Tuesday 14 April 2015 by Alen Golubovic Opinion

The week that was in iron ore

Without a doubt the past week has been a volatile period for iron ore. The changing dynamics of Australia’s largest export is shaping not only the credit outlook for the entire industry, but will also have broader implications for the Australian economy.

Iron ore price forecasts slashed

Citigroup has slashed its iron ore price outlook to USD37 per tonne for the second half of 2015, tipping an average of USD40 per tonne until 2018 and cut its share price target to 70 cents. These revised forecasts are a massive reduction from its previous estimates of USD58 per tonne through 2015, USD62 per tonne in 2016 and USD73 per tonne in 2017. On these forecasts, it expects Fortescue to burn through USD670 million (AUD885 million) this financial year, and USD900 million the following year - more than enough to eat up its USD1.6 billion cash backing.

If Citigroup’s forecasts prove to be correct, Fortescue will need to act quickly to sure up its balance sheet position. As we mentioned in Fortescue - commentary following further iron ore price falls the company will either need to relaunch the refinancing process and push out its debt maturity profile with a new debt raise, or find other ways to raise capital such as asset sales, divestment, prepayments or an equity raise. The company has cash-generating options, but these revised analyst forecasts will place increased pressure on the company to act quickly.

We will be looking closely at the company’s March quarterly production report due this Thursday so will make further comment then. In particular, we will be focused on any revised guidance on costs, price realisation and any other news relevant to the company’s balance sheet.

The fall of Atlas

Firstly, Atlas Iron, a small Australian producer, suspended trading in its shares and is subsequently mothballing its operations. It is the first major casualty of the supply war in iron ore. On its own, Atlas was producing relatively small amounts of iron ore so this news in isolation won’t shift the outlook for iron. Let’s not forget through, that at one stage this company was worth AUD3 billion on the back of surging Chinese demand for iron ore. It’s a timely reminder that market capitalisations make for great headlines but can evaporate very quickly when things turn sour. The fall of Atlas is a likely signal of things to come. Supply needs to come out of the system to match the reduced demand for iron ore to allow prices to rebalance.

China iron ore imports rise as foreigners take market share 

Interestingly, a rare bright spot in China's trade performance during March was iron ore, which saw volumes rise 2.4% in the first quarter, compared to the same time last year. The surprisingly robust performance at a time of weak steel demand in China indicates that the big foreign miners are stealing market share from their higher cost domestic rivals. China imported 227.1 million tonnes of iron ore in the first quarter at an average price that was 45% lower than 12 months earlier. While volumes were slightly higher than the first quarter of 2014, the rate of growth has slowed substantially. It was just 2.4% over the first quarter, compared to nearly 20% between the same quarters in 2013 and 2014. This provides a strong indication that Chinese iron ore demand is reaching peak levels. 

China set to introduce iron ore subsidy to local producers

It appears that China is stepping in to protect its local iron ore miners, with local state-owned media reports that the Chinese government is planning to offer a subsidy of around six Yuan per tonne to local iron ore producers in an attempt to prop up the local industry in the face of intense oversupply coming from seaborne iron ore production.

S&P places iron ore majors on CreditWatch negative

Standard & Poor’s (S&P) has placed the ratings of eight iron ore producers on CreditWatch negative, including domestic majors BHP Billiton, Rio Tinto and Fortescue. The iron ore producers in S&P’s list together represent the majority of the seaborne iron ore supply globally. S&P cites that the severe supply and demand imbalance in the iron ore market could continue for the next two years. As a result, the rating agency has revised down its price assumptions for iron ore to USD45 per tonne for the rest of 2015, USD50 per tonne for 2016 and USD55 per tonne for 2017. 

The rating agency expects downsides typically of up to one notch, but also hasn’t ruled out rating affirmations and two notch downgrades. Given S&P’s comments, we see a high likelihood of Fortescue’s rating being downgraded either by one or two notches, which would translate to a corporate credit rating of BB or BB-. The senior unsecured bonds, issued by Fortescue’s financing subsidiary, are rated one notch lower than the corporate long term rating. In the event of a one or two notch downgrade their ratings would fall to either BB- or B+. In terms of the recent article Understand the risks of foreign currency bonds listing S&P defaults by credit ratings, the probability of default should Fortescue’s 2022 bonds fall to these levels are 14.10% and 19.82% respectively. 

So, what this does all mean for bond investors?  

Firstly, the recent turbulence in iron ore and the later dated Fortescue bond prices is a timely reminder that bond capital prices can fluctuate prior to the maturity date. Factors that contribute to this are revisions in the credit outlook of a company and trading activity in a particular bond. This makes diversification important. If you haven’t done so already, it is worthwhile considering whether you are overly exposed to a particular name or sector. Excessive exposure in one name is great when bonds are performing well, but the flip side is also true.

And more broadly, the fall in iron ore revenues is going to create a serious dent for the Australian budget. Over the shorter term, interest rate cuts would provide much needed relief to domestic miners through a weakening of the currency. We expect the continued deterioration in iron ore will place increased pressure on the RBA to further cut interest rates at the forthcoming May meeting.

The fall in iron ore prices is also flowing through to government credit ratings, with S&P placing the Western Australian state government’s credit rating on negative CreditWatch.

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