There are four fronts in the battle for pricing power in the iron ore market: BHP Billiton (ASX: BHP), Rio Tinto (ASX: RIO), Fortescue (ASX: FMG), and spot market for iron ore. It’s hard to tell who is winning…or what losing really means.
The Australian reports this morning that, “Chinese interests have approached a major Australian superannuation and investment fund to be their partner in a multi-billion-dollar swoop on 9 per cent of BHP Billiton.” This proposed deal involves three parties, the Chinese Party, an Australian fund, and a global private equity firm.
That’s pretty clever. Under that deal, reports the Oz, China gets a 4.5% stake in BHP Billton. That’s would be worth about $12.15 billion, using yesterday’s closing price. The Oz also reports that under the terms of the proposal, the Chinese could buy back the fund’s stake in BHP Billton in five years at an agreed upon price.
That sounds like a call option to own another 2.25% in BHP Billton in the next five years. Given the earnings BHP Billton may generate from its iron ore and oil divisions, that could be a handy little capital gain. What do you think the intrinsic value of an option like that would be? The Aussie fund better stipulate a high price for that future agreement.
But remember, this is just one front in the ongoing strategic resource game playing out. The second front is Rio Tinto. In March, Chinalco’s Xiao Yaqing said he would like to eventually increase his stake in Rio Tinto from the 9% he picked up in the late January over-night raid with Alcoa (NYSE: AA) (which has made a nice little move in New York, by the way).
Since then, China’s interest in Rio Tinto has taken a back seat to China’s interest in Fortescue and BHP Billton. But could the Rio pursuit revive? Aluminium prices are likely to rise with the shut-down of some of aluminium smelters in China (more on that below.) What will commodity will generate the most earnings growth in the next five year: iron ore, aluminium, or oil?
The third front is Fortescue. Yesterday was a milestone for Andrew Forrest’s mob in the Pilbara. They went from being an iron ore explorer to an iron ore exporter. Take away an “l”, add a “t” and you have a whole new ballgame. Fortescue loaded 180,000 tonnes of iron ore from its Cloudbreak mine on to a Cape-sized Baosteel ore hauler. It’s on its way to China.
What are Fortescue shares really worth? Charlie Aitken at Southern Cross Equities reckons they are worth more than today’s price. The company aims to produce 100 million tonnes per year by 2010. If the company averages $50/tonne, that’s $5 billion pretax. After 30% corporate taxes, you’re still looking at $3.5 billion in earnings for shareholders.
Andrew Forrest says he’d welcome Chinese investors on the Fortescue share register. But spots on the register are already at a premium. Over 70% of Fortescue’s issued capital is owned by just five major shareholders (including Forrest himself). If China Inc. wants in, someone else is going to have to sell out.
Joel Steinberg’s holding company Leucadia (NYSE: LUK) which some people call a mini-Berkshire Hathaway, owns just under 10% of Fortescue. Aussie institutional investors shunned Twiggy Forrest when he went looking for extra capital to cover cost blow-outs in 2006. Steinberg ponied up over $400 million, $300 million for the 10% equity stake and another $100 million in unsecured notes paying a 4% royalty on Fortescue’s production.
At the time, Fortescue wasn’t producing anything, and no one was sure it ever would. And because Leucadia’s offer valued Fortescue at $15.20 a share (a 35% premium to the share price at the time), it looked like Steinberg had overpaid. But maybe not.
A 4% royalty on production of 100 million tonnes per year at $50/tonne is about $100 million a year. And over ten years, that’s about $1 billion in royalties (not a tough sum to calculate)-and remember that’s on just the $100m in unsecured notes. With that kind of return, Steinberg could sell some of the equity to, say, China, and still come out well ahead on the deal.
If Steinberg doesn’t sell to Baosteel, will Harbinger Capital Management? That’s the firm run by Phillip Falcone in New York, and rumoured this week to be shopping its 16% stake in Fortescue to potential buyers. Harbinger’s stake is held in trust by its Australian representatives.
All we know is that Aussie institutions are on the outside looking in when it comes to the Fortescue registry. Existing shareholders might make the Chinese pay a pretty penny. But the Chinese might be happy to do so.
The final front in the iron ore wars is the negotiation for this year’s contract price. It’s going nowhere. In fact, the China Iron and Steel Association ordered all its steel mills and traders to boycott Rio Tinto’s sales of ore in the sport market, according to today’s Financial Review. Yikes.
Earlier this year Rio Tinto threatened to sell more ore into the spot market-while still fulfilling all its contractual obligations and the pre-agreed price. With spot prices nearly double the contract price, Rio Tinto was both taking advantage of the higher spot price, and indirectly pressuring China to agree to the 85% rise in contract prices that both BHP Billton and Rio Tinto are asking for.
China’s move to ban the purchase of Rio Tinto ore in the spot market is the negotiating counter punch.
Will the ore wars spread beyond these four fronts? They already have, of course. While these big battles are entertaining, real ground is being gained at the junior level as Chinese companies get on to the registers of many smaller iron ore companies.
The Daily Reckoning Australia