Iron ore prices have persisted with their downward trajectory since the withdrawal of the Fortescue (FMG) tender offer. Prices are now at levels below the company’s estimated all-in cash breakeven price. From here, we will see bond price movements strongly linked to movements in the iron ore price. The major risk to FMG bond prices over the near term remains a continued fall in the iron ore price (as previously noted). This risk has heightened with the iron ore price now below US$50/tonne. The severity and duration of the iron ore slump will be driven by, amongst other things the following factors.
- Chinese steel production, which is in turn linked to housing demand and economic growth. Note the recently announced stimulus measures by the Chinese Government, part of which are intended to reinvigorate housing demand
- Continued increases in production in excess of demand, and the timing of high-cost supply withdrawing from the trade over time
- India’s growth leading it to becoming a net importer of iron ore over time
While most analysts continue to predict prices in the $50’s over 2015, it is more likely we will see continued falls as the ‘big 3’ major producers (BHP, Rio, Vale) continue flooding the market with excess supply. This projected surplus in iron ore production is unsustainable and the most expensive producers will be forced to withdraw from the market to allow the iron ore cycle to turn. The question is how long will it take for the supply to come out of the system, and in the meantime how far will iron ore prices will continue to fall.
There will be a lot of volatility and media coverage on FMG. While the company is highly geared, note that it has a sound liquidity profile and competitive cost curve position which mitigate the near term pressures of negative margins, outlined as follows:
- US$1.6bn in cash on hand as at 1H15
- No debt maturing until April 2017
- Relatively sound cost position with further cost reductions achievable into FY16 – see recent chart by the RBA
Note: FMG is represented by the larger orange bar to the right of the ‘Brazil’ text, i.e.: it sits in the lower half of the global iron ore cost curve.
Further, there are a number of potential options available for FMG to manage its credit profile over time.
- Relaunch a refinancing process – note Cliff’s Natural Resources (a weaker credit than FMG with a ‘single B’ corporate rating) has just issued an 8.25% senior secured bond maturing in 2020
- Rollover iron ore prepayments (a means of short-term borrowing)
- Sell a stake in its assets – mine, port and rail valued at US$18bn versus net debt of US$7.5bn as at 31 December 2014
- Divest a stake in the company. The company’s full control of its mine, rail and port assets provide a strategic advantage would make sense for a Chinese steel producer looking to control its supply chain
- Raise equity
- Seek government support (for example, through royalty relief which is already being provided to the WA juniors: http://www.reuters.com/article/2015/04/01/bciron-australia-idUSL3N0WY1ZU20150401)
In addition, the effect of lower iron ore revenues on the Australian economy is likely to further weaken the Australian currency, which will provide some support to local producers. The persistent fall in the commodity’s price will be weighing on the mind of the RBA at their forthcoming April meeting.
In summary, we expect bond price volatility to step up now that iron ore is trading below $50 per tonne. It is likely that the bond price falls will overshoot the mark in the near term, as buyers inclined to support the price step away from the market until iron ore finds a bottom. Having said this, we remain confident the company will remain viable through cycle, given the points noted above around liquidity and cost position. We note the Capital Group (a US fund manager with over US$1.2 trillion in assets under management) has built up a 7% stake in the company’s equity since February. This demonstrates at the very least there are large, institutional investors are prepared to look through the cycle and back the company.
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