The rising threat of substitution:
mining & metals

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Substitution comes in many forms and can have a market-altering impact on an organization.

“The super-cycle has been unprecedented in its scope and duration. This uniqueness has sown the seeds of the next disruption to business models.”
- Bob Stall, Americas Mining & Metals Transactions Leader

The starkest example is that of the switching of shale gas for coal in the United States. Coal’s share of power generation stood at about a third and natural gas accounted for approximately 30% in 2012, compared with 50% and 18%, respectively, in 2002.

Top risks for coal in 2013-14

EY - Threat of substitution
Source: Business risks in mining and metals 2013-2014, EY.

The prolonged existence of large scarcity premiums in many metals during the super-cycle provided the economic incentive for metals consumers to look for alternatives; the greater the scarcity, the more urgent the hunt.

Those most at risk are single-commodity organizations, or organizations where one commodity dominates the product mix/ profit share.

Although substitution appears to have taken some by surprise, close monitoring of its major drivers can be used as an early warning system. These drivers include:

  • Regulatory change
  • Market drivers — market mismatches between metals allowing arbitrage or so-called price-driven substitution
  • Products with low-profit margins and less dependence on quality and performance
  • Environmental concerns
  • Advances in technology
  • Reduction in dependency on imported material

We take a closer look at the substitution of:

  • Shale gas for coal – An increase in gas production, an associated fall in gas prices driven by the technological breakthroughs allowing large-scale shale gas production, and a change in regulations have caused large-scale coal-to-gas switching in the US.
  • Aluminum for steel – The US Government’s new emissions standards have led to a steel-for-aluminum substitution, with steel producers turning to high-tech steel products as a means of defending their market share.
  • Aluminum, plastics, fiber optics or steel and graphene for copper – With a scarcity premium still present in its price, copper is at significant risk of substitution in roofing, plumbing tubes, refrigeration, air-conditioning and computer chip interconnects.
  • Palladium for platinum – Related to the automotive industry is the substitution of palladium for platinum in gasoline and diesel catalytic converters. Palladium demand is intensifying globally due to more stringent government emissions regulation.
  • Pig iron for nickel – Chinese nickel pig iron production remains a major issue for global nickel supply.
  • Rare earths – China’s export restrictions and the associated challenges of availability and supply security have caused automakers, clean tech developers and rare-earth substitute makers to look for alternatives to reduce their exposure to these expensive raw materials.

How are companies responding?

The knowledge of possible substitutes is generally well known, but historic price relationships, regulations and technologies tend to reinforce thinking that the status quo will be preserved.

This causes the risk to be underplayed in enterprise risk management activity, where the likelihood of substitution is often considered remote. Hence, adaptive planning is not seen as a priority.

This approach misses the likelihood of any individual disruptive event giving momentum to a substitute. While this may seem improbable, the current environment (the super-cycle) has raised the risk of all events (e.g., technology, regulation, market dislocation). The likelihood of one or more of these risks occurring is now also much higher.

Therefore, prudent mining and metals companies are considering the following approaches:

1. Diversifying: by taking an option on the rise of a potential substitute to buy “insurance” while the “premiums” are inexpensive and understanding commodity switching in the long-term capital budgeting process
2. Improving business intelligence: buying time through early warning to increase the potential of adaptive strategies being effective
3. Matching risk management with investment time horizons: as investment in mining and metals is a long-term prospect, so is the period over which risk management needs to be effective
4. Becoming the lowest quartile producer: greater asset quality, productivity and cost competitiveness will generally assure business continuity and provide longer buffers for adaptation
5. Using derivatives in risk management: if playing for time is necessary for adaptation, the derivatives market can increasingly provide lower cost, temporary insurance
6. Investing in research and development: broadening the usage base of products or examining the superiority (and higher economic value) of the product vs. the substitute
7. Lobbying governments to remove unfair incentives: substitutes that arise from unequal treatment in regulation require early identification and need to be brought into the political debate
8. Developing coping mechanisms where relative price performance is only temporary: some substitution may only be temporary, but producers need to be able to survive to prosper once again
9. Revisiting the optimal capital structure to compete: considering whether historic debt and gearing levels are appropriate for a lower margin environment
10. Divesting businesses and products at most risk: acting early and decisively before market sentiment changes and asset prices fall