When the bull goes bear, the boom is done

Fortescue has to date been the most bullish of the major iron ore producers, and only in July it took on more debt to fund its long-term target of producing 155 million tonnes of iron ore annually by the middle of next year.

The plan to build Fortescue into a major producer has always been an exercise in operating against the odds, and over the past few months it's been a race against time.

Due to its highly leveraged structure, Fortescue needs serious cash flow to pay down its debt. So, it needs to maximise production to produce the cash. But thanks to the price of iron ore falling like a stone over the past couple of months, from $US135 a tonne in July to below $US90, the economics of the Fortescue corporate plan has been placed under enormous pressure.

The only viable solution was to cut capital expenditure, slash costs and abandon the 155 million tonne production target or risk blowing up the balance sheet and the share price.

No amount of buying by chairman Andrew Forrest to prop up the share price has had any effect. Last week he soaked up $40 million of Fortescue stock but the share price has continued to head south.

The company has no option but to divert its remaining capex from higher-cost developments. Until the iron ore price recovers, the Kings deposit in the Solomon hub will be deferred, as will the completion of the fourth berth in the Port Hedland inner harbour.

This, combined with cost savings, will shave $1.6 billion from expenditure, which the group says (in combination with asset sales) will deliver the cash flow that had previously been expected for the 2013 financial year.

But the announcement, combined with some negative comment by a ratings agency, was enough to push the share price down. That was a boon for the short-sellers - those who had been placing bets on the company's share price falling - the most vocal of which has been US hedge fund investor Jim Chanos.

The free falling iron ore price has left the investment community with one major question - how low can it go? The glass half-full team at Fortescue take the view that the drop is a short term aberration and that in a couple of months it will recover to some extent - certainly above the crucial $US100 a tonne level and more likely to $US120.

Until a few weeks ago the market believed there was a floor under the iron ore price because the high-cost Chinese producers would exit the market and take with them the excess production.

But that theory is now looking shaky. Only a week ago Fortescue chief executive Nev Power gave a speech in which he said the iron ore market was really hard to pick and that the large downward price movements were due to thin trading in the spot market. He said these were quite deceptive and didn't reflect underlying demand.

Forrest blames Chinese producers dumping excess inventory into the market which, once cleared, will pave the way for the price to move up again.

But the slowing economic growth out of China doesn't augur well for any price recovery, and neither does the fact that Chinese steel makers are hurting.

Fortescue probably pulled enough levers yesterday to escape any large funding problems but if the iron ore price continues to fall it will need to have a plan B.

Attempting to read this uncharted market is taxing the investment bank analysts who are now hedging their bets.

Citigroup, for example, said yesterday that predicting a bottom was not easy, given the potential for the spot market to get flooded as producers shift excess shipments into it. It expects prices to bottom at about $US90 a tonne and rally back to more than $US100 in the fourth quarter as high-cost Chinese capacity exits. But if this capacity does not exit, the downside will likely be greater and longer.

Because of its particular financial situation, Fortescue has had to undertake a more radical response. But, if commodity prices do not recover, plenty of other producers will be rethinking projects and investment pipelines.

Other companies have already put billions of dollars of capital projects under review. BHP Billiton is re-engineering its investment in Port Hedland (going with the cheaper option than the $20 billion expansion of the outer harbour) and the next stage of expansion at Olympic Dam is up in the air.

Curtailing investment will have a major flow-on effect to the broader economy - an effect that the government clearly doesn't want to focus on.

Prime Minister Julia Gillard says she believes reports declaring the end of the mining boom have been exaggerated, but concedes that the commodity price-boom phase has passed.

In contrast, her Mining Minister, Martin Ferguson, said exactly the opposite less than two weeks ago.

Releasing BC Iron's full-year results yesterday, managing director Mike Young acknowledged the falling price had "everyone a little nervous at the moment".

"My view is that very little is being said of the effect of the leadership transition in China going on right now.

"I expect that, following the election of China's next premier, Li Keqiang, you will see a loosening of monetary policy and systematic stimulus."

However, the man most nervous about the commodity price fall would have to be Treasurer Wayne Swan, who has already allocated the money he believed the government would receive from the Mineral Resource Rent Tax to pay for an increase in superannuation contributions. So much for that.