Iron Ore Miners: The Squeeze Is On

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-Significant price recovery unlikely
-Few small-mid caps profitable
-Development projects likely shelved
 

By Eva Brocklehurst

Iron ore miners are being squeezed. Global production has ramped up considerably this year and brokers are downgrading forecasts for iron ore prices. Citi regards the situation as a simple equation of supply exceeding demand. To Goldman Sachs it means the end of the "Iron Age", a long period of supply tightness, cost inflation and above-trend profitability.

Macquarie's commodities analysts have reduced iron ore price forecasts by 20% for 2015 and 2016. The broker expects iron ore prices to remain below US$100/t for the foreseeable future. Longer-term pricing of US$90/t is unchanged but now starts in 2027, which implies 15-20% cuts to the broker's forecasts over 2020-2027. Macquarie concedes that the recent recovery in the implied discount for 58% iron material suggests there is upside risk to price forecasts, given assumptions of a 10% discount in future.

Citi has been bearish on iron ore but rising supply and falling steel prices have driven the spot price down harder and faster than expected – to US$83.60/t. At this price only one pure play iron ore producer, Fortescue Metals ((FMG)), generates cash, in the broker's view. Moreover, port inventories are high, seaborne supply is still growing and the Chinese property market is deteriorating. Fortescue remains the broker's preferred pick for that small cash margin and ability to increase shareholder returns on any improvement in the outlook. Fortescue's debt situation is now more about de-leveraging than liquidity, given it has cash of US$1.9bn and no major debt maturities until FY17.

Lower prices have arrived sooner than Goldman Sachs expected. Moreover, the weak demand outlook in China and the structural nature of the surplus mean a significant recovery is unlikely. Goldman Sachs expects new approvals for capital intensive projects will become increasingly rare, largely because the economics of greenfield projects will be challenging in an oversupplied market. A period of over-investment in production capacity has ended. Iron ore has already moved to an exploitation phase in which the broker notes commodity prices are typically subject to the deflationary pressure of mining productivity and the depreciation of commodity currencies. Supply growth will come mainly from efficient utilisation of existing capacity. As the market moves further into surplus, excess iron ore can only be absorbed via an increase in inventories and/or displacement of marginal production. The broker maintains a US$80/t forecast for 2015.

Already there have been two small Australian casualties of the slump in the iron ore price – Sherwin Iron ((SHD)) and Western Desert Resources ((WDR)). Brokers suspect few of the small-mid cap pure play operators are profitable at the current price. Initially, China is likely to account for the majority of mine closures, as the smaller mines have probably not invested sufficiently in mechanisation and productivity. However, Goldman believes tier 2 seaborne producers are increasingly vulnerable, with up to 40mtpa in seaborne capacity at risk of closure in 2015 and 2016.

Macquarie has downgraded Grange Resources ((GRR)) to Underperform from Outperform, and BC Iron ((BCI)), Sundance Resources ((SDL)) and Iron Ore Holdings ((IOH)) to Neutral from Outperform on the back of the lower prices. Atlas Iron ((AGO)) and Flinders Mines ((FMS)) retain Underperform ratings, while Mount Gibson Iron ((MGX)) retains the broker's Outperform rating, as the stock is supported by a large cash balance and has a favourable position on the cost curve given higher product grades. Lower prices have translated into 50-100% reductions to earnings forecasts across the mid-cap miners and Macquarie suspects many of those under coverage will report only marginal profits or even losses over the next few years. The broker also points out that Mount Gibson's net cash position now accounts for 72% of current market capitalisation.

Macquarie expects all producers will undertake more aggressive cost cutting to break even, with only Mount Gibson, BC Iron and Grange Resources in a position to weather weak pricing. Unfunded development projects will probably be shelved in the current climate. Macquarie has ruled out development of the Shine project (MGX), McPhee Creek and Corunna Downs (AGO), and Flinders Mines' Pilbara project, while the Buckland project will likely be delayed (BCI).

Macquarie retains an Outperform rating on Fortescue.

Citi calculates that Atlas Iron would burn through $75m in FY15 cash at spot prices, increasing net debt to $105m. At spot prices the company's US$275m term B loan maturing in December 2017 would need to be refinanced because of the lack of cash flow generation, and any growth beyond Horizon 1 becomes very unlikely because of funding constraints, even if rail access is secured. Citi agrees that Mount Gibson has the strongest balance sheet but considers the cash will be needed to fund Koolan Island pre-stripping, and at spot prices cash would fall to $180m by FY18. This would make M&A less likely and may entail another change to the Koolan Island mine plan to lower the strip ratio and reduce the cash burn.

Citi has actually gone the other way with BC Iron, upgrading to Neutral because of the fall in the share price. The broker would welcome the takeover of Iron Ore Holdings falling over, as – in the same vein as Macquarie – the broker does not believe BC Iron can generate enough cash to fund the Buckland project at current price forecasts.

Spot cash margins tell the story, in Deutsche Bank's view. Based on the broker's FY15 all-in cost and product discount estimates, Atlas Iron is achieving a negative 2% cash margin, while Mt Gibson has a positive 4% margin, Fortescue positive 7%, and BHP Billiton ((BHP)) and Rio Tinto ((RIO)) are still well in the black at over 45%. The broker notes BHP's cost performance during the June half was impressive, more than halving the cost gap to Rio Tinto. Deutsche Bank has Buy ratings for BHP and Rio Tinto and Hold ratings on Fortescue, Mt Gibson and Atlas Iron.

Will prices recover to what they once were once marginal supply is gone? Goldman Sachs does not believe so. In principle, a displacement of marginal producers should lead to a balanced market with a high level of concentration among the top four miners. In practice, the broker believes fundamentals will continue to mean supply growth outpaces demand growth by 3-to-1 over the forecast period. Several large projects are coming on board such as Minas Rio, Roy Hill and Serra Sul and there are large expansions underway at Rio Tinto's and BHP's mines. Moreover, many idled mines will be waiting on the sidelines should prices recover sufficiently.
 

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