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Why the share price of Fortescue Metals Group Limited (ASX:FMG) is rallying when miners are falling

The share price of Fortescue Metals Group Limited (ASX: FMG) is bucking the downtrend as it jumped after Citigroup made an about-face on the stock.

Shares in Fortescue jumped 1.4% in late morning trade to $4.44 when the mining sector dragged the S&P/ASX 200 (Index:^AXJO) (ASX: XJO) was down 0.4% with BHP Billiton Limited (ASX: BHP) losing more than 1% while Rio Tinto Limited (ASX: RIO) shed around 0.5%.

Fortescue is still lagging the two bigger iron ore producers by a Pilbara mile with the stock plunging 18% over the past year when its larger peers have gained between 20% and 30%.

However, everything has a price and Citigroup’s upgrade of the stock to “buy” from “sell” has sparked the latest round of bargain hunting.

The bullish change of heart follows the broker’s revised forecast price on iron ore, the lower Australian dollar and the potential benefit from Fortescue’s plan to overcome its lower quality product.

Fortescue’s ore contains around 58% iron content compared to 62% from BHP and Rio Tinto. The price difference between the low and high-grade ore has widened significantly over the past several months on falling Chinese demand for the low-quality ore, which produces more pollution when processed into steel.

This is the key reason behind the large gap in Fortescue’s share price performance and that of BHP and Rio Tinto.

Fortescue blends ores of different qualities that it mines from different ore bodies in the Pilbara. The general idea is that Fortescue will use the higher-grade ore to create a better quality product with around 60% iron content.

It sounds like what coffee roasters would do and the plan could work to narrow the discount on Fortescue’s ore (in theory at least), although Citigroup points to a few issues the miner will need to overcome.

For one, no one knows what price the Chinese will pay for the 60% Fe ore. Fortescue plans to test the market in FY19 with a trial shipment, so we can’t call this plan a success yet.

The other issue is that for every one tonne of high-grade blend Fortescue sells, one tonne of its regular blend will drop in quality from 58.4% Fe to 56.7% Fe, noted Citigroup.

Then there’s a question about the price Fortescue can get for its regular blend, which will constitute the bulk of its shipments. Fortescue currently mines around 170 million tonnes of ore and the high-grade blend will likely constitute around 30% of its total production.

It doesn’t help that the iron ore market is generally illiquid and opaque, so it will be interesting to see how much of an improvement in Fortescue’s margins can be achieved under the new strategy.

Citigroup doesn’t think you should wait to find out. It’s lifted its price target on the stock to $4.90 from $4.00 a share.

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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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