Business risks facing mining and metals – CFO perspective

Business risks facing mining and metals: CFO perspective

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As the mining and metals industry shifts its focus to margin quality rather than price-driven volume growth, CFOs need to manage increasing risks and balance divergent stakeholder demands, while maximizing returns.

Six insights for CFOs

  1. CFOs of major mining and metals companies must balance capital allocation

The rapid decline in commodity prices in 2012, rampant cost inflation and falling returns have created a mismatch between miners’ long-term investment horizons and the short-term return horizon of new yield-hungry shareholders in the sector.

These investors have short-term investment horizons. They are not comfortable with the sector’s cyclical nature and its longer-term and often countercyclical development, investment and return horizon. In large companies, CFOs need to balance the demands of shorter-term shareholders with those investing for long-term returns.

The risk is that pandering to the markets today could damage growth prospects, destroying shareholder value over the longer term. Balanced communication with long-term messages will help to reach and attract the long-term investors and greater transparency will ensure the trust of all shareholders.

  1. CFOs of many junior miners should be in survival mode

Investors pulling back from riskier investments in the junior end of the market have created a capital desert for this segment of the market. Companies with a market value of less than US$2 million had on average less than US$1 million in cash and equivalents on their balance sheets at 31 December 2012.

The situation is so severe that many are not in a position to wait for market conditions to improve. For these smaller firms, CFOs must go into survival mode, optimizing the company to ride out the capital drought.

This obviously entails cost discipline and cutbacks, but CFOs must take care to preserve assets that are not easily replaced so that the company can move forward once capital flows are stronger. A rationalization of the market is expected, and CFOs should also look to attract private capital investors who are favoring the juniors with more advanced projects.

  1. CFOs need to optimize operating costs and support the drive for higher productivity

With such a significant shift in the market under way, CFOs are now required to focus on improving productivity by removing inefficiencies that occurred during the period of high commodity prices.

Even a return to the productivity levels of labor and equipment that existed a decade ago would yield major benefits to margins. Some of the factors squeezing margins, such as scarcity premiums for inputs or high producer currencies, will self-correct as mineral prices fall. However, high costs will continue to take their toll on margins until CFOs can drive a longer-term optimization of operating costs and capital allocation.

While the market has been rewarding any cost decreases, CFOs should remember that those that improve long-term value by being embedded and sustainable will prove the most valuable and ultimately be rewarded by the market on a sustained basis.

  1. CFOs need to be more politically savvy than ever to factor country risk properly into investment models

Resource nationalism remains widespread and many mining and metals companies have become better at managing this risk. There are some signs that the retreat in capital investment by the sector may see governments take a more considered and cautious approach. The sector must continue to engage with governments to foster a greater understanding of the value a project brings to the host government, country and community.

CFOs need to be more politically astute than ever before so that country risk is accurately featured in models. Top companies are driving strong relationships with government, effectively communicating the positive impacts of mining and increasing the transparency of government payments.

  1. With heightened price and currency volatility, CFOs need to implement best practice in measuring uncertainties, probabilities and the impact of decisions on expected returns

Lower commodity prices are testing the viability of marginal mines in the face of increasing costs. In addition, supply and demand are now approaching equilibrium, but longer lead times in production shifts mean corrections in supply will cause increased price volatility.

The next two-to-three years will be characterized by sharper and more frequent movements in prices. CFOs will no doubt be implementing short-term commodity hedging but, for most, the opportunity to establish an effective hedge has passed.

CFOs should now be considering potential price and currency outcomes well beyond current forward curves and mine plans. The goal is to improve the estimation of uncertainties, probabilities and the impact of decisions on expected returns.

This is a deep challenge, but some measures CFOs can spearhead include the following:

  • Document the volatility of critical cash flow elements and improve mine planning to match volatility
  • Better integrate mine and financial planning
  • Consider how price and currency volatility will change the corporate risk appetite
  • Choose the right tools to react to price risk
  • Increase the flexibility of costs to vary production levels
  • Create the process to assess new price data quickly and amend mine sequencing in order to react to price and currency volatility

The next price upswing will give companies the opportunity to commence a new hedging program that provides better protection from future downward price volatility.

  1. CFOs should be more involved in leading project selection and managing capital execution risk

While the ramifications of poor capital project execution have largely been absorbed by the sector, a record amount of construction is still in progress and more failures could be ahead. Managing capital project execution risk increasingly depends on increased involvement and accountability of executive management in portfolio management, project selection, size and scoping decisions.

CFOs are central to this as the role becomes much more strategic. This involves a focus on prudent project selection and planning, improved capex predictability, establishing a robust governance structure and contingency planning.

In an environment of volatile commodity prices, low profitability and mounting pressure from shareholders, future mega-projects should be approved as programs with multiple projects. This will provide CFOs with more options for reassessment throughout the project life cycle, granting them much needed flexibility in an otherwise inflexible environment.