Core strength

Global demand for metal falters, which affects prices and exploration budgets. But there is light at the end of the tunnel as emerging economies grow and the long-term outlook for the sector brightens, writes Helen Burnett-Nichols.

While commodities prices see-sawed in 2011, global mining companies were busy making plans – with capital expenditure budgets surging as producers and explorers seemed to shrug off short-term volatility and put their confidence in the long-term demand story for metals.

After soaring to record highs in 2010 and early 2011, metals prices did an about-face last year, plagued by uncertainty over the eurozone and fears of a hard landing in China.

The London Metal Exchange LMEX Metals Index fell 19.7% in the year to January 4, according to Bloomberg data.

A tumble for metals prices in late 2008 and early 2009, although much steeper than the fall in 2011, proved difficult for many miners. PricewaterhouseCoopers (PwC) reports that 14 of the top 40 mining companies announced mine closures, production cuts or placed mines on care and maintenance in the first quarter of 2009, with $13 billion (£8.5 billion) of capital expenditure deferred or cancelled.

Exploration budgets
Although high metals prices initially buoyed companies’ desire to spend in 2011, some managers and analysts say confidence, coupled with balance sheet health and flexibility, is allowing many miners to continue with their plans this time around.

In its 2011 review of trends in the mining sector, PwC reports that the top 40 global mining companies had more than $120 billion in capital programmes planned last year, more than double the total 2010 spend. (Cover story continues below)

Estimated 2011 total exploration budgets for nonferrous metals – precious and base metals excluding iron ore and aluminium – surged 50% to a new high of $18.2 billion, up $6.1 billion from 2010, according to a recent exploration strategies study by Canada-based Metals Economics Group.

Following its third-quarter 2011 results, Freeport McMoRan Copper & Gold’s chairman and chief executive noted that although the near-term economic outlook is uncertain and the copper price had declined in recent weeks, the fundamentals of its business are strong and they “have a positive view of the long-term market fundamentals” – a sentiment echoed by many in the sector.

“Longer-term, we believe that the fundamentals are positive, and that demand growth will outstrip supply growth in the long term and that will keep commodity prices at attractive levels,” says Richard Davis, manager of the BlackRock World Resources Income fund.

For the emerging economies, forecasts seem to back up this long-term view. Responsible for consuming more than 40% of all global metals supplies, according to the World Bank, China is forecast to grow 8-8.5% each year from 2012 to 2016, notes the Economist Intelligence Unit. This compares with expected eurozone growth of 1.2-1.7% in the same period.

Although positive views on the long-term demand story abound, near-term risks and uncertainty for the sector persist. Opinions differ on whether volatility and pressure from shareholders will ultimately lead to a slowdown in exploration spending.

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The level of volatility seen in metals prices in 2011 was not unprecedented, says Jason Goulden, the vice-president of research at Metals Economics Group. But the situation is also not as comfortable as it would have been in 2007, early 2008 and even in 2010.

“The longer that volatility stays in the market, the less confidence companies have. Metals prices are the primary driver of exploration spend. So long as metals prices are high, or people have a high degree of confidence, exploration spending will remain high or continue to increase,” says Goulden.

During the last peak in exploration spending in 2007/2008, many companies indicated that they would continue to spend through any correction, he explains. But while a handful of companies did maintain a fairly high level of exploration following the severe correction of late 2008 and early 2009, many did cut spending.

”Demand growth will outstrip supply growth in the long-term and that will keep commodity prices at attractive levels”

While large and intermediate companies are generally self-funding on the exploration front, with low metals prices, this type of spending can become difficult to justify to shareholders, says Goulden.

“The tell-tale signs will be in the first couple of months of 2012. If we have a significant correction in a basket or any particular metal, that will have a negative impact on exploration spending,” he adds.

For many market observers, the nearer-term picture for metals demand coming from China and the OECD countries remains murky, with volatility expected to persist as long as economic and political uncertainty continue. According to the International Copper Study Group, in the third quarter of 2011, copper usage fell 8.5% in the European Union, 12% in Japan and 4.9% in America, compared with the same quarter of 2010.

Threats to demand
Meanwhile, the International Monetary Fund (IMF) is expecting growth in China to slow to 9% in 2012, down from 10.3% in 2010. Copper imports in China fell 5.1% in 2011 compared with the previous year, according to data from China’s General Administration of Customs data, although December’s import total was significantly higher than the same month of 2010.

On the other hand, gold demand rose 6% in the third quarter of 2011, driven by investment demand as a result of the American credit rating downgrade and the eurozone sovereign debt crisis, according to the World Gold Council.

As a result, Caroline Bain, senior commodities editor and economist with the Economist Intelligence Unit (EIU) says she expects volatility to remain a feature of 2012.

“We certainly expect financial markets generally to be quite fragile in the first half of [2012]. We think there’ll be more mini-crises and quite volatile exchange rates, which will affect commodity markets as well,” she says.

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After climbing more than 45% in 2010 and 22.5% in 2011, the EIU’s global forecasting service expects prices as measured by their industrial raw materials index, which gives a heavy weighting to copper and aluminium, to fall by an annual average rate of 13% in 2012, before stabilising in 2013 and starting to strengthen from 2015.

Bain explains that the EIU does not see prices falling significantly more than they already have, as a lot of the “bad news” has already been priced into metals markets, with the metals that are in relative short supply, such as copper and tin, expected to outperform the others.

Still, there are several risks affecting metals prices in 2012, says Bain. Although the EIU has put a low probability on China slowing more than anticipated, she says the obvious risk is that the eurozone situation deteriorates, which would have a greater effect both on emerging market growth and demand for metals. “If that were to happen, then I could see base metal prices falling very sharply,” she says.

”So long as metals prices are high, or people have a high degree of confidence, exploration spending will remain high or continue to increase”

While Peter Ghilchik, multi-commodity manager with CRU International, is also not expecting 2012 to be any less volatile for commodity prices, he says short-term investor influence and newsflow is, in some senses, contradicting what fundamentals for the industry are saying.

“The medium-term outlook for the industry is still quite positive on prices because we still see demand for metals in the medium term, looking out five years or so,” he says.

As such, from the miners’ perspective, many seem unyielding in their plans to press on with their growth strategies.

In its Global Capital Confidence Barometer for the mining and metals sector, released in the fourth quarter of 2011, Ernst & Young noted that half of executives in the sector intend to focus on growth over the next 12 months. Only 7% of companies are focusing on survival, which the organisation says is the lowest number since 2009.

“Currently, leading companies are shrugging off continued market upheaval and focusing on growth and M&A [mergers and acquisitions]. For them this is not 2008 all over again. They have spent the past three years reducing the financial risk on their balance sheet and taking tough efficiency measures needed to strengthen their positions, which helps them manage in volatile times,” says the report.

Indeed, with months or years of greater volatility ahead, many companies are realising they cannot afford to sit on the sidelines.

They are instead developing greater strategies, particularly around flexible operations, to look at how they cope with that volatility and potentially even use it to their advantage in the short term, says Mike Elliott, Sydney-based global mining & metals leader for Ernst & Young.

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“In short periods of potentially lowering prices, they can do things such as accelerate plant maintenance and shutdown maintenance and take advantage of that particular window, with a view that also in the short term, there will be some kick in prices and they can do the opposite.

“At that point in time, they can make short-term deferrals in their flexible mining operations of maintenance and things like that, to be able to accelerate production and take advantage of some of the spikes that might exist from time to time,” he says.

In addition, he says, the fundamentals for long and medium-term demand still haven’t changed.

“I think the confidence in being able to make long-term investment decisions, knowing that there’ll be long-term demand for those products, is still underwriting some of that growth strategy that exists among several mining companies,” he adds.

In contrast to late 2008/early 2009 when many miners ended up in precarious financial situations in terms of their balance sheets, says Neil Gregson, manager of the JP Morgan Global Mining fund, their financial houses are much stronger and their large projects are at the lower end of the cost curve.

While slowing down expansion programmes and capital development is still a choice for miners if the situation deteriorates further from a commodity price point of view, says Gregson, the large mining companies so far have said that they don’t want to delay or push back their capex programs.

“Most of them delayed all these projects post-Lehmans and then they find out that it costs them a lot more to get them going again, to get all the labour back on site, to get the engineers and consultants back on site,” he adds.

”In short periods of potentially lowering prices, they can do things such as accelerate plant maintenance and shutdown maintenance”

Davis says many companies are still pressing ahead with expansions and trying to bring on new supply, making decisions with a 10 to 25-year view, rather than the next quarter or two, which, in this type of market, is what investors are interested in.

“The fact that they’re going ahead today with these expansions and programmes of expenditure tells us that they believe in the long-term fundamentals in the commodity market,” says Davis.

In 2011, for example, BHP Billiton outlined a five-year plan to invest $80 billion in capital expenditure on “tier-one, value-adding growth opportunities.”

Further emphasising their confidence and added risk tolerance, companies also started to explore in higher-risk areas in the last year, with countries perceived to be high risk accounting for 23% of the 2011 aggregate exploration total, up from less than 16% in 2010, according to Metals Economics Group.

Ani Markova, co-manager of the Smith & Williamson Global Gold & Resources fund says mid-tier and larger cap companies trying to optimise their production will be undertaking a lot of brownfield exploration work, with producing companies still focused on replacing their reserves and resources through organic growth – trying to better optimise licences and explore parts of their concessions where they haven’t looked before.

She says companies with new discoveries will potentially be taken over by the mid and large-cap companies with the intent of those assets being developed further and being brought under their production umbrella.

“Last year, we’ve seen a lot of junior financing, we’re now starting to hear exploration success in various situations, various belts and countries, which is very encouraging. And certainly, we don’t particularly think there will be a slowdown. I think the companies and the projects that have economic potential will get financed,” she adds.

However, in a period of volatility, says Elliott, with a variety of views as to the medium-term outlook for commodity prices, fewer people have the risk appetite to put new capital into exploration.

“We’re seeing at the moment, juniors finding it harder to raise that equity, that risk capital, and by virtue of them not being able to access the markets as easily, you would expect that their exploration budgets are likely to be reduced, compared with where they were last year,” he says.

Looking at the long-term pipeline, another possible issue, says Goulden, is the industry-wide trend away from grassroots work towards later-stage projects or near-term developments, even when it comes to junior mining companies.

“Its not just the major companies that are focusing on their larger assets, their producing assets, the juniors themselves are working on later-stage projects of variable quality because shareholders demand that there be an asset and they need something to be able to advance it and with the hopes of someday maybe selling it up. But without a more concerted effort by someone in a grassroots, in that generative arena, it’s possible that the long-term pipeline could be pinched,” he says.

Even if smaller projects are able to obtain financing, with costs rising so much in recent years, some miners are still struggling to make profits. Other supply-side factors such as labour shortages also persist, resulting in delays.

Metal prices

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“There is a big risk [in 2012], I think, for the more medium-term outlook, that if demand is lower, and costs don’t fall significantly, that we could see less investment going in. If credit markets start to tighten again, it could mean that once demand picks up, the supply side will be lagging behind,” says Bain.

However, the double-digit tumble in 2011 on average for base metals prices is not disastrous for metal producers of a commodity such as copper, where most producers still have comfortable margins even at current prices, says Ghilchik.

“Global demand growth for copper has probably been the lowest of any metal in the last 10 years, yet its price performance has been three-fold return versus flat for aluminium, which has seen the highest demand growth”, says Gregson.

Copper has also experienced supply side problems, including some mines not able to increase production in 2011, with managers saying companies need to manage their exposures to global constraints such as labour shortages, deposit constraints and country risk over the longer term.

In aluminium production, a large amount of the cost input is power, says Ghilchik. With power prices rising, the cost of production has increased substantially, meaning marginal producers at the top end of the cost curve get squeezed.

”If credit markets start to tighten again, it could mean that once demand picks up, the supply side will be lagging”

“Those marginal producers in certain regions are being squeezed and we expect that they’ll continue to be squeezed [in 2012]. So the story is quite different when you look across the metals spectrum,” he says.

“There’s not that many aluminium companies that are making money at current prices, so several commodities are already at prices where you start to see some of the marginal production knocked out,” says Gregson.

In early January, aluminium producer Alcoa announced that it intends to curtail operations at three European aluminium smelters, as a result of “an uncompetitive energy position, combined with rising raw material costs and falling aluminium prices”.

Indeed, although the long-term picture looks positive, only so many factors are under miners’ control. According to a recent report from Deloitte Touche Tohmatsu Limited, one of the top trends expected to affect the mining sector in 2012 is commodity price chaos, and the fact that there will be no price stability without greater transparency. “Making informed decisions in this highly uncertain environment requires a level of forecasting many companies lack,” says the report.

James Thomson, manager of the Rathbone Global Opportunities fund agrees, noting that the business model and prospects for the sector look too risky.

“Ultimately the biggest risks are wild swings in valuation and revenue streams that are at the mercy of commodity prices, key variables entirely out of the company’s control. If you’re looking to invest in a sector that has some control over its own destiny, look elsewhere,” he says.