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Iron ore juniors still a good betWednesday, 20 August 2008

LONDON-based broking firm Ocean Equities says that despite the plunging market, the junior end of the Australian iron ore sector still offers value for investors. By Kate Haycock

The company, which specialises in small and mid-cap mining stocks, said iron ore juniors still represented a solid investment opportunity despite volatility in resource equity.

The brokerage noted that Rio Tinto’s recent win with the Chinese in gaining the freight premium – which passed on to BHP Billiton and Australia’s newest iron ore miner, Fortescue Metals Group – further de-risked the sector and was a formal recognition of the greater value-in-use of Australian iron ore.

Analysts at the company said the freight premium set a precedent for longer-term pricing that was expected to continue beyond 2009.

“Given the higher-cost freight environment and longer-term outlook for the oil price, freight appears set to become an ever increasingly significant component in the total cost of steel production,” the brokerage said.

The firm also predicted next year’s negotiations would be just as tense, with Australians again pushing for a higher recognition of the freight differential.

“We believe the break in the traditional price negotiation process will result in an aggressive resumption of negotiations into [the next Japanese financial year] as the Australian majors attempt to gain further benefit from the freight cost differential and further close the gap between the annual contract and spot price mechanisms,” the brokerage said.

The freight premium also would partly insulate the iron ore sector against the risk of a contraction in iron ore pricing in the medium to long term, offering further support to the junior iron ore sector.

Meanwhile, iron ore miners would continue to take advantage of the new over-the-counter iron ore market established by Credit Suisse and Deutsche Bank.

The shortfall in ore supply in relation to demand would continue, with another 50-60 million tonnes per annum to be required by Asian steelmakers in the medium to long term – both factors boding well for the continued strength of iron ore as a commodity and an investment opportunity.

“This [rising demand] is effectively the equivalent of 1.1 to 1.23 new Fortescue’s coming onstream each year,” analysts at the company added.

Out of the junior iron ore sector, the brokerage said the change in contract pricing to a higher value for lump ore over fines had increased the Australian premium for this product to around 40%.

This could be expected to continue, Ocean Equities said, if shipping costs continue to rise, with lumps representing better value in transporting.

As a result, the premium for lump ore could be expected to widen in coming years, which will continue to favour companies with higher-grade, lower impurity deposits.

Nevertheless, with the higher-quality Brockman deposits becoming depleted in the Pilbara, other deposits – such as the Marra Mamba style of ore, and Yandi or Channel Iron Deposits – will continue to produce a growing quantity of the Pilbara’s ore.

Ocean Equities said given the increasing importance of higher grade and lower impurities, its pick of the juniors included Perth-based Atlas Iron and Adelaide-based FerrAus due to their estimated lump to fines product ratios.

Atlas is targeting production of 1 million tonnes per annum from the Pardoo operation, beginning in December. When additional direct shipping ore export tonnages start arriving from the Abydos project, the company is targeting exports of 6Mtpa by 2010 and 12Mtpa DSO by 2012.

FerrAus, meanwhile, has two key projects in the Pilbara: Davidson Creek and Robertson Range, which it hopes to bring into production in 2009 to ship some 6Mtpa by 2012, increasing to 10Mt in 2014, and up to 20Mt by 2017.

However, the brokerage warned potential investors in the sector to carefully consider the major impediment to any junior play wanting to establish an exporting mine – infrastructure.

The brokerage came down firmly on the side of juniors pushing for third-party railway access, and said that while the Western Australia government’s push to open access was welcomed, it was in the interests of the major miners and juniors to come to a suitable agreement among themselves – such as that recently signed by Rio Tinto and Iron Ore Holdings.

Atlas and BC Iron were well-placed in terms of infrastructure and memorandums of understanding with FMG over its rail and port system, while Brockman and Iron Ore Holdings were best placed to strike deals with BHP and Rio, the company added.

The brokerage also suggested keeping an eye on leading Asian steel makers looking for further “upstream integration” and further acquisitions, joint ventures and off-take deals would be expected in the Australian iron ore industry in coming months and years.