Why Fortescue Metals Group Limited share price may have further to fall

The third force in our iron ore market is trapped between China and US President Donald Trump as speculation mounts that Fortescue Metals Group Limited’s (ASX: FMG) share price could have more room to drop.

Another industrial city in China is looking to implement steel production curbs of up to 25% from April to September to combat pollution, according to the Australian Financial Review.

This means the discount on Fortescue’s lower quality and more polluting ore could extend well into 2018 or even wider.

Either of those outcomes will likely mean a profit downgrade for Fortescue. If both were to occur, well I don’t need to spell it out for you.

The historical discount for Fortescue’s ore stands at around 10% but this has recently blown out to about 32% as pollution controls have prompted Chinese steel makers to favour higher quality ore supplied by BHP and Rio Tinto so they can maximise production output to capitalise on high steel prices.

Fortescue’s management is counting on a narrowing in the discount in the near-term as the depressed price for lower quality ore is more a seasonal than structural issue.

Some backers of the stock were counting on a rebound in Fortescue’s share price given that it has lagged the market and its peers by a Pilbara-mile!

Fortescue has tanked over 26% over the past 12 months when rivals like BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO) have jumped ahead by 13% and 22%, respectively. In contrast, the S&P/ASX 200 (Index:^AXJO) (ASX: XJO) is up around 2.5% over the same period.

Steel Falling: Fortescue’s relative share price performance

Source: Yahoo Finance

However, news that Handan, which is in the industrial province of Hebei, will follow the pollution-busting lead of China’s biggest steel producing city, Tangshan, will give analysts pause for thought.

The real threat to Fortescue comes from the risk that other Chinese cities will also implement pollution-fighting curbs on the steel industry, as that will almost certainly guarantee an extension of the pricing discount on the miner’s inferior ore.

But President Donald Trump’s 25% steel tariff could ironically prove to be a blessing in disguise. If the added tax on imported steel brings down global steel prices as many are predicting, Chinese steel producers may turn their focus on cost-savings instead of production-maximising.

This would mean steel mills could suddenly favour buying the cheaper ore as they scale down their output in response to the global glut.

More water will need to pass under the iron bridge before investors can get a cleaner view of Fortescue’s future.

In the meantime, you might be better off sitting on the sidelines instead of jumping into what could become a “value trap”.

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Motley Fool contributor Brendon Lau owns shares of BHP Billiton Limited and Rio Tinto Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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