Interesting view (courtesy of andres on SDL thread) from Charlie Aitken:
Clearly spot iron ore prices ($95) have fallen quickly to levels none of us thought possible, while the AUD hasn’t fallen. The first 40 minutes of the meeting with Nev Power was focused on the spot iron ore markets.
In terms of spot iron ore there are three main indices, PLATTS 62%, Metal Bulletin and The Steel Index (TSI). There are two trading platforms, BHP’s GlobalORE and the Chinese CSMX.
Each index has a different way of calculating the so called ‘spot’ price, but most rely on a combination of volume weighted trade inputs. On that basis in theory if China Inc. wanted to lower the reported spot price they only have to “arrange” a trade between an SOE Trading House and a SOE Steel Mill. If you print a large enough volume trade at a lower enough price, it can clearly manipulate the reported spot price lower. It’s like manipulating VWAP lower via crossing, not specialling, an ASX stock trade.
The major iron ore suppliers, including FMG, sell the vast of their product on long-term off-take agreements, with the price received set off one of the spot prices. They don’t sell many spot cargoes at all into the spot market (Vale has been recently tendering cargoes at spot that it can’t sell in Europe), but their price is set off the spot price. Only 10-15% of the global iron ore market is physically traded on the spot market, yet the tail sets the price for the long-term off-take agreement pricing dog. The spot market trades between 6m to 9m tonnes a month. FMG’s pricing is set off the PLATTS Index.
The two platforms can go for days without a trade, but they are far more transparent in terms of bids/offers and volume traded. Eventually, a greater percentage of the spot market will move to electronic platforms as participants get more comfortable with them. This would lead to greater transparency in iron ore pricing which would be a good thing for everyone involved. I believe one reason iron ore equities trade on a discount to other mining stocks is the fact the iron ore market is so opaque. That should change over the next few years as more of the spot trade moves to electronic platforms.
But right here right now the spot markets are in turmoil as Vale dumps cargoes, traders who have been caught long at higher prices cut that trading inventory, and Chinese steel mills sit on their hands and run down inventories. It is estimated that Chinese steel mill inventories are down to 10-15days, down from an average inventory position of 30-35days. The trading houses are waiting for the knife to stick and the whole situation has turned into a buyers strike. FMG also disagrees there has been any structural shift in the Chinese iron ore cost curve. The vast bulk of Chinese iron ore remains low fe magnetite, while labour and energy costs continue to rise in mainland China, remembering magnetite is energy intense.
Yet, buyer’s strikes end and to me this spot iron ore market is like watching any market where “stop losses” have been triggered. The final forced capitulation selling is always the most spectacular, gets the most attention, yet does actually generate a price bottom.
The trading rubber band in spot iron ore is extremely stretched. To use todays spot prices as permanent will prove incorrect in my opinion, with 60% of the world’s iron ore production loss making at current prices. Yet, as you can see, iron ore equities move almost perfectly in tandem with the daily spot price which suggests spot prices are priced in to iron ore equities.
My personal view is there is going to be a upside bounce back to $120-$130t in spot iron ore over the next six months as both China, Eurozone and US fire further stimulus bullets, Chinese steel mills restock, traders move back into the spot iron ore market and high cost supply shuts down. The potential for a spot price rebound is very high in my view, but of course that’s hard to see at the crescendo of a major correction in the spot price.
In terms of FMG, Murphy’s Law suggests that you will be hit with a spot price collapse and AUD spike right as your capex spend and gearing peaks. At a critical moment for the company, FMG has the “perfect storm” against it. However, the perfect storm will pass and as we come out the other side FMG’s production will have tripled, the iron ore price bounced +30% and hopefully the AUD loses -10%.
But to put this “perfect storm” in context, it is far less damaging that the 2008 GFC storm which hit FMG. FMG is in a significantly stronger position now ($5.6bil in cash and liquids) and is only a short period away from significantly higher production.
While there is investor and analyst pressure on FMG to raise equity to fill any ramp up funding gap if iron ore prices stay at these oversold levels, the company has a variety of other options to raise short-term capital that don’t involve new equity. The company has already announced it intends to sell one of three power stations it owns. It is estimated a utility would pay $300m for a single power station. Outside of that FMG owns 11,000 accommodation units that could be sold and leased back from a property investor, they own three fly-in, fly out airports which could be sold to an infrastructure investor, while they also own $2.5b of mining fleet. Outside of the cash and liquids of $5.6bil, there’s arguably around another $4.5bil of non-core assets on balance sheet, all of which could be quickly turned into cash.
FMG need to generate around $1.5b of cashflow in FY13 to finance the final capex spend on the ramp up to 155mt plus. I believe for a “safety margin” they will sell a power station or two. When those sales bring in $500m+ I suspect both investors and analysts cash squeeze concerns will be allayed. This will be happening as spot iron prices are bouncing and fears of an equity raising will evaporate. Remember, many of the big shorts in FMG are hoping for an equity raising (to cover those shorts) that I strongly believe won’t happen.
Of course it’s understandable in the current environment that the first 2/3rds of the meeting with FMG were focused on the spot market and then FMG’s balance sheet. Interestingly, and on a more positive note, the ramp up to 155mt plus is going very well. This is an important point as lower spot prices mean it’s imperative for FMG to get as much product to market as quick as possible.
I use the term “155mt plus” because the recent approval for a 5th berth at Pt. Hedland means FMG has a maximum ship loading capacity of around 170mtpa. Yes, the 5th berth needs to be built, but the FMG OPF and train set capacity is around 180mtpa. It needs to be noted there is no upper limit on the amount FMG can ship from the Pt. Hedland inner harbour while that harbour remains below its PHPA maximum capacity of 495mtpa. Over the next few years, BHP will be using around 240mt of that capacity, AGO 10, and FMG, in theory, can use the rest. I think this point is not widely known by investors or analysts. The issue is when the inner harbour hits theoretic capacity and allocations are enforced. Of course, the higher the FMG output, the lower the cash costs, the higher the EBITDA margins etc. etc.
However, at the moment the only true influence on FMG’s daily share price is the spot iron ore price. That price brings attention to FMG’s balance sheet as capex spend/debt peaks and the negative circle is self-fulfilling.
Yet, in my view inside the short-term influence of the spot iron ore price remains a contrarian investment opportunity in FMG. For me it’s be a very frustrating year in FMG ($4.00 to $6.00 to $3.70), feeling our analysis of the company and its ramp up etc. etc. has been fine, but like everyone else, we have been caught by the spot iron ore price collapse. Unfortunately, in the short-term getting the company specific variables right meant nothing, it was all about spot iron ore prices.
In my view we are reaching a negative crescendo in iron ore analysis, with analyst downgrades, analyst downside scenario analysis, the press focused on iron ore company CDS, and any stock the producers iron ore being massively shorted.
Unfortunately, FMG currently trades as a listed spot iron ore price derivative. That will change as production ramps up over the next year, but the chart below reminds you the FMG share price is all currently about daily spot iron ore prices. The correlation is perfect. Unfortunately, I made the mistake of paying too much attention to analysing the company specifics and have been caught out by the spot iron ore price fall.
However, we have to look forward to make money and FMG remains a member of my high conviction buy list. All the best calls I have ever made have had a share price moment like FMG is having right now, but the key was to stick it out through the maximum point of pain and come out the other side. Right here, right now is FMG’s maximum point of pain and it was good to sit down with the CEO of the company this morning to discuss all the elements driving the share price.
