April 2017

Lessons from history for miners

  • By Hedley Widdup MAusIMM, Lion Selection Group Ltd

Efficiency, excellence and growth – challenges of the evolving demands of the mining cycle

Miners face two challenges that, when combined, make them unique against other businesses:

  1. uncontrollable revenue volatility over time due to commodity price fluctuation
  2. finite lives of mining assets.

As a result, there is potential for substantial swings in the value of a mining business and, consequently, there is typically greater volatility for miners’ share prices than for companies in other industries, even for mature mining companies. Because of this, mining investment forms very clear cycles. While it might appear obvious for an industry with a long history of cyclicity to strive to balance periods of weakness with phases of strength, history shows that the industry does not anticipate changes in the cycle. Instead, the mining industry tends to extrapolate an optimistic outlook and live accordingly. Concepts such as excellence and efficiency are treated most seriously out of necessity during tough times. During much of the rest of the cycle, there is an investor influenced appetite for growth.

Demands of the cycle – greed and fear

At the risk of presenting an overly simplistic analogy to highlight cyclicity – people who sell ice creams understand the seasonality of cash flows and plan accordingly, because cold weather arrives regular as clockwork, every year. Hot weather also returns with the same predictability. However, in mining, investors and mining companies alike rarely anticipate the ‘change of season’. When this occurs, investors react as a herd as the emotions that rule a boom give way to those that govern a bust.

Greed

‘Summer’ for miners can be balmy and intoxicating, so much so that miners and their investors create for themselves the perception that the good times are the new normal. Risks of price weakness are disregarded, while interest focuses on becoming more exposed to high prices. Instances of operational mediocrity can be forgiven on the basis that prices conceal any potential financial impact. In a boom, the price of miners reflects future optimism and can be much higher than a traditional valuation would dictate.

Fear

When ‘winter’ comes to mining, it brings about a cataclysmic, never-to-be-the-same-again outlook from investors. Exuberance in pricing of the boom quickly washes out.

It stands to reason that a profitable project should result in a profitable investment. Investors target the latter, but do not require the former. Investors buy mining shares hoping for price appreciation, and so might be motivated by a range of factors, such as a discovery, commodity price increase, production news or the potential for long-term profitability. Their luxury is that irrespective of their investment case being realised, if the price goes up they can sell. Therefore, investors’ interest is often on a time frame shorter than mine development or cyclical turnaround. Company focus necessarily needs to be
on a profitable project, and therefore on the risks that threaten achieving and maintaining ongoing profitability. Temptation for short-term capital gains is not necessarily aligned with long-term success.

Recent cycles

Over the past 50 years, the duration of a typical full cycle has been around ten years (without being so precise as to set your clock by it). The following provides a summary of the most
recent cyclical trends:

  • Beginning in 1998, but most evident from 2000-11, there was tremendous uplift in commodity prices as Chinese demand outstripped supply of just about everything that is mined. There was a short interruption caused by the Global Financial Crisis in 2008, but for most of this period, producers and explorers alike scrambled to find, assess, acquire and build new supply, incentivised by all-time high prices.
  • The music stopped from 2011-15 as demand from China waned and supply caught up to demand in some cases. Commodity prices fell to levels that brought on financial distress and even led to some mine closures. Consequently, investors shifted their gaze away from miners. The crescendo of this collapse came in 2015, when the final flush of investors selling out of mining brought
    on substantial falls in mining equities – capitulation – which marks the end of a bust.
  • In early 2016, the new boom commenced. Many mineral commodity prices and mining equities broke down trends to return positive performances in 2016.

Effect of greed and fear on miners

Desire for growth in the boom – driven by greed

Over a multi-cycle time frame, the investment market has superimposed its own recipe for success onto miners: if big is good, more must be better. When commodity prices are going up, or are expected to go up, investors like to hear that a company will be exposing itself to more of the commodity. Greed seeks growth, and that can be either via acquisition or organic.

An acquisition provides certain growth, and there are a range of factors that are used as justification. Scale buys efficiencies – at some stage once a company is large enough (after the costs of consolidating), cost benefits and therefore margin improvements will come. At company level, a diversity of projects manages the risks of single asset failure and commodity exposure and provides some stability to cash flows.

However, the investing rationale is the real driver, and it is simple: a bigger company means a bigger market multiple. The market value equation is something like: 2 + 2 = 5 or 6. Company value is increased by market forces (even though revenues continue to obey the laws of simple arithmetic), and thus during the boom, greed encourages growth by consolidation.

The product of consolidation is larger companies, and the consolidation coin has a flip side, especially for how people function within a large mining company. The increased size of a company means increased distance between asset managers/champions and the CEO/board, which can lead to a tendency to run the asset collection like supermarkets. That is, there is limited variation and difference between assets, and there is a tendency for company management to become aloof of mine site-level details. Corporate cultures can become quite mechanical, which not only stifles the creativity of individuals within, but can also lead to false efficiencies.

Organic growth requires funding and then a phase of investment, so once it is committed to, it is difficult to abandon. When the pursuit of scale drives the business, it is not unusual for the focus to become achieving tonnes moved or project completion, often to the detriment of cost once the course has been plotted. Notably, pursuit of scale only suits large projects, so when the industry chases growth, small projects are marginalised. This can provide an insinuation that small projects are either uninvestable or less likely to be economic – both of which are false. The pursuit of scale can result in highly adequate small projects being turned into poor-quality larger projects.

One common casualty of growth is exploration. Budgets often increase in absolute terms but rarely in proportion with the business. Exploration is a scientific, iterative and intuitive process. Patience is essential and success is rarely quick, but it is essential for future mines. A close link between explorers and company management is crucial for continuity of funding and aligning exploration to the company strategy, and this link is lost with size. In addition, exploration budgets face stiff competition in rising commodity price environments, as already known but marginal deposits may become economic or more certain growth is pursued via acquisition. Sadly, when exploration is marginalised, science, experience and knowledge are lost.

Despite the windfall that rising commodity prices should create during a boom, costs often appreciate at a similar rate to prices, with a range of key contributors:

  • The underlying enabler of cost increases is the fact that the necessity for cost discipline is diminished when a margin is buffeted by rising prices.
  • Access to cash is easy – cash shortfalls brought about by expenditure overruns and ‘one off’ budgetary requirements can be raised in the market through the issuance of new shares, meaning that the consequence of budget overrun is not severe.
  • Unavoidable inflation, such as increases in energy prices and materials.
  • Lazy inflation driven by companies competing against each other for people, services and materials to expand supply. Lazy inflation may also take the form of headcount increases over time without a commensurate increase in production.
  • Cost of growth – increased exploration budgets, corporate advisory fees, etc.

One of the most impressive effects of greed on the mining industry over the duration of a boom is the investment market’s willingness to sponsor mass population expansion of mining companies, mostly at the lower end of the capitalisation scale. As an example, more than 650 new companies with a resources focus were added to the ASX from 2000 to 2011 (for comparison, there are presently some 2193 ASX-listed companies).

A phenomena that has been much more prevalent in the last five to ten years than in previous cycles is miners taking on balance sheet risk by accessing cheap and easy debt to fund acquisition or expansions. As a result, many were dangerously overleveraged when the market turned. On top of the financial distress this caused, it also reversed an historical trend. During previous busts, major miners with the luxury of best-in-class margins and cash flows were normally able to weather the storm and then be opportunistic in the aftermath, placing bets on smaller peers or opportunistically buying assets cheaply. However, between 2011 and 2015, many major miners that had bought assets expensively at the top of the boom using excessive debt came under severe financial distress. Consequently, rather than being opportunistic when assets became cheap, many major miners have had to divest assets.

Diversity in all forms is of great value to any enterprise as it provides a mixture of skills, experience and points of view. However, the development of a strategy for a mining company through the cycle depends on intimate knowledge of how the industry functions, especially during the bust phase of a cycle when decisions about mining practice become central to company profitability and even survival. As the size of the large modern mining companies has increased, mining disciplines and mining experience have become severely under-represented at board level. To a person with a hammer, everything appears to be a nail – so if a company board is comprised similarly to an investment bank, perhaps the appearance of financial leverage and overly ambitious acquisition behaviour is not so surprising.

Seeking efficiencies – driven by fear

When commodity prices fall, margins contract, higher-cost mines may close and investor mentality changes. Fearing erosion of value, investors sell and shift their interest to other sectors. The effect of many investors selling at once can create dramatic falls.

During boom times, many miners access the equity capital markets as a working capital buffer, and when this facility disappears, it exacerbates financial stress. The only sources of cash become those that a miner can generate for itself. Against a backdrop of flat to falling commodity prices, the mechanism to generate cash becomes cost cutting or asset sales.

Miners cut costs in several ways:

  • cutting exploration budgets
  • eliminating largesse
  • reducing headcount and salary
  • pressuring suppliers or contractors to pare back their margins
  • cancelling or deferring capital expenditure – this may mean that new projects are deferred, but may also mean that sustaining capital is deferred, which doesn’t so much cut costs as kick a portion down the road.

Asset sales produce a one-off windfall but also have an effect on costs as selling a high-cost asset reduces the overall cost of production per unit.

There is a visual effect on the ranks of junior companies too. During bust times, many of the versatile entrepreneurs (that had previously been attracted to the mining sector by easy capital and value creation) also move on. Evidence of this is a change of business for many small, early-stage companies. From 2011-16, more than 70 miners re-branded, mostly into technology plays.

Case study – Australian-listed gold producers

From 2001-11, the gold price increased from $468/oz to $1780/oz, a 3.8 times increase. In the same period, Australian gold equities increased in value more than commensurately; the index that captures the largest and most liquid producers of gold listed on the ASX rose from 980 in January 2001 to a peak of 8349 in 2011, an 8.5 times increase. The gold price then weakened from 2012-14, dropping by 24 per cent to $1350/oz. However, gold equities collapsed, falling 80 per cent in the same time frame. The price increase from 2001-11 appears to be a substantial windfall, and on the theory that most of the price increase would manifest as margin expansion, it would increase the value of the underlying business – this is how investors priced equities. However, investors were ignorant of how gold producers were performing on the basis of cash profits. In all of the years of gold price growth, the collected ASX-listed producers did not make a cash profit and spent more than they had taken in as revenues.

From 2011 onwards, equity prices suffered terribly as gold price weakness was laid on top of the realisation that actual cash generated each year had all been spent, and then some. Cash profits in 2015 were generated by cost discipline, not commodity price movement. Thanks to a return to cash profitability and an appreciation in the gold price, gold producer equities began to rise again in 2016.

Lessons learned from history?

The logic of cost discipline and maintaining positive cash flow is extremely clear and basic. Even so, history has shown that the temptation of large investment returns from growth (greed) infects the psychology of many miners and their owners when the boom is underway. Excellence and efficiency, although perhaps not abandoned, are certainly neglected. A change of season (fear) brings companies back to a cash flow focus.

There are some great examples of companies that have managed over many years to maintain a focus on costs, margin and prudent investment through the cycle – but these are the minority. A major trap of the cycle is to indefinitely project a trend; in the boom times, this is implying that the good times are indefinite. This is largely human nature, and investors of all kinds are susceptible to this, irrespective of timeframe. People can’t pick turning points. Even so, this should not matter. Knowing a turning point will arrive is the critical knowledge to managing a business through the cycle.

There are some simple lessons that miners could take from their own history (or from the handbook of selling ice creams):

  • Plan to invest in growth through the cycle in a measured fashion.
  • Size is not important if a company is not making a cash profit. Growth is a fine ambition and can deliver strategic benefit, but must be affordable.
  • Scale assets according to what geology permits. A great small mine is better than a poor big one.
  • Beware of leverage, especially when times are good.
  • Focus on returns on equity.

Master the core business, especially costs, because costs can be managed. As revenues cannot be managed, cost discipline to see out the cycle is essential.

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