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UPDATE 3-Australia's Aquila fights to trim $7.6 bln cost of iron ore project

* Firm says project costs soar by a quarter just as China demand falls

* Aquila says could save A$2.3 bln by outsourcing port, rail * Aquila and partner also need to resolve budget dispute * Counting on Chinese funding

* Australia's $250 bln pipeline of planned mine investments looks on shaky ground

(Adds detail on cost spike, recasts)

By Sonali Paul

MELBOURNE, Oct 8 (Reuters) - Aquila Resources is scrambling to cut planned spending on an Australian iron ore project after cost estimates jumped a quarter to A$7.4 billion ($7.6 billion), putting the investment at risk in a sector squeezed by cooling Chinese demand.

Aquila aims to build a mine, rail and port in Western Australia with annual iron ore production of 30 million tonnes, but its half-owned project is under pressure due to weak Chinese steel demand, soaring capital costs and a strong local dollar.

The West Pilbara Iron Ore project is one of the biggest in a $250 billion pipeline of planned mining investments in Australia that may be frozen or delayed as bankers get nervous about the outlook for iron ore and coal, and escalating costs.

Iron ore prices hit a three-year low of $86.70 a tonne last month before reviving slightly, forcing miners from the world's largest BHP Billiton down to the smallest to review their investment plans.

In an effort to cut capital spending, Aquila said on Monday studies had identified up to A$2.3 billion of possible savings by outsourcing the operation, ownership and funding of such tasks as ore processing, rail freight, ports, power and fuel.

Handing over those elements to other investors would add about A$15 a tonne in operating costs, currently estimated at A$24.20 a tonne, Aquila said, adding that no decision had yet been made on the recommendations of its capital spending study.

Aquila said the cost of the project, previously estimated at $6 billion, had risen due to a general rise in costs since the previous estimate in 2010 and because of changes in plans for the new port by the Western Australian state government.

Australia is the world's biggest producer of iron, but a failure to get Aquila's project off the ground would mean a big chunk of ore supply could be left stranded with BHP and Rio Tinto maintaining a lock on rail lines in the area.

The project's progress has been slowed by delays in approvals and financing, compounded recently by the fall in iron ore demand and prices.

It has been further set back by a dispute between Aquila and its partner AMCI (WA), a joint venture between private mining investment and trading group American Metals and Coal International (AMCI) and steel giant POSCO .

They had been in talks to conserve funds but the partners were unable to agree on a budget for the 2012/13 financial year, a dispute that now needs to be resolved by an arbitrator and could result in one of the partners being bought out.

More than A$460 million has already been spent on studies, design work and state and federal approvals.

Aquila has around A$500 million in cash and no debt. It has been shedding assets, including a stake in a coal mine that was its only producing asset, to raise funds to help cover its share of the iron ore project, on which it hopes to begin construction in mid-2013.

COUNTING ON CHINESE FUNDING

Aquila, 14 percent owned by China's biggest listed steelmaker, Baoshan Iron & Steel Co , has been counting on China Development Bank to help fund the project.

To line up that debt funding, Aquila has to be able to show that the port for exporting the ore will be built.

China Development Bank is reluctant to sign off on mine funding in light of the long delays and cost spikes that other Chinese iron ore projects in Australia have faced, including CITIC Pacific's Sino Iron project. Costs on that mine have more than tripled to $8 billion.

Final environmental approval from the state of Western Australia for the port, a key hurdle, is expected before the end of this year, Aquila said.

The state had been encouraging joint development of the proposed port, Anketell Point, involving Aquila and Australia's No.3 iron ore miner Fortescue Metals Group , but debt-laden Fortescue has slowed its expansion plans and does not see a need to use Anketell Point in the next few years.

The initial plans are for Anketell Point to have an annual capacity of 115 million tonnes, eventually expanding to 350 million tonnes, and the state is eager to ensure whoever wins the rights to build it will have the funding.

Lining up third parties to fund construction of the port could help secure the state's go-ahead.

The West Pilbara Iron Ore project already has preliminary approval for a 282-km railway, which it needs to build as it will not have access to existing railways in the area, owned by the world's No.2 iron ore miner, Rio Tinto.

Shares in Aquila fell 1.1 percent to A$2.65 in a slightly softer market, having tumbled from a 12-month high of A$6.83 in December.

($1=0.9767 Australian dollars)

(Additional reporting by Lincoln Feast in SYDNEY; Editing by Ed Davies and Clarence Fernandez)

((Lincoln.Feast@thomsonreuters.com))

Keywords: AUSTRALIA AQUILA/IRONORE