agricultural power on a much greater level than it is now?

NP: Well, I think one of the keys for us, Robert, is low-cost energy and I think there’s a great analogy here with the US and one of the concerns I have is that Australia could put itself at a competitive disadvantage versus the US, particularly in grain production, because if we think about agriculture, fertilisers typically come from energy, tillage and transportation from energy, and of course shipping anywhere in the world for us is significant use of energy.

So, I think important for us is that we have low-cost energy and for that reason we’ve been leading the debate about the development of domestic gas supplies in Australia. I think for a start in the mining industry it is crazy that we buy oil from the Middle East, have it refined through Asia, transported down, transhipped through a whole series of complex logistics to get it to our mine sites, when right next door to us are some of the largest gas deposits in the world, but they’re undeveloped and we’re seeing increasing domestic gas prices.

So, we’re encouraging more supply. We’re encouraging the governments to enforce use it or lose it policies on natural gas, so that we can see more energy come into the domestic supply and I think that’s key for agriculture because energy is so important.

RG: Do you think the major miners could do a deal with an undeveloped field in North West Shelf to take a whole lot of energy?

NP: Yes, I do.

RG: Are they talking about it?

NP: Yes. Those discussions are ongoing. And I think for us we see the development of infrastructure as important, so we’re building and investing in the Fortescue River Gas Pipeline, which will connect our Solomon Hub back to the Dampier to Bunbury Pipeline. We see that as the first stage. And that pipeline for us needed to be eight inch diameter; we’ve made it 16 inch diameter. We’ve invested in that additional capacity.

I think that’s a great example of what could be done with direct action in terms of greenhouse gas emissions because if we converted to natural gas for our mining fleet and power stations, it would halve the amount of greenhouse gas emissions from our mines.

As well as that, it’s much cheaper than diesel. So, we see developing gas infrastructure and then converting not only power stations but mining fleet over to gas as a great way to reduce our costs and at the same time improve emissions.

RG: So, you’d do the same thing in agriculture?

NP: In agriculture, exactly the same. I think we should be looking at developing as much domestic supply gas as we can, so we have low cost, competitive gas available to agriculture, to mining and to manufacturing, for that matter, in Australia. Our major competitors in agriculture are, in fact, the US and they are availing themselves of that low-cost energy.

SB: Beyond the pipeline we’ve seen people like Incitec, Orica and Dow actually buying into the development of gas fields and I’ve got a feeling that you might have even actually speculated about Fortescue doing something similar.

NP: We have looked at that, Stephen, in the past and we’ve continued to consider that, but our major focus is on ensuring there’s enough supply coming into the market. I think the West Australian market is a separate market to the east and I know there are some specific issues around supply here, but Western Australia’s not too much different and we see that unless new supply comes in, the domestic gas price will go to an LNG netback price, which I think would be a travesty for Australian business.

RG: Would you think of selling some of your infrastructure such as the pipeline to superannuation funds? Will you guarantee an income?

NP: Yes, Robert. In fact, we’ve looked at that on a number of occasions. The Fortescue River Pipeline is a build-own operate scheme that we’ve done with TransAlta and Dampier to Bunbury Pipeline. We’ve also done the same with our Port Hedland power station, which TransAlta again is the build-own operator of that and we have a long-term take or pay agreement. And, likewise, our Solomon power station is another example of that.

So, we’re very selective about it because obviously if you’re on both sides of the transaction, we have to be careful that we don’t get a big payout for that infrastructure but end up just increasing our costs and reducing our flexibility long term. So, we will be selective, but for the right terms and conditions and obviously the right value, we are in the business of selling down infrastructure.

AK: In terms of the gas price and the price of energy, you seem to be suggesting that there’s a role for a change of government policy in this. I mean because Australian government policy has not really been to get involved in this sort of thing to reserve domestic gas or to mandate prices in some way. Do you think that that’s what should happen?

NP: Alan, I think the policy and the legislative framework is okay. It probably just needs to be applied more diligently. And there is a really good analogy with the iron ore tenements that are now Fortescue’s tenements. It was only through the enforcement of a ‘use it or lose it’ policy by the Western Australian government on those iron ore tenements that allowed those tenements to be released and of course Fortescue then pegged them and developed tenements that were otherwise considered uneconomic.

I think that exact same analogy could apply in gas where smaller satellite deposits of gas, which are not economic to be developed for LNG, could be developed for domestic supply. So, it’s not so much a change of policy or legislation, but rather a more diligent application.

AK: Are you talking about onshore or offshore?

NP: Both.

RG: Dow says that the way to get fracking off the ground is to reward the farmers.

NP: Yes.

RG: Do you agree with that?

NP: I do. I do agree that the biggest difference between what we see in the US and what we see here is the level of interest, if you like, that the farmers have in the mineral rights of their land. So, I think due compensation and proper returns for the farmers are a really important part of that equation.

Now, our legal system is different here, but I think pragmatically we can change that as development companies in resources and energy to make sure that farmers are rewarded because there is a great partnership there at the end of the day if we look at it a bit differently.

AK: So, who needs to step up to make that happen?

NP: I think it’s beholden on energy companies to do that, Alan, to make sure that farmers are properly included and consulted in that process, but I also think that we need a bit of a change of attitude from a community point of view and from the collective of our farmers, and to look perhaps a little bit beyond locking the gate to looking at what’s long term and sustainable for those communities.

After all, farming communities can only prosper in the long term if there is good business development and if they’ve got access to cheap energy. So, having large tracts of land locked out of minerals and energy development I don’t believe is in the best interests of those farmers long term or the country.

AK: You say that Fortescue has a unique culture. What’s unique about it?

NP: It’s unique, Alan, because we try to maintain a sense of empowerment and for everybody in Fortescue to behave like they own the company, because they do. If you think about companies, I mean it’s not just the shareholders that own the company. Each of us only have one lifetime to put into our working careers and we spend so much of our time at work.

We encourage our people to take a positive attitude to work and work life and to make a difference when they come to work and to make a difference by being owners of the company. So, we encourage people to bring innovation, to bring ideas, to bring their brains to work and to think of new and different ways to do things. And sometimes that can be quite difficult because we have to have consistency and standards across the business, but at the same time we encourage people to make decisions for themselves and empower them to operate as if this was their business. What would decisions would they make and what changes would they make?

AK: On that note, we’ll have to leave it there. Thanks, Nev.

NP: Thank you.