https://www.engineeringnews.co.za

Mining majors prioritising value over volume as profits, valuations sag

4th April 2014

By: Henry Lazenby

Creamer Media Deputy Editor: North America

  

Font size: - +

Bruised and battered, the global mining industry today is undergoing a sea change. Practices and policies that might have worked wonders in the past are not as relevant today, and new approaches to running profitable mining operations need to be found.

Many mining majors, across all commodity groups, are currently grappling with sagging profits and low company valuations. This is often regarded as the result of the industry’s ‘sins’ of the past, when companies were in pursuit of growing their output at all costs in a high commodity price environment.

Professional services firm KPMG’s national industry leader for mining in Canada, Lee Hodgkinson, says it seems clear that some of the traditional approaches to the mining business are simply not working anymore.

Following the firm’s latest Annual Mining Executive Forum, he said that an often-expressed notion is that “$800/oz gold looked amazing on the way up, but $1 200/oz gold at this time is not nearly as positive”.

“The runaway costs of building and operating mines have almost squeezed out profit margins. Lower grades of ore are inflating production costs. Mining companies need to look at the business with fresh eyes, and develop strategies to attract equity capital.

“Companies continue to struggle with market valuations and cost control. They are trying to find the right balance between optimising current operations and preserving their agility to grasp future opportunities. As investors increasingly look at the quality and depth of management as the number one factor in making an investment, CEOs and CFOs are facing tough questions from their shareholders and their boards,” Hodgkinson says.

FROM HIGH HIGHS TO LOW LOWS

Barrick Gold president and CEO Jamie Sokalsky agrees, pointing out that despite global demand and prices for many metals slumping, gold topped $1 800/oz in August of 2011.

“At that time, none of us fully comprehended the impact of a trend that would play out over the next couple of years,” he says.

Valuations for gold companies have eroded substantially. This has occurred despite the gold price remaining historically high and its under- lying fundamentals still remaining strong.

He notes that part of the reason for this is the ability of investors to buy the gold exchange- traded funds (ETFs) as an alternative to gold mining equities.

“However, the gold ETF is really a litmus test for the way we create value as gold mining companies. As an industry, we brought on many of our own problems by following an old axiom: produce more when the price is high,” Sokalsky says.

With a rising gold price, gold companies began to chase more marginal ore at existing mines and develop low-grade projects in more remote parts of the world where infrastructure is lacking, project costs are high and resource nationalism is more prevalent.

Many investors did not want to take on those risks – not when they could directly invest in gold through the gold ETF.

Sokalsky points out that the industry is only now beginning to recognise that the single-minded pursuit of production was destructive to margins and valuations.

Under the leadership of Sokalsky, Barrick more than a year ago adopted a strategy to guide its capital allocation decisions, underpinned by a simple mantra – “returns will drive production, production will not drive returns”.

That means shelving higher-risk, lower-return projects, concentrating on cost reduction and focusing on free cash flow instead of production.

If the gold price should ever revert to historic norms, gold mining equities may naturally become more attractive than the gold ETF.

“Nevertheless, the industry cannot forget this lesson we have learned, and we must now outshine our own product in the competition for investment capital,” Sokalsky says.

House Mountain Partners founder and coauthor of Morning Notes Chris Berry, in a recent research piece, notes that the mining boom in the first decade of the twenty-first century added a great deal of capacity by way of not just mining infrastructure, but also reserves and resources of a number of commodities. Conversely, the fall in metals prices, from gold, to rare earths, to silver, to graphite has rendered much of this investment worthless at current prices, calling for massive write-offs.

Recent months saw many commodity prices settle at levels above their historic averages; however, these were offset by costs rising just as much.

Berry argues that there are several issues the industry must deal with at this point in the commodity super cycle.

He points out that it is clear that the days of China’s increasing appetite for a host of commodities are over, or at least paused. Companies across all market capitalisations have written down the value of assets, sold properties at a discount and instituted strict cost discipline going forward.

Despite China’s reduced appetite for commodi- ties, Berry says he does not believe China is headed for a ‘hard landing’, but gives China’s leadership credit for at least acknowledging the necessity for a slower, more sustainable brand of growth.

Owing to China’s great size and scale, which is why so many analysts and investors focus on the country, a careful study of the growth dyna- mics of countries such as Indonesia, Poland or Colombia would be prudent going forward as it is ostensibly countries such as these which will fill a demand void left by China.

China’s biggest listed steelmaker, Baoshan Iron & Steel, in March complained that iron-ore prices were still too high, given weak demand and government efforts to close outdated and polluting mills.

But big iron-ore miners such as Fortescue Metals Group, Rio Tinto and BHP Billiton say Chinese demand will not peak until around 2025, at about a billion tonnes a year. The big miners have room for manoeuvre with landed prices to China at about $50/t, but further falls could land some higher-cost miners in trouble.

Berry further notes that geopolitics is set to play an increasingly important role in the mining industry. The crises in Ukraine and Venezuela bring this issue to the fore, compounded by issues such as slowing growth and inflationary pressures in emerging markets, and resource nationalism, which appear set to provide investment opportunities but also to wipe out unsuspecting or careless resource investors.

CREEPING COSTS

KPMG’s Hodgkinson stresses that the frequency and extent of capital cost overruns in the mining industry is well documented.

The last year was characterised by several significant mining projects stalling, and soaring project costs. The year saw several billion-dollar project write-downs and impairment charges, mainly driven by significant decreases in long-term metal price assumptions following the sharp declines in spot gold prices in the period.

Examples include Barrick’s roughly $8.5-billion Pascua-Lama copper/gold project straddling the Argentine/Chilean border, where the Chilean environmental regulator suspended the controversial investment last year, citing “severe environmental harm”, as prestripping activities had begun before water protection infrastructure was finished, threatening the local water supply.

Also, fellow Canadian miner Goldcorp’s $3.9-billion El Morro copper and gold mine, also located in Chile, was blocked. An indigenous community said it was not properly consulted about the project, which it said was located on sacred ancestral land and could pollute a local river.

Vale, the world’s largest iron-ore producer, in February announced that it would continue austerity measures this year even as the outlook for prices and sales volumes was improving, its CEO Murilo Ferreira said.

The company says it will also continue efforts to sell underperforming units and control investments as it sharpens its business focus on iron-ore, responsible for about three-quarters of its revenue and nearly all its profit.

“Today, it is not uncommon for companies to delay or even cancel capital projects because costs are spiralling out of control. Although the reasons for these cost overruns are both complex and intractable, the mining industry must regain the confidence of financial markets by finding ways to deliver on large capital projects,” Hodgkinson says.

Throughout this century, mining companies have been riding the ‘super cycle’ of higher commodity prices supported by demand from emerging markets; however, most miners now find that these benefits have been eroded by out-of-control cost inflation. Virtually every major mining company has announced a programme of aggressive cost reduction to help widen margins and restore profitability.

Hodgkinson notes that the ‘80/20 rule’ was applied to most of these programmes – companies have targeted exploration expenditures and indirect costs as easy cutbacks.

“To preserve the long-term health of the business, the remaining cuts will require more effort and different ways of thinking about the business. Realistically, companies must truly understand the nature of their cost inflation if they are going to peel back costs in a sustainable manner.

“To do this, they must get very granular in the way they view their cost structures, and take a hard look at how much their cost inflation relates to lower-grade ore, price inflation, or loss of productivity,” he argues.

TOUGH MONEY

The big miners are also dealing with tough capital markets. Many mining companies are wrestling with contradictory pressures as they pursue capital to operate and expand their businesses. There is reluctance to raise equity capi- tal in prevailing market conditions owing to any new offering diluting the holdings of current shareholders.

“The unwillingness to pursue equity has caused many major and intermediate companies to tap into the debt markets, which has leveraged their balance sheets and increased their exposure to interest rate and liquidity risk. Most companies are also trying to generate working capital from within and are taking a hard look at capital allocation,” Hodgkinson says.

Some of the larger companies that had increased dividends in better years are now reassessing. Despite still being committed to returning capital to shareholders, they are also focused on balance sheet strength and judging their ability to protect against so-called ‘Black Swan’ events, all while staying agile enough to grasp opportunities.

Mining companies need to fully understand the potential impact of macro and micro events that could be caused by sudden, severe change in market conditions, commodity prices, costs, foreign exchange rates, interest rates, production shutdowns, global economic conditions and/or resource nationalism.

A truly damaging Black Swan event, Hodgkinson says, could involve a combination of these issues.

“That is why better-managed mining companies are running scenario analyses to understand the impact of sudden shocks on future cash flows, bank covenants and the overall strength of the balance sheet. Using a prudent approach based on robust risk-management practices, they are developing contingency plans to handle a variety of situations that could arise over the coming years, and developing finance strategies to meet a variety of situations,” he says.

Not surprising, mining companies by default make money by extracting and processing ore; however, the most successful companies have always sought to grow by doing more and more of these activities, and doing it better than the competition.

MORE MERGERS?

Hodgkinson notes that the mining industry has now entered into an unusual period where growth has almost become a “dirty word”.

However, conditions are ripe for more hostile takeovers in mining as buyers capitalise on share prices that plunged last year, while targets hold out for more amid a glimmer of recovery.

There have already been four unsolicited or hostile bids for mining companies announced this year, with a total value of $4.54-billion, compared with $594.4-million for the whole of 2013, according to data compiled by Bloomberg.

Despite 2013 having seen the number of mergers and acquisitions dwindle, 2014 kicked off on a high mergers and aquisitions (M&A) note, with Vancouver-based Goldcorp’s C$2.94-billion offer for Osisko being the largest unfriendly bid for a mining company since First Quantum Minerals bought Inmet Mining for $4.7-billion in November 2012.

Hudbay Minerals in February also announced a C$540-million all-scrip hostile takeover offer for US project developer Augusta Resource Corp.

While the major miners are busy restructuring their balance sheets, PwC’s ‘2014 Global Mining Deals Outlook’ predicts a notable uptick in joint ventures (JVs) this year.

As opposed to assuming all the risk associated with financing a project, mining companies are using JVs as a way to derisk their projects. Canadian diversified miner Teck Resources CEO Don Lindsay says that the company is always looking for high-quality, sustainable growth opportunities that align with its business objectives. “We’re open to partnering if the fit is right,” he says in the report.

Meanwhile, many majors are expected to remain sellers of assets, and more midtier companies are expected to step up and become active buyers this year. Gold Fields senior VP Brett Mattison notes that history has shown that the midtiers are probably slightly more aggressive.

PwC also expects to see an increase in earn-in-type arrangements in the junior sector, which is positive from an exploration perspective and should help increase juniors’ valuations moving forward. “Now is the right time to build a portfolio of partnerships with junior exploration and development companies,” KGHM International CEO Derek White told the report’s authors.

For the foreseeable future, access to equity capital depends on placing shareholder value creation ahead of production growth.

Nevertheless, the business has not changed so much that companies no longer need a pipeline of growth opportunities for the future.

“As part of the overall strategy and planning process, companies need to identify which kinds of opportunities will give them the best chance to succeed. Some of the criteria may include the scale of projects, the ideal jurisdictions relative to existing operations and resource nationalism, and their familiarity with the type of mining and processing of the ore,” Hodgkinson says.

Further, the interest that private equity is starting to show in the mining industry suggests that the current adverse climate has opened up a window of opportunity.

PwC says new mines coming into production are providing companies with more money to fund activities such as M&A. Also, the companies’ development teams that have just finished bringing these mines into production are ready to work on new projects.

All of this should help to spur M&A in 2014.

Hudbay Minerals CEO David Garofalo says: “It is the process of drilling out new reserves and derisking mine projects through construction that creates all the value in our industry.”

He argues that for the industry to attract investors, companies need to make decisions that will provide investors with leverage to the commodity price.

RISING NATIONALISATION

Another increasingly relevant issue mining majors the world over have to deal with is the ever-present spectre of resource nationalism.

Deloitte’s national mining leader in Canada, Jürgen Beier, points out that local community demands in many areas are ramping up, as are governments’ increasing demands for a bigger share of the pie.

Governments demand contributions from the mining sector in the form of taxes, royalties and other concessions and mining companies have to improve government relations, while governments need to foster greater regulatory stability.

Examples could be found in Barrick’s Pueblo Viejo project, in the Dominican Republic, where the government demanded more revenue; in the Australian mining tax regime that is characterised by some analysts as “moving back and forth”; in Zambia’s increased mining taxes; and even Quebec’s efforts to extract more taxes from the resources sector.

Hodgkinson notes that, in developing countries, mining nationalism can take the form of expropriation, compulsory co-ownership, or erratic and irrational shifts in legislation and regulation governing taxes, royalties and licences. In developed countries, such as was most recently witnessed in Canada and Australia, resource nationalism usually takes the form of policy changes to raise taxes and/or royalties, or decisions to forbid foreign acquisitions.

“[Despite] resource nationalisation being largely out of a mining company’s control, it must still be addressed with a proactive strategy. Just as companies have strategies for managing relations with customers, shareholders and employees, they must also maintain effective strategies for managing relations with governments and communities in locations where they operate.

Especially at a time when production growth is not a priority, jurisdictions should understand that resource nationalism could cause new mines to be cancelled or delayed, or cause producing mines to be shut down, cut back or suspended indefinitely. Financial gain from mining is not an annuity for any jurisdiction; it always requires a partnership approach, Hodgkinson says.

Freeport-McMoRan Copper & Gold earlier in March cut ore production at its Indonesian Grasberg copper and gold mine by about 60%, two months after the US miner halted exports over a dispute with the government on a new tax.

Freeport’s Indonesian unit runs the world’s fifth-largest copper mine in remote Papua and any prolonged stoppage in production could send global prices of the red metal upwards, while increasing the risk of layoffs in a volatile area with a simmering separatist movement tensions.

Freeport and fellow US miner Newmont Mining have refused to pay an escalating export tax introduced on January 12, as part of a package of new mining rules aimed at forcing miners to build smelters and process raw materials in Indonesia.

“A strategy to counter resource nationalisation cannot give a mining company control over every outcome, but building a better understanding of the viewpoints and arguments will help mitigate the risk,” Hodgkinson stresses.

Meanwhile, another impediment to the development project pipeline in Canada, the US and Mexico is what is referred to as ‘Nimbyism’ (an acronym for “not in my backyard”). In Canada and Mexico, aboriginal groups have increasingly been causing a stir around issues relating to land ownership – and some First Nations often have ill-advised concepts of their ‘rights’ to land. In the US, environmentalism is increasingly impeding mine development.

Edited by Martin Zhuwakinyu
Creamer Media Senior Deputy Editor

Comments

Showroom

Hanna Instruments Image
Hanna Instruments (Pty) Ltd

We supply customers with practical affordable solutions for their testing needs. Our products include benchtop, portable, in-line process control...

VISIT SHOWROOM 
Rentech
Rentech

Rentech provides renewable energy products and services to the local and selected African markets. Supplying inverters, lithium and lead-acid...

VISIT SHOWROOM 

Latest Multimedia

sponsored by

Option 1 (equivalent of R125 a month):

Receive a weekly copy of Creamer Media's Engineering News & Mining Weekly magazine
(print copy for those in South Africa and e-magazine for those outside of South Africa)
Receive daily email newsletters
Access to full search results
Access archive of magazine back copies
Access to Projects in Progress
Access to ONE Research Report of your choice in PDF format

Option 2 (equivalent of R375 a month):

All benefits from Option 1
PLUS
Access to Creamer Media's Research Channel Africa for ALL Research Reports, in PDF format, on various industrial and mining sectors including Electricity; Water; Energy Transition; Hydrogen; Roads, Rail and Ports; Coal; Gold; Platinum; Battery Metals; etc.

Already a subscriber?

Forgotten your password?

MAGAZINE & ONLINE

SUBSCRIBE

RESEARCH CHANNEL AFRICA

SUBSCRIBE

CORPORATE PACKAGES

CLICK FOR A QUOTATION







sq:0.272 0.331s - 156pq - 2rq
Subscribe Now