Iron Ore Rally May Hamper, Not Help, Deals in Australia's Pilbara

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Iron ore prices have nearly doubled over the past four months, delighting producers, yet the surge is hindering expansion of iron ore mines in Western Australia, the site of the world's largest known deposit.

Several deals are in the works that could lead to new production of more than 100 million tons a year of iron ore in Western Australia's Pilbara region, which is the size of Spain and supplies nearly 45 percent of global trade in the mineral.

Australia currently exports 480 million tons of iron ore a year.

The biggest obstacle to setting up new mines in the Pilbara is the location - the sea is hundreds of kilometres (miles) away and rail links are few.

Plans by the world's fourth-largest iron ore miner, Fortescue Metals Group, to sell a minority stake in its port and rail unit in the Pilbara could provide the crucial link for at least four companies planning to start or expand production - Atlas Iron, Brockman Mining, BC Iron and Flinders Mines.

(Read More: Fortescue May Sell Multi-Billion Dollar Port, Rail Assets)

But that plan may have been set back by the iron ore price increase, since cash-strapped Fortescue is now under less pressure to sell.

"If you look at Fortescue's monthly cash generation at $160 a tonne, they do not need to sell this," said a resources banker in Australia who declined to be named as he had not spoken to Fortescue on this issue.

The iron ore price collapse last year to around $87 a tonne left Fortescue so cash-strapped it was forced to slash 1,000 jobs, slow its expansion plans, sell some power assets and refinance $5 billion in debt. Since then, iron prices have soared to a 15-month high of $158 before slipping back a bit.

A partial sale of the unit, The Pilbara Infrastructure (TPI), would help Fortescue pare down debt and, with a new owner, allow other miners to access the port and railway line.

The Roy Hill project owned by "Pilbara Princess" Gina Rinehart could also look to use Fortescue's rail line rather than struggling to raise funding to build its own rail line.

Fortescue's rail line is the only iron ore railway built in Western Australia to challenge the stranglehold of mining giants Rio Tinto and BHP Billiton, who have not allowed other miners to use their rail lines.

(Read More: Rio Tinto Output Tops Forecast on Resurgent China)

Besides the iron ore price surge, another factor likely to stymie the deal is Fortescue's insistence on maintaining control over TPI, while buyers would ideally like a majority stake. Losing control of the assets would just complicate Fortescue's integrated mine-to-port operations, two Australian resources bankers said.

"Only if they get an outrageous price will they sell," one banker not involved in the sale said.

Fortescue declined to comment on the status of the sale process.

The ultimate value of TPI would depend on how much a third-party owner will be allowed to charge other miners who want to use the rail line and also on long term forecasts for iron ore prices. Analysts estimate a 40 percent stake could fetch $4 billion to $5 billion.

For the expanding producers, the infrastructure link is crucial.

Flinders Mines says it is talking to international steel makers interested in the company's output, but they need comfort the iron ore will have a path out of Australia.

"We're playing multiple games of chess in multiple locations at the moment," Managing Director Gary Sutherland told Reuters. "We've just got to be patient."

Currency, Volatility

Other obstacles to expansion include the strong Australian dollar, which inflates the price-tag for foreigners eyeing the assets and looking at construction costs, and the increasing volatility of iron ore prices.

No one expects iron ore prices, now around $145 a ton, to hold for long, just as no one expected the market to remain stuck at $87 a ton, the three-year low hit last September.

All the rally has done is highlight the volatility of a market that now depends on daily trades, rather than annually negotiated contracts, to set prices, and makes it harder for buyers and sellers to agree on asset valuations.

"It just adds to the complexity of trying to figure out what a long-term price might be," said Grange Resources Managing Director Richard Mehan, which is looking for partners for an iron ore project outside the Pilbara region.

Bankers hope mergers and acquisitions in the mining sector, which shrank 56 percent to $19 billion last year, according to Thomson Reuters data, to pick up this year, as share prices on potential targets have come down and Asian steel makers like China's Baoshan Iron & Steel (Baosteel) and South Korea's POSCO are still looking for assets.

(Read More: China Iron Ore Output Hit by Harshest Winter in 30 Years)

But along with currency and commodity price volatility, an uncertain outlook for steel demand is holding back buyers. Demand growth from China, the world's top steel consumer, is unlikely to be brisk given an economic recovery that could be tepid, and demand elsewhere remains uncertain.

"There has to be more confidence in the outlook of steel producers," said a Hong Kong-based resources banker.

"The bid-offer spread, the valuation gap is just going to be too large to close given the current environment."