Cost-competitive FMG steps up

ANALYSIS: WA’s resources-focused business community is eagerly awaiting the next round of figures for iron ore production costs.

A month before the eyes of the sporting world turn to the Rio Olympics in August, Western Australia should know the result of an equally competitive event in which it is a competitor – the race for the title of the world’s lowest-cost iron ore producer.

June quarter production costs of WA’s big three iron ore miners – Rio Tinto, BHP Billiton and Fortescue Metals Group – will be reported in the first few weeks of July; and while it’s too early to accurately tip a winner, there is the chance of an upset result.

FMG, a minnow compared with the mining giants, has traditionally been the recipient of the bronze medal in the iron ore Olympics, but heavy-duty cost cutting and the benefits of highly efficient mining and transport systems could put it in the race for gold.

Some analysts, such as those at Macquarie Bank, believe Fortescue’s costs have already dropped below those of BHP Billiton, and that Rio Tinto is now in the sights of the company that once described itself as the ‘third force’ in iron ore but might soon be able to claim the title of industry leader (on costs, if not size).

Early forecasts for June quarter cash costs (the raw measure of what it takes to mine and ship a tonne of ore without allowing for layers of accounting and other charges) are for Fortescue to report $US13 a tonne, Rio Tinto $US13.20/t and BHP Billiton $US15/t.

Those C1 costs mean the three WA iron ore producers are at the top of the global iron ore league table, with the only serious competitor being the big Brazilian, Vale, which faced a few turbulent years as it settles a financial and reputational damaging tailings dam disaster. That fallout will also affect BHP Billiton, of course, as half-owner of the Samarco mine.

Whether Fortescue wins the cost race by cutting from $US14.79/t in the March quarter to a target of $US13/t, displacing the long-term leader in Rio Tinto, will depend on multiple factors and a degree of interpretation, especially the thorny issue of what costs are included in the calculation.

While the cost competition is a tight-run race, there is no doubt about the pecking order when it comes to volume. As at June 30, Rio Tinto will be the winner with 12-month output of around 330 million tonnes. BHP Billiton will be second at around 240mt, and Fortescue third at 175mt.

In the background is a new player, the Gina Rinehart-controlled Roy Hill mine at about 27mt for the 12 months to June, on its way to a target of 55mt.

Further back still is a group of smaller mines such as Atlas Iron and BC Iron, which ship out of the Utah Point common-user wharf with a collective 24mt.

Tonnes, interesting as they might be, are not what today’s iron ore industry is about. The steep fall in price from a boom-time $US140/t to around $US50/t means that profits have become much harder to earn, cost-out has become a critical measure of success, and those not able to make the transition have simply not survived.

However the fact the race has become one of who’s got the lowest costs, rather than who’s shipping the most tonnes, is a comment on how far Fortescue has come in the past few years.

Once regarded as a novelty business built on debt, the business world’s equivalent of steroids in athletes, Fortescue is on the cusp of achieving a maturity that many critics did not expect, especially those working for Rio Tinto and BHP Billiton.

That it has made so much progress in little more than a decade is a result of booming Chinese demand for commodities, and a lot of luck.

Fortescue’s founder and major shareholder, Andrew Forrest, would probably dismiss luck as being a factor and claim good timing, but whatever the reason there is no doubt that China’s rapid growth created the market for Fortescue’s iron ore and that high prices ensured access to debt markets, albeit at high interest rates.

Luck kicked in again earlier this year when the iron ore price enjoyed a mini-boom, again thanks to Chinese demand, and luck might come into play later this year if the iron ore price slips to a widely forecast $US40/t-$US45/t – and the Australian dollar follows with a fall into the US60-cents range, delivering a financial tailwind for everyone exporting in US dollars.

Not many people outside WA are interested in the race between the three big iron ore producers. But within WA, and its resources-focused business community, there is a lot riding on the bragging rights of costs and claims of industry leadership.

Management changes at BHP Billiton, which lost its local leader, Jimmy Wilson, after the Samarco dam burst, and Rio Tinto, which is soon to lose its local champion, Sam Walsh, to retirement, means that Mr Forrest and Mrs Rinehart will cement their places as the loudest voices of WA mining.

Whether they will also be the most profitable players in iron ore is a question that will come after the cost cutting has ended, a process that will fade as it becomes a game of cents rather than dollars, and kilograms rather than tonnes.

Even a move by Fortescue to operate its own fleet of tugs in Port Hedland at a cost of around $200 million is a minor development that might shave a fraction of a cent off annual operating costs.

For Fortescue, which was peering into the abyss of disaster a few years ago when it was caught with too much debt, sky-high costs and overly ambitious expansion plans, the future looks more assured now than at any time in the past.

Debt is being retired at a rapid rate with more than $US1.2 billion paid back early through the repurchase of high-cost bonds, trimming interest payments, and more debt is expected to be paid back early in the next few months.

The speedy removal of debt commitments is one of the best pointers to how Fortescue has changed from being a growth-oriented company driven by tonnes across the wharf to a financially focused business forced to recognise the dramatic change in global demand for steel and its primary ingredient, iron ore.

The switch from growth to a production and costs-out focus is why Fortescue has been able to retire debt so fast.

Capital notionally allocated to lift annual production from 175mt of iron ore a year to 350mt has been redirected into debt repayments and, potentially, increased dividend payments.

Perhaps the most interesting aspect of the Fortescue story is that, after a decade of seemingly non-stop growth, it is settling into what might called a middle-age pattern of near-steady annual revenue for the next three years of around $US6.4 billion, near-steady annual pre-tax profits of around $US650 million, and a near-steady annual dividend of between five and 8 cents a share.

Variations will occur as the iron ore price rises and falls, and as the drive to reduce net debt from around $US5.7 billion today to less than $US4 billion by 2019, but the benefits of the drive to cut costs have effectively run their course.

From one perspective Fortescue (and the rest of the iron ore industry) has become a less exciting place, but from an investment perspective it has become a more predictable business that has survived difficult times and has reached what economists call ‘steady-state’.

Unknown, but interesting to watch, is whether steady-state revenue and profits will satisfy Mr Forrest, who prefers growth but might be forced to keep that off Fortescue’s agenda until there is another surge in demand for iron ore, or if he chooses to diversify into other commodities.