Capital mine shafting

Ernst & Young Global Mining and Metals leader Mike Elliott says:

– Capital allocation and access has become the biggest risk to Australian mining operations in 2013.

– The cash situation is critical for Australia’s junior miners, with a large number on track to enter administration in the next six months.

– Australia has probably the best opportunity to improve margin performance through productivity improvements, of any country in the world.

– The market is still in the first stage of reaction to miners’ attempts to tread a line between short-term and long-term shareholder interests.

– Companies with diversification strategies, like BHP Billiton, are best placed to weather the threat of resources substitutes.

– A change in government and the impact of resource nationalism will only have a fairly modest impact on the mining sector.

John Conroy: So what are the biggest risks for mining companies today, and how do they rate against each other?

Mike Elliott: Our latest report lists the top 10 strategic business risks in the global mining and metals sector: 

1. Capital dilemma – allocation and access (8 in 2012) 
2. Margin protection and profitability improvement (4) 
3. Resource nationalism (1) 
4. Social license to operate (6) 
5. Skills shortage (2) 
6. Price and currency volatility (7) 
7. Capital project execution (5) 
8. Sharing the benefits (9) 
9. Infrastructure access (3) 
10. Threat of substitutes (new) 

JC: Has it been surprising to see how quickly these capital concerns have emerged as the top problem facing miners?

ME: The market has certainly changed its attitude and a lot of that was precipitated by concerns about growth in China and elsewhere about a year or so ago. The decisions that were being made, you know, 18 months ago were being seen as bona fide appropriate decisions in the environment of high prices and encouraging maximisation of production. But once that changed, the market changed its attitude and started to reinterpret those particular positions and it’s had many ramifications. Not least of which is that there is now a new breed of management that has come in to run these companies in a different environment. So now there’s a new agenda and new people running that agenda.

JC: To what extent are these capital challenges uniquely Australian, compared to those facing major miners in other areas like Canada?

ME: Certainly the capital allocation decision is universal. The capital access probably has more bite in those countries that have deep risk capital markets for the mining sector. So with the ASX having so many juniors, just like the TSX (Canada), there’s a lack of risk capital that is available for the exploration sector and for the small scale mining. So that’s really bitten hard, particularly here in Australia. And the concerns that exists out there as to the viability of many of those companies if they don’t get access to new capital – because a majority of them do not have access to a cash flow stream – becomes quite critical for the second half of this year.

JC: How extensive could the coming expected rationalisation of junior miners be if they are unable to access capital?

ME: We’ve seen publically available information that cash is absolutely critical across the junior sector. We’re not talking about just a handful of companies; we’re talking about many dozens if not hundreds of companies here, in Canada and in the UK. We saw multiple companies that were sitting with less than $500,000 cash back in December of last year. And with their cash burn rates, the expectations are that many if not most of those would be in fact running out of cash in the second half of this year, the six months we’re just about to enter. So it’s in the next six months that we think there will be a large number of companies that will be put into administration if they’re not able to find either alternative financing. Some of that desperation financing is available, or is starting to find itself available now – or if the equity markets don’t open up such as they are able to do survival capital raisings.

JC: Can you quantify the just how much risk capital has fallen for junior miners in past 12 months?

ME: We’ve certainly seen a dramatic fall in the amount of capital that has been raised. And probably the easiest way to actually see it is really in the number of new initial public offerings that have taken place during the last quarter or so. In the last quarter there was an unprecedented absence of mining IPOs in either of the Toronto exchanges and I think there was only two or three that existed on the ASX. And that compares to a year ago when you would be talking many dozens would have occurred in a similar pattern. So while IPOs are new companies and new risk, it is indicative of how far that has dropped off.

JC: Is there anything that could change in the macroeconomic environment that could aid those junior miners and mitigate such widespread company failures?

ME: There are probably some positive signs that private capital is becoming more active in the market. By private capital I don’t mean market sources of capital, so whether they are wealthy individuals, private equity, dedicated resource funds or state-owned enterprises, they’re starting to become more active in looking at both the assets that are being divested by the majors. They’re also cherry-picking some of the good projects that are under financial stress in the junior sector as well and potentially coming in as partners on those particular projects. So we will expect to see more of that activity playing out over the rest of this year.

JC: To what extent is the second highest risk factor – margin protections and productivity improvement – a uniquely Australian factor?

ME: If we look at productivity in the Australia context, particularly where you’ve seen probably some of the largest growth over the super cycle, generally it is highly correlated with the poorest performance in terms of productivity. So as more capital, for instance, has been added into the Australian market context it has probably seen a greater decline in productivity of that capital. And so, if you want to turn that around and look at the positive, Australia probably has the best opportunity of improving margin performance because if they even just return to productivity levels that existed the middle of the last decade there would be more achieved from the Australian base than in many other countries in the world.

JC: How difficult will it be for the mining sector to address its productivity issues?

ME: It might be challenging to address productivity. For the most important part it’s a real cultural change. We’ve had such a sustained super cycle that the whole generation of mine managers, mine engineers and so forth, have really only be operating in a growth part of the cycle and to be able to increase productivity is something that they’ve not had to do for most of their professional lives. So there is a lot of hanging fruit there. If we can return to those labour and capital productivity measures that were in existence in the middle of the last decade then there could be a significant amount of value that could drop to the bottom line. The question will be are there the skills, expertise and corporate memory within the organisations to even just do what was being done circa 2006-7. If they are able to, they don’t have to innovate, they just have to return to practises of the past, and there could be a lot of value unlocked.

JC: To what extent are these productivity concerns universal across the sector?

ME: Around productivity, it is somewhat universal but the urgency to do something about it varies by commodity. So gold is the most recent commodity, or metal, to experience a significant price decrement so that’s clearly brought into focus in the gold sector. Something, for instance, base metals have been living with for more than a year now. So the impact has different timing for different commodities but it’s the same for all – they have to improve the productivity of capital and labour if they are going to move down to the lower end of the cost curve.

JC: Back to the majors and capital allocation troubles, has there been a standout performer among the big companies in balancing long-term capital allocation with short-term shareholder demands?

ME: You can look at the capital allocation challenge from two aspects of relative performance. How quickly people can get early-mover advantage – and you can probably go back in time and see that companies such as BHP Billiton were probably some of the earlier movers when they recognised that there needed to be a new capital allocation paradigm created last year. And there is clearly some advantage to early moving on that front. The other way you can look at it is that those that are able to take a bit of a contrarian aspect to the current situation can find buying opportunities while others are selling. Most of the majors are in a similar pattern of divesting assets, rationing capital and looking to increase the amounts they are returning to shareholders. There are a number of smaller, more tightly controlled companies – quite often by wealthy families – or those that come, as I said before, from the private capital space, that are using the current circumstances to take that contrarian view and look at the present market as a buying opportunity and to set themselves up with a pretty low cost of investment for the next time they see prices rally.

JC: How are CEOs doing at balancing these demands?

ME: Clearly the incoming management has a particular challenge as their opening mandate was to bring short-term returns to shareholders. They essentially have a real communication challenge that on their part. They need to communicate to what is a fairly hostile shareholder group around what they’re doing to accede to those wishes. But they also have a traditional base of long-term mining investor shareholders that are really looking for long-term value creation and maximisation. And so, it seems they’ve really got a paradox there – they have to be preaching about maximising short-term returns while increasing long-term value. It’s going to be those who are most skilful in being able to preach messages to both of those constituencies that will be the most successful.

JC: Where are we at now in terms of the market reaction to the majors’ attempts to tread a paradoxical line between short-term and long-term shareholder interests?

ME: We’re going to go through some stages of reaction to this. We’re still probably at the tail end of the first stage, which is really looking at what can be done to take costs out of the business. So the market is rewarding those that are most able to take larger and larger amounts of costs out of the business, because it will ostensibly give a short-term return. Now, that might include significant reductions in the exploration program, but ultimately that is only short-term benefit. Exploration is the lifeblood of future investment that needs to be made to replace the resources that are being mined today, and so you can’t continue exploration suspensions for very long. So they’re going to have to balance some of that future investment activity and that’s when we’ll probably see a move from cost to really looking at productivity as the next challenge. And we probably expect to see that to run over the next couple of years, and then how they reset themselves up for growth without all the problems that came with the last growth cycle, such as capital project overspends, etc.

JC: Which companies will be best placed to manage the threat of resource substitutes?

ME: We can certainly see that companies which operate a diversified model are somewhat hedging against some of those particular risks. For example, through the year, what BHP Billiton has done in increasing its exposure to unconventional oil and gas meant that while they might lose a bit on their thermal coal interests they would protect value through their oil and gas interests. So that diversified portfolio approach means you don’t have to pick winners, but to be on both sides of that particular equation. For single commodity companies, that becomes a lot harder and they have to look at external risk management techniques to do that. Whether that be entering into long-term off-take agreements or being more active with hedging strategies, they’re things single commodity producers must consider.

JC: Resource nationalism threats have long been at the top of the risk table. Should we expect much change if there is a change of government at the federal level in September?

ME: Clearly there is a difference in policy. If the Coalition were to be elected it may impact some things at the federal level but a lot of what’s taken place in the past year or so has already been embedded in the budget which the Coalition has said they will pass so while they might wind back the MRRT the bulk of the government take out of the sector is actually borne at the state level. And at this point, given the fiscal situation of many of the states, there is no indication that they are going to wind back the amount of impost they are putting onto the mining sector. So from an Australian perspective, a change in government and the impact of resource nationalism will only have a fairly modest impact in the overall government take but many in the sector will probably still see anything as better than nothing.

JC: Mike, thanks for your time. 

ME: A pleasure.