Fortescue must shut for the good of Australia

Judging by the many sympathetic comments on the blog for Twiggy Forrest, find below a repeat of why his arguments in favour of major miners cutting production are poppycock and very damaging to Australia.

Owing to geographic concentration, the benefits of scale and capital intensity, iron ore extraction is a natural oligopoly business. What’s at stake here is who owns the cartel and whether than benefits Australian welfare. Let’s take a quick look at two scenarios to make the point.

The first scenario is the cartel structure favoured by various pollies that seeks to protect and include iron ore juniors by pulling back major miner supply expansions. The second is also a cartel but one that results from swift junior rationalisation enabling the major miners to consolidate their pricing power.

In the junior cartel, Australian iron ore produces 837 million tonnes (mt) of iron ore from 2016 onwards. It does so at a slightly improved price for 2016 as oversupply is reduced in the short term by 43 mt as majors retrench.

However, as Sino, Roy Hill, Anglo and Vale continue their expansions and Chinese demand keeps falling, the glut builds from 2017 onwards and the price keeps falling.

In due course, smaller members of the junior cartel require enormous subsidy to stay afloat as they register huge losses year after year in a price environment stuck at $20 and below. It’s either that or the cartel must negotiate spectacularly implausible shared volume cuts across all Australian producers (at least those in the cartel).

Trade rules must be junked, Chinese relations destroyed and the WTO as well as ACCC told to piss off. To operate this would require a virtual nationalisation of all players as total transparency governs quotas, otherwise widespread cheating is inevitable, as in OPEC.

In the alternative model, the major cartel, Australian iron produces 880mt in 2016. It does so at an average $10 lower than the junior cartel in that year given the higher supply glut. However, as the 50mt of junior and 165mt of Fortescue production shuts down by 2017 the iron ore price at first stabilises and then slowly rebounds as some pricing power returns to the major producer’s cartel. Iron ore volumes are down to 715mt but the price is trading at $40 per tonne in a rough market balance.

Juxtaposing these two scenarios gives you the following total revenue chart for the sector (and nation):

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Most importantly, in the junior cartel there are no profits for anyone as protected oversupply crushes all margins, including those of the majors. There is also a gigantic Budget drain for WA as it supports the juniors with huge subsidies that completely overwhelm royalties.

In the major cartel, unprofitable iron ore is driven out and solid profits return to the low cost producers as Roy Hill emerges as the marginal producer around $40. There is no budget drain and solid royalties, as well as a Federal tax take (if much lower than the past).

When you cut through all of the crap it’s really very simple, the juniors and Fortescue must die as soon as possible for the good of the nation. It is the only viable fix for iron ore.

Comments

  1. website isnt working again in chrome, no pics load, and goes to mobile view. Have cleared all caches.

  2. So if the juniors survive, it would be like a China sponsored enterprise, no profits for the government, just keeping them going to create jobs but selling Iron Ore for less than the costs of production. I think if one is a true capitalist at heart, that wouldn’t be what one wants. To be honest there never was a business case for letting the juniors set up shop, as prices are now too low for them to make a profit. that capital should have been deployed into another area, but what area?


    • that capital should have been deployed into another area, but what area?

      Isn’t the answer obvious? Real Estate.

      • “Isn’t the answer obvious? Real Estate.” That’s the problem, anything that could be created to generate income and employ people, is too hard in this capital starved environment called Australia.

    • Have a look at the aluminium sector – the omens are not good… you have first and second quartile cost producers wanting to exit the industry because fourth quartile cost producers just keep producing. That is just not supposed to happen?

  3. It is unfortunate that Twiggy is claiming to speak in the national interest because that is hardly believable.

    What is unclear is whether Twiggy’s claim that Australia has pricing power in the iron ore market is credible.

    If Australia has real pricing power than it may be in the national interest to exert that power. Though this would not be any real comfort for Twiggy as all it would mean is that at a national level Australia should control the amount of iron ore being exported into the international market.

    In such a scenario the lowest cost producers would still prevail but the margin they would make would be larger.

    But of course this is all moot if in fact Australia does not have pricing power. The confusing thing is that the survivor major cartel oligopoly argument involves the assumption that once we get rid of all the juniors (which the argument says is a good thing because Australia has currently no pricing power and keeping them alive is a waster of time) the oligopoly survivors will suddenly have pricing power.

    What is much more likely is that those oligopoly survivors will continue to fight for market share right to the bottom even after the juniors have gone and on the way down they will continue to whinge about the cost of wages in Australia, the level of taxation and the rate of royalties.

    On the assumption that Australia does have pricing power the most sensible option in the national interest is to manage the volumes available for export by use of transferable auctioned export volume permits and nice fat royalties.

    That will limit supply at a national level and ensure the volumes exported are by the lowest cost most profitable producers (as they will bid more for the export licenses)

    A regime such as this would not help Twiggy though as BHP and RIO would be able to out bid FMG for all the export volume licences.

    Yes – if Australia actually has no pricing power such a regime will not work and will just need to rely on extracting the highest level of royalties that the market will bear (the point at which we take their threats to go elsewhere seriously) but if we really have no pricing power than a oligopoly cartel by the majors is not going to give us any real advantage either.

    Finally – I am in two minds where it is moral for Australia to seek to manage the market using its resources as there are real benefits to allowing Chinese consumers and others access to cheap materials for housing and manufactured goods. But thinking like that is hardly what any of our currency war trade rivals are thinking about so why should Australia?

    China has been playing all sorts of games with its rare earth minerals on the basis that having a large supply gives them market power so why shouldn’t Australia play the same game with its very low cost iron ore resources.

    • PF, there is nothing more certain to lose a sale than to play with an edgy customer.
      Everyone makes out the Chinese need us , they dont, we are just convenient, like 7-11.WW

      • “….Everyone makes out the Chinese need us , they dont, we are just convenient, like 7-11…..”

        That is the question I am asking with regard to iron ore – though of course convenience has a price and as we know 7-11 charge through the nose for being convenient.

        If Australia has no market power with regard to iron ore (which is what you seem to saying) the answer is clear, we cannot hope to succeed in controlling the market with supply and therefore must make do with setting royalties at the highest possible point before the miners decide it is more profitable to head overseas. And that level of royalties might be quite low.

        I don’t know the answer to the question of whether Australia has pricing power – Twiggy reckons we do but a lot people seem to think we don’t. I am merely pointing out that if Australia has no pricing power than a surviving majors cartel is unlikely to be of much benefit beyond a relatively small workforce in hi-vis vests.

        The damage has already been done. Plus wasting all that labour and capital in a mountain of pointless CAPEX that bent the rest of the economy out of shape and will make the politicians even more susceptible to the inevitable arguments from the surviving majors that they need wages and taxes cut to the bones or they will go off shore.

  4. I have never read so much biased crap in all my life. Fortescue will be producing at 39.50 a ton all up cost in 2016 and is now at 41. Read their statements. They have met every cost and production target they have set. Right now they are making $1.6bill profit even at an 85% of 62% FE price. They are the fourth lowest cost producer in the world. And houses and holes they ain’t going to go broke, with the refinancing Right now at forward p.e. of 12 they should be trading around the $7 mark. It is only the bull**** shorts that are keeping the price down. And you are so so transparently short. You advice is pure crap and from self interest.

    • Lol. Well, I guess we can conclude that you are transparently long!

      For the record I don’t trade at all.

      It’s not shorts keeping the price down, it’s the collapsing iron ore price. The current dead cat bounce does not make them $1.6b unless it is sustained and it won’t be.

      As well, I’m arguing longer term about the national interest and against Twiggy’s distortions, not about today’s share prices.

      Look to your own biases, old boy.

  5. H&H I certainly hear what you’re saying and in some ways it’s the logical path for Australia to follow, however make no mistake about it a state sponsored IO Cartel (or defacto cartel) would be thumbing it’s nose at China. Is Australia ready to take this step, are average Australian’s ready for their government to take this step?
    Think about Mike Smith over at ANZ, is he ready to have his dreams of an Aussie operated pan Asian bank banished to the nether regions in the next China FTA agreement? there is no mistaking it our actions in one area of bilateral trade have consequences in other areas. For this reason, if no other, I believe the Australian gov’t will be very reticent to be involved in any action that even suggests the establishment of an IO cartel.

    OK so given the above, FMG as an equity is probably all but finished however this does not imply that FMG’s IO assets will simply be idled.

    I see two paths forward for FMG’s assets
    1) FMG effectively becomes a Chinese State-owned-entity (SOE) it is intentionally operated at a small loss and becomes the marginal producer supplying somewhere between 5 and 15% of sea bound IO. The nature of this mode of operation will drive the owner of the asset to seek permission to operate with a much more flexible work force than is supportable under Australian labor laws (means FMG ultimately becomes China owned, operated and staffed)
    2) The IO futures market becomes the invisible hand that keeps FMG alive and operating, again it operates at a loss but can always find the “investment” capital to keep the ponzi bonds rolling over year-in year-out.

    The only case that I can imagine where FMG’s assets are shut-down would be that Roy-Hill takes the place of FMG as the marginal producer but this logically suggests an even lower average IO price than the case where FMG is the marginal producer….meaning Australia is actually worse off.