Ord Minnett has reviewed the drivers of the price discount that Fortescue Metals Group receives for its lower-grade 58% iron (Fe) ore product, relative to the benchmark 62% iron ore price, and finds the overwhelming majority of the drivers that have pushed the 58/62 spread as high as 30% are cylical in nature.
The cylical factors for such a spread in the realised prices include elevated steel spreads driving greater demand for higher grade ores to maximise output; high coal prices causing blast furnace operators to minimise coke consumption; high China port stocks of low-grade ore; a decline in scrap steel prices leading to substitution in blast furnaces; and a rise in Indian exports to China. All these drivers currently favour the use of higher-grade ore, but over time, we expect conditions to normalise from the current 25% to 17% in the long term, equivalent to circa US$10 a tonne and in line with the average discount since the start of 2015.
Efforts to cut pollution in China and a reduction in inefficient steel capacity, however, appear to be permanent, i.e. structural changes. These are likely to keep demand for higher-grade ore somewhat elevated. Furthermore, recent blending initiatives at China ports (from Brazil’s Vale and traders) have restricted availability of high-grade iron ore to blend with lower-grade material. We note that this could also be a structural change if blending economics remain favourable.
We forecast Fortescue’s realised price to be 35% below the 62% Fe benchmark in the June quarter. This is based on an 11% provisional pricing impact, along with a 27% product discount. Beyond this, under a range of iron ore price scenarios, Fortescue continues to screen attractive on valuation, balance sheet and free cash flow measures. We reiterate our Accumulate recommendation and our price target of $6.30.