hen Champion Formula 1 driver Lewis Hamilton says, “every lap is different”, long term investors studying the current mining cycle know what he is talking about. After the highs and lows of the last ‘super’ cycle, companies and investors this time around appear much more cautious and disciplined.
Since commodity prices bottomed in Q1 2016, the major mining companies have made good progress managing cash and driving efficiencies to capture the gains for investors. With key commodities performing well, analysts are forecasting that average sector EBITDA margins of the major mining companies will hit a seven-year high in 2018. This will see average margins approach 2010/11 levels of circa 45%, turning the corner after the 2015 trough. Meanwhile the brakes remain firmly on capital investment. Aggregate capital expenditures are forecast to remain at half of 2011 to 2014 levels. Spending remains focused on sustaining capital and absent are large scale development projects. This is driving higher free cash generation, increasing dividends and reducing net debt across the sector.
For now, growth seems largely off the agenda of the big producers. With focus on essential sustaining capex, new capital investment has been modest and mostly targeted on debottlenecking, process improvement and/or technological efficiencies. Sweating assets provide good returns on limited capital, but the gains are incremental and will see diminishing returns over time.
The key questions are when will growth and an M&A focus return to majors? This is key to the share price performance of both mid-tiers – being the likely targets – and junior mining companies advancing the next generation of assets. While further commodity price increases are possible and desirable, it would seem the largest price-driven margin gains have already been achieved for this cycle, at least amongst the big diversifieds.
Production from the Majors in copper equivalent terms are projected to be broadly flat on 5-10 year view, sustained by long life assets but lacking net planned growth. This may be favourable for investors if margins are maintained, but will they be?
At constant prices and production levels, the threat to margins is cost inflation. While it is still early days, costs inflation has begun. Recent results from BHP cited rising inflationary pressures in coal. Australian statistics show mining wage growth in Australia was up 1.4% in 2017, advancing each quarter since the trough of 0.6% YoY in March 2017 (albeit it remains a long way below the 2006 to 2012 average of 5%). The oil price has also returned above US$70 per barrel, up 28% YoY to the end of March, and is looking well supported with a reduced inventories, output and heightened geopolitical risks. Flat output and rising costs risk dampening earnings.
This could lead investors and majors to look for accretive growth opportunities. Investors in the major miners, keen for now to realise cash returns, may come to question the corporate strategy of the companies they hold when facing limited growth and declining earnings. The severity of the last downturn and the scale of misallocation of capital in the prior upswing seem to have left investors with long memories and an acute resistance to large scale acquisitions. The deals which have arisen to date have been tentative, strategic stakes – majors getting a toehold on growth options. Examples are Newcrest’s strategic partnership and investment in Lundin Gold, and stake building by South 32 in Arizona Mining, or Gold Fields in Cardinal. This suggests majors and mid-tiers know the market timing is right to refill their pipelines but are currently hesitant to go large.
With increasing available capital and confidence, the pressure to maintain or grow earnings will likely surpass this resistance and see merger and acquisition activity intensify over the next 12-18 months. Timing is always key – and the best time to acquire growth projects, is ahead of the inflation curve.
Like Formula 1, a “perfect lap” may remain elusive, with the mining cycle equally hard to navigate as conditions and events change. However, companies and investors will continue to try to anticipate what is around the next bend, and the market has pace left in it yet.