Risky Business: The Focus Of Risk Has Swung

Business risks facing mining and metals 2013-14: A new report from Ernst & Young.

The twin capital dilemmas of 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. These capital dilemmas are strategic risks that 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.

Risk 1a – Majors learning to balance shareholder demands with long-term growth strategies

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 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 sector’s cyclical nature and its longer-term and often counter cyclical development, investment and return horizon. This raises the question of how to balance the demands of short-term shareholders with those investing for longer-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.

Risk 1b – Junior miners fight for survival

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 at levels we have not seen in 10 years. 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. Companies with a market value of less than US$2 million — about 20% of listed mining companies across the main junior exchanges — had on average less than US$1 million in cash and equivalents on their balance sheets at 31 December 2012.

Risk 2 – 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 use of labour and equipment. These companies are also focused on using innovation as a means of enhancing productivity. The increased digitization of mines also means that firms can better monitor and analyse processes in order to understand why productivity is falling and to identify and employ better practices.

“CEOs and boards today are protecting returns and managing the interests of varied and often competing stakeholders. This is in stark contrast to just 12 to 18 months ago when fast-tracking production and capacity constraints were top of the agenda.”

Risk 3 – Resource nationalism remains prolific

This risk is every bit as critical as it was last year; it is only that other risks have exceeded it in the urgency with which they need to be addressed, bumping it back to third place. 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.

Our newcomer – Threat of substitutes

This horizon-watching risk is one to 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.

Other top risks

Social license to operate has crept up the list to fourth position 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 slips to five 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 steps up a place 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.

Some old faces in the crowd

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. New risk entrants over these years largely reflect the cyclical nature of the sector and the sector’s ability to overcome these challenges.

To read the full report visit www.ey.com.

Mike Elliott

Global Mining & Metals Leader

Ernst & Young