Capital allocation risk threatens miners’ future growth

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Capital allocation and access to capital have rocketed to the top of the business risk list for mining and metals companies globally, up from number eight in 2012, in Ernst & Young’s annual Business risks facing mining and metals 2013-2014 report released today.

Ernst & Young’s Mining and Metals Sector Leader for Africa, Wickus Botha says these “capital dilemmas” threaten the long-term growth prospects of the larger miners at one end of the sector, and the short-term survival of cash-strapped juniors at the other end.

Margin protection and productivity improvement (two, up from number four) and resource nationalism (three, down from one) round out the top three risks, while the threat of substitutes is a new entry in the rankings at number 10.

“The rising business risks that are top of mind with mining and metals CEOs and Boards today are being driven by the need to protect returns and manage the interests of varied and often competing stakeholders. This is in stark contrast to just 12-18 months ago when fast-tracking production was still top of the agenda and capacity constraints defined the key business risks,” says Botha.

For larger miners, 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 shorter-term return horizon of new yield-focused shareholders in the sector. The sluggish share price performances of the sector also shifted the focus to returns through dividends.

“Many years of high growth in earnings, cash flows and capital appreciation has attracted a different group of investors to mining, investors with shorter-term investment horizons who are not as comfortable with the sector’s longer-term, and often counter-cyclical, development, investment and return horizon,” he says.
“Shareholders with very short-term investment horizons do not seem to understand that every shovelful of dirt miners pull out the ground is a shovelful closer to not having a business – investing in growth is fundamental for the sector.”

“This raises the question of how to balance the demands of short-term shareholders with those investing for longer-term returns. There is concern that the pendulum may swing too far, raising the possibility of another period of endemic underinvestment in new supply and resulting in future price volatility.”

“There is a profound risk that the decisions taken by mining and metals companies today could damage their growth prospects, destroying shareholder value over the longer-term.”

Junior miners fight for survival
On the other side of the “capital dilemmas” are the junior miners – they are cash-starved and their survival is under threat.

Botha says: “The dramatic and continuing sell-off in equity markets has starved the junior end of the market of capital. Advanced juniors and mid-tier producers have been caught in the middle, exposed to a fragile balancing act between investors’ thirst for yield and low tolerance of risk.”

The cash and working capital position of the industry’s smallest companies underlines the severity of the situation. On average, they have less than US$1 million in cash and equivalents on their balance sheets at 31 December 2012.

The 2013 top 10 strategic business risks in the global mining and metals sector:

  1. Capital dilemma – allocation and access (8 in 2012)
  2. Margin protection and profitability improvement (4)
  3. Resource nationalism (1)
  4. Social license to operate (6)
  5. Skills shortage (2)
  6. Price and currency volatility (7)
  7. Capital project execution (5)
  8. Sharing the benefits (9)
  9. Infrastructure access (3)
  10. Threat of substitutes (new)

Margin protection and productivity improvement essential

A decade of higher prices has concealed the impact of rampant cost inflation, falling productivity and poor capital discipline in the sector.

The softening of commodity prices in 2012, the legacy of the “growth at any cost” phase of the super cycle, and rising costs created a “perfect storm” to squeeze margins and drive down profitability. As a result margin protection and productivity improvement has jumped to number two in the risk rankings.

Botha says that while some of the factors squeezing margins – such as scarcity premiums for inputs or high producer currencies – will ultimately self-correct as mineral prices fall, companies still need to address operating costs and capital allocation.

“Productivity in the sector has been on the decline for nearly a decade, across manpower, equipment, processes and logistics,” says Botha.

“Those who have tackled costs early are now focusing on optimising productivity through more judicious use of labour, equipment and using innovation as a means of enhancing productivity.”

Resource nationalism remains prolific

Resource nationalism remains prolific around the world and continues to be a critical issue for mining and metals companies.

Botha says increasing taxes and royalties, mandated beneficiation, government ownership and the restriction of exports continue to spread across the globe.

“As resource nationalism has become more endemic, mining and metals companies have become better at managing this risk,” he says.

“There are some signs that the retreat in capital investment by the sector may see governments take a more considered and cautious approach, but the mining and metals 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.”

Social license to operate persists

Social license to operate has consistently been placed between four and six in the risk rankings. Community and environmental activists have become more vocal and powerful through the use of social media, around concerns over climate change, competition for water and the impact mining has on communities.

The speed with which new issues arise continues to accelerate, and anti-mining sentiment continues to proliferate against a backdrop of community and climate change concerns.

As with resource nationalism, the key to achieving and maintaining social license to operate is in better communicating the shared value of mining projects with local communities and other stakeholders.

Skills shortage

Skills shortage slips to five as the deferral or cancellation of new projects brings temporary relief, but staffing the massive current development pipeline still remains an issue.

Botha says, “In addressing the skills shortage challenge, companies must continue to adopt creative and innovative approaches to access new pools of talent; leverage technology; and motivate, engage and retain existing skilled workers.”

Sharing the benefits

Sharing the benefits steps up a place as stakeholders increase their call for a bigger slice of the pie, despite lower margins. While stakeholder demands will naturally rebalance over time, those companies that communicate with their stakeholders to bring that rebalancing forward will create greater value. As sharing the benefits are short term, locking in the stakeholders for the long term is a positive trade-off.

“Stakeholder demands and needs differ depending on the group and their associated drivers and demands. These groups typically include governments, communities, shareholders, employees, suppliers and downstream industries. Understanding their differences and managing these accordingly, will secure the best outcome for all,” says Botha.

Threat of substitutes

The US shale gas boom and the gas-for-coal substitution that has occurred in North America has highlighted the very credible and looming threat of substitution for single commodity companies or companies where one commodity dominates the product mix or profit share.

Botha says: “Threat of substitution has been transformational for the US coal market, with global ramifications. For other commodities, it has the capacity to radically and rapidly change their market should the right conditions prevail.”

Other examples of this threat include: aluminium for steel; palladium for platinum; aluminium, plastics, fibre optics or steel and graphen for copper, and; pig iron for pure nickel.

Substitution affects some commodities and some countries more than others, with the first indication a threat exists seen in factors such as: regulatory changes; commodity cost or supply issues; products with low profit margins and less dependence on quality and performance; environmental concerns, and; technology advances.

For South Africa, the warning bells are sounding to diversify its “commodity mix” and the importance of monitoring interdependent sectors. “Once substitution starts occurring, it is potentially irreversible as it could cause a structural shift in consumer habits,” concludes Botha.

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