It's unusual for the share price of Fortescue Metals Group Limited (ASX: FMG) to lag behind arch rivals BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO) by a large margin, but that's what been a hallmark for the iron ore major this year.
The share price of Fortescue Metals is down 20% since the start of 2017 when BHP is up around 12% and Rio Tinto is flying 20% higher.
The 30+ percentage point gap that's opened up between Fortescue and the other two iron ore giants is not unprecedented but it is highly unusual.
This could be a great trading opportunity as any mean reversion will see Fortescue outperform strongly in the short term.
But don't get too excited. The poor performance of Fortescue is not due to "random walk" or sentiment driven factors that tend to be fleeting. The gap exists because Fortescue sells lower quality iron ore (ore with lower iron content) than BHP and Rio Tinto.
The real issue is the price discount for lower quality ore has increased recently, according to a report by the Australian Financial Review.
Traders in China said the discount for Fortescue's ore with 58.3% iron content is now 29% in December compared with 25.5% in November and a mere 8.5% at the start of 2017.
If you listen to Fortescue's management and its supporters, this discount is a cyclical issue and will narrow in early 2018.
The problem though is that the widening discount is driven by government policy and not by market forces. In my opinion, government policy is far more unpredictable than market forces – particularly in a country like China.
The Chinese government is trying to curb the country's notorious pollution issue by shutting down dirtier steel producers. This in turn is driving demand for higher quality iron ore with at least 62% iron content as it is cleaner to process such ore.
Steel producers that are still in operation are also scrambling to get higher quality ore to maximise production to fill the hole left by the exit of dirtier steel producers.
The Chinese government's clean-up campaign is expected to last to March 2018. But experts believe that this won't be a one-off exercise as the pollution issue in Australia's most important trading partner can't be solved easily or quickly.
The silver lining for Fortescue is its low production cost at US$11.65 a tonne. That leaves it with a decent margin although its margins will be skinnier to Rio Tinto's even though its production cost is around 15.6% higher at US$13.80 a tonne.
It's hard enough trying to predict the iron ore price, but investing in Fortescue will mean you also need to be able to forecast the discount for its lower quality ore and what the Chinese government will do next.
That's one too many hoops to be jumping through.
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