‘Good’ for Fortescue. Bad for Australia.

Loading of iron ore

This, folks, is going to be interesting…

I have often written in The Daily Reckoning that what is good for the Commonwealth Bank [ASX:CBA] is good for Australia. It’s said in jest of course. It reflects the fact that Australia has turned into an asset based, interest rate dependent economy with house price speculation at its core. While this speculation continues, the Commonwealth Bank should do well.

Now, it’s time to add another dictum…

That is, what’s good for Fortescue [ASX:FMG] is bad for Australia.

The big news today is that the Chinese are after a piece of Fortescue. As the Financial Review reports:

Chinese-linked companies have applied to the Foreign Investment Review Board seeking permission for an investment involving Fortescue Metals Group.

Australia’s third-largest iron ore producer has held discussions with China’s largest steel producer, Baosteel, and China’s largest conglomerate, CITIC, about a recapitalision to shore up its balance sheet.

Hmmm. No wonder Twiggy Forrest was on a PR rampage last week. His 30% stake in Fortescue is about to get diluted big time. Unless, that is, the iron ore price rallies enough to improve Fortescue’s cash flows and balance sheet…and ward off potential ‘investors’.

Which is unlikely to happen. Fortescue has about US$7.5 billion in debt. That’s pretty onerous when your operations are only just keeping their head above water. It’s under immense pressure right now. And when you have high debt levels, you don’t have many options.

That’s why the Chinese are sniffing around Fortescue. They know that in its current fragile state, a major recapitalisation offer will be hard to refuse. This is good news for Fortescue (sort of) as it will improve the balance sheet and allow it to continue to churn out iron ore even if it’s losing money.

But it’s bad news for Australia. Really bad news.


Well, let’s just assume Treasurer Joe Hockey approves this mooted Chinese investment in Fortescue. That means you’d have some major shareholders with deep pockets, more intent on ensuring cheap supply of iron ore rather than the profitability of the operations.

Fortescue is a pawn in the global iron ore game, being used by China to keep pressure on the iron ore price.

Remember last week I told you how China planned to lend Brazil’s Vale a few billion dollars so it could complete its massive high grade iron ore project? That’s clearly telling you China wants to keep pressure on the iron ore price by encouraging supply.

Now, they’re putting their hand up to recapitalise the world’s fourth largest producer — the highest cost producer out of the four. That means they are intent on keeping as much supply in the iron ore market as they possibly can.

What do you think that will do to the price? It will keep it much lower for much longer.

With the current demand/supply dynamics, in a free market there is a good chance Fortescue’s supply would be knocked out, or reduced within a couple of years. But that would revert pricing power to the big three producers, Rio, BHP and Vale.

That’s something China wants to avoid. By keeping Fortescue’s tonnage in the game, China retains leverage over pricing power. It means Australia’s terms of trade will continue to decline, while China’s will improve.

The government should realise this and block any sale to the Chinese on strategic grounds. But there’s a lot of things the government doesn’t realise so who knows what these bozos will do?

For now, though, it’s quite clear what the aim is…control of iron ore pricing. And if the Chinese throw Fortescue a lifeline, it will be to the detriment of Australia.

It will be to the detriment of Fortescue too. Not that the market cares about that this morning. At the open the stock is up nearly 12% as short sellers scramble to get out.

Still, there’s not much to celebrate if you understand what China’s aims are. According to consensus forecasts, Fortescue will make a small loss in the 2016 financial year, and only recover to generate a 4% return on equity in financial year 2017. And that’s assuming an improving iron ore price!

For a company as highly geared as Fortescue, a 4% return on shareholders’ equity is abysmal. The bottom line is, with iron ore prices around current levels Fortescue can barely make any money. You’d only buy it if you thought prices were going higher. China doesn’t think that at all, which means it’s only looking to invest on political/strategic grounds with operating losses a consequence of that.

But it’s not all gloom and doom in commodity land. There are some bright spots elsewhere. Consolidation in the gold space continues. Yesterday, Evolution Mining [ASX:EVN] announced a US$550 million purchase of Barrick Gold’s Cowal Gold Mine in western NSW.

The big US majors have been selling off their Aussie assets for a while now, giving companies like Northern Star [ASX:NST] and Evolution the opportunity to pick up quality long life assets for an attractive price.

This is the sort of thing that happens towards the bottom of a bear market. The big spending, indebted companies succumb to shareholder pressure to sell assets and improve the balance sheet. They do so at fire sale prices, which is great for the acquiring companies.

And don’t forget the Aussie dollar gold price is much more attractive for Aussie companies. As I’ve argued since the start of the year, gold in Aussie dollars is at the beginning of a new bull market. As you can see in the chart below, since peaking in February the price has spent the past few months ‘consolidating’ the strong gains made from November 2014 to January 2015.

Source: StockCharts

Click to enlarge

What you want to see now is for the price to move above the April high of $1600 an ounce. That would provide confidence that the bull market is intact.

Nickel is also getting some action. Yesterday, gold and copper-zinc miner Independence Group [ASX:IGO] made an offer for nickel player Sirius Resources [ASX:SIR]. If the deal goes ahead, it will create a $2.7 billion dollar mining house.

This is good news for the resources sector. It also tells you Resource Speculator Jason Stevenson is on the right track in looking for the next big thing in nickel.

At a time of stretched valuations in the banking sector, it’s good to see some recognition of value in the resources space.

Or, if resources are a little too risky for you, you can check out my relatively low risk way of playing the coming infrastructure boom.

That’s the beauty of the stockmarket. There are always opportunities…especially in the areas where not many are looking.


Greg Canavan+,
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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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