Fitch Ratings: Eliwana Raises Fortescue Flexibility Amid China Demand Shifts

(The following statement was released by the rating agency) Fitch Ratings-Sydney/Singapore-November 25: Fortescue Metals Group's development of the Eliwana iron ore mine in Australia's north-west Pilbara region is likely to support the company's profit margins, enhance its competitiveness and help it to retain market share over the longer term, say Fitch Ratings and CRU. In particular, the mine will improve Fortescue's production flexibility, allowing it to produce higher grade ore and adjust to both cyclical and structural demand shifts in China's steelmaking industry. China's steel sector reforms since 2015 have eliminated over 250 million tonnes of capacity, initially removing excess capacity within the system and then capacity not complying with environmental recommendations. This increased capacity utilisation to above 85%, from 70%-75% and, when combined with elevated steel profit margins, led to higher demand by steelmakers for high-grade iron ore, as premium input materials improve steelmaking productivity and allow them to maximise output and profits. This shift in Chinese demand has widened premiums and discounts for various grades of iron ore relative to benchmarks, with negative implications for Fortescue, which has historically produced a lower grade product than its competitors. Fortescue's price for its average 58% blend was 36% below the benchmark price (62% Fe Platts CFR Index) in the financial year ended 30 June 2018 (FY18), for example, compared with 23% in FY17. This discount for lower grade ore is likely to lessen over the medium term as steel profit margins return to more normal levels. However, we do not expect a return to the historical average discount of around 15% for the 58% Fe blend, as some of the increase in the discount is driven by structural factors - including environmental controls. The development of the Eliwana mine, which will replace production at the company's Firetail mine, has improved Fortescue's production flexibility and will allow the company to introduce a 60% Fe content blend - its West Pilbara Fines blend - from the first half of the 2019 calendar year. Volumes of the higher-grade blend will be limited initially to 5-10 million tonnes (Mt) per year from existing operations until Eliwana comes on line in December 2020, with production ramping up to 40 Mt per year. CRU estimates that the shift could boost Fortescue's revenue by USD400 million per year, based on its assumption that 60% Fe iron ore will be priced USD16.7/tonne higher than Fortescue's signature 58% blend in 2022. The increased production flexibility provided by Eliwana is reflected in its position on CRU's business cost curve, which adjusts for grade and price realisation (see chart). Fortescue is already one of the lowest cost producers in the world, which has supported its profitability and cash flow generation even in the face of lower price realisation - and we expect the development of Eliwana to allow the miner to retain this position over the longer term.