Global mining businesses have had a remarkable fall from grace over the past 18 months. Talk has moved from a 20-year supercycle and commodity shortages to that of bankruptcy risk and the need for additional equity capital. Andrew Lapping examines the situation.
When an industry is booming, whether it is IT, banking or metals, it is very difficult to see any future other than a continuation of the trend. During the commodity boom, just about all the mining company management teams bought into the higher-for-longer theory and were supported by their shareholders. A good example of the extent to which management believed in the supercycle is BHP Billiton’s progressive dividend policy, which sets out that BHP aims to pay a dividend that only goes up over time. Management went into denial about the fact that BHP is a cyclical commodity business and began to think the business had the stability of a Nestle or a Unilever. BHP has yet to cut its dividend but is now having to use debt to finance the payout – an unhealthy situation.
THE INCENTIVE PRICE IS A MOVING TARGET AS CURRENCIES, COSTS, THE AVAILABILITY OF CAPITAL AND TECHNOLOGY CHANGE.
Investors who own mining companies during booms clearly believe the good times will continue, otherwise they would not own the shares. These bullish shareholders encourage management to borrow money for organic and acquisitive growth. Since investors who don’t believe in the supercycle vote with their feet and don’t own the shares, their dissenting voices that would otherwise balance a debate are not heard at all. The result is skewed and extremely poor capital allocation as management teams invest in marginal projects, buy back expensive shares and pay unsustainable dividends. The mining industry is dealing with the fallout of the most recent cycle of this behaviour and will do so for a number of years to come.
The debt hangover
What seemed like a sustainable level of debt during the good times is now a burden. The ratio of net debt to cash flow before interest, tax and capital expenditure is perhaps the most common measure of debt sustainability. There are a couple of problems with this. Firstly, cash flow increases during times of super profits make the debt ratio appear low; as commodity prices fall, the ratio increases rapidly to a level the balance sheet does not change. The second problem is that interest, tax and capital are very real and necessary costs. A mining company requires capital investment just to stand still, let alone grow. A more appropriate number to look at when assessing a business and its debt level is cash flow after all costs, including maintenance capital, have been deducted, while inputting mid-cycle and trough commodity prices.
A second problem, one which management can do something about, is the overhang of high-cost mines that should never have been built. The additional supply weighs on prices, depressing returns for all mines and the high-cost mines generate cash losses for their owners. Instead of making a tough decision, unfortunately, management teams usually fall prey to the twin traps of denial and hope. They deny the asset is as bad as it seems and they hope to cut costs to a level where the mine makes money. Or they hope commodity prices recover soon to a level where the mine is profitable. The decision to close a mine is obviously very difficult: many jobs are lost and there are immediate cash costs to closing. It is also an active decision. Often managers choose to sustain operating losses for years on end rather than facing the immediate once- off pain of closure (see Ian Liddle’s piece in Quarterly Commentary 3, 2015).
Forecast commodity prices at your peril
Chinese industrial commodity demand growth has slowed down or begun to decline off its unsustainable high base. Chinese demand rose to a level where China was consuming more that 50% of the world’s iron ore, aluminium, copper and nickel. China is a large and populous country but 66% of global seaborne iron ore is a little excessive. As Chinese demand has slowed and the wave of new supply has reached the market, commodity prices have fallen sharply. Nickel is down to US$9 000/tonne from its peak of US$54 000 in 2007 and US$20 000 in May last year, copper is down 35% over the past 18 months and iron ore is down from US$136/ tonne in January 2014 to US$39. Needless to say, the extent and speed of the price declines have shocked observers. Analysts spoke of iron ore not being able to fall below US$80/ tonne, as that was the price at which 250 million tonnes of high-cost Chinese supply would leave the market; nobody mentions the Chinese high-cost supply anymore.
Forecasting commodity prices is extremely difficult as shown in Graph 1. Analysts build detailed supply and demand models that look to forecast the surplus or deficit into the future. These forecasts do not work, especially in the short term when commodity prices can do almost anything. Still, one can make an assessment of whether prices are unsustainably low or high. Prices are high (and likely to fall at some point) when even the high-cost mines are making good margins, the industry is attracting heavy capital investment and companies are buying back shares with ’excess’ cash. Conversely, prices are low (and likely to rise at some point) when even good quality mines are making cash losses, the industry is forced to raise equity capital to fund losses, mines are closing and no projects are in the approval process.
Currently zinc, copper, nickel and oil prices look low. These four sectors have seen severe capital investment cuts, large groups of producers are making cash losses and even the low-cost producers are finding the going tough. For example, more than half of all nickel mines are cash-flow negative before maintenance capital and overheads at spot prices. Meanwhile, 61 of the 62 companies in the Bloomberg North America Independent Exploration and Production Index generated negative free cash flow over the past year.
Historically, investors have reaped rewards by investing in commodity producers when commodity prices are low. In time, low prices cause production to decline and the market to tighten to a level where prices are high enough to incentivise new supply. Other things being equal, low prices should also cause demand growth. Unfortunately it is not possible to know how long it will take for the market to rebalance, nor how quickly and to what level prices will rise. The incentive price (the long-term price corporates have to assume in order to invest in a new project and thus increase supply) is a moving target as currencies, costs, the availability of capital and technology change.
Given that the timing of any commodity price recovery is uncertain, it is important that equity investments are able to weather an extended downturn. Unfortunately these opportunities are few and far between.
The only large mining company with a healthy balance sheet and positive cash flow is BHP Billiton; the problem with BHP is that most of its profits come from the iron ore division where industry margins are still high relative to the past (the potential exit of high-cost Chinese supply, which may allow margins to remain high, is something we are looking at closely). Both Anglo American and Glencore have substantial debt burdens. Glencore is actively cutting its debt, has a cash generative trading business and is closing loss-making mines. Anglo American has sold some assets but is not addressing the high-cost structure as aggressively as we think it needs to, nor is the group looking to close high-cost mines. Anglo management also has a particularly poor capital allocation track record.
We are net buyers of mining shares, Glencore and African Rainbow Minerals being the two most significant, but we are cognisant of the risks.
How do we value these businesses given the difficulties in forecasting commodity prices?
Our approach is layered. We look at long-term margins, together with industry returns, and calculate the expected earnings if margins and returns go back to their long-term norms. In an industry like copper or oil, where production on existing assets declines relatively quickly, it is useful to consider the incentive price for new investments. To do this, we look at what recent projects have cost and adjust these costs to reflect the current environment (development costs are lower when commodity prices are low). We also consider the quality of deposits or reserves that may be developed. Of the known metal deposits, it is usually only the poor or high-cost ones that have not yet been developed – this puts the existing assets in a good position, as new mines tend to have higher cost structures. In spite of the current benign engineering costs, very few (zero) mining companies will approve a new nickel, zinc or copper mine development at current prices. If they had a decent ore deposit, they would have developed it when sentiment was positive and cash freely available.
After valuing a mining company using normal margins, replacement costs and cash flows at incentive prices, we only invest if the risk/reward profile is heavily skewed in our favour. It is important to have a substantial margin of safety when investing in mining businesses given the uncertainties, poor economics and generally weak management in the sector.
A spot commodity price gives almost no indication of what the price will be in a year’s time or average over the next 10 years. Interestingly, many investors use the spot price as the basis for their long-term price assumptions; this is natural as we all tend to anchor our assumptions on the present situation. What is more surprising, is the extent to which equity prices move on a day-to-day basis with the spot commodity price. For example, if the oil price falls 2% on a day it is likely that most oil company share prices will fall at least 2%. If an oil company trades on 10 times annual earnings, the share price should discount the expected average oil price for the next 10 years. So the oil price move on a single day is totally irrelevant (well it does affect 1/3650th of the value, so a 2% lower price on a single day should move the share price by 2%/3650 or 0.00055%).
Share price volatility tells us that investors use the spot price as the main input into future prices. This can result in exceptional equity investment opportunities if, as investors, we can form a strong view on the long-term sustainable prices for a commodity. We can take advantage of the market’s short termism and invest when the share price discounts an unsustainably low commodity price. This applies when spot prices are well above the sustainable price, as well as below.
The oil story
The position where we have the strongest sense of a sustainable price is oil. We believe an oil price of US$40 is totally unsustainable. Outside of Russia, Saudi Arabia, Iraq, Libya, Iran and the UAE (these six countries account for 38% of supply), the rest of the world cannot sustain production at these prices: in our view, prices need to be at least US$60 to maintain production. Fortunately in Sasol we can express this view. Even better, Sasol is cash-flow positive before growth capital at spot oil prices and, as of June 2015, was debt free, so time is on our side. The lower risk profile and favourable time dynamic of Sasol is why it is one of our largest shares, while the cash flow negative, indebted mining companies are far smaller positions.