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Fortescue set to struggle in 2013

The share price of Australian iron ore miner Fortescue Metals Group (ASX: FMG) has bounced recently, from a low of $2.87 to Friday’s close of $3.80. The rise has been attributed to the ongoing strength in the iron ore price, weakness in the Australian dollar, and broker optimism that the company could achieve the planned volume increases.

That optimism was vindicated during last week’s quarterly update. Fortescue shipped 23% more iron ore in the June quarter than the March quarter, and 39% more in FY13 than FY12. The company also reported that cash costs had reduced from $44 to $36 per tonne, and the reported cash position had improved from $48 to $46 in FY13. The results were broadly in line with expectations and previous guidance.

Fortescue noted that it had achieved “record results from its outstanding portfolio of assets [which] mark the transformation of Fortescue into a mining company of global scale”. Unfortunately for Fortescue, a number of analysts took exception to the summary. While it is true that the company is of global scale, it is currently the fourth-largest iron ore miner and its assets are not considered outstanding by most outside the company.

An analysis by HSCB showed that Fortescue is one of the highest cost iron ore producers in the world, well above majors Anglo-American (LON: AAL), Rio Tinto (ASX: RIO), BHP (ASX: BHP), and Vale (NYSE: VALE). The chart below shows the production cost of each company. Morningstar agreed, noting that Fortescue requires an index price of around $90 per tonne to break even due to the low quality of the ore mined recently. At the current iron ore price of around US$130 the company is receiving a healthy margin on sales, however Fortescue will run into trouble if the Goldman Sachs prediction of the price dropping to US$80 per tonne by 2015 proves correct.

ironore

Beyond the iron ore price, the medium term outlook for the company is of considerable concern. Fortescue has a huge debt load and has struggled in recent months to offload its port and rail assets known as “The Pilbara Infrastructure”. The delay is slowing the company’s efforts to reduce debt, but if it goes ahead may result in higher production costs, as payments will be made to a third party to use the facilities. Analysts are questioning whether the inability to find a buyer was as a result of an overly optimistic value of the assets by Fortescue.

Foolish takeaway

As Australia’s largest pure-play iron ore miner, Fortescue’s fortunes are heavily linked to future Chinese iron ore demand and thus the iron ore price. The company has high debt, rail and port facilities it is struggling to sell, and a plethora of competitors able to produce the same product at a lower price.

Fortescue has a history of disappointing, as evidenced by the many sharp falls in its share price over the past five years. The latest rally may also be short lived if there are any hiccups by the company, perilously perched near the top of the cost curve with no competitive advantages over its peers.

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Motley Fool contributor Andrew Mudie owns shares in BHP.

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