Are miners betting the house on iron ore prices?

Fortescue takes on more debt

Fortescue Metals Group (ASX: FMG) has announced that it has arranged more debt financing for its Pilbara iron ore expansion, at a time when iron ore prices are hovering near a 30-month low. Profits at Chinese steel mills have fallen 96% since the previous year, due to weak demand according to the China Iron and Steel Association, with iron ore a major input used in steel making.

Fortescue has arranged a US$750 million term loan and a revolving credit facility also for US$750 million. It’s a short term loan due to mature in December 2013, so the company will need to have the funds available to repay the loan by then, as well as meet the ongoing interest payments.

The company has also warned that junior miners could be in trouble, as falling commodity prices make projects uneconomical, and they would be unlikely to be able to attract finance. Fortescue’s chief Executive Nev Power has told the Australian Financial Review that the appetite for equity investments in new ventures is drying up, as the sector prepares for tough times ahead. If companies don’t have their financing in place already, they could struggle to get projects up, and many current projects could fail.

What Mr Power didn’t warn about was the issue of companies that have taken on a large chunk of debt. As iron ore prices continue to fall, miners around the world have ramped up production, which could see further falls in the iron ore price. Fortescue itself could be at risk, not because it doesn’t have the funds available, but because of is massive debt levels. As at the end of December 2011, the company had more than US$6 billion in debt, but has announced further debt raisings of more than US$3.5 billion so far this year. The problem for Fortescue is that if it fails to meet the interest payments or repay the principal when it come due, its bankers may call in its longer term loans as well. Falling iron ore prices could reduce its profits and cashflow, making it harder for the company to meet its debt obligations.

Iron ore floor

Some companies, media commentators and analysts have suggested there is a natural floor to the iron ore price of around US$110 to US$120 a tonne. At around these levels many Chinese iron ore miners cease to be uneconomic, so stop production or stockpile their resources. The drop in Chinese production is theoretically meant to increase demand in imports.

Supply of iron ore has increased massively globally, so foreign iron ore suppliers, like Rio Tinto Limited (ASX: RIO), BHP Billiton Limited (ASX: BHP) and Brazil’s Vale could fill the gap left by Chinese iron ore miners. That could see China’s  iron ore producers go out of business altogether, although China might want to protect its miners, so may take any number of measures to support them. Propping up the iron ore price is just one method of protecting its local producers. It could also subsidise its steel makers to buy iron ore at higher prices from Chinese manufacturers, and exclude foreign iron ore exporters. There could be an outcry over the fairness of that, but governments can do what they want when it comes to protecting local businesses.

The Foolish bottom line

All in all, tough times are coming to the iron ore producers, including smaller tier Australian producers like Atlas Iron Limited (ASX: AGO). But it’s not just the smaller or medium iron ore miners that could be in trouble. As always, companies with high levels of debt  – in any industry – are those most likely to face issues when their industry takes a turn for the worse.

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Motley Fool writer/analyst Mike King owns shares in BHP. The Motley Fool‘s purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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