Description

I normally wouldn’t consider or write-up a quarterly earnings event but I think FMG’s upcoming production results on July 27th presents a unique and interesting short-term catalyst that the market is overlooking.

There have been a few VIC write-ups on FMG so I would encourage you to read those for background. FMG is an Australian iron ore producer.  Importantly, FMG produces a low-grade iron ore product which is ~58% iron ore vs. the benchmark iron ore at 62%.

In brief, I view FMG as a short due to 3 factors:

1. 58% Grade Discount: Throughout 2017, and specifically in the most recent quarter, the discount being paid for 58% product has continued to increase, reaching 30-40% at its recent peaks.  Generally the market is aware of this but the consensus is that this is a temporary impact and will revert back to a 85% realization (15% discount) over time.  I believe there are several compelling reasons to believe this is more of a structural change and will certainly not be resolved as fast as the market believes

2. Provisional Pricing Impact: basically FMG actually sells and realizes pricing 1-2 months after it is shipped; the adjustment for this happens in the following quarter, therefore for the results for quarter end June 30 (FMG’s yearend), the company will have a big negative provisional pricing adjustment as iron ore prices declined materially quarter over quarter – this will show up as a further discount to the 62% iron ore benchmark

1. Importantly, those who I have spoken to about this believe that the market is only focusing on the low-grade discount and not paying attention to the additional impact of provisional adjustments.  The market is likely to be surprised in the next quarterly production results (July 27th)

3. Iron Ore Downside: with the recent increase in iron ore prices, potential for downside rather than upside in directional price move.  Risk to the downside exists due to:

1. Strong economics from global iron ore produces at current prices, resulting in continued supply

2. Chinese port inventories at all-time highs

3. Growing production from marginal producers (i.e. India)

4. Ramp-up of Vale’s S11D project

5. Seasonally weak period where steel restocking was completed in Q4/Q1 and now is being drawn down

However, as a word of caution on iron ore price direction – in the short term, Chinese speculation, credit and steel prices have a high degree of influence over the price of iron ore, so one need to acknowledge the degree of non-fundamentally driven volatility.

While FMG’s financial health has dramatically improved in the last 18 months, it remains highly sensitive to a number of factors, chiefly:

• Iron ore price

• Low-grade iron ore discount

• Shipping rates

• Operating costs (although I will give them the benefit of the doubt that these remain low)

Despite the recent increase in low-grade iron ore discount, FMG has only marginally underperformed its direct peers, Rio Tinto and Vale.  While I believe an outright short position in FMG is interesting at these levels, one could consider a pair trade with Rio or Vale to neutralize one’s view on iron ore.   

Below I discuss the first two factors (low-grade iron ore discount and provisional pricing adjustment) in more detail.

Low Grade 58% Iron Ore Discount – increasing since Q4 2016 but really increased in Q2 2017

Equity Relative Performance

Trading Comps – FMG isn’t even cheap on a relative basis (all based on Bloomberg consensus)

1. 58% Grade Discount: Key reasons stated by the market for the 58/62% iron ore price discount:

• Less iron: There is 6.5% less iron content vs 62% Fe, hence there is an efficiency loss for steel makers in using the ore. It is more expensive for a blast furnace operator to use the ore due to greater volume per unit of steel, i.e. more energy, sintering, waste, transport etc.

• Obviously… this will always be the case

• Steel mills are chasing maximum production via high grade ore (DEBATABLY STRUCTURAL): Rebar margins are at multi-year highs, incentivizing maximum steel production.

• Somewhat of a structural change given steel capacity cuts and strong Chinese reinforcement

• However, the spikes in low grade iron ore discount in May 2016, Jan 2017 and June 2017 do correspond well with the spikes in Chinese rebar profitability; yet with overall steel inventory and long inventory at lows in terms of nominal value and number of days of consumption, it is difficult to see rebar prices and therefore profitability decline (as long as China continues to clamp down on steel production and capacity)

  

• Steel mills are minimizing coke consumption (NOT STRUCTURAL): Due to high coal / coke prices, mills are minimizing consumption through purchasing higher grade ore.

• This seems logical but the chart below would negate this factor as the 58/62% iron ore discount didn’t move when met coal spiked in 2011

• China pollution (STRUCTURAL): Clearly a large and growing concern in China, which is getting attention from Chinese policymakers.  Ongoing inspections for induction furnace (IF) production has been confirmed by multiple sources.  Processing lower grade ore is more pollutive (waste, sintering etc.)

• Scrap steel prices have fallen materially (STRUCTURAL): Steel mills have increased scrap consumption in blast furnaces from ~10% to ~20% due to availability as IFs reduce scrap consumption as they are shut down, this displaces low grade ore.

• China port inventory overhang (MED-TERM STRUCTURAL): Around 25Mt of China's port stocks comprises of FMG ore (19% of total inventory) that has been purchased by traders, with additional low grade ore from others. This means traders are directly competing against FMG to sell FMG ore.  Chinese port stocks by source country as below:

• Lower availability of high grade ore to blend (MED-TERM STRUCTURAL): Vale is blending at 8 different ports in China, and traders are doing the same. This means that less high grade is being sold separately, which previously allowed steel mills to blend up FMG ore to higher grade spec. This is somewhat of a structural change, although BHP’s 80Mtpa Yandi mine, which is 57% Fe ore, will deplete in the early to mid 2020’s.

• Resurgence of Indian exports to China (STRUCTURAL): India sells a significant portion of lower grade ore which is competing with FMG and other lower grade products. This has ramped up to a peak of ~50Mtpa rate from almost nothing a few years ago.  Monsoon season from July-Oct could cause Indian production to decline in the short term but aside from a material decline in iron ore prices (also bad for FMG), Indian production is unlikely to decline.

  

• Shift toward higher quality steel (STRUCTURAL): What is not being talked about in the market is China’s shift to higher quality steel and therefore requiring higher quality feedstock.

• Channel checks indicate that HBR 20035 steel is being completely removed from the market: 20% of China’s steel production in 2016, this grade was using mainly low-grade iron ore combined with manganese to produce low resistance steel. The removal of this grade decreases the demand for lower quality iron ore.

2. Provisional Pricing Impact: While the market is focused on the low-grade iron ore discount, it appears to not be focused on the additional impact of provisional pricing

• Overview from a prominent iron ore trader:

• Iron ore price is priced on Monthly average platts price. The “month” used to be the month of shipment but as iron ore became more mature more and more mills wanted to get pricing closer to consumption. So the “month” used for pricing became month after month of shipment (m+1) or even “m+2”

• If iron ore is sold with “m+1” pricing, then the final price is not known when the cargo loads, so payment for cargo is made provisionally using the price on the day/month of shipment and then adjusted later.

• Producers sell on a variety of pricing months; depends on producer to a large extent - BHP and RIO sell most on monthly pricing; FMG is selling quiet a lot on a mixture of m+1 and m+2; Vale sells a lot of forward QP (because brazil voyage time is longer)

• FMG tries to pull back on forward pricing when market is higher / weaker but it is not always that easy

• Therefore there are three elements of the calculation for provisional pricing:

• Sales sold and booked within the quarter, likely the sales that occur within the first month

• 1-2 month of sales outstanding at quarter-end: i.e. on the water between WA & China, therefore booked at the quarter end (provisional) price.

• Quotation period adjustment from last quarter: Represents the difference in the provisional price from the last period (i.e. for sales that were outstanding last quarter), and the actual price achieved for those sales (typically represents the average of month 1-2 in the current quarter

• A falling market will drag down the ‘realized’ price before applying FMG’s product discount due to the quotationally period adjustment

• June 2017 quarter impact: Using a variety of calculation methodologies and datasets, the chart below illustrates there is likely to be a ~US$7 - 15/t difference between the quarter average, and FMG’s quotation period price, for the 62% Fe benchmark. Therefore, FMG already faces a “realized price discount” of 11 - 24% before applying FMG’s product discount, depending on the methodology that one believes to be most accurate (impossible to know exactly).  Note that I have calculated this a few different ways because the company doesn’t provide sufficient disclosure to know exactly how they do this, so I have tried to arrive at the conclusion a few different ways.

• Combining the provisional pricing “discount” with the average 58% iron ore price discount as already realized in the quarter ending June 30, the combined pricing discount to FMG is likely to be between 38% and 50% - this is not anticipated by the market:

  

• Translating this all into to share price impact, assuming that the upcoming quarterly discount surprise is a catalyst to allow the market to consider a more structural headwind face by FMG, the following analysis illustrates the NPV sensitivity to the low-grade iron ore discount.  Conservatively assuming the low grade discount reverts to 15 - 20%, there is an estimated 40-60% downside to FMG’s current share price

• Alternatively, if one were to assume that the low-grade discount is largely for structural reasons and the discount remains at 20-30%, one can easily see up to 80% downside to the current share price

• To note, the NPV sensitivity is also quite sensitive to the shipping rate, as illustrated below

• For simplicity, the analysis below is all run at current spot iron ore price of $60/t and shipping cost of $6/t

  

Catalyst

• Upcoming quarterly results with provisional price impact
• Low-grade iron ore discount continuing 
• Decline in iron ore prices