With global commodity prices expected to remain depressed, Australia’s iron ore miners are scrambling to meet cash flow forecasts and stave off a liquidity crisis.
The first task has been to cut costs by renegotiating supplier contracts and to improve productivity along the supply chain.
In this, the industry has been helped by a decline in diesel costs and a drop in shipping prices caused by high-cost Russian producers exiting the market and freeing up capacity.
But looking further ahead the job of eking out savings looks set to become harder, dimming the outlook for company earnings.
Profit forecasts are tied to predictions about how far the volatile iron ore price will fall. The benchmark price began 2014 at $135 a tonne and stumbled through the year, touching a five-and-a-half year low of $66 a tonne just before Christmas.
The price traded up slightly to $70 a tonne in early January but analysts labelled it a dead cat bounce and braced for further downward pressure. By late January it was back down at $68 a tonne.
The share prices of local mining companies are also down, particularly at the junior end of the market. Atlas Iron and BC Iron both lost close to 80% of their value over a 12-month period, while Fortescue Metals Group’s share price halved.
Titans BHP Billiton and Rio Tinto ended 2014 down around 15-20%, protected somewhat by the quality of their ore deposits and their integrated business models.
While the market has been helped by the weakness of the Australian dollar, which has made local operating costs cheaper and improved earnings for those that report in AUD, the currency was only down 10% over the year compared with the 50% drop in global US dollar ore prices.
Since returning from the Christmas break, mining analysts across the board have readjusted their valuation models to include a lower long-term iron ore price. “We cut our rates last week from the low-to-mid $80s [per tonne] to $66 for this year and $65 for next year,” Glyn Lawcock, senior mining analyst at UBS, said. Even then he’s not necessarily finished: “I expect the price has further downside risk, ” he said.
Ratings agency Moody’s is running its models at an average of $75 to $85 per tonne, though it is aware these rates are too high. “We don’t see a catalyst for a material improvement in the iron ore price in the next 12 to 24 months, particularly as new supply comes on stream and demand remains hard to predict,” Matthew Moore, a senior analyst at Moody’s in Sydney, said.
The demand/supply imbalance is forcing producers to take deeper discounts on their shipments. While the benchmark price represents an average of recent sales of 62% grade ore, the actual price achieved by each producer is based on the quality of their ore, and last year the discounts widened significantly.
In a buyers’ market, the steel mills can be choosy about the level of impurities they are prepared to feed into their blast furnaces. “Discount rates for lower quality iron ore are still stubbornly high,” Lawcock said. “Last year we experienced one quarter where the highest discounts were up to 21% and they are still in the high-teens.”
With prices at around $70 a tonne, large-scale producers like BHP Billiton, Rio Tinto and Fortescue Metals are the only producers able to make meaningful profits. Moody’s puts BHP Billiton’s and Rio’s breakeven point at around the $40-45 per tonne mark.
“Breakeven points are reached by taking a producer’s underlying mining costs and adding shipping costs, royalties, overheads, ongoing capital costs and interest payments,” Moore. “Producers with higher quality ore bodies and an ability to leverage fixed costs by boosting production will always fare better in a tight market.”
BHP Billiton and Rio also have diversified portfolios of commodities and greater bargaining power.
According to Moody’s, single commodity producer Fortescue Metals has a current breakeven cost of around $51 a tonne. “This figure has been achieved following a substantial cost-cutting exercise,” Moore said. “Between the June quarter and October last year the company stripped some 30% from its all-in unit costs which is an incredible achievement.”
At the junior end of the market, single commodity producer Atlas Iron breaks even at $66 per tonne, Mount Gibson Iron at $65 and BC Iron $63.
“We are most concerned about the junior miners who came into the market at the top and built their businesses models around high prices,” said UBS’s Lawcock. “Atlas Iron is sailing particularly close to the wind and can’t make a profit at current headline rates.”
Pump up the volume
Atlas and BC Iron are less able to ramp up production to take advantage of economies of scale.
BHP Billiton and Rio Tinto have spent the last two years expanding capacity and production to meet prices. Both reported double-digit increases in their Western Australian output last year. The idea is to force the withdrawal of uncompetitive miners, particularly in China and other emerging markets, but such high-cost producers haven’t been exiting at the same rate as new supply is being added.
The oversupply situation is set to worsen in September this year when the $10 billion Roy Hill project comes online. Owned and operated by Gina Rinehart – Australia’s wealthiest woman – the mine is being built with equity injections from Japan’s Marubeni Corp, Korea’s Posco, and Taiwan’s China Steel Corp, and a $7.2 billion debt package backed by five export credit agencies and 19 commercial banks.
Roy Hill claims to be sitting on a high quality ore body with an average product grade of 61%. At peak production it will generate 55 million tonnes of iron ore a year and has a total mine lifespan of 20 years.
Roy Hill aims to be one of the lowest cost producers in the Pilbara and plans to maximise its price per tonne by taking care when blending its shipments. “Our port access limits our annual shipping capacity so we can spend time blending the ore and thereby extending the life of our reserves,” Roy Hill’s chief executive officer Barry Fitzgerald told FinanceAsia last July.
Being a private company, Roy Hill’s cash and interest costs are not published. When FinanceAsia visited the mine last year, sources close to the company’s funding package said there was a “sufficient cash flow buffer in its loan facility before the banks start to get nervous.” At the time these comments were made the iron ore price was at $92, significantly higher than where it is today.
Creditors on alert
Australia’s iron ore sector owes a lot of money. Along with Roy Hill’s $7.2 billion loan, Fortescue Metals owes creditors $6.9 billion (down from $10 billion in March 2013) and Atlas Iron has outstanding debt of A$140 million.
Most companies have taken advantage of favourable credit markets in recent years to refinance their loans and remove nasty maintenance covenants that allow lenders to run regular interest cover and leverage tests. Moore at Moody’s doesn’t expect covenant breaches to be an issue for the rated sector.
“The real challenge will be delaying and deferring capital expenditure to protect liquidity and then generating enough liquidity to maintain ongoing payments to debt facilities,” Moore said. “Atlas is already in a critical position with regards to generating free cash flow.”
As companies scramble to find solutions, Moore believes the ability to reduce costs is diminishing. Most of the service agreements that were signed with contractors at the top of the cycle have been renegotiated. At the same time, plans to upgrade existing mines or build new ones have been shelved.
In late November, Fortescue Metals said it had reduced its capital expenditure forecast for the 2014/15 year from $1.3 billion to $650 million, indicating that it was prudent in the current environment to defer additional capital investment.
“The cost of new project development work is just too difficult to justify in this market,” Jay Leary, a partner and co-head of legal firm Herbert Smith Freehills’ mining practice, said.
The next move might be to lease existing infrastructure to third parties. The railways operated by Fortescue Metals and Roy Hill that cover some 350 kilometres between their outback mines and Port Hedland are subject to a third-party access regime, which means they can carry ore for other producers for a fee. Fortescue Metals already has a rail sharing agreement with BC Iron, for example.
Another option is to sell auxiliary non-core businesses such as power plants, workers’ camps and other infrastructure. There are precedents for this in other industries including the $5 billion sale of a gas pipeline built by BG Group for its liquefied natural gas project in Queensland.
The pipeline was bought by gas transporter APA Group, which fended off several rivals including Hong Kong’s Cheung Kong and financial investors Queensland Investment Corp, IFM Investors, AMP Capital and China Investment Corporation.
Asset sales are an instant cash spinner, said Leary, who believes future bidders for these assets might include private equity firms or Asian trading companies. “They offer the chance to quickly reduce staffing costs and outsource to a third party who is a specialist in that area.”
Leary believes the key to success for the iron ore industry will be its ability to introduce smarter productivity measures. “Buyers are no longer under pressure to accept impurities in ore blends and it is up to producers to fill their sales contracts in the best possible way. They need to have systems that allow them to track a single tonne of ore at every stage in the mining process so they are better able to identify delay points in the supply chain and understand the exact quality of the ore they are producing,” he said.
As customers continue to ask for a better quality product at a cheaper price, junior producers might be inclined to join forces and combine their output.
Again, there are precedents for this in the coal industry where in November last year Glencore and Peabody signed a joint venture to link their two mines in New South Wales. By mid-2017 the producers will share existing blending and logistics capabilities to produce a higher-quality lower-cost product to meet the market.
Working to implement smarter production methods is a better bet than waiting for China to close unproductive mines. According to UBS estimates, 200 million tonnes of China’s total output of 270 million tonnes in 2014 will be kept online as it is captive or state owned.
But the decision to close a mine in China isn’t based entirely on economics. “There are social and political factors at play,” said Moore at Moody’s. Government-run mines that supply directly to national steel mills can go on producing ore even when the numbers don’t stack up – an option not open to publicly listed companies answering to shareholders.
