From gold to lead

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31 Oct 2008

WHO wants to be a gazillionaire? Dotcom tycoons in the 1990s rose and fell over a period of years. The recent commodities boom, by contrast, made people fabulously wealthy in a matter of months. But their fortunes have evaporated just as quickly. There is no better example than Andrew Forrest (pictured), who left mobs of Australian investors howling back in 2002 after a foray into nickel mining blew up, only to recover in spectacular form. In 2003 he assembled a new company, Fortescue Metals Group, out of a tiny investment in iron-ore tenements in Australia’s Pilbara region. These areas had already been rejected by the industry’s giants as too costly to develop because of their complex geology and relatively low-grade ore. By early 2008, before Fortescue had even pulled ore out of the ground, the global commodities boom had made Mr Forrest Australia’s richest man, worth over A$8 billion ($7.7 billion). By June, just after the first (small) shipment, he was worth A$13 billion and his company A$36 billion. Four months later, he is worth A$3 billion ($2 billion), Fortescue is worth A$8 billion, and whether there will be a rebound or a further collapse is anyone’s guess.
The contract price for iron ore to Chinese steel mills, of which Fortescue is a beneficiary, is for well over $120 a tonne, almost twice its level last year, and triple that of five years ago. It is enough to make even the highest-cost producer rich. But the word “contract” is losing its meaning. Chinese spot prices, having traded above the contract price for five years, have crashed from $186 a tonne in July to $80 a tonne today and continue to slide (see chart). Buyers are breaking contracts, bankers are pulling financing and projects are, inevitably, being scaled back.
On October 28th Fortescue reversed its long-standing public optimism and announced it would curtail expansion, a huge blow given the importance of scale in efficient mining of iron ore. There had already been delays caused by technical snags, but nobody cared when prices were rising. Now they care quite a bit. How much it will cost Fortescue to produce a tonne of ore is the source of much debate in Australia’s mining community. The best Australian producers can get their products to a port for under $10 a tonne, and then pay another $25 a tonne to ship it overseas, which makes them profitable even at today’s prices. Fortescue’s cost of getting ore to the ports ranges from $20 to $60 a tonne, reckons Carlo Caiani of Caiani & Company, a consultancy based in Melbourne. So it is unclear whether it can operate at a profit or not.
If Fortescue’s production costs exceed the spot price, it would hardly be the only Australian commodities firm in trouble. Citigroup estimates that the spot price is below the production costs for 15% of copper producers, 25% of aluminium producers, 50% of zinc producers, 30% of nickel producers and 10% of iron-ore producers. High-cost producers in India are at risk, and high-cost producers in China—which are legion, because ore quality is poor—are already quietly shutting down, says Clarke Wilkins, an analyst at Citigroup.
So far no big company has gone bust. Much mining development in Australia is funded with equity, not debt, and is consequently not as financially stressed as you might think. In Fortescue’s favour, it raised equity and debt in 2006, and more money last year. But not everyone is so fortunate. Over the past four years, 380 junior mining companies have gone public in Australia and the crunch means few will ever produce anything, says Mr Caiani.
One of the greatest difficulties faced by a start-up is that financing is often done in stages, subject to meeting benchmarks. This is a difficult time to be moving from one stage to another. Mirabela Nickel, a firm listed in Australia, is developing a big nickel project in Brazil and, bankers say, is having to seek funds in a market that has lost any appetite for risk. It is hardly alone. And if the depressed prices continue for more than a year or prices fall further, even companies that are thought be safely capitalised will begin to be stretched.
At the very least, the falls mean that the wave of new output forecast over the next few years is unlikely to materialise. It is even possible that supply could contract. That, at least, is the prevailing sentiment. But a contraction could, in turn, provide a medium-term opportunity for marginal producers when Chinese demand starts to pick up again—and, perhaps, some further unexpected reversals of fortune.

Source: Bloomberg