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Iron ore market forces favor Fortescue for near future, experts say

Fortescue Metals Group Ltd. is set to reap the benefits of what experts believe will be a continuation this year of the dynamic shift in Chinese mills' behavior whereby they prefer lower-grade Australian ore.

At the March 2018 Global Iron Ore & Steel Forecast Conference in Perth, Western Australia, experts from Citigroup, BHP Group and Wood Mackenzie supported the view that Chinese steel mills' preference for high-grade ore and discounts to lower grades was a structural, rather than cyclical, market move.

Fortescue has since maintained that there would be greater demand for its lower-grade product as the issue was cyclical, and events over the past five months have borne out that prediction.

Though Fortescue's US$644 million net profit after tax in the first half of its fiscal 2019 represented a 5% drop year over year, it was still 66% better than the prior quarter.

Fortescue COO Greg Lilleyman told this year's conference March 20 that early in 2018, Chinese mills were "effectively pinching themselves as they were making so much money."

However, lower profitability in recent months caused mills to "change their buying behavior and look towards lowering their input costs when their margins come under pressure."

He showed a chart reflecting both hot-rolled coil steel and rebar steel producers' margins in China plummeting from September to December 2018 to reflect this trend.

Also working in Fortescue's favor are the "rapid declines" in Australian-produced iron ore stocks since about August 2018, which Lilleyman said was "not coincidentally aligned" with the drop in Chinese steel mill profitability for flat products.

He also noted the gradual increase in stocks of Brazilian iron ore at Chinese ports, which again was "not coincidental" given those higher-quality but higher-cost premium products have had lesser demand.

Lilleyman said Fortescue stocks in particular at major Chinese ports have declined significantly in recent months and are now at about half the level they were in mid-2018.

"Not surprisingly, the demand has been outstripping supply and therefore we've seen the natural response," he said, which was the difference, or spread, between low- and high-grade iron ore reducing significantly in recent months.

Lilleyman said Fortescue now finds itself in a position where these factors, along with the overall price of iron ore, particularly into China, "make for some very good settings for the company as we look to our second-half performance."

Pricing and intelligence service Mysteel Global's head of indices, Alina Arnold, told a panel at the conference that iron ore prices were range-bound until September and October 2018, when domestic steel demand in China started falling.

This subsequently hit steel mill margins as they lacked both the "appetite and finance" to maintain the levels they were paying for higher-grade product.

S&P Global Market Intelligence Senior Metals & Mining Commodity Analyst Max Court told the same panel that a "sizable chunk" of lower-grade ore is being "very well received" by steel mills.

He said that while the 62% to 65% iron product market is "relatively stable," albeit having suffered a shock this year with the exit of an estimated 50 million tonnes of production from Vale SA following the Feijao disaster in Brazil, the market for greater-than-65% iron is small and diminishing relative to the rest of the market.

"The improvements in the discount for lower grades is something that we expect to continue now that now you have the scarcity of product" due to the exit of such a large chunk of Vale's production, Court said.

Lilleyman said the narrowing spreads between low- and high-grade iron ore products are unrelated to the Vale incident, which naturally sent prices soaring.

"The spreads were already closing during that period of months leading up to that disaster," he said.

Arnold also believes that the reduced spread between prices for higher- and lower-grade products will continue in the short to medium term but warned that China's steel mills are also "very dynamic" and thus could switch to high-grade product if the price is right.

Joe Maloney, senior economist for the Australian government's Department of Industry, Innovation and Science, said in an interview on the conference sidelines March 21 that the price spread reduction between high- and low-grade products came much quicker than his department expected.

Maloney said that while the mills' profitability may recover in coming months as China's construction sector picks up seasonally, 2019 will be different because the Vale incident has reduced the amount of high-grade ore available.

"This means they're still going to be dependent on the low grade, which would keep the price spread a bit more narrow," Maloney said.