Diversifieds boxed in by past mistakes and Glasenberg's language
MINING FINANCE / INVESTMENT
The world's major diversified mining companies have been ratcheting up production and cutting exploration in a bid to combat falling costs, but it could come back to haunt them.
Author: Alex Williams
Posted: Tuesday , 29 Oct 2013 LONDON (Mineweb) -
“Mining companies were producing copper for 80 cents a pound and selling it for 60 cents a pound,” one speaker at an Australian small-cap conference quipped last week, “but they all tried to make it up in volume.”
Record volumes, particularly in iron ore, have been the mainstay of this month's reporting season.
BHP's output from Western Australia jumped 23 per cent year-on-year to 48.8m tonnes, with
Rio Tinto also hitting new production highs on delivery of its so-called 290 rail-port expansion in the Pilbara.
Bumper volumes were not confined to Australian iron ore. BHP reported record output in petroleum and from its coal divisions in Colombia and New South Wales, whilst Rio broke records in bauxite and thermal coal. Aided by its Oyu Tolgoi goliath in Mongolia, its share in mined copper meanwhile leapt from 132,00 to 162,000 tonnes, whilst
Anglo American cranked up copper volumes by 32 per cent, driven by its Los Bronces mine in Chile.
Most bullishly, majors are “making hay while the sun still shines.” In its last full year, Anglo American made net profit margins of 18 per cent in copper. Prices have since come off by 38 cents per lb, leaving Anglo with all-in copper margins of around 10 per cent, even before any cost improvement. As margins go, they're up there with sportswear and fizzy drinks, if not wholesale lingerie.
More sceptically, miners are cranking up output to defend earnings in the face of lower prices. Higher grades played their part in Anglo's output splurge at Los Bronces and likewise at Escondida, part-owned by Rio and BHP. In a soft price environment, the front-loading of ready tonnes and high grade ore inflates production, offsetting revenue declines whilst lowering unit costs. The result is less volatile earnings, but the tactic defers high cost production rather than lowering it, with the risk that it is rendered uneconomic.
Market Capacity
A secondary consequence of record output levels is an upset market balance. Chinese steel production and inventory restocking have buoyed iron ore prices in recent months to $135 per tonne, but the figure comes under renewed strain the quicker majors turn up volume.
By the end of the first half of 2014, Rio expects its Pilbara operations to be running at 290m tonnes per annum, a 7 per cent increase on current levels. The group's board has approved a further $5.9bn expansion to its throughput capacity in the region to 360m tonnes per annum. Even more threateningly, Brazil's Vale plans to produce 480m tonnes by 2018, versus 306m presently. Mid-tier producers are also in on the game, with Atlas and BC Iron both ratcheting up exports as quickly as their infrastructure allows them.
Whilst volume gains help to offset price declines, applied industry-wide they have the perverse effect of feeding lower prices. In their defence, since miners are price-takers, mining is only ever a volume game. The current environment however is especially conducive to a supply glut caused by a mutually destructive game of output tonnage chicken.
Glencore's Decoy
Record production figures are the direct consequence of a renewed focus by majors on the rhetoric of returns. Shareholder discontent at capital cost blow-outs and disastrous acquisitions, including Anglo's $8.8bn Minas-Rio project in Brazil and Rio Tinto's $38bn purchase of Alcan, has seen a raft of new chief executives instated, eager to distance themselves from the industry's reputation, tarnished in the eyes of investors.
Anglo's new chief executive Mark Cutifani is due to report a full business review in December, whilst BHP boss Andrew Mackenzie has promised a “laser-like focus” on costs. The cost-tough brownfield-obsessed mindset however has been led by
Glencore's Ivan Glasenberg, who has routinely lambasted the industry for ploughing more capital into expansion than into shareholder returns. Glencore has dropped half the 88 projects it acquired with Xstrata, whilst closing two offices a week since the deal closed in May.
“We are not focused on replacing depleting assets,” Glasenberg has said. “If it does not make economic sense and does not give us a return on equity, we will not do it. If our company gets smaller so be it.” The attitude has been lauded by the market, with Bernstein analyst Paul Gait crediting Glasenberg with “genuine industry leadership.”
Ironically, Glencore is the only major to have sizeably increased its mining footprint in recent years. Besides its Xstrata deal, the largest transaction in the history of the mining industry, Glencore jointly paid $1bn for Rio Tinto's majority share in the Clermont coal mine in Queensland last week through a joint-venture with Japan's Sumitomo. It has meanwhile written $7.7bn off the value of its mining assets this year.
That the company is pursuing the opposite path to its rhetoric is incidental: by broadcasting the toughest line, Glasenberg has set the tone, with peers dashing off in pursuit. “Returns” or “return on” was used 12 times in Rio's most recent financial results, versus only once in the same report 3 years ago. Over the same period, Anglo American likewise bumped-up its use of the phrase from 2 to 6 times, whilst BHP held steady at 7. (Vale clearly uses a different PR company, having trended in the other direction.)
The dogma favours brownfield investment over green as previously burned fingers are reluctant to contemplate new acquisitions and exploration viewed as a straight-up expense. Rio Tinto is cutting $750m from its exploration budget this year, with 97 per cent of the savings achieved already, three months ahead of its year-end. BHP has been less granular in detailing cut-backs, but with the exception of copper in the Andes, is believed to have abolished spending on virgin exploration entirely.
LIMITED STRATEGIC ALTERNATIVES
Unable to buy, explore or develop new projects, majors have been boxed into two strategic alternatives. One is to divest, though they must not be seen to do so at fire-sale prices. “This is not market day at the bazaar,” Rio's Sam Walsh has said. The result has been a constipated market, with private equity and mid-tier miners expecting distressed valuations, but majors wanting a dial-moving price.
As a case in point, Walsh has so far been unable to budge Rio's diamond business or its share in ASX-listed Coal & Allied. In the face of an asking price above $3.5bn, China's Minmetals is also reported to have dropped out of the bidding for its iron ore assets in Canada.
The last remaining option open to majors is to expand their existing operations, escalating near-term tonnage and cash flow. Higher incremental returns can be earned from sites where money has already been sunk, the thinking goes, than on new vanity projects, where returns are further out and therefore less certain.
Importantly, investing in existing assets is also less conspicuous for chief executives and therefore less risky than forging ahead into new ones. Rio's cap-ex pipeline in the Pilbara is a $20.6bn, with a further $1.4bn slated for its share of costs at Escondida, an obligation matched by BHP.
Investment once budgeted for exploration, acquisitions or development is instead being funnelled into near-term tonnage. Rather than staggering capital over a mine's full life-cycle, it is being ploughed into that with the quickest and most gaugeable return.
Advising miners to hold tonnes in the ground is as futile as telling consumers to stop driving up prices with buying. Majors must recognise however that at some point, their focus has to shift from their own capacity to that of the market's. It is a realisation unlikely to be acted upon until prices force their hand.
Ricardo Moraes/Reuters Eike Batista with President Dilma Rousseff of Brazil last year.
