Why Fortescue Metals Group Limited (ASX:FMG) shares are falling despite its record production

The ugly duckling of the iron ore sector just can’t catch a lucky break. Despite Fortescue Metals Group Limited (ASX: FMG) recording an impressive uplift in fourth quarter production to the highest on record for any three-month period, the stock is being flogged by investors.

The share price of Fortescue slumped 1.9% to $4.48 after the first hour of trade today after management reported iron ore shipments hit 46.5 million tonnes for the June quarter as costs fell 7% over the March quarter to US$12.17 per wet metric tonne.

It should be a double boost to sentiment for this under-performer with the stock sinking 16% into the red over the past year, when rivals BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO) have surged 32% and 25%, respectively.

In contrast, the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index is up 8% over the same period.

There could be a few reasons for the poor reaction to the stock today. Perhaps investors were disappointed that the miner won’t be able to hold its record quarterly performance as the annualised run rate in the June quarter suggests Fortescue should be shipping 186 million tonnes in FY19.

But that’s far from the case with management forecasting this financial year’s shipment target at between 165 million to 173 million tonnes.

What’s more, the latest quarterly record isn’t due to record production of the ore. The amount of ore mined in the June quarter fell 7%, while the volume of ore processed declined 4%. The miner probably drew down on its stockpile to hit its FY18 target of 170 million tonnes.

Those hoping for signs that the huge discount offered for Fortescue’s lower quality ore was narrowing would also be disappointed. The miner is only getting 64% of the benchmark price offered to BHP and Rio Tinto in FY18, compared to Fortescue’s initial hope of getting 75% to 80% of the benchmark price.

I think this large discount gap is set to remain with speculation that the Chinese government would come down harder on polluting steel mills this northern hemisphere winter.

But perhaps the biggest drag on the stock today is RBC Capital’s prediction of a collapse in the iron ore price in the current half year (click here to read more about this warning).

Unlike BHP, which is more diversified across a range of other commodities, Fortescue is entirely exposed to this one mineral.

Perhaps just as telling is that the share price of Rio Tinto is down by a similar amount to Fortescue, as Rio Tinto makes 50% of its revenue from iron ore, and this figure is likely to increase as it divests other non-iron-ore assets.

While bargain hunters might believe buying Fortescue shares is like purchasing the worst house in the best street, I would stay away.

This theory works in a hot market, but the strategy doesn’t apply if the iron ore market is cooling. It is better to stick to quality under such conditions.

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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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