Major Industry Trends
The mining sector covers everything that companies extract by way of geological materials 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 extraction techniques, while the fortunes of particular companies in the sector will be touched on collectively, through an examination of merger and acquisition deals conducted during 2008/2009.
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. However, the latest boom and bust saga in the industry, associated with the global downturn, which really hit the sector in the last quarter of 2008, has been as sharp as anything witnessed in decades.
In its survey of mining sector deals in 2008, published in January 2009, accountants PricewaterhouseCoopers (PwC) pointed out that, buoyed by the boom years of 2006/2007, the mining sector was within a whisker of making 2008 the third record year in a row for M&A deals. However, when the global crisis began to bite a number of the larger deals, as well as many smaller deals, were called off, some at the very final hurdle. One instance was BHP Billiton’s decision not to pursue its US$150 billion offer for Rio Tinto in the teeth of opposition from the UK’s Competition Commission. Another example was Xstrata’s decision to call off its bid for Lonmin. As a result, 2008 turned out to be a record year for bids, but, after a spate of cancellations in the final quarter, deals actually done returned to 2005 levels. In all, a total of 1,668 deals (with a combined value of US$153.4 billion) were completed in the sector. This was lower than the levels seen in 2007 (1,026 deals with a combined value of US$158.9 billion), and leaves 2008 as the story of what might have been. The total deal value could easily have doubled or even trebled, had some of the largest deals gone through.
Moreover, as PwC reported, many companies that successfully transacted deals in 2008 found themselves facing the sudden downturn with overstretched balance sheets. “Mining shares went from rising star to plunging asteroid status,” said PwC in its report.
Demand for iron ore in 2008 was massive, as global steel mills scrambled to keep abreast of rising demand from China and India, until the building frenzy was choked off by increasing concerns over falling global demand. PwC reported that the total value of deals for iron-ore assets nearly tripled in 2008, up from US$7.5 billion in 2007 to US$21.4 billion in 2008, with deal numbers rising from 40 to 107. Economic growth is also energy-hungry, and that drove demand for coal and uranium mining, with deals in both areas rising by 28%. The total value of coal and uranium mining deals in 2008 rose from US$29.9 billion to US$54.2 billion, year on year.
One of the features of the 2008 mining year, PwC pointed out, was the belief (finally abandoned in the last months of 2008) that the financial and economic downturn, which had begun to manifest itself in mid-2007, would pass without inflicting damage on the commodities sector. The hope was that demand from China and India would be strong enough to sustain the boom in the global mining sector despite falling demand in the developed economies. This continued to drive mining companies to look for mergers, as well as resource acquisitions, well after it became apparent that developed markets were in trouble. Then, in August 2008, reality caught up with the sector. Prices for copper, aluminum, and tin fell to their lowest levels in more than six months, and zinc fell back to November 2005 prices. According to the news channel Bloomberg, between May 2008 and February 2009, more than US$2 trillion was written off the global listed resources sector.
Another feature was the unexpected strength of the US dollar in the closing months of 2008 and the opening months of 2009. A rising dollar makes dollar-denominated metals extremely expensive for non-US buyers.
In January 2009, the metals desk at MFGlobal, a leading broker for exchange-traded futures and options, published its “Metals outlook 2009/2010” report, and sounded a cautiously optimistic note for the year ahead. “We suspect that markets will start to discount a far healthier supply/demand balance by the middle of 2009, at which point base metals should stabilize and work higher going into 2010,” MFGlobal said.
One option for mining companies when prices fall is to build up their inventories instead of pushing product onto the market. Massive inventories, of course, both choke off supply, which pushes prices up, but also tend to act like a brake on rising prices, which can readily pull more supply into the market.
MFGlobal pointed out that, although stocks are building (copper stocks, for example, now stand at 450,000 tons), this is nowhere near the desperation levels of 1,000,000 tons of copper reached in the downturn of 2002. Zinc stocks too, are only around one-third of their 2002 peak. The two metals that are stockpiling hard, getting into “extreme territory” in MFGlobal’s terms, are aluminum and nickel.
Copper is currently still being produced at close to pre-crunch levels, with copper producers being slower than other producers to cut production. The reason, MFGlobal analysts suggested, is that many copper producers are still either just making a profit or breaking even, with production costs standing at US$3,000–3,500 per metric ton. More recently though, a number of major copper producers, such as India’s Hindustan Copper, and Freeport McMorRan Copper & Gold, have announced reductions. There was a surplus of copper on the market in 2008 of around 200,000 tons and estimates vary for the scale of the expected surplus in 2009, from under 300,000 tons to more than 600,000 tons. Again, a large surplus should be sufficient to check any sudden upward movement in pricing, which could fall to under US$3,000 per ton, MFGlobal suggested (its trading range for copper is US$2,640–4,250).
Aluminum stocks are currently standing at 2,700,000 tons, according to MFGlobal. This is a record high, and analysts suspect that there are at least a million tons more stockpiled in China. The International Aluminium Institute’s figures for unwrought aluminum stocks stand at 1.604 million tons, as of November 2007, making the combined inventories (excluding China) equal to around 11% of global annual production. This suggests that prices could have a long way to fall before production cutbacks start to drive up pricing again, MFGlobal said.
Zinc producers are cutting back production hard, with many of them acting before the general price collapse of Fall 2008. MFGlobal estimated that, at present, some 65% of zinc producers are either operating at a loss, or are on marginal breakeven.
Market Analysis
In an analysis titled “Commodity price moves and the global economic slowdown” (March 2008), the International Monetary Fund (IMF) pointed out that commodity price developments in 2007/2008 highlighted the dual nature of commodities. In the case of metals, they are both used as inputs in the production of other goods and, in their secondary role, they are used as financial assets. They can be used as such because they can be bought and sold, used as a store of value, and their price can be a basis for speculation, with traders taking long or short positions depending on whether they think the price is trending upwards or downwards.
In recent times, the financial side has come very much to the fore, the IMF says. Falling interest rates have forced investors to look for higher returns elsewhere, and metals have long been seen as a hedge against inflation. (Simply put, their price rises naturally with inflation in a way that investments in government gilts absolutely do not). Gold has, of course, a well-established place as a safe haven for investors when markets become turbulent. As a general rule, one can see an inverse correlation between, for example, a chart of Wall Street equities and the gold price chart, with the one falling as the other rises. In boom times, investors expect gold prices to fall (as there is more money to be made in more active investments) so they pull their money out of gold, which accelerates the price falls. When the markets become scary, investors flee back to gold, and the price pushes up sharply. As the global downturn has deepened, the price of gold has risen to record levels.
Another factor influencing metals prices was the dollar depreciation that was seen in 2007 and the opening months of 2008. By displaying a graph of the dollar and the euro plotted over time, against an index of commodity prices on the Y2 axis, the IMF makes the point that a depreciating dollar increases the cost of acquiring metals for dollar-economy producers, by comparison with euro-economy producers. It also opens the way for speculative arbitrage and hedging, and commodities have become increasingly used for portfolio diversification. “This trend has been reflected in rising inflows into commodity funds and assets,” the IMF says. The increase in crude oil prices in 2008, as well as the rises in other commodity prices, are a case in point. Once this trend went into reverse and funds started flowing out of commodities, it accelerated the implosion of the commodity price bubble, and massively destabilized and complicated the market for mining companies.
Looking ahead, PwC says in its “Deals report” that depressed and, in some cases, collapsed share prices and an inability to access debt markets were causing immense distress for some mining companies in spring 2009. However, others have relatively healthy balance sheets. This kind of mixed environment is one that suggests both that acquisition activity will be muted in the short term, but with some companies under huge pressure to raise finance and with others having the means to buy, but over the medium term an increase in deal activity looks certain. The shape of the future ownership of the global mining industry looks set to change fairly dramatically over the next few years, PwC argues. As in other markets, however, those with strong balance sheets are “sitting on their hands” at present, motivated more by the belief that, if they wait, the assets they are targeting will become even cheaper, than by any faith that the market has now reached the bottom (by definition, the best time to buy).
In particular, the Chinese appetite for acquiring access to the raw materials the country sees as essential to its growth plans, seems undiminished. PwC expects to see acquirers from China being very active in the present depressed market. Chinalco’s increased stake in Rio Tinto is simply the most high profile example of this. However, Chinese acquisitions of Western assets tend to generate disquiet in government, regulatory, and military strategic circles, so the response to increased acquisitiveness by China will bear watching, PwC says.
Another phenomenon PwC sees as likely in the mining sector is the possibility of both private equity (PE) and sovereign wealth funds moving into this space. Traditionally, PE has not been a big player in the mining sector, but the chance of buying in at the bottom of a market with very depressed values could well attract both sets of investors, PwC says.
“Since access to equity and debt has more or less dried up for many small to mid-cap mining companies, those with portfolios that are at the development stage or that are not sufficiently revenue generating will need to sell assets to survive,” PwC says, reiterating its point that the shape of the sector, in terms of who owns what, is likely to change very substantially during 2009 and 2010.
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