Mining's mountain of money

Summary: Assuming current metal prices continue to 2020, Australia's biggest miners are headed for a mountain of money, which has three possible uses detailed below. China is once again dictating the terms of commodity markets, but there are some changes compared to the last time the mining industry found itself in this situation.

Key take-out: Three of Australia's biggest miners look to be headed for a cash flow of between $73 and $92 billion. Investors should note the game of rising prices is being played again, but the good work has largely been done in advance this time, where mining companies have made substantial progress in repairing bruised balance sheets.

If you believe that latest research from one leading investment bank, there is a $92 billion prize that explains the tug-of-war between mining company managers who would like to expand into a period of strong commodity prices, and hard-nosed shareholders who want fatter dividends.

That handsome pot of money (equivalent to $US70 billion) is what Citi reckons will be harvested by three big miners alone over the next three years, assuming current metal prices continue to the year 2020.

But even if prices ease back to long-term forecast levels, the free cash flow heading for BHP, Rio Tinto and South 32 will be an almost-as-exciting $73 billion ($US56 billion).

That mountain of money has three possible uses. It could be reinvested in new projects, returned to shareholders, or divided in a way that satisfies both demands – a devilishly tricky process which will fully test mining company directors over the next few years.

On the one hand, there is a need for all mining companies to reinvest, for the simple reason that every day they ‘eat' the orebodies they're mining, and while it is a fashionable public relations claim, there is no such thing as a ‘sustainable' mine.

On the other, there is a need to reward shareholders who have travelled a rocky road over the past few years. The mistakes of the boom which ended in 2011 are still being absorbed, including massive overinvestment in production capacity bumping into slowing demand in China, leading to a collapse in commodity prices.

Today, the game of rising prices is being played again. China is, once again, dictating terms in commodity markets through internal supply cutbacks in the name of cleaning up its polluted environment. There are a few subtle changes this time around, such as the entry of battery metals, to meet forecasts of a big increase in the production of electric cars.

It is this outlook of strong prices and lack of new investment which prompted Citi to tip a massive boost to the free cash flow of the major miners in a report titled Bull back in the China shop.

Underscoring Citi's theory that commodity prices and miner share prices are heading higher is a claim that global growth is accelerating. Global growth is tipped to be heading for 3.4 per cent in 2018, comprising an expansion of 4.8 per cent in the economies of emerging countries, 2.4 per cent in advanced economies – and 6.5 per cent in China.

Those growth forecasts fit neatly into the bank's argument that “commodity demand should continue to expand, particularly given that the broad-based recovery is driven by materials intensive investment and trade growth”.

Examples of what is expected to happen next year include a 20 per cent increase in the price of iron ore with Citi upgrading its forecast for the steel-making material from $US53 a tonne for benchmark (62 per cent iron content) material to $US64/t.

The outlook for metallurgical (or coking coal used to make steel) has been lifted from $US133/t to $US155/t. The copper price forecast has been raised from $US2.91 a pound to $US3.22/lb and aluminium has been increased from US92c/lb to US95c/lb.

As with all commodity price forecasts, the latest from Citi needs to be understood as just that – a forecast. However, in this case, the bank has backed up its optimism with a plausible explanation that starts by noting that all through the current calendar year there has been a process of consistent upgrades as the effect of better-than-expected Chinese growth flows through metal markets.

Prices might not continue to rise next year, but the good work has largely been done with mining companies having made substantial progress in repairing bruised balance sheets. They are ready to start the reinvestment process, or at least become a lot more generous with their dividend and share buyback programs.

“If the disciplined capital allocation approach of companies is maintained, which we expected it will, given a lack of projects and viable merger and acquisition targets, this free cash flow will flow to shareholders,” Citi strategists said in the research note.

The three diversified miners analysed by Citi for this latest look at future potential cash flows were BHP, Rio Tinto and South 32. But the argument supporting those stocks can essentially be applied to the entire mining sector.

“We expect BHP, Rio Tinto and South 32 to deliver a cumulative free cash flow of $US56 billion over the next three years on our commodity forecasts, with further upside to around $US70 billion at spot commodity prices,” Citi said.

How the mining industry manages its good fortune this time will be closely watched by investors who have not forgotten what happened in the latest period of strong cash flows when much of the money was wasted.

This time, as has been said many times before, it might be different (fingers crossed).