Major Industry Trends
The mining sector covers everything that companies extract by way of economic minerals (minerals with commercial value) from the earth, from base and precious metals to coal, uranium, diamonds, rock salt, and potash. Oil and gas extraction is covered in a separate sector profile and will not be considered here. This profile will focus on the commodities aspect of mining rather than on the fortunes of particular companies in the sector, which will be touched on collectively.
The sector, along with agricultural products such as grain and coffee beans, constitutes the commodities sector, which is notorious for price volatility and boom-and-bust cycles.
In its most recent survey of the sector published in its annual “Mine” report, subtitled “Review of global trends in the mining industry—2013,” PricewaterhouseCoopers (PwC) says that the mining industry is facing a crisis of confidence caused partly by rising costs of production. However, it adds that on the demand side the long-term fundamentals remain positive. PwC points out that China consumes around 40% of global metal production and will continue to be the industry’s most important customer, and that although Chinese growth rates are slowing down, they are coming from a bigger base. This, combined with the continued emergence of large developing economies such as Brazil, India, and Indonesia means that future demand for commodities still looks healthy. However, PwC adds that regaining investor confidence depends on how the industry responds to its rising costs, increasingly volatile commodity prices, and other challenges such as resource nationalism.
In its report, PwC says that the mining industry needs to fundamentally reduce operating costs and increase the productivity of its existing assets. Although 2012 was a record year for capital spending, the overall message from the “Top 40” companies is that the capital expenditure tap is being tightened. Project hurdle rates have been increased, with some of the Top 40 stating that only projects with a return greater than 25% will be pursued. PwC adds that recently “Many suppliers have announced lower than expected profits as a result of capital spend reductions. Supply and demand economics suggest this will lead to prices falling for suppliers.”
PwC concludes that the solution to these problems of operating costs and productivity “does not solely rest in trying to spread costs over a larger base to gain economies of scale. It will not be possible for the industry to ‘grow’ itself out of trouble.”
Historically, there has been a strong relationship between the price of gold mining stocks and that of gold itself. However, in recent years gold equities have declined despite steady increases in the gold price. In 2012, PwC notes, the market capitalization of gold producers in the Top 40 fell by almost 15% to US$29 billion, despite gold prices closing the year up more than 7% at over US$1,676 per ounce.
PwC points out that write-downs, lower commodity prices, and increasing costs halved the Top 40 mining companies’ earnings to US$68 billion in 2012 and, as a result, the Top 40’s year-end price-to-earnings ratio (PE ratio) shot up to 18, double the year-end 2011 ratio of 9. However, after adjusting for impairments, the PE ratio at year-end 2012 was a more modest 11.
PwC says that various developments have hurt the global mining industry in recent years. These include overspending on capital projects, overcapacity, commodity price volatility, increased labor costs, reduced productivity, and resource nationalism. It notes that when commodity prices picked up in 2009 the industry rushed to bring capacity online, setting new records for capital expenditure, but in the process productivity declined. The industry’s operating costs have also increased faster than those of other industries, which has affected margins.
Nevertheless, PwC says that long-term global demand fundamentals remain intact despite sluggish global growth. Interestingly, it says that in view of depressed growth prospects in the advanced economies, global growth prospects depend on emerging and developing economies. However, at the time of writing this industry sector report the situation had reversed and many analysts now believe that it is the developing economies that will drive global growth in 2014.
For example, in March 2014 David Donora, commodities head at London-based investment manager Threadneedle, wrote that “while the rise of the emerging markets, and particularly China, has been the key driver of commodity prices in recent years, we believe that the recovery of the developed economies, and in particular, the US, will prove the main influence on global commodities in 2014.”
Donora added that the economic recovery under way in member countries of the Organisation for Economic Co-operation and Development (OECD) will result in a “cascade effect” within commodities, with oil-based energy the first sector likely to experience positive price momentum and base metals among the last. He explained that this is because the advanced economies are not as infrastructure-intensive as emerging markets and thus are more reliant on cheap and readily available energy than on base metals.
He believes that base and precious metals will be the last area to be influenced by the recovery in the developed world. Emerging markets are much more intensive users of base metals, reflecting their heavier investment in infrastructure than the advanced economies; therefore base metals will pick up as burgeoning demand in the OECD economies boosts the developing world and, hence, eventually, infrastructure spending.
However, for much of 2014 base metals will likely remain weak, affected by decelerating growth in China and a slowdown in the growth of infrastructure spending among the emerging economies in general. Infrastructure spending is certainly not growing as fast as the main suppliers of base metals had anticipated, Donora says. Although these companies are now cutting capital expenditure, projects already under way will continue to boost capacity, and that situation will not change until the end of 2014. Subsequently, production will start to level off slightly, but more time will pass before demand and supply are balanced. In terms of individual metals, Donora takes a positive view on nickel, zinc, and lead and a negative outlook on copper and aluminum.
Threadneedle’s commodity chief believes that a strong dollar will be the key factor influencing precious metals, particularly gold. The United States will lead the recovery in the OECD, boosting the dollar. Consequently, investors who were using gold as a safe haven are reevaluating their positions and looking to redeploy into dollar-based assets, such as US bonds, equities, and infrastructure projects. Donora believes that this investment shift will continue as the dollar strengthens over the next few years, reflecting the shale energy revolution.
Finally, Donora says that apart from being one of the key drivers of the US recovery, shale energy will have a dramatic impact on geopolitics and the global economy—and hence commodity markets—in the coming years as the United States becomes increasingly energy-independent. In particular, the long-standing relationship between the dollar and commodity prices will change. The dollar will likely enjoy a period of sustained strength for three reasons: fewer dollars spent outside the United States to pay for its oil consumption; increased foreign investment in US energy production and related industries, such as chemicals and engineering; and the background of the economic recovery in the country generally. Given that these developments will take place amid strengthening global growth, which will tighten commodity markets, Donora expects that this will result in a period of strong commodity prices together with a robust dollar.