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BMI Research: continued strength depends on restraint

BMI Research is a unit of the Fitch Group.

In 2017, miners posted strong financial results across the board, driven by higher metal prices. As the industry returns to a period of growth, continued profitability will depend on companies’ commitment to keeping costs down, targeting value over volume and sticking to core commodities.

Cost inflation related to higher commodity prices will become a central challenge for miners, as emerging market currencies continue to strengthen, oil prices rise, and governments look to increase revenues from a recovering industry.

Building on their recovery in 2016, top mining companies reported stellar 2017 fiscal year results, including Glencore‘s record US$14.8 billion EBITDA, Rio Tinto‘s largest-ever dividend of $5.2 billion, and Anglo American‘s highest dividend in a decade of $1 billion.

The significant jump in metal prices drove the strong performance, while miners also cited cost savings and efficiency gains as key reasons behind the earnings improvement.

Years of divesting from non-core assets and implementing stringent spending programmes has allowed firms to significantly reduce debt-loads: Anglo American’s drastic restructuring plan announced in 2015 lowered the firm’s total debt-to-EBITDA ratio from a staggering 22.8 x in 2012 to 1.5 x by 2017.

While Anglo moved away from the initial plan to whittle down its portfolio to exclusively copper, diamonds and platinum, the firm still shed 32 assets (from 68 in 2013) over the past four years and continues to offload high-cost mines.

In Q118, Anglo completed the sale of the Drayton coal mine in Australia and several thermal coal operations in South Africa.

Return to core commodities

Refocusing on core mineral segments and streamlining business operations will remain a theme among top miners looking to regain investor confidence.

While the majority of financial results were quite positive, BHP Billiton under performed, reporting an underlying attributable profit of $4.1 billion, compared to market expectations of $4.3 billion for the half-year ended December 2017.

The firm’s attributable profit declined by 37.5% y-o-y to $2 billion due to an exceptional loss of $2 billion over charges related to US tax reform and the 2015 Samarco dam failure.

Activist investors began lobbying the firm in February to simplify the organisational structure of the company to realize significant cost savings.

Previously, the firm faced investor pressure to divest all oil and gas assets, ultimately agreeing to sell its US shale oil unit.

Similarly, Freeport McMoRan, which exited the oil and gas business in 2016 following an investor campaign, has returned to prioritizing its core copper assets, focusing on negotiations to maintain production at the Grasberg mine in Indonesia, developing the $850 million Lone Star copper project in Arizona and evaluating expansion plans at the El Abra mine in Chile.

On the other hand, facing declining iron ore prices over the long-term, top Brazilian miner Vale will look to reduce its reliance on the segment, which accounted for 86% of adjusted EBITDA in 2017.

Vale, which also produces copper and nickel, plans to increase the share of its base metal segment to account for at least 30% of earnings by 2019, by lowering operating costs and evaluating strategic acquisitions.

The firm’s net debt also remains elevated compared to peers, at $18.1 as of December 2017, due to continued spending over the commodity price downturn to bring the multi-billion-dollar S11D iron ore project online.

Glencore to lead the charge in deal making

The highest free cash flow in six years for miners will support the return to growth strategies, although cautious language from executives and in reports indicates the focus will be on brownfield projects and partners hips.

We expect miners to target metals used in the production of electric vehicles and batteries, namely copper, nickel, lithium and cobalt.

Already ahead of peers, Glencore completed several transactions over 2017, most notably purchasing the remaining stakes in the Mutanda and Katanga copper-cobalt mines in the DRC for $922 million and $38 million, respectively, acquiring a 49% stake in the
Hunter Valley coal operations in Australia from Yancoal for $1.1billion in cash, and increasing its stake in Peruvian miner Volcan Compania Minera to 23.3%
for $734 million.

Glencore’s growth strategy reflects the industry theme of favouring partners hips and brownfield investment over riskier new projects, however the firm diverges with peers regarding coal.

While other major miners are exiting the coal market in response to a global shift away from emissions-heavy power sources, Glencore will continue to extend its monopoly in providing cheap energy to the developing world.

Currency appreciation, higher energy prices to remain a challenge

Cost inflation related to higher commodity prices will become a larger challenge for miners in the coming quarters as key emerging market currencies continue to strengthen, oil prices rise, and governments look to increase revenues from a recovering industry.

Whereas the spike in metal prices largely offset these effects in 2017, we expect more muted price gains in 2018, meaning that rising costs will have a larger negative impact on profits. BMI Research’s Country Risk team forecasts continued currency strength in key mining countries in 2018, including South Africa, Australia, China and Canada.

Oil & gas team forecasts

Brent crude to average $67/bbl in 2018 and $75/bbl in 2019, due to accelerated market re-balancing and strong sentiment-driven support.

Regulatory changes adding costs to miners include Indonesia’s higher domestic owners hip structure, higher royalty rates in Brazil, planned increase to copper and cobalt royalties in the DRC, and the proposed new mining charter including higher black ownership
requirements in South Africa.

Protectionist trade measures from the US, a top metal importer, will also pose challenges for producers as the country is set to implement tariffs on steel and aluminium imports from all countries.

In February, Rio Tinto sold its last European aluminium smelter in Iceland for $345 million to focus on its core aluminium assets in Canada.

However, the planned tariff announcement from the US will significantly dent Rio’s aluminium segment, as the firm’s Canadian operations export to the US market.
As a result, we expect miners operating in stable political environments with less nationalistic leaders, such as President Kuczynski’s administration in Peru and Chile’s incoming President Pinera, to be more insulated from rising costs.

Additionally, miners invested in advanced technology and digitalised operations will be well-placed to realize further cost savings by reducing the workforce and improving efficiency.