from Ocean Equities WEEKLY REVIEW - Tuesday September 2nd, 2008...

from Ocean Equities WEEKLY REVIEW - Tuesday September 2nd, 2008

Iron Ore sector update - Macro concerns overshadow improving fundamentals (Wed, 13 Aug)

Despite improving fundamentals and positive news flow the performance of the Australian iron ore sector has been driven by increasing macro concerns. Since May’08 the ASX 200 Index has fallen 17% with the resource sector underperforming the general market as a number of investors look to take profits, de-risk and rotate sectors. The diversified majors, who currently dominate the worlds iron ore seaborne trade, are down an aggregate of 32%, driven by weakening sentiment for China's raw material consumption (the key driver of improved iron ore pricing this cycle), coupled with a deteriorating outlook for the broader market.
Given the increasing macro concerns we believe a number of investors are actively reducing exposure to bulk commodities. Fortescue, the largest and most liquid of the pure play iron ore stories, has seen its share price contract 45%, wiping off ~A$17b in capitalisation, as it has become a target of short sellers wanting to gain exposure on the downside to iron ore. Not surprisingly the aforementioned developments have had a negative impact on the Pilbara developers, which are down an aggregate 48% despite the fundamentals for the junior iron ore sector continuing to materially improve.
We believe the structural themes behind the current commodities and iron ore cycle remain in place (refer below for further details). Indeed we would highlight that iron ore pricing is set in annual contracts (eg the current contract April’08 to March’09), and the current spot iron ore price (which in Australian dollars is only 8% off the year to date high), supports a further increase to annual contract prices next year. Additionally the continued high fuel price environment provides the Australian majors leverage to recoup a larger portion of the outstanding freight differential between Australian and Brazil ore (which remains over US$40/t).
Whilst we expect volatility to continue in 2H’08 and do not expect sentiment will turn positive towards the junior iron ore sector in the short term, we do believe that trading opportunities will present themselves.
We believe a number of recently de-rated, fundamentally attractive stories are increasing likely to become the target of Asian financial/strategic investors and cashed up domestic players. As highlighted in our recent sector report, we prefer exposure to juniors with high quality and high tonnage deposits, and believe these companies are best positioned to benefit from the improving fundamentals for the emerging iron ore producers and an improvement in market sentiment.