Here’s an easter wish for investors in Fortescue (FMG) and other struggling iron ore stocks.
The local market was hit by another iron ore shock today with the price under $US50 a tonne for the first time in a decade. That won’t bring tears of joy to the furrowed brows at Fortescue and other under pressure producers. The spot price dipped 3.5% to $US49.53.
But could there be a glimmer at the end of the tunnel for Fortescue and its chairman and founder, Twiggy Forrest? Well, turn the Twig’s calls last week for production and export caps (‘cartel) by the big producers on their head and look at the situation the other way and reduce the number of suppliers – big suppliers.
Could the production oversupply be cleared in one fell swoop by BHP Billiton (BHP) and Rio Tinto (RIO) (with or without the assistance of some major shareholding institutions) taking over Fortescue and putting its operations on care and maintenance, thereby taking more than 130 million tonnes of annual production and exports out of the market – a sort of reverse cartel? That would be controversial, but it would clear the surplus quickly and push supply/demand back into balance (Fortescue’s production and exports are about equal to current excess of supply over global demand).
It’s either do it this way to resolve the situation and give Fortescue shareholders some cash, or its wait for the approaching crisis and swoop to buy the company at a cheaper price and rationalise the supply/demand imbalance brutally and with losses for investors and Mr Forrest.
Instead of paying cash, Fortescue shareholders could get shares in BHP and Rio Tinto (so that they can continue to get some revenue and involvement in the industry) and the two companies could commit to keeping Fortescue’s assets operational and to bring them back into production in the event of an over supply situation re-emerging.
So how much would it cost? Well, at Wednesday’s closing price of $1.895, Fortescue was valued at $5.9 billion. A price of $3 a share would cost around $9.3 billion. The Federal government would smile on the deal because it would be positive for the budget, eventually. Of course the moaning Chinese steel mills would be strongly opposed (they are making $US10 billion a year from the price fall at the moment) and the Chinese competition regulator would probably go spare. But if our regulator agreed, that would get it over the hump. Twiggy Forrest wouldn’t go quietly, but if he got some value from his company, enough to remain interested in BHP shares and not cash, he might be seduced into playing along.
BHP and Rio would also benefit from a rise in prices and pressure off their still solid profit margins in their iron ore businesses. Shareholders would be split – the big institutions would be opposed because, greedy as they are, they want the cash and hate investment. But if some of them were brought into the deal, they would roll over and say ‘yes’. The $9 billion price could be sweetened by linking the share issued by BHP and Rio (or just one company is one, say BHP, moved on Fortescue on its own) to the iron ore price. A deal like that would give some value for the Fortescue assets.
The problem for Fortescue and people who would oppose such a a deal is that each fall in iron ore price brings Fortescue closer to crisis. At prices under $US50 most analysts reckon it is losing money. Its cash reserves are not huge – $US1.2 billion of the $US1.6 billion in cash on its balance sheet are pre-payments from customers and Fortescue has to supply more than 23 million tonnes at current prices in the next two years to get its hands on that money. The debt is $US7.4 billion (remember it couldn’t refinance $2.5 billion last month). In the event of Fortescue being forced to cut costs and production to avoid collapsing, all BHP and or Rio will do would be the wait and buy the assets at a cheaper price, and then shut them down and bring the market back into balance.
Both companies would be more tempted to do that than bid now to tidy up the situation. But it should be clear to everyone now that getting rid of Fortescue, the weak one of the global iron ore quartet (BHP, Rio, Vale of Brazil and Fortescue), and its 100 million tonnes a year plus production and exports (building to 155 million tonnes this year) is the key to stopping the price rot and bring the market back into some sort of balance.
The big danger to this scenario is that higher prices would relieve pressure on Chinese iron ore producers and on higher cost competitors around the world. So BHP and Rio would have to go on producing as much iron ore as they can to pressure their highest cost peers. But by removing Fortescue from the market they would get greater control, and do the country a favour, or would they?
