Making sense of Fortescue's upside surprise

Fortescue Metals' much-anticipated December quarter production report provides an insight into the cross-currents swirling through commodities markets. The immediate spike in its share price this morning signals that some of them have surprised on the upside.

As discussed yesterday (How Fortescue became a victim of its own success, January 28), Fortescue's Nev Power needed to explain and defend the group's position in the context of the plunge in iron ore prices and provide a convincing strategy to respond to the challenging environment. He hasn't done a bad job of it.

What appears to have been underestimated is the extent to which Fortescue has been able to reduce costs.

Some of the 11 per cent reduction in C1 costs to $US28.48 a tonne and in total delivered costs by 9 per cent to $US41 a tonne relates to actions within its own control. There were, however, external influences that also contributed.

Iron ore prices have, of course, been smashed. Fortescue's average realised price for the December quarter was $US63 a tonne compared with $US71 a tonne in the September quarter of last year.

Fortescue ore sells at a discount to the 62 per cent Platts CFR index prices, which fell from $US90 a tonne in the September quarter to $US74 a tonne in the December quarter. The index price is now about $US63 a tonne, so Fortescue would be realising a price in the mid-$US50s a tonne range. That's why its share price took some big hits in the lead-up to the report.

What may have been underestimated are the offsetting benefits Fortescue and other commodity producers are experiencing as a result of the collapse in commodity prices.

The Australian dollar, oil prices and shipping costs have all also tumbled in response to the abrupt and quite savage implosion of the commodity price bubble.

Between the September and December quarters the dollar fell from an average of US93c to an average of US86c. It is now trading below US80c.

At the end of the September quarter oil was still above $US90 a barrel. By end-December it was below $US70 a barrel. Today it is below $US49 a barrel.

The cost of shipping ore to China has also fallen dramatically. Fortescue said its average cost for shipping ore was $US8.50 a tonne in the December quarter. It didn't provide a comparable figure for the September quarter but there have been estimates that the collapse in oil prices has lowered the cost of shipping ore to China by nearly 40 per cent.

With Fortescue's C1 costs impacted by between US20 cents and US25 cents a tonne for every one cent movement in the $A:$US exchange rate it benefited to the tune of about $US1.60 a tonne from the Australian dollar's depreciation in the quarter. It would be experiencing a similar benefit this quarter, given that the Australian dollar has continued to fall.

With fuel and energy costs making up about 12 per cent of C1 costs and impacting shipping costs, the lower oil prices reduced Fortescue's costs by about US26 cents a tonne in the quarter and would be having a very similar impact on costs this quarter.

With production volumes for this year forecast at between 155 million tonnes and 160 million tonnes the impact of the exchange rate and oil prices is quite material to Fortescue and will help to dampen the impact of the lower iron ore prices on its cash flows and profitability.

The group is forecasting C1 costs of $US28 to $US29 a tonne for the full-year (previous guidance was $US31 to $US32 a tonne) and total delivered costs of about $US35 a tonne by the end of the financial year.

That ought to deliver positive margins and cash flows unless there is another structural shift downwards in iron ore prices.

As discussed yesterday, Fortescue has flexibility and options to respond to another fall in prices. While it has $US9.1 billion of gross debt, it also has $US1.6bn of cash. Its debt has no maintenance covenants and Fortescue has the option of pre-paying or refinancing it.

It has $US1bn of debt maturing in 2017, another $US400m in 2018 and it isn't until 2019, when $US4.9bn matures, that it faces a particularly challenging refinancing task.

It has, therefore, plenty of time and a number of options (because it fully owns its mines and infrastructure) for managing its liabilities if the environment continues to deteriorate. It has already halved its planned capital expenditures for this year, from $US1.3bn to $US650m.

There isn't an iron producer that hasn't been adversely impacted by the extent and rapidity of the price declines. Fortescue, as the Pilbara producer with the higher costs, lower quality ore and greater financial leverage relative to Rio Tinto and BHP Billiton, is more exposed than their iron ore businesses.

The lower Australian dollar and lower oil prices -- and management responses through cost-cutting and big cuts to planned capital expenditures -- are, however, providing a more than handy softening of the impact of the lower iron ore prices as well as a pointer to the offsetting influences that will affect any of the resource operations with Australian dollar cost bases and US dollar revenues.