Dryblower: Iron ore silly season kicks off

SILLY season in the Australian iron ore industry kicks off this week when the big three miners of the material boast about their low costs per tonne while everyone, including Dryblower’s dog, knows that the more important measure of success is profit per tonne.

Measuring costs, while important, will never tell an investor whether a mine is profitable because the quality of the dirt being dug could be absolute rubbish and price received making it not worth digging in the first place.

Of course, that’s not the case with most of Australia’s iron ore, but the game of “my costs are lower than your costs” is about as pointless as children calling each other names in the playground.

One recent study of the iron ore industry nailed this point perfectly, through the publication of two graphs. One showed the global iron ore cost curve. The other showed the global iron ore (profit) margin curve.

No prize for guessing that the graphs could have been about completely different industries with a number of the low-cost leaders dramatically shifting position when it came to profit margin.

Rio Tinto’s Robe River system of mines was the low-cost winner in the cost analysis by Deutsche Bank, followed by Fortescue’s Chichester operations.

But when it came to profit per tonne it was a clear win for the big Brazilian, Vale, with its northern and southern system of mines sitting in first and second spot.

Rio’s Robe River mines shifted from the far left, the low side of the cost graph to a mid-point on the profits graph, while Fortescue’s Chichester mines went from the left of the costs graph to the far right of the profits graph.

According to Dryblower’s reading of the graphs Fortescue was in the top 10% of the iron ore industry as far as costs go and the bottom 25% as far as profits go.

That’s some swing, but it’s not one which Fortescue is likely to talk about when filing its September quarter production report on October 26, roughly 10 days after Rio Tinto and BHP file their quarterly reports this week (Rio on Tuesday and BHP on Wednesday).

One reason for pointing out the issue of costs v profit is that recent quarterly reports by Fortescue have hammered home its cost leadership, boasting in the June quarter report that the US$12.16 per tonne cost was a record low.

But after a bit of digging into the detail it was discovered that the price received from contracts signed in June was just 73% of the industry standard for or containing 62% iron.

The problem of “realised price”, a nifty euphemism for what Fortescue actually gets paid can be boiled down to a simple question of quality and while it is one that Fortescue acknowledges the hefty discount applied to its ore by Chinese steel mills it might not be corrected as quickly as the company would like.

Two key problems are squeezing profit margins for all producers of second-grade ore. Supply is rising and demand is flattening after 20 strong years.

In the boom years, when iron ore prices are high, and demand from steel mills strong, the ore quality issue can be managed without too much stress, which is why Fortescue has performed so well in recent years, posting high profits, retiring debt at a rapid rate, and paying handsome dividends.

It really has been a stellar performance, and one of which every worker at Fortescue can be proud.

Now we come to the tricky bit because there is a sea-change rolling through the iron ore industry with abundant supply doing a bit more than meeting demand.

At the other end of the industry, where iron ore is converted into steel, there is an even more significant sea-change, and that’s the way in which China’s steel mills becoming fussy about ore quality.

The quality issue will not change quickly, and might even become critical for some miners, because the Chinese government is enforcing stricter pollution laws and that means steel mills must use high-quality feedstock to limit production runs for the required amount of steel.

Investment banks are onto the realised-price problem with Macquarie saying last week that the outlook for iron ore was all about “quality over quantity”, adding ominously that: “quality has now become too important for investors to ignore when seeking exposure to the iron ore market”.

Deutsche bank made the same point in an iron ore reported headed: “High grade to stay warm over winter”.

While expecting high grade ore (62% iron) to slip to around $55 a tonne this quarter it should rise back to around $70/t in the New Year.

But what happens on either side of that 62% grade is significant with premium material (such as Vale’s 67% iron) enjoying a 15% price premium and low-grade ore forced to incur a discount as steel mills demand high quality – and are prepared to pay for it.