Australia’s Iron Ore Miners In Trouble

This story features FORTESCUE LIMITED, and other companies. For more info SHARE ANALYSIS: FMG

– Brokers turn bearish on iron ore
– Low grade price discount widens
– Cash flow issues in the offing for pure-plays
– Fortescue and Atlas downgraded
 

By Greg Peel

In September 2012, the Chinese iron ore price plunged sharply through the psychological US$100/t mark to US$86.70/t, implying cash-burn levels for Australia’s smaller, low-grade, high-cost iron ore miners such as Fortescue Metals ((FMG)) and Atlas Iron ((AGO)). The plunge, and the heart attacks, proved short-lived, and the iron ore price just as quickly recovered to spend the interim period comfortably in a US$120-140/t range.

Until this year. The iron ore price has not so much plunged in 2014 but has steadily fallen by one third since December to under US$95 currently. Initially, the price fall met with broker expectations given an anticipated ramp-up in Australian seaborne supply through mine expansions. Analysts expected a drop but also assumed a rebound before stabilising at a lower level around US$110-120 after a brief foray to below the average cost of Chinese domestic production. Now, however, analysts are quickly changing their views.

Morgan Stanley is one broker who, having held the above view previously, has now completely changed tack. MS has today downgraded its iron ore price forecasts to an average US$105 in 2014 from a previous US$118 (11% reduction), and 2015 to US$90 from US$114 (21%).

In previous periods of iron ore price weakness, notes Morgan Stanley, prices were always quick to rebound after briefly dropping below marginal mining costs. The Chinese produce lower grade and thus higher cost ore than is available from Australia and Brazil, hence it is assumed Chinese production would quickly shut down were iron ore prices to fall below domestic average cost. But if this were to occur, a supply deficit would result which would force prices back up again. On this assumption, iron ore traders and steel mill operators have always been quick to buy up inventories at low prices and thus restore price stability.

It’s all a balancing act, given Chinese producers would then not shut down. The overriding factor in the past has nevertheless been tightness in seaborne ore supply in the face of ever-growing Chinese steel production. But following an extensive ramp-up in Australian production by everyone from the majors to the minors, seaborne supply is no longer tight. Indeed, the opposite is true.

Chinese inventories have remained stubbornly high, notes Morgan Stanley, and seaborne supply growth has actually occurred faster than anyone originally had forecast. MS believes this time is therefore different, and some Chinese production will indeed begin to shut down, entrenching lower prices.

CIMB has also cut its iron ore price forecasts for 2014 and 2015, by 3% to US$111 and 5% to US$105 respectively. CIMB also acknowledges a difference between the price plunge of 2012 and now, suggesting a more fundamental basis this time around. That said, the analysts do believe prices have overshot, and will track back towards US$105-100 in the second half of the year.

Citi believes a price level of US$90 offers “robust downside support” provided by Chinese trader and steel mill purchases and domestic production cutbacks. But Citi warns a sustained US$90 price would also see the first production cutbacks outside of China.

The broker was nevertheless among those anticipating a price fall in the June quarter but still expects stabilisation thereafter as the June quarter surge in new seaborne supply levels off and Chinese production declines, which is already happening. Seasonality suggests Chinese demand will remain weak for the next couple of months but improvement should follow thereafter, and Citi retains a December quarter price forecast of US$100.

Citi remains longer term bearish however, retaining average price forecasts of US$90 for 2015 and US$80 for 2016.

It must be appreciated that when the market speaks of “the iron ore price” it is a reference to the base price of 62% Fe fines, which is high grade ore. Lower grade ore is priced by the Chinese at an appropriate discount to the base price. In 2012-13 the discount applied to 57-58% ore was an average US$10/t, but after discussions with a Chinese ore trader Credit Suisse has established that US$10/t is abnormally low a discount and US$20/t is more realistic. In 2010-11 the discount exceeded this level and currently it is at US$19/t.

Steel of sufficient quality cannot be made using only lower grade ore, but at the least requires a blend of low and high grades. Production of lower grade ore has increased but demand has not met increased supply, notes Credit Suisse, given high grade ore is still required. Hence the widening price discount.

Thus when the Australian stock market assesses the impact of a fall in “the iron ore price” from last year, one must also consider a wider discount on lower grade ore than last year. Heavyweights BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Brazil’s Vale produce high-grade ore, but newer players Fortescue and Atlas produce only lower grade ore.

Morgan Stanley’s change of heart has thus led to sharp valuation downgrades for Fortescue and Atlas.

Previously Morgan Stanley, and the market, were looking forward to Fortescue achieving a point of cash accumulation after the company’s rapid but nevertheless time-consuming production expansion phase. Earlier concerns over FMG’s level of debt had diminished as it was expected this debt would be taken care of from cash flow and dividends would even be increased. But on Morgan Stanley’s new forecasts, a margin of US$10/t over cost will keep FMG afloat but will not be sufficient to meet future debt repayments, thus forcing a debt restructure ahead, the broker believes.

The broker has cut its share price target for FMG by 48% to $4.00 and double-downgraded its rating to Underweight from Overweight.

Morgan Stanley has cut its price target for Atlas Iron by 37% to 63c and retains an Underweight rating.

On the broker’s new forecasts, Atlas’ earnings are negative. The company will still be able to generate enough cash to cover debt repayments and the balance sheet is not stretched, particularly after current FY14-15 capex obligations roll off, but AGO is likely to report a net loss for several years, Morgan Stanley warns. This brings into perspective the company’s Horizon 2 expansion plans and the infrastructure investment required to see those plans to fruition. Horizon 2 has become a lot less likely in the broker’s view.

It must be noted that no ratings downgrades have been forthcoming from FNArena database brokers for BHP and Rio despite a rush to downgrade iron ore price forecasts. Not only do both produce high-grade ore, their legacy operations sit further down the cost curve than those of the newer players, providing a comfortable buffer during periods of price weakness.

And, of course, both are diversified resource companies and not iron ore pure-plays, more so in BHP’s case than Rio’s. However, the market is pricing in anticipated capital management ahead from both, and sustained lower iron ore revenues may well bring the extent of any capital management into question.

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