Someone's wrong on Fortescue

Over-supply and fear of a fresh fall in the price of iron ore if the Chinese economy continues to slow is keeping a lid on investor interest in Australia's iron ore miners despite evidence that cost cutting is keeping the industry one step ahead of the price.

Fortescue Metals Group, the biggest of the pure-play producers, delivered a surprise last week when it revealed a massive fall in the cost of producing a tonne of ore.

In the three months to September 30, Fortescue's cash cost was a record low $US16.90 a tonne, down $US5.26/t, or 24 per cent, on the $US22.16/t of the previous three months to June 30.

On an annual basis the fall is even more impressive because in the September quarter of last year it was costing Fortescue $US32.08 to produce a tonne of ore with the latest cost representing a fall of $US15.18/t, or a drop of 47 per cent in 12 months.

The cash cost (or C1 cost which miners use) is not the break-even price. That's a number which includes financing and other costs which, in the case of Fortescue, is around $US37/t while the bigger miners such as BHP Billiton and Rio Tinto have a break-even cost of around $US30/t.

However, at its latest cost per tonne, and even without allowing for management guidance that the cash cost should fall to $US15/t by the end of next year, Fortescue seems set to ride out the iron ore storm which has slashed the price of high-grade material from around $US130/t to last night's price of $US52.93/t.

There is a similar but slightly different picture among the handful of small iron ore miners that have survived a sector-wide cull, and that's the interesting point that most are trading below their cash backing.

In a perfect example of investors fearing another severe price correction stocks such as BC Iron, Mt Gibson and Atlas Iron currently have more cash in the bank than their market capitalisation.

BC is valued on the market at $59.8 million but had $71.8 million in the bank on September 30. Mt Gibson is valued at $207 million v $334 million in cash at June 30, and Atlas is valued at $80 million v an estimated $126 million in cash at June 30.

Mt Gibson and Atlas are yet to file their September quarter reports. If they are still valued at less than the cash they have in the bank (like BC which reported earlier today) it will be an interesting comment on the gloomy outlook which pervades the once high-flying iron ore sector.

For investors who retain an interest in iron ore there is plenty to think about with the list of concerns topped by China's demand for steel, the only use for iron ore, closely followed by concern that iron ore production continues to rise into what looks to be a flat, or falling, market.

The next test for the iron ore industry will be the start of exports from the Roy Hill mine which is majority controlled by Australia's richest person, Gina Rinehart. When it hits nameplate capacity Roy Hill will add 50 million tonnes a year to the market.

Another concern is that the low-cost leaders of the industry, Rio Tinto and BHP Billiton, are not slowing production, and might even be getting ready to blow the mothballs off expansion projects thanks to cost-cutting which is keeping their iron ore divisions handsomely profitable.

Earlier today BHP Billiton revealed in its September quarter production report that iron ore was the fastest growing division with a 7 per cent increase in output on the September quarter of last year and a 2 per cent increase on the latest June quarter.

Rio Tinto, the lowest cost of the big iron ore miners, produced 12 per cent more ore in the September quarter compared with the same three months last year, and more interestingly shipped 17 per cent more as it dug into stockpiles to meet demand.

With its mines running at capacity Rio Tinto is brushing off plans to develop a new mine in WA's Pilbara region. The Silvergrass project has been long in the planning stage and would cost around $US800 million to build and produce an estimated 40 million tonnes of ore a year.

The tricky question for everyone exposed to iron ore is whether Australia's low cost mines are forcing high cost material mined in China, India and Africa out of the market, ensuring future reasonable levels of profit.

BHP Billiton and Rio Tinto will certainly survive another fall in the price. The smallest miners might struggle, while Fortescue Metals continues to generate widely differing opinions among investment banks.

After last week's September quarter report, and despite the impressive cost reduction, the jury of bank opinion about Fortescue remained split with an equal number of buy, sell and hold tips on the stock.

One of the most optimistic views was from Macquarie which retained a buy tip and forecast a 114 per cent increase in Fortescue's earnings to $677m in the current financial year, though the dividend was forecast to fall from 5c a share to 2c.

Macquarie liked Fortescue's rate of production, a higher than expected price for its ore and the re-purchase of $US384m of its own debt at a price of US80c in the dollar.

Other stockbroking firm and investment banks are not so sure. Morgans liked the lower costs but added: “We continue to struggle with the longevity of a significant fall in costs and the onus it puts on equipment in the long term.”

De-coded, Morgans is raising one of the oldest questions in the mining handbook and that's whether Fortescue is high-grading its mines by extracting only the best quality ore while also pushing its equipment and people to the limit.

UBS, however, is a believer in the Fortescue revival story, upgrading its view from neutral to buy and going 5c above Macquarie with its 12-month target price; $2.85 v Macquarie's $2.80.

Citi, however, is not a believer in the Fortescue story, maintaining a sell tip despite the company's good September quarter, noting that “costs were falling, but iron ore was expected to follow”.

And then you get to the biggest banking bear in the room when it comes to Fortescue and that's Goldman Sachs which is also sticking to its sell tip despite describing the September production report as a “solid result on costs in a difficult market”.

Goldman Sachs is the most concerned of the banks about the Chinese steel industry which it believes has reverted to using lower-grade ore (of the sort mined by Fortescue) in order to maximise steel throughput in the production process while minimising steel output.

In the current year Goldman Sachs expects Fortescue to see its net profit fall to $122m, before the company plunges to a loss of $449m in 2017, and then down to an even steeper loss of $611m in 2018 – an outlook which explains why its 12-month target price for Fortescue is 85c, 64 per cent below today's price of $2.39.

Sometime over the next 12 months either Goldman Sachs or Macquarie and UBS will have boasting rights about their price tips for Australia's most interesting mining stock – and someone will be explaining how they got it so horribly wrong.