What soaring iron ore prices will mean for Fortescue

Growing supply problems in Brazil mean today's soaring iron ore prices could last for longer than many expect.

In Brazil, the world's largest supplier of iron ore, Vale, is in trouble for the state of its tailings dams.

A recent review found that many of Vale's 50 or so dams were below standard but about 17 were in such bad condition that their stability couldn't be guaranteed.

The company has halted operations on at least 10 dam sites and many more are at risk. An important part of the world's iron ore supply is now under threat.

The world's other great iron ore basin, the Pilbara, is unlikely to be able to replenish Brazilian supply.

Iron ore prices, which are touching $US100 a tonne, could stay elevated for years while the dam situation in Brazil is sorted out.

In this environment, Fortescue has announced a new high-grade project. The Iron Bridge magnetite project will produce modest free cash flow at budgeted iron ore prices but sensational returns at spot prices.

It also lowers overall risk as higher grades from the deposit offer blending potential that could raise margins across the business and reduce vulnerability to lower-grade iron ore.

Yet it is the potential Brazil deficit that has propelled the share price.

At spot prices, Fortescue could be worth about $14 a share, about twice the market price. The large gap between theoretical value and market price suggests market scepticism that current iron ore prices will hold. With widespread and intractable infrastructure woes in Brazil, today's prices could, in our view, hold for years.

Of course, this is one outcome among many, but we judge it to have a reasonably high probability. Even after doubling, Fortescue could still be cheap - not cheap enough to buy but it does warrant a change in our price guide.

We're raising our buy price from $4 to $5 and our sell price from $6 to $9.

The possibility of a larger than expected gain is now present. Our recommendation moves from sell to hold but we still suggest reducing your exposure and holding less than our maximum portfolio limits. HOLD.

The author holds Fortescue Metals after selling half his holding.

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