For a succinct explanation of why Vale and Fortescue Metals are setting up a joint venture to sell some 80 million to 100 million metric tons of iron ore a year, your first stop should be the British-Irish sitcom Father Ted.
Father Ted [holding two toy cows]: OK, one last time. These are small. [Points out window.] But the ones out there are far away. Small. Far away. [Father Dougal shakes his head.] Ah, forget it.
Vale's iron ore deposits are far from their target markets in China. The iron content of Fortescue's ore, on the other hand, is too small to attract the best prices. From the perspective of a Chinese steelmaker, the two look pretty much the same. That means both Vale and Fortescue get less cash in return for their product.
The most widely used iron ore benchmark tracks the price of rock with a 62 percent iron content and all transport costs paid to Qingdao port in China's Shandong province. Fortescue's main product is a 58 percent iron ore that prices at a discount to the benchmark, but it costs just $3.50 a ton to ship the metal from its mines in northwestern Australia. Vale's is a higher-quality ore that attracts a premium price, but the journey from near the mouth of the Amazon round Africa and through Southeast Asia drives the freight cost up to $14.10. Strip out the effect of royalties and expenses, and Chinese buyers of Vale's iron ore are spending more money on shipping than on the metal itself.
By blending a share of the two companies' products in Chinese ports, Vale and Fortescue hope they can minimize their respective shortcomings compared with BHP Billiton and Rio Tinto, whose product is better-quality than Fortescue's and closer to China than Vale's.
Vale, which would have spent about $4.7 billion last year on freight based on its year-end costs and 333 million metric tons output rate, will only need to ship 50 to 60 percent as much ore as it would without the joint venture. Fortescue will be able to offer a better product to loss-making Chinese steel mills that are paying more attention than ever to their input costs.
This may not seem like a day for miners to be scrimping for cents on the ton in this way. That benchmark price jumped 19 percent yesterday to $63.74 a ton, the highest level since June and well above both miners' costs. Fortescue Chief Executive Officer Nev Power described that as an overdue return to normality in a call with journalists Tuesday -- but you wouldn't expect someone in the business of selling iron ore to say anything else.
A more likely explanation, according to Gadfly's Liam Denning, is that such a violent move is the result of short-covering by traders after after China's National People's Congress said it was prepared to increase the budget deficit to buttress higher economic growth. It's notable that coking coal, a key steelmaking input that has a less-developed futures market than iron ore and steel products, isn't showing the same level of exuberance:
The benefits from the Vale-Fortescue joint venture, and a possible opportunity for the Brazilian company to take a 15 percent stake in Fortescue, are longer-term. At a time when China's steel industry is retrenching -- mills had been losing money on every ton for nine months until this week's price surge put them back in the black, according to Bloomberg Intelligence's Kenneth Hoffman -- producers will look for the product that maximizes their chances of breaking even.
Power refused to be drawn on how he hoped the market would value the Vale-Fortescue blend relative to products like Rio Tinto's Pilbara blend and BHP's Newman and Yandi fines, but if it can get a better price, then the current losers among the big four iron ore miners could leapfrog the leaders. That's worth much more than a one-day price surge.
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