Why BHP should buy FMG

Fortescue Metals Group surprised investors earlier today with a better-than-expected December quarter production report, but that should not stop speculation that it could be a key player in Western Australia’s deal of the decade.

What FMG demonstrated is that it can cut costs as sharply as the other big Pilbara iron ore miners, though BHP Billiton and Rio Tinto retain their clear lead in the low-cost stakes.

What’s devastating small iron ore miners (and making life tough at the top) is that as fast as costs are cut, or benefits gained from the falling oil price, the iron ore price continues to slip lower.

For example last night, just before FMG reported near-steady iron ore shipments of 41.1 million tonnes for the December quarter and a fall in total delivered cost to $US41 per tonne, the iron ore price dipped to a fresh six-year low of $US63.09/t.

The outlook is for FMG to cut its total delivered cost to $US35/t, which sounds good and obviously impressed investors, who boosted the company’s share price by around 5 per cent in early trade.

But even as the cost cutting grinds on in what is a brutal race to the bottom involving all players in the WA iron ore industry, future price projections were ratcheted down another notch with the forecast of $US56/t from the investment bank, UBS, hanging over the sector – a number slightly higher than the $US52/t other analysts are tipping.

And that’s before considering the warning from former Western Mining Corporation chief executive Hugh Morgan that long-wave commodity cycles such as that hitting the iron ore sector today tend to last around 30 years – which means that by the time of the next boom, today’s industry leaders will be in their 90s, or dead.

These are grim times for anyone in the iron ore business, with devastating share prices forcing mine closures and slashing the fortunes of the industry’s super-rich.

Gina Rinehart, according to today’s edition of Forbes magazine, is down to her last $US11.7 billion, shedding an estimated $US6 billion over the past 12 months, while FMG boss Andrew Forrest is down to his last $US2.1 billion after suffering a 60 per cent pruning.

Shrinking fortunes along with most small iron ore miners such as Atlas, BC, and Mt Gibson trading at share prices below cash backing indicate that there is the prospect of tough times triggering sensible deals.

The potential transaction that most interests some long-term observers of the iron ore industry is less about mining and more about infrastructure, especially access to all-important port facilities.

Well-developed egos stand in the way of a deal in which everyone could emerge a handsome winner, but there would enormous financial benefits if BHP Billiton would swallow its pride and toss a $10 billion cheque in the direction of FMG shareholders; that’s a price 50 per cent higher than the $6.7 billion value of FMG on the stock market today.

Mr Forrest, who also has a lot of pride riding on what he has achieved, would probably be quick to reject his share of the deal, even though $3 billion in his hand today could be far more valuable than the hope of quickly returning to the $US6 billion his stake in FMG was worth 12 months ago.

If cash today is the lure for FMG shareholders as they contemplate the threat of Mr Morgan’s 30-year downturn, then a huge saving on expanding its business is what ought to have BHP Billiton taking a close look at what FMG has to offer.

Mines churning out more than 160mt of ore are one appeal, though FMG’s ore is of a lower grade than that exported by BHP Billiton.

The real appeal is the multi-berth harbour facility that FMG has developed in BHP Billiton’s backyard.

And while it may seem odd to buy a business just for its infrastructure, that might be the best $10 billion (as well as assuming FMG’s large debt load) BHP Billiton ever spent, because it was planning to outlay $20 billion on the Port Hedland outer harbour to achieve much the same result as what FMG’s facilities offer.

BHP Billiton could easily make FMG shareholders an offer too good to refuse, with $3 a share likely to secure the target today, integrate the best bits of FMG’s mine and rail operations, and get the extra harbour space it needs.

In one deal, perhaps with one phone call to Mr Forrest, BHP Billiton gets everything it wants, including the capacity to continue expanding in a way that ensures most smaller rivals to its Pilbara business are destroyed in the process.

It sounds ruthless, and it might never happen, but there’s no doubt that the numbers add up for everyone. BHP Billiton gets the extra port capacity it needs and FMG shareholders get a fistful of dollars – or go on playing a game of race-to-the-bottom that BHP Billiton and Rio Tinto will eventually win.