Different markets, different cycles. Mining companies suffered for their sins in the downturn a little earlier than the oil and gas sector. Now they are emerging into a new upturn, also ahead of the game.
What challenges do they face that oil and gas companies might learn from? I asked Julian Kettle, Vice Chairman of Metals and Mining Research, to share his thoughts.
A battle is underway in the mining sector between proponents of capital discipline (fund managers) and those paid to take a longer term view (the boards of mining companies). The latter wrestles with satisfying shareholders' desires for dividends and the knowledge that production cannot be turned on like a tap.
There is a growing need for the industry to invest in greenfield capacity to meet not just incremental demand, but also to replace the inexorable reduction in base supply as ore depletes and grades decline.
Mined commodities entered the broad down-cycle in 2011/2012, ahead of oil, and have recovered strongly since early 2016. Base metal prices have risen by between 25% and 50%, iron ore by 20%, thermal coal by 35% and metallurgical coal over 100%. Nickel is the exception, still suffering from a capacity/stock overhang, with prices rising by just ~5%. Oil’s price swings have been tame in comparison.
Price rises in mining have been largely driven by fundamentals: supply discipline from producers (notably in lead/zinc), Chinese government intervention to constrain overcapacity for the bulk commodities and aluminium, plus strong Chinese demand. China’s impetus to improve air quality during the winter heating season has also supported prices as domestic plants adjusted buying schedules to meet demand.
Mined commodity prices are now at or above long-term levels, resurging on fundamentals and optimism surrounding global economic growth.
Add to this the strong dollar, subdued input prices and cost control, and it’s been a recipe for strengthening corporate balance sheets, burgeoning free cash flow, and more recently, record dividends. All this is happening after an extremely lean period for the mining community from 2012-2016 that saw the major miners lose 60% to 90% of their value – famine to feast.
Some causes of capital destruction in the lean period were outside the industry’s control. Others came from within – and resonate with the oil and gas sector. The Great Financial Crisis led to lower demand growth just as a wave of new projects came on stream after a period of heavy investment in the boom times.
Prices collapsed along with market confidence. Project delays and capex over-runs blotted the copy books of many companies. The fallout was a sharp fall in share prices and an extended period of low-equity valuations. A partial recovery in fortunes over the last year or so has raised concerns that miners will start spending rising cash flow on investment and project development.
Investors understandably fret that the industry will repeat the sins of the past.
But our view is that all-out capital discipline risks storing up trouble for the future. Big mining projects have long lead times, and measured investment is essential if the industry is to meet market requirements and avoid exaggerated price movements.
M&A may be another way for the mining majors to participate in growth. This could be an attractive option with equity levels buoyant again and debt financing accessible and still cheap. Buying growth can work for individual corporates, but does not resolve the market’s need for new project development.
The base metals industry needs to invest north of $200 billion over the next 7 to 10 years – $100 billion alone on copper – to close the supply gap. It’s going to be a tough balancing act for boards to appease short-term equity investors wanting to ride the revaluation wave and scoop up the dividends that are flowing again.
Long-term investors, many of whom are still out of the money and want reassurance before supporting a big new phase of capital spend, remain committed to the sector. Similarly, the oil and gas industry is mulling whether under-investment in this down-cycle is leading to supply shortfall in the early 2020s.