OREANDA-NEWS. Fitch Ratings says that Australia-based Fortescue Metals Group Limited's (BB+/Negative) memorandum of understanding (MOU) with Brazil's Vale S.A. (BBB/Negative) could strengthen its business profile.

Fortescue on 8 March 2016 said it has entered into a non-binding MOU with Vale. The agreement proposes the formation of one or more joint ventures (JVs) for the blending of selected volumes of iron ore from both companies. It also provides a framework for the potential investment by Vale in Fortescue through an acquisition of a minority equity stake on the market and / or investment in current or future mining assets.

Fortescue should benefit from stronger earnings if the proposed JVs with Vale are established, as the company says it could result in up to 30% of its annual output being blended with Vale's high-grade ore, creating a premium product to be sold in China. Fortescue expects JV operations to start as soon as in six months, provided that the MOU receives the requisite approvals from the boards of both companies and regulatory bodies.

Fitch expects Vale could also benefit from this agreement because Fortescue's ores, although lower in grade, have low impurities and strong sintering capabilities. The blend is likely to have stronger demand than if the individual ores are sold separately. The blend should also benefit from Fortescue's lower cost of producing and delivering iron ore into China. However the overall benefit to Vale's larger earnings base is likely to be lower than for Fortescue.

Fortescue's lower production and delivery costs for China are due to significant improvements in its C1 cash production costs over the last 24 months, as well as lower shipping costs because Fortescue is located closer to China - the main market for both companies. However some of Fortescue's cost advantage is offset by the higher quality of Vale's ores, which have a higher grade and lower moisture content, and Vale's sale of value-added products, such as iron ore pellets, which fetch premium prices.

Fitch estimates that at end-December 2015, Fortescue delivered iron ore to China at a cost of USD30/ton after adjusting for moisture and iron ore grade, but before accounting for interest costs and capex. Vale's comparable cost is around USD32/ton. However the gap widens in favour of Fortescue if interest costs and capex are included.