In a competitive market, such as that of seaborne iron ore, prices will fall as supply increases without an equal or greater increase in demand.
For iron ore miners, like coal producers before them, it doesn't paint a pretty picture.
In hindsight, that could mean the current iron ore spot price of around $US70 per tonne will look good.
Already we've witnessed small, high-cost producers go bust as a result of falling prices.
The collapse in price, which some believe to be 'surprising', is the result of a transitioning Chinese economy and massively increased supply coming online. Most of it from the three major global iron ore miners – Vale, Rio Tinto Limited (ASX: RIO) and BHP Billiton Limited (ASX: BHP).
With each of them pumping out hundreds of millions of tonnes of iron ore per year, their ability to scale is second to none. This affords all three low breakeven costs, believed to be around $US60, $US42 and $US51, per tonne, respectively. They're unlikely to go bust under current prices.
Higher cost Australian producers however probably aren't making money and are a high-risk of going under. Atlas Iron Limited (ASX: AGO), Gindablie Metals Ltd. (ASX: GBG) and Arrium Ltd (ASX: ARI) are examples of higher cost producers.
Then, somewhere towards the middle of the pack, is Fortescue Metals Group Limited (ASX: FMG). Fortescue has been through a number of unnerving situations in the past but the near-term is going to be yet another challenge for management.
According The Australian Financial Review, Fortescue could be forced to make some tough decisions in the year ahead, which could include selling assets to shore up its balance sheet which, at June 30 2014, held some $US9.4 billion of debt. Since then, Fortescue has repaid $US500 million of unsecured notes and an additional $500 million to $1 billion was expected to be paid this year.
Whilst Fortescue has $US2 billion of cash and its next major payment of debt isn't due until April 2017, its margins are under pressure at current prices.
Indeed at $US70 per tonne, the AFR reports, "Fortescue – Australia's third biggest producer – is making about $US9 to $US10 [per tonne] cash. That's about $US1.5 billion ($1.8 billion) cash a year across the 155 million tonnes of iron ore it is pumping out."
However that figure falls to around $US1 billion with a spot price of $US66 per tonne, as witnessed last month. With lower quality ore than the two majors, Rio and BHP, Fortescue realises just 86% of the 62% Platts index price. And despite significant reductions to its breakeven price over the past year, it mightn't be enough to keep it above water.
Some analysts expect the iron ore spot price could dip as low as $US60 per tonne in the coming 12 months. Deutsche bank, for example, are forecasting an average spot price of $US68 per tonne and believe Fortescues profit will fall to $US339 million in the current year and $US205 million in 2016.
In year ended June 30 2014 (FY14), Fortescue produced a profit of $US2.74 billion, meaning investors can expect a huge fall in the miners' bottom line over the coming year. In Fy14, it had $US720 million in net finance expenses and its last two dividends cost around $US570 million.
Foolish Takeaway
According to Morningstar, in the next year, analyst consensus is for a dividend equivalent to a yield of 3.4% at the current market price of $2.88 per share. Analysts are also expecting a 71% fall in earnings.
For deep value investors with a healthy knowledge of the sector, or spot price speculators, there could be opportunity in Fortescue throughout 2015. But personally, I'm not so enthusiastic.
China is transitioning its economy at a time when seaborne iron ore is in surplus. Couple the bleak outlook with low quality ore, high debt levels and the real possibility of significant reductions to its dividend; and the investment case for Fortescue is anything but sound.
Whilst an asset sale could be its saving grace, is it really worth holding shares to find out?
