Banks Betting On Iron Ore?

by: Seth Walters

Today I am going to give you an update on what has been going on with iron ore since the last time I wrote about it (submitted before the NYSE opened on Sep 7th). At a time when every analyst as far as the eye could see was prophesying doom and gloom for iron ore, I went out on a limb and made a bullish call, due to the latest Chinese infrastructure stimulus. Though my target price of between $120 and $150 a ton by the end of this year has not yet been reached, we are moving rapidly in that direction, and I am confident iron ore will spend some time within this range, despite a certain recent event.

The event of which I speak is the propping up of a certain struggling iron ore producer known as Fortescue Metals Group (OTC:FSUMY) by a couple of banks called JP Morgan (NYSE:JPM) and Credit Suisse (NYSE:CS), who recently agreed to extend FMG a $4.45 billion credit line to refinance some of its existing debt and extend it some new capital too. Fortescue is infamous for planning to triple iron ore production of ~50M tons in 2012 to over 150M tons in 2013, and this into a seaborne iron ore market of just 1.09 billion tons in 2012.

Bear in mind that FMG is not the only iron ore miner that wants to make more money by expanding production, but they are certainly the only one that thought they could triple production in a year and get away with it without suffering huge losses. They have recently scaled back this planned tripling of production to "only" a doubling, due to the sharp plunge in iron ore. To achieve such an expansion, Fortescue has had to take on massive debt leverage (FMG is currently sitting at a cool 56.44% debt to assets and 225.97% debt to equity according to Google Finance).

The recently plunging price of iron ore prompted FMG to seek relaxation of its covenant restrictions from its lenders, which prompted a sharp fall in the share price and a suspension of trading of FMG stock, as shown in the chart below. A failed or severely weakened FMG would clearly take a lot of supply weight off of China's future demand for iron ore, and I suspect that that was a good part of the reason why Cliff's Natural Resources (NYSE:CLF) and other iron ore producers such as BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO), and Vale (NYSE:VALE) were rallying strongly lately. When it became clear that FMG would not fail in the near future, the strong price rises of iron ore stocks turned into a pullback, even in the face of a strongly rising iron ore spot price and Shanghai rebar futures price. This happened as of this Monday. Note that at this time, trading in FMG shares was still suspended.

While it is impossible to conclusively attribute market moves to any one piece of news, the evidence is here that news of the JPM and CS rescue deal of FMG likely gave the rest of the iron ore industry a bit of a kicking, even in the face of a rapidly rising iron ore and rebar price.

With FMG boosted back up to move ahead with their still massive production expansion plans like a charging bull once more, the situation is a little bleaker for everyone selling iron ore into the seaborne market, because as big as that Chinese iron ore demand lifeboat is, and as much as it has been growing, there is only so much it can hold in a given year without sinking under the weight of huge supply.

This situation is especially interesting in light of the fact that as an investment bank JP Morgan also has an analyst division. And that, two days ago, JP Morgan downgraded CLF. Note the timing. Since the fall of the Glass-Steagall Act, it has been possible for banks to both influence the market by lending, as JP Morgan and Credit Suisse have done by propping up FMG, and to bet for or against the market via a whole variety of options, short selling, futures, derivatives, and all manner of contracts. This puts the truly large financial institutions in a position to place their bets and then help them come true. A pretty sweet deal if you ask me.

I have no idea if JP Morgan and/or Credit Suisse have shorted iron ore securities or the iron ore market by any innumerable manner of contracts or derivatives. But they could, and it could make sense for them to do so in light of the fact that their lending division is helping to boost the supply end of this market by supporting the expansionist and heavily debt leveraged FMG when it was in trouble. If something like that is going on here, then the banks win either way. If FMG succeeds, then the investment banks would be likely to win on their possible short positions as that Chinese iron ore demand lifeboat I mentioned will get loaded down with more millions of tons of supply than it can easily bear, and iron ore prices will be depressed.

If FMG fails, as the iron ore lifeboat of Chinese demand is sunk by the weight of excess iron ore supply, JPM and CS have a claim against FMG's assets, AND they would also win on any possible short positions. Either way, the banks, the steel industry and various downstream industries are the winners of this move. Given that FMG's entire future existence is levered against a long term bullish recovery in the iron ore price, I don't know that I would call them a winner here, but at least they are still alive and able to keep operating now. The iron ore industry as a whole is obviously going to lose some margin due to having a stronger Fortescue participating, due to the law of supply and demand.

However, if Fortescue's bullish iron ore projections prove to be correct, then perhaps the industry will continue to have a strong future in the long term after all. Given the doom and gloom that has been permeating this industry lately, it is interesting that JP Morgan and Credit Suisse would be interested enough in FMG's assets to ACCEPT them as collateral for their massive loan, especially when you consider that the great bulk of Fortescue's assets consist of mineral rights and some rail and mining infrastructure dedicated to turning those mineral rights into lots of seaborne iron ore.

To me, this suggests that the banks may be making a large bet that those assets will not become marginal in the future but will continue to be worth a lot. Ironically enough, this decision on the banks' part might even be bad for iron ore companies but good for the global economy overall in the long run, as it should lower the cost of raw materials inputs. It's awfully easy to be able to see the future when you have the ability to make your predictions come true by moving a few billion dollars here and there, and JPM and CS seem to have decided to do this with the iron ore industry

Disclaimer: The above represents my analysis of publicly available information about the iron ore market. I am predicting that FMG is exceptionally risky, that the whole iron ore industry now has less upside because FMG was not allowed to fail (in proportion to how high on the cost curve the producer is, probably), that the steel industry and other downstream industries will benefit financially from lower raw material input costs, and that JPM and CS are going to win on this deal no matter what happens. This article should not be taken as a sole reason to buy or sell any security or position, as you should do your own due diligence before investing.

Disclosure: I am long CLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.