THE DISTILLERY: Shockin' ore

Jotters bring out the slide rule to explain the iron ore price outlook, while one wonders whether Boart Longyear investors are putting two and two together and coming up with five.

Australia’s business commentators have conducted a thorough analysis of the iron ore markets, such a crucial source of Australia’s prosperity. Fortescue Metals Group chief Nev Power, who leads a company that’s more vulnerable to price weakness than BHP Billiton and Rio Tinto, sparked the conversation with a speech to the Sydney Mining Club.

Not to be biased here, but we have to start with Business Spectator’s Stephen Bartholomeusz, who explains why the "quite rational” argument that the costs of marginal producers set an iron ore floor price isn’t panning out.

The Distillery highly recommends readers go the source, but this is what follows - a concise picture of how supply has soared over the past two years courtesy of production ramp-ups from BHP, Rio and Fortescue.

"What about demand? It was going along nicely until about September last year when the combination of the deepening troubles within the eurozone and China’s own internal attempt to stamp out a credit driven property bubble combined to slow its economy. It has kept slowing and, as Europe’s woes have worsened, China’s exports have fallen away sharply – with an obvious and intensifying impact on its steel mills. Conventionally that would drive down steel prices, as it has, produce a significant increase in inventories, which it has, reduce demand for iron ore, which it has, but also lead to reduced steel and domestic iron ore production – which it hasn’t. Steel and iron ore prices have fallen to levels last seen during the worst of the financial crisis but steel production has held up and, it appears, domestic iron ore production, while it has been cut back, hasn’t responded as completely to the price signals as it should have. That’s why the iron ore floor price thesis has broken down.”

The Australian Financial Review’s Matthew Stevens takes readers to China to the ultimate destination of much of Australia’s iron ore, the steel mills.

"There are reports Baosteel will lead this charge by shutting one of its unprofitable mills. It should be remembered that there are 50 mills in China that run at less than 5mtpa. They account for 30 per cent of steel production and many of them would be operating on the margin at current prices. There is speculation these mills have been running on stockpiled ore feed for the past few months, that they have not been selling the steel they have been producing and that they will not be free to return to the iron ore market until steel demand and prices recover. Now there are some who suggest that the most inefficient of these smaller makers will not find their way back into the system and, as a result, the market needs to trim its longer forecasts for Chinese steel capacity and, with it, demand for iron ore and coking coal. But our major producers are having none of that.”

Now, more specifically, we move to the address by Power.

Fairfax’s Malcolm Maiden discusses Fortescue’s well-known vulnerability to a narrowing in the cost of production and the sale price, compared to its senior rivals.

"Fortescue is producing ore at a cost of about $US53 a tonne. It has $US5.7 billion in cash and undrawn debt available to part-fund a $US9 billion expansion of production from 57.5 million tonnes in the year to June to 100 million tonnes by the end of this year and 150 million tonnes by June 30 next year. The addition of lower-cost production will cut its overall production costs by about $US10 a tonne. But it raised the estimated cost of the project by $US1 billion to $US9 billion in July, and needs to add its cash flow to debt funds and existing cash to fully finance the expansion, pay interest on its debt and begin reducing its debt load, as planned.”

The Australian Financial Review’s Chanticleer columnist Tony Boyd also talks about Fortescue’s numbers from a slightly different angle.

"FMG prefers not to talk about the current bleak scenario of iron ore prices remaining where they are around $US90 a tonne. Instead, Power asserts that the iron ore price will rise about 25 per cent in the next ‘couple of months’ to $US120 a tonne. That is not to say that it cannot handle the $90-a-tonne scenario. FMG can deliver iron ore to China at a cost of $US65 a tonne, according to a chart published by the company at the recent Diggers and Dealers conference in Kalgoorlie. Some analysts dispute this number and say its costs are higher. But if prices stay where they are, the company can take a number of actions including selling non-core assets such as power stations, airports and accommodation it has built. Also, it could sell a share or all of its interest in a Pilbara ore body called North Star, with 3 billion tonnes of ­magnetite.”

Presuming that the wording of Maiden and Boyd is correct, you can find out what Fortescue’s shipping cost is per tonne. Maiden says Fortescue produces at about $US53 per tonne, while Boyd says the miner delivers to China at $US65 a tonne. Ergo, it costs Fortescue about $US12 to get a tonne of iron ore to China.

Amidst all this, something of great magnitude actually happened on the markets yesterday that reflected on the state of the mining sector. Fairfax’s Adele Ferguson tries to bridge the gap between a 10 per cent revenue guidance downgrade at Boart Longyear, tempered by a strong statement about the company’s long-term future, and the savage 37 per cent plunge in its share price.

"One reason for the market's reaction is that Boart Longyear is seen as a bellwether for the mining sector. As the world's biggest drilling services company, it has a relationship with most types of mining companies. So when its boss came out saying he had seen a fall in product backlogs and increased rig churn and that his clients, the mining companies, were talking about lower revenue and smaller investment portfolios, it was interpreted as a portent of worse to come. This was despite a record interim profit and a 34 per cent increase in its dividend to US6.4¢, and a full-year profit and revenue figure that it expects to come in slightly ahead of 2011. It seems with so much bad news globally, investors are feeding on the negativity and putting two and two together and coming up with five.”

In related news, The Australian’s John Durie gives some background on the confidence of Orica chief executive Ian Smith. Put simply, explosives demand is outstripping that of iron ore and coal, and its pace is increasing.

Elsewhere in mining, Fairfax’s Insider columnist Ian McIlwraith goes to town on billionaire Gina Rinehart for an article she wrote in an industry magazine calling for tax breaks and labour concessions.

In other company news, The Australian’s Bryan Frith calls for the Takeovers Panel to investigate the latest episode between Alesco Corporation and DuluxGroup to give a definitive ruling on where it stands when it comes to franking credits.

Fairfax’s banking writer Eric Johnston relays comments from Perpetual chief Geoff Lloyd, who is slashing jobs at the fund manager, that investor confidence is the worst he’s seen in his career.

The Australian’s Giles Parkinson says the axing of the carbon credit floor price in 2015 is actually a positive for CO2 Group, according to its managing director Andrew Grant, which purchased $50 million of credits the day before the government’s announcement.

In economic matters, Fairfax’s Michael Pascoe highlights the gulf between the low business confidence figures and the business investment figures. Even when you exclude the mining sector, the signs are good.

And finally, The Australian’s economics editor Adam Creighton takes economists to task for underestimating the contribution of technology to economic growth. The writer muses that some economists appear to think that a certain amount of a nation's economic growth comes not from a greater integration of computers into the workforce, but thin air.