At the same time, we raised the rating on the company's senior secured to 'BBB-' from 'BB+', and the rating on the senior unsecured issue to 'BB-' from 'B+'. The recovery rating on the senior secured debt issue remains at '2' and the recovery rating on the senior unsecured debt remains at '6'.
The upgrade on Fortescue follows the company's announcement of a further debt reduction of US$1 billion in December 2016. Once completed, this will bring total debt reduction to date for the year ending June 30, 2017, to around US$1.7 billion, generating an interest saving of US$64 million.
"We consider the additional debt repayment has strengthened the company's resilience to iron ore price pressure, enabling Fortescue to maintain credit metrics commensurate with the 'BB+' rating level even under a moderate stress scenario," said S&P Global Ratings credit analyst Sam Heffernan.
In our opinion, the company's credit metrics are still sensitive to iron ore prices. However, we believe the additional debt repayment has provided sufficient buffer for Fortescue to withstand moderate volatility in its key earnings drivers: iron ore prices; wider spreads between the company's average 58% iron (Fe) ore blend compared with that for 62% Fe blend; or an increase in C1 cash costs (production costs excluding administration, marketing, and freight expenses) beyond our expectations. In our view, the company can maintain the current credit profile should iron ore prices (62% iron [Fe] Platts delivered to China) fall to US$40 per ton (assuming an 85% realization rate for Fortescue's products), a level below our current price assumption.
We expect Fortescue to continue reducing its production costs to between US$12 and US$13 per wet metric ton (wmt) though fiscal 2017, due to further operational efficiencies the company has identified. We forecast its all-in breakeven costs would be about US$30 per dry metric ton (dmt) at the end of fiscal 2017. These costs include interest expense and sustaining capital expenditure on a 62% Fe Platts price incorporating delivery costs to China.
With the sustained and our expected decline in the company's costs, Fortescue is at the lowest end of the seaborne cost curve including delivery to China. The company's production costs could be the lowest among its peers', although margins are affected by the grade adjustment on Fortescue's average 58% blend versus 62% Fe Platts. Nevertheless, Fortescue's lack of commodity and geographical diversity means the company is highly sensitive to economic growth in China, particularly compared with more diversified peers such as Rio Tinto PLC and BHP Billiton Ltd. We continue to assess Fortescue's business risk as satisfactory, based on the company's large-scale iron ore production, competitive cost position, and long reserve life. Tempering these strengths is the company's lack of commodity and geographical diversity.
Mr. Heffernan added: "The stable outlook reflects our expectation that Fortescue will operate within its financial policy and that its growth strategy will remain unchanged."
We expect the company's funds from operations (FFO) to debt to be higher than 30% and debt to EBITDA to be lower than 3x when industry conditions are conducive.
In our opinion, Fortescue's credit metrics have sufficient headroom at the current rating level to withstand moderate downside risk in iron ore prices should external pressures intensify. This includes our expectation of slower demand growth from China's steel industry amid a continued increase in the supply of low-cost seaborne iron ore.
We could lower the rating if Fortescue's key credit metrics weaken such that the company's FFO to debt falls below 20% or debt to EBITDA approaches 4x. This scenario could occur if benchmark iron ore prices fall below US$40 per ton for a prolonged period (assuming an 85% realization rate for Fortescue's products), and the company fails to offset this through deeper debt reduction or further cost savings. Further rating pressure could occur if the company undertook aggressive capital management that in our view would undermine the current financial policy of 40% of gross debt to total capital or reduces the buffer in credit metrics to withstand lower iron ore prices.
We view the prospect of further upward rating action as remote due to Fortescue's limited customer, geographic, and product diversity. Typically for a single-commodity producer in the investment-grade category, the company would have financial policies that support credit metrics in line with that category, as well as developing a track record of its ability and willingness to support a business at the investment-grade rating level throughout the cycle.