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Fortescue Metals Group Limited surges more than 4%: Here’s why

Shareholder in iron ore miner Fortescue Metals Group Limited (ASX: FMG) have had a slight reprieve today, with shares rising 4.3% to $3.40 in lunchtime trading.

That’s in stark contrast to junior miner BC Iron Limited (ASX: BCI), which has seen its share price drop 4.7% today.

So why are the two iron ore miners heading in different directions?

For one, it’s their respective production costs. I’ve previously noted that Fortescue’s 2014 all-in production costs were around US$79 per tonne (including capital expenditure), but were likely to fall as low as US$55 per tonne this financial year. That’s heading into the three major iron ore miners’ territory. Rio Tinto Limited (ASX: RIO), BHP Billiton Limited (ASX: BHP) and Brazil’s Vale have estimated production costs of less than US$50 per tonne.

In contrast, I estimated BC Iron’s all-in costs at around A$82 per tonne. With the current iron ore price at around US$80 per tonne, that’s not much of a margin, despite the Aussie dollar buying 86.9 US cents. Overnight, the commodity gained 1.7%, but it may be temporary.

The problem for both miners is that iron ore prices are likely to continue heading lower, with an estimated 200 to 300 million tonnes of excess supply coming onto the market. At the same time, Chinese steel production is forecast to remain flat and possibly fall in the year ahead.

Simple economics suggests flat or lower demand combined with rising supply can only result in one thing – lower prices. Those in the firing line are the higher cost producers – mostly the smaller miners, but also those selling lower grade ore – including many Chinese iron ore producers.

Fortescue still has its own challenges, not least of which is its US$9.3 billion of debt. A falling iron ore price reduces cash flows, and limits the amount of debt the company can repay each year. While the company had US$2.4 billion in cash at the end of June, Fortescue is also spending US$1.3 billion on capital expenditure this financial year.

As a result, Fortescue is still a speculative investment, and Foolish investors may want to give it a miss for now.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

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