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Fortescue's low discount dream evaporating, analysts say

There is a slim chance that Fortescue Metals Group Ltd.'s hoped-for retraction in discounts for its lower-grade iron ore could play out but the likelihood is more pain going forward as both S&P Global Market Intelligence and CRU believe the capacity removed from Chinese supply is permanent.

S&P Global Market Intelligence Senior Commodity Analyst Max Court expressed "very little surprise" that Fortescue now realizes 65% of the 62% iron ore price.

This implies average discounts of 35%, which is a worrying increase from 32% in the fourth quarter of 2017 when Fortescue reportedly realized 68% of the 62% iron ore price. Court believes that the news merely adds to the evidence that the lower-grade discounts are structural.

He noted that the Shanghai Futures Exchange rebar futures fell along with rebar margins and iron ore prices, while the discounts on lower-grade material widened.

"A greater percentage off a lower price illustrates how difficult it is for lower-grade producers to claw-back a dollar-per-tonne discount within their contracts," Court said.

All eyes are now on Fortescue's next quarterly report, but whatever the case, Court believes this issue represents a structural component to the Western Australian miner's prices.

Fortescue CEO Elizabeth Gaines, however, is defiant. In an article published March 27, the executive resisted The Australian Financial Review's suggestion that the higher discounts would be the company's new normal.

"This is not the new normal. We have reiterated our guidance around 70% to 75% price realization and we expect that coming out of the winter-mandated production shuts in China that there will be an increase in demand for our high value-in-use ores," the report cited Gaines as saying.

Sydney-based CRU senior iron ore consultant Adrian Doyle believes China permanently removed 65 million tonnes of steel making capacity in 2016 and 55 million tonnes in 2017, plus an estimated 140 million tonnes of induction furnace capacity, which means the country's steel industry has moved into a sellers' market.

"Those changes effectively made blast furnace operators in China value productivity at the blast furnace stage much more," he told S&P Global Market Intelligence.

"Exacerbating the situation are the high level of low-grade stocks sitting portside in China, as well as the winter heating season cuts which removed another large amount of capacity from northern cities."

Asked whether this meant more pain in store for Fortescue, he simply stated his belief that the removals of capacity are permanent, albeit with the possibility for some creep in the next couple of years with some more steel mills being built.

Yet CRU still expects China's net capacity to come down, and that smaller capacity base is a structural change, which means the conditions are more conducive to higher discounts for lower-grade ore.

Fortescue re-iterated its expectation on March 27 that its price realization as a percentage of the Platts 62 CFR index will increase — a belief the miner says is supported by an expectation of strengthened demand for lower iron content ores as steel mill margins moderate and end users look to lower their raw material input costs.

Doyle said that while there was a chance of this eventuating, it would take a move away from profitability among the Chinese steel industry, and at this stage it's making quite good margins.

"Having said that, the ore prices have come down quite considerably in the last few weeks, as well as raw material prices, so that could be an indication that perhaps there hasn't been as much a pick-up in demand than was expected," Doyle said.

"We would say that the narrowing of those discounts is not probable, but it's certainly possible.

"If demand were to fall and China's steel industry moves away from profitability and starts being loss making, then we could go to a situation we saw in early 2016 when Chinese steel mills effectively didn't buy for the productivity of the ore, so the discounts were extremely narrow.

"But given so much capacity has come out of the system since then, it's much less likely in our opinion for that to happen … it's much more likely we'll see much wider discounts than historical averages, in the future."

Patersons Securities noted March 29 that Chinese iron ore prices continued to trend lower in Asian markets on March 28, with the 62% content fines price now hovering around the US$65/tonne mark.

"Reports were circulating that demand for the raw material from steel mills was still soft," Patersons said.