Profits matter more with iron ore

Summary: Iron ore miners BHP Billiton, Rio Tinto and Fortescue Metals Group report their quarterly results in the coming weeks. Cost per tonne discussions may take away from talks about profit margins, where the gaps between the miners might become clearer.

Key take-out: Investors might like to focus less on the cost per tonne for iron ore miners and more on their profits per tonne. The former measure doesn't give the full picture, and there can be a significant difference between the quoted price and the real price for these producers, largely because of the quality of ore they are dealing with. 

Never mind the costs, focus on the profit margin.

That's some advice investors could find handy over the next two weeks as Australia's biggest iron ore miners file their September quarter reports, with the spotlight on cost per tonne when it really should be on profit per tonne.

Driving costs down after a decade-long capital spending boom has dominated recent interest in the iron ore divisions of BHP Billiton and Rio Tinto, and single-purpose iron ore producer, Fortescue Metals Group.

In what has become a curious race to the bottom, the big three have tried to outdo each other quarter-by-quarter with Fortescue claiming to be the low-cost leader thanks to a cash-cost per tonne in the June quarter of $US12.16.

BHP wasn't far behind with a cash cost per tonne of $US14.60, while Rio Tinto split the difference at $US13.80/t.

Given that all three had been producing iron ore at more than $US30/t a few years earlier, and close to $US50/t in the case of Fortescue, the cost reductions are spectacular. A bit of corporate boasting is to be expected.

BHP and Rio Tinto report next week and Fortescue the week after. Bragging rights about cost per tonne are likely to remain with Fortescue, but not profit margin per tonne.

There are two problems with the headline cash-cost numbers which tend to cloud reports of how well the iron ore miners are performing.

Firstly, they are not the total cost. In the case of Fortescue, this is roughly 80 per cent higher at a total delivered cost of $US22/t after factoring in shipping, royalties and administration.

Secondly, there is the question of price received per tonne, an absolutely critical point which is becoming more important as Chinese steel mills demand higher quality raw materials to cut locally produced pollution.

Quality in the current climate means that secondary material is being whacked with a hefty discount, sometimes as high as 30 per cent of the commonly quoted price for iron ore, that of which is applicable to materials with a 62 per cent iron content.

Much of Fortescue's material is in the 58 per cent range which means the current quoted price of just below $US60/t could drop below $US50/t after a quality discount is applied.

The gap between the quoted price and the real price is appropriately known as the “realisation price” or, in plain English, what a mining company actually gets paid rather than what it might get paid if it was producing benchmark quality ore.

More will be known over the next two weeks but the profit margin issue is starting to influence the way investment bank analysts are assessing the iron ore sector.

Two graphs incorporated in a lengthy report by Deutsche Bank last week highlighted the costs versus margins issue.

One showed the ‘all-in cost curve' of the world's major iron ore miners with Rio Tinto's Robe River operations in WA leading the way at around $US22/t, followed closely by Fortescue's Chichester Hub operations, with Fortescue's Solomon Hub the third lowest.

Next in the low-cost line were the northern systems of Brazil-based Vale, Rio Tinto's Hamersley mines in WA, and BHP's Pilbara mines.

The second graph was more significant for investors – the ‘global iron ore margin curve' – in which Deutsche Bank ranked the miners on profit per tonne.

The clear winner on the profit curve was Vale's northern system of mines which generated a profit margin of around $US58/t, a number which reflects the combination of low costs and a high price paid for the premium quality ore Vale mines with grades around 66.7 per cent iron.

Other Vale mines are also near the top of the profits curve. Australia's big two, Rio Tinto and BHP, are in the middle with profit per tonne around $US41/t.

Fortescue, Australia's second lowest cost producer on a per tonne basis according to Deutsche Bank, is close to the other end of the profit per tonne graph. Fortescue's taking around $US25/t – less than half the margin of Vale and substantially below BHP and Rio Tinto.

None of this is a criticism of Fortescue which has performed brilliantly to become a world-class cost leader.

But there is a good reason Fortescue is focusing so hard on costs – it simply had to, because of the discount on the quality of its ore.

Deutsche Bank highlighted the quality question in its iron ore analysis which will become more important over the northern winter as steel mills are forced to minimise pollution in what is known in China as ‘the heating season', which means warming homes and offices takes precedence over factories.

“With blast furnaces looking to maximise yield, we have lowered our 58 per cent pricing realisation over the medium term,” Deutsche Bank said in a research note.

The flipside of reducing the realisation price is that high quality ore is attracting a price premium which has blown out to an extra $US15/t for lump ore.

Macquarie Bank picked up the quality-over-quantity theme this week in a comment on iron ore which includes a warning that the market is facing a cumulative surplus of raw material of 120 million tonnes over the next three years which could see the benchmark (62 per cent) price in the mid-$US50/t range over the next two years.

But investors might like to pay even closer attention to the price for 58 per cent ore, and for ore which might contain high levels of impurities such as phosphorous, alumina or silica which brings an additional layer of discounting.

As Macquarie put it, quite simply: “Quality has become too important for investors to ignore when seeking exposure to the iron ore market.”