The controversy surrounding the spike in Fortescue Metals’ share price ahead of its announcement of a potential alliance with Brazil’s Vale is something of a sideshow, not the main event.
On the face of it a 23.7 per cent leap in a share price ahead of a major announcement might appear suspicious, and indeed might be so and therefore does need to be investigated by the authorities.
If, however, one stands back from the movement in the price, and looks at it in context and in absolute terms — the share price rose 59 cents on Monday and since then has given back about 37 cents of that gain — it doesn’t appear quite as dramatic.
More particularly, in the background, there was a 16.3 per cent leap in the iron ore spot price on Monday — up $US10.20 a tonne to $US62.60 a tonne — followed by another US70 cents a tonne rise yesterday.
That kind of movement in the iron ore price and, indeed, Fortescue’s price, would tend to support the Fortescue explanation that there was a lot of short-covering going on by those who had taken up understandably bearish positions on all things iron ore and were caught uncovered by the unexpected price rise.
Fortescue, as a pure-play iron ore miner with higher “all-in” costs than the other three major seaborne iron ore producers and $US8.4 billion of gross debt, is the most leveraged big play for those wanting a listed equity exposure to the iron ore price.
The fact that its own share price fell back a little today (down about 8c, or nearly 3 per cent) even though the iron ore price held up would tend to support the short-covering thesis.
That’s not to say that Fortescue shouldn’t have suspended trading in its shares on Monday until after it announced the alliance with Vale yesterday morning, nor that there mightn’t have been a leak of the imminence of a deal, but rather that the alternate explanation for the gyrations in the price has significant credibility and could be regarded as a much more material influence than any other potential factor.
The focus on Fortescue’s share price has distracted from closer analysis of the fundamentals of the relationship with Vale that Fortescue outlined yesterday.
At this point all the parties have agreed is a memorandum of understanding under which, if it leads to a final agreement, the two companies would create joint ventures in China which would blend ore sourced from Vale’s ferrous-rich Brazilian ore and Fortescue low-grade but low-impurity Chichester Hub ore.
A separate strand of the memorandum would give Vale the opportunity, but not the obligation, to acquire Fortescue shares on-market up to the 15 per cent individual foreign ownership limit.
Vale could, of course, do so today if it wished, assuming the over-leveraged Brazilian group, with $US29bn of debt, could afford spending up to $1.5bn to acquire the maximum holding envisaged. Share purchases of any consequence are unlikely unless and until Vale has significantly reduced its debt levels and returned to profitability.
The obvious near-term beneficiary of the agreement if it is finalised is Fortescue, which would be able to mine lower-grade ore with lower strip ratios — and therefore lower costs — to be blended with Vale’s higher-quality material at ports in China.
If the blended material commands a better price than is available to Fortescue and Vale today (Fortescue has experienced a discount on the index price of up to 15 per cent because of its ore quality) then both would share in a premium not available to either individually.
That would be a bonus for Fortescue beyond the impact on the economics of its operations. A key question as to whether the benefits of blending extend beyond that is whether both Fortescue and Vale could get a better price for a blended product than if they sold their products individually.
Vale would presumably be encouraged by the initial experience it has had with its own “Brazilian Blend” product, where it has sold about 20 million tonnes of the blend and says it has been receiving an average premium of about $US3 a tonne.
Fortescue is talking about contributing about half its capacity of 165 Mtpa — or about 80 million to 90 million tonnes a year — to the joint ventures, so we’re talking about far, far bigger volumes of blended product than Vale has been selling.
The Chinese steelmaking sector is under quite severe pressures, with a significant proportion of its steelmaking capacity losing money and earmarked for closure. The most recent signals from the central authorities of another attempt to sustain economic growth levels through expansionary and investment-intensive policy might help, but higher iron ore prices will not.
If most of China’s blast furnaces were operating near capacity and profitably, the mills might be discriminating about the quality of the ore they were buying and prepared to pay a material premium for higher quality material. Will they do the same when they are plagued by overcapacity and are losing money?
The fact that, as Fortescue’s Nev Power keeps reminding us, China has been absorbing the increased supply of seaborne iron ore and that Fortescue has been selling all of the 165 million tonnes a year it produces would suggest that some mills are as or more focused on costs than quality.
Against that, of course, Rio Tinto has been able to attract a price premium for its “Pilbara Blend”. It is possible that, instead of generating a premium for their blend, Fortescue and Vale could reduce Rio’s premium. In the post-boom environment, there is always a risk that the customers capture efficiency and quality gains from commodity producers selling into an oversupplied market.
Longer term, if a definitive agreement is reached, the memorandum envisages potential joint ventures in Australia as well as the prospect of Vale buying a shareholding in Fortescue. That would give Vale a beachhead in its archrivals’ Pilbara stronghold that Twiggy Forrest took advantage of the commodity boom to breach.
The obvious threat to the memorandum morphing into an actual agreement is from competition regulators, although the only ones that would appear to have a real reason to become involved are the Chinese authorities.
Given that they have encouraged the emergence and growth of Fortescue and a Chinese entity, Hunan Valin, already owns a 15 per cent interest in it, the Chinese steel sector — indeed (and more importantly) the Chinese authorities — could be regarded as having a good relationship with the group and with Twiggy Forrest himself.
China has also been developing a relationship with the recession-wracked Brazil, whose biggest trading partner is China. It has been investing heavily and strategically in Brazil. Last year it also provided Vale with $US4bn of credit and Chinese companies injected $US445 million of liquidity into Vale by acquiring some of its “Valemax” iron ore carriers.
Given their historic distrust of Rio and BHP Billiton and the still-rising supply-side capacity in the iron ore industry, the prospect of a closer relationship between two of the four big seaborne iron ore producers — the two it has been most supportive of — might not be regarded as inimical to China’s long-term interests as it might superficially appear.
FMG Price at posting:
$2.71 Sentiment: Buy Disclosure: Held
(20min delay)