Why Fortescue needs to become bullet-proof

With capacity expansions underway from Rio and BHP and analyst predictions that iron ore prices may head south again, Fortescue needs to keep a firm grip on costs.

With the release of Fortescue Mining’s half-yearly results, all three of the big Pilbara iron ore miners have reported and shared their views of the outlook for the iron ore market. They are mixed.

In discussing Fortescue’s impressive first-half earnings of $1.72 billion (up from $478 million previously), its chief executive Nev Power maintained his optimism about the near-term outlook for the iron ore price. For Fortescue the price averaged $US124 a tonne over the December half, in line with the current spot price.

Power believes that most of the new supply flowing from the producers, mainly from the three big Pilbara producers, has already entered the market and has been absorbed by the eight per cent increase in China’s demand last year.

As more low-cost supply hits the market, he says, it will displace China’s domestic production and therefore the price impact will be constrained.

He sees a price that ranges between about $US110 a tonne and $US120 a tonne for the rest of this year, with the caveat that the price might be volatile as the Chinese steel industry moves through de-stocking and re-stocking cycles.

Rio Tinto is also reasonably sanguine about the outlook, although it did note that there was a 17 per cent increase in Australian iron ore exports last year and that, while Brazilian exports were flat year-on-year, they increased 25 per cent in the December half relative to the same period of 2012.

Rio sees continued growth in China’s steel demand through 2014, accompanied by a continued ramp-up in supply, and shares Power’s view that inventory cycles will create price volatility.

BHP’s chief financial officer, Graham Kerr, provided the most precise and probably least optimistic assessment of the outlook for this year when he told a UK media briefing that BHP expected the growth in demand for iron ore this year would probably be smaller than the growth in new low-cost supply.

Steel demand in China, he said, was expected to grow by just over three per cent – less than half the rate experienced in 2013 – and, with the demand from the rest of the world, would see iron ore demand growth of about 60 million tonnes in 2014.

That would, however, be outstripped by the growth in seaborne supply of more than 100 million tonnes, which he said would see some high-cost Chinese supply pushed off the top end of the cost curve and, of course,  prices coming down.

As with Fortescue and Rio, BHP’s Kerr cautioned that the trends wouldn’t be linear, with a possible acceleration of steel production in China in the first half supporting the price but the rising supply outweighing demand in the second half and pushing prices down.

Neither Rio nor BHP expects a neat and orderly displacement of high-cost domestic Chinese iron ore production with the new low-cost production ramping up in the Pilbara and Brazil.

For social reasons some Chinese producers will keep producing regardless of the price and, more particularly, they both assume that iron ore mines located close to, and integrated with, steel mills will keep producing. Both have similar approaches to factoring the integrated producers into their assessment of supply and demand – they notionally reclassify them as the lowest cost producers!

The reliance on the iron ore price and demand levels of Rio and Fortescue – Rio generates most of its earnings from iron ore and Fortescue all of its earnings – means the near outlook for the price is critical to both of them.

Longer term Rio does have a good position in copper, where the medium term fundamentals of supply and demand probably favour the producers, as well its coal and aluminium businesses (where the prospects are more clouded) to help reduce an over-exposure to a single commodity.

Fortescue’s Power has done a terrific job of managing a massive increase in production while also significantly reducing costs – its C1 cash costs were about $US50 a tonne a year ago and are now down to about $US33 a tonne – and lowering its previously threatening debt levels by $US3 billion since November last year.

Assessments of Fortescue’s ability to make further significant inroads into its debt levels – gross debt peaked at $US12.7 billion last year but after completing recently announced repayments its net debt is about $US8.6 billion – are slightly complicated because its cash flows in the December half included iron ore prepayments of $US712 million and prepayments of port access fees of a further $US500 million. It also has a tax instalment of $US750 million due in December.

Power has shifted Fortescue a long way from the position of real vulnerability it had in 2012 but in an ideal world Fortescue needs the iron price to hold around current levels for as long as possible to complete the process of de-risking itself.

Despite the reduction in its cash costs, it wouldn’t want to see the sub-$US90 a tonne prices that some analysts believe are in prospect as the market shifts into an increasingly material surplus of supply over demand.

There are still a lot of expansions of capacity underway in the Pilbara and elsewhere, with Rio and BHP, as the lowest cost suppliers once transport costs are taken into account, looking to both increase volumes and reduce their already low production costs to offset the lower prices they anticipate.

Power said today that Fortescue has a cash break-even price in the low $US70 a tonne range, so there is some margin for error. But Fortescue clearly has to continue to lower its operating and finance costs (and is focused on doing so) if it is to make itself bullet-proof from a misjudgement of the price impacts if the market moves more quickly than anticipated into a position of significant over-supply.