EY’s annual Business risks facing mining and metals report recently has highlighted that the twin capital dilemmas of capital allocation and access to capital have rocketed to the top of the business risk list facing mining and metals companies globally. These capital dilemmas are strategic risks that threaten the long-term growth prospects of the larger miners at the one end of the sector, and the short term survival of cash strapped juniors at the other end.
Large mining companies have had to learn to balance shareholder demands with long-term growth strategies. The rapid decline in commodity prices in 2012, rampant 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.
Many years of high growth in earnings, cash flows and capital appreciation have attracted a different group of investors to mining. These investors have short-term investment horizons and are not as comfortable with the sectors’ cyclical nature and its longer-term and often counter cyclical horizon. This raises the question of how to balance the demands of short-term shareholders with those investing for long-term returns. 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.
The dilemma for junior miners could not be more different. The dramatic and continuing sell-off in equity markets has starved the junior end of the market of capital levels not seen in the last 10 years. Advanced and mid-tier producers have been caught in the middle, exposed to a fragile balancing act between investors’ thirst for yield and low tolerance risk.
The cash and working capital position of the industry’s smallest companies underlines the severity of the situation. Companies with a market value of less than US$2 million – about 20% of the listed mining companies across the main junior exchanges – had on average less than US$1 million in cash and equivalents on the balance sheets at 31 December 2012.
The second risk highlighted in the report is margin protection and productivity improvement. A decade of higher prices has concealed the impact of rampant inflation, falling productivity and poor capital discipline in the sector. In 2012, the softening of commodity prices in an environment of escalating costs had a major impact on bottom lines, resulting in significant impairments and derating of company stock prices. A weak external environment and the lack of investor confidence have heralded an industry-wide directional change from growth for growth’s sake towards long-term optimisation of operating costs and capital allocation.
Some of the factors squeezing margins, such as scarcity premiums for inputs or high producer currencies, will ultimately self-correct as mineral prices fall. However, high costs will continue to take a toll on company margins until companies address the longer-term optimisation of operating costs and capital allocation. While the market has been rewarding any cost decreases, those that improve long-term value by being embedded and sustainable will prove the most valuable.
Alongside this, productivity in the sector has been on the decline for nearly a decade, across manpower, equipment, processes and logistics. This has significantly impacted the sector’s input to output ratio. Those who have tackled margin protection early are increasingly turning their focus towards optimising productivity through their capital structure, and more judicious use of labour and equipment. These companies are also focussed on using innovation as a means that firms can better monitor and analyse processes in order to understand why productivity is falling and to identify and employ better practices.
Resource nationalisation is a business risk which is every bit as critical as it was last year. The other business risks mentioned above have now exceeded it in the urgency with which they need to be addressed. In some respects, companies are becoming less sensitive to the shock of resource nationalism as it becomes increasingly prolific year-on-year (y-o-y). Rising 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. 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.
The threat of substitutes is a business risk to the monitor closely as its most acute ramifications are being felt across North America. The US shale gas boom and the gas-for-coal substitution that has occurred was sudden and the impact unexpected, with global ramifications. It 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. The first indication that a threat exists can be seen when there are regulatory changes, commodity cost or supply issues, products with low profit margins, environmental concerns or technology advances. And once substitution starts occurring, it is potentially irreversible as it could cause a structural shift in consumer habits.
Substitution has the capacity to radically and rapidly change their market should the right conditions prevail. Other substitution examples include aluminium for steel; palladium for platinum; aluminium, plastics, fibre optics or steel and graphene for copper; and pig iron for pure nickel.
Social licence to operate has become a more important business risk in the most recent survey as activists become more powerful and vocal through the use of social media around concerns over climate change, competition for water and the impact mining has on communities.
Skills shortage has declined as a business risk as the deferral or cancellation of new projects brings temporary relief, but staffing the massive current development pipeline still remains a red hot issue. Price and currency volatility sees lower commodity prices testing the viability of marginal mines in the face of increasing costs. While the ramifications of poor capital project execution have largely been absorbed by the sector, a record amount of construction is still in progress.
Sharing the benefits has become more important as a business risk as stakeholders increase their call for a bigger piece of the pie despite lower margins, and infrastructure access continues to test the miners as financing evaporates.
Half of the risks that were present six years ago remain as critical today. A sector participant’s ability to mitigate these challenges can mean the difference between survival and profitability.
More information regarding EY’s annual report relating to business risks facing mining and metals can be obtained at: www.ey.com/ZA/en/Industries/Mining--Metals
Contribution by Cameron Kotzé, EY Namibia mining and metals sector leader. PF