December 2015

Mining cycles and the end of the bust

  • By Hedley Widdup, Lion Selection Group Ltd

Following more than four years of negative performance, investment sentiment towards miners is showing signs of turning – laying the foundations for the next boom

Investment in the mining sector is cyclical, and sector valuation fluctuations between boom and bust are evident over time in share prices and index prices for miners (Figure 1). Mining is a capital intensive business, so the cycle is driven by liquidity – the availability of investment funding. Liquidity is the product of sentiment, which swings between greed and fear. While the shape of historic cycles reflected in share prices of miners differs from cycle to cycle, indicators of liquidity follow a similar pattern of evolution through each cycle.

BOOMfig1

Most recently, the mining sector has experienced a bust that produced sustained share price declines across most of the sector, starting in mid-2011. All busts end, and since mid-2013 there has been strengthening signals that a change in sentiment towards miners is underway.

Mining booms are characterised by greed – investors fall over themselves to pay a premium to value, and apply generous market valuations to intangibles such as exploration potential. Several previous mining booms have been the result of industrialisation of large Asian economies (eg Korea 1975-, China 2000-) and investor expectations were led by clear appetite for commodities. Other booms have been driven by phases of exploration discovery success (eg
the 1980s).

In contrast the sentiment of mining busts is fear, which drives market attitude toward risk aversion. A rush of sellers and few buyers causes liquidity to dry up, and miners trade at a discount to value with little to no market appreciation of upside. In the past busts have most often been tied to globally significant macro-economic events such as the Global Financial Crisis (2008), the Asian Currency Crisis (1998), or the bursting of a speculative bubble like the 1987 stock market crash. Sector-specific catalysts have also occurred, such as the Bre-X fraud (1997), which caused a major loss of trust between investors and explorers on technical reporting, especially of ‘geological potential’, and eventually led to the codification of technical reporting standards.

Liquidity drives the cycle

Trends in liquidity and sentiment tend to be opaque from current share prices and indices. Instead, a range of liquidity indicators can be tracked, which provide an indication of what stage of the cycle miners are experiencing.

Mining IPOs

Initial Public Offerings (IPOs) of mining companies are the best measure of sentiment and liquidity, because investing in an IPO is more discretionary than investing in a company that is already listed and trading.

The IPO market struggles, or may close completely, in the depths of a bust because mining investors direct what available cash they have toward supporting their existing investments, or listed companies with established market values and track record. There is a psychological aspect to this – raising funds in an already listed company can be priced at a discount to recent trading, providing the perception of being a cheap entry. This is not possible for an IPO, where there is no historic price to guide investors’ perceptions of value.

In a boom, when the market is more buoyant, substantial liquidity facilitates a high number of new listings, and at the cycle peak it is possible for very large IPOs to take place. Early 2008 was the peak for miners before the Global Financial Crisis (GFC), and in 2007 Boart Longyear listed on ASX raising A$2700m (services companies tap a similar pool of liquidity to miners). There were correspondingly large IPOs in the other global mining exchanges: Eurasian Natural Resources raised £1499m to list on LSE and Franco Nevada (mining royalties) raised C$1090m to list on TSX. In 2011 the listing of Glencore (largest mining IPO ever) on the LSE raised £6193m and was finalised within a month of the 2011 peak in mining equity index prices. As a comparison, the typical fund raisings of the 143 ASX mining IPOs in 2007 was between A$5m-A$10m.

There have been no mining IPOs onto ASX during 2015, so this indicator shows the cycle has bottomed. However, it is still possible to gain a listing for a mining enterprise via a reverse takeover transaction (RTO). Under this process, an unlisted company is taken over by a listed company, usually when the ‘shell’ (ie the listed company) needs to reinvent itself in order to continue trading. At present, there are a substantial number of ASX listed companies that have not been successful in their mining ambitions, providing a pool of potential shells. Mining RTO volume has increased during 2015, from 13 deals in 2014, to 29
in 2015 year to date, which is an early signal that funding (ie liquidity) is flowing in small volumes again to early stage mining endeavours.

Exploration

Without exploration, there would be no new resources for future mining. Even so, exploration is often viewed as risky and therefore discretionary by management of many companies. Exploration is generally funded from cash profits or by raising new funds. In bust periods, both forms of funding are scarce, so exploration becomes difficult to justify in the face of more essential (for the short-term) spend. In boom markets, when funding is plentiful, exploration activity also booms. For this reason, exploration expenditure is a useful indicator of mining companies’ views of the availability of funds, and therefore the stage of the cycle.

The Australian Bureau of Statistics tracks exploration expenditure in Australia on a quarterly basis, and this is a useful and accessible proxy for global expenditure. This data has displayed a negative trend since 2012. Generally, exploration spend begins to recover once the boom is underway, and therefore is more useful as a trailing indicator that a cycle turning point has been passed.

Recent indications of exploration activity are encouraging. Despite the downward trend in expenditure data, some of the larger companies active in Australia (eg Northern Star, Sandfire, Evolution, Independence, etc) have shown intentions to increase their exploration budgets. These are selected examples, but recent efforts by these companies have produced discoveries and extensions to mineralisation.

Even with sharply reduced activity during a bust, there can be a counter-intuitive result on exploration effectiveness. Because funding is scarce, exploration work that does take place has to be well justified and is carefully planned and executed – the mind of the explorer is sharply focused. For this reason, some of the best exploration successes often happen in cyclical lows and bodes well for others regaining the confidence to explore.

Mining deals

The nature of large (ie greater than $100m deal value) mining transactions provides an insight to company growth ambitions, and ability to fund that growth. Smaller mining deals can be instructive, but in small companies it’s possible for single or small groups of investors to influence outcomes, so large deals are a better reflection of the average state of the market.

Mining deals evolve through several distinct stages through a cycle:

  • Just after a bust, deals tend to be motivated by ensuring survival, so the earliest deals are usually mergers with little or no premium to the target designed to capture cost savings and synergies. Example: Xstrata’s nil premium offer (never completed) for Anglo American in 2009.
  • The merger phase can evolve quickly into opportunistic acquisitions, mainly for share based considerations. As with the base of most asset price cycles, low valuations present opportunities for bargain hunters. Generally it is the junior to mid-tier sized miners that are earliest to recognise this as an opportunity, and can capitalise on it, and deal size tends to be small (sub-$1B). Competition between acquirers is limited, as generally there are copious opportunities and many would-be acquirers are dealing with the fall out of a boom ending (cost reductions, balance sheet repair). Example: Merger of Independence Group and Sirius Resources, 2015; Project acquisitions by Northern Star, Evolution Mining and OceanaGold during 2014 and 2015.
  • The earliest stages of a new boom is characterised by increasing deal sizes, consideration becoming predominantly cash, and there are more and larger acquirers. Example: Xstrata’s takeover of MIM in 2003.
  • In the later stages of the boom, greed is at its peak and shareholders and company management alike often believe the cycle will go on forever  – this is when the largest deals can take place. The market pays the greatest premium for scale during the boom, so the incentive for growth is substantial – as generally a larger valuation premium is applied to an enlarged group. Motivations are highly strategic (rather than value driven), and usually these deals are competitive takeovers as management teams jostle to be in control of the largest project portfolio and aim for the greatest possible economies of scale (thereby justifying their rock-star like salaries), or to cement a position in a crucial sector as projects of world class scale change hands. Considerations comprised of cash are limited because of deal size, and with the confidence of an increased premium, historically considerations have been large premium paper deals, although more recently have also been debt funded (eg Rio Tinto’s takeover of Alcan, or Freeport’s takeover of Phelps Dodge,
    both in 2007).

Mining transactions in Australia since 2013 have increased in frequency and also displayed a trend of increasing transaction size. A substantial portion of these transactions have been a junior or mid-tier company acquiring a project from a major miner, raising capital to fund the deal. Recent mergers have featured sizeable premiums over pre-deal trading prices, and to date these acquisitions have been generally well received by the market. This has led to the market funding more and larger transactions, and increasing paper premiums, which are a sign of improved liquidity towards the acquirers. So far there are few examples of cash being paid directly off of a balance sheet for a large acquisition, which signals that conditions are still pre-boom.

2015: the cycle turns

In 2011, 2012 and most of 2013, miners fell whilst the rest of the equity market was positive. 2014 saw stabilisation in miners’ equity performance and in 2015 miners have remained weak, but for the first time this has been against a falling broader market. The correlation between miners and the rest of the market for Australia’s ASX200 index (ie Resources vs Industrials) was negative during calendar years 2011-14. Year to date in 2015 the correlation is strongly positive (r2 = 0.72), signifying that miners are no longer ‘falling out of bed’. Combined with signals from liquidity indicators, there is a very strong sense that the sentiment of a bust is now passed. Although it is too early yet to call the next boom, this shift in sentiment strongly suggests the mining sector is now passing through the base of the cycle.

The Lion Resources Clock (Figure 2) depicts the mining cycle, and the time is set according to the liquidity indicators discussed here. At present, the time is 4:30 – ie just prior to the start of a new boom.

BOOMfig2

Signals of the cycle moving into the next boom will be IPO volume restarting then picking up, increasing exploration spend, and mining deals becoming cash denominated. It is quite likely that mining equities will broadly remain weak, especially as commodity prices are weak, and many cycles have experienced a period of several years of negative to sideways performance after the bust has ended and before a boom takes place. History, however, has been quite clear – bust has always given way to another boom as cycle follows cycle. It is not a question of if there will be another boom, only when.

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  • Jonathan Higgins
    13 Jan 2016 at 2.50pm

    Great article but I disagree with the time on the clock. With commodities prices and exploration expenditure still declining we are somewhere between 2.30 and 3.30 on the clock depending on whether your glass is half full or half empty. Whilst there is still plenty of pain to come, the night is also darkest before the dawn.