Investment Matters

Mining capex outlook (and the implications)

Background

Mining investment in Australia peaked in around 2012.  By mining investment we refer to capital spending on construction of new mines and associated infrastructure (such as railway haulage and commodity-export ports).  But it also refers to lesser-value capital investment, such as expansions of existing mines, new equipment (haulage trucks for example), rehabilitation efforts, and processing system upgrades.

As can be seen by the graph, below, from the RBA, there has been a steep decline in mining investment spending - not quite a bust, but certainly a large impact not just on the resources sector, but also on Australia's economy more broadly. 

During this time, the miners and energy producers minimised spending - generally, all but essential spending and pre-contracted spending was stopped (unless there was a really clear and particular reason not to), and production was conducted in a manner to maximise cash flow and minimise cost. 

Companies were driven to do this because of:

  1. the fall in commodity prices (as seen by the second RBA graph below);
  2. uncertainty for the outlook in prices; and
  3. often, quite high gearing levels (and hence the need to maximise cash flow to get debt down).

Production volumes remained elevated (and in some cases continued to increase) during this time.  However, revenue and profit obviously fell with the lower realised prices. 

There is an expectation in some quarters that prices have now stabilised, as can be seen by the uptick in prices recently.  We remain cautious in relation to this.

Where are we at now?

The RBA has noted that "the end of the fall in mining investment is coming into view" (speech by Christopher Kent, Assistant Governor (Economic), 13-Sep-16).  This is also shown by the expectation dot on the graph from the RBA above. 

Goldman Sachs has also done a detailed analysis (The Mining Capex Cycle, 14-Sep-16) and assessed that the bottom of the cycle has been reached, but a slow recovery is expected.  

This also makes sense, particularly for the mining sector.  Most miners have been operating on the smell of an oily rag, so to speak, for quite a while (2 years+).  There is only so long, for instance, equipment replacement can be delayed, or low grade easy access ore can be used. 

What we are likely to see is more of the shorter term and lower cost capital spending come back first.  We certainly don't see new multi-billion dollar greenfield mines being commenced in the short term.

What this means for First Samuel investors?

As mentioned in last week's Investment Matters, we see this development as a positive for Emeco, a company in which many of our clients have a small investment.   Its rental equipment provides miners with the ability to undertake some of the lesser value, shorter time frame capital investment.  For example, opening a new mine pit.  

In relation to the miners (BHP Billiton and South32 for First Samuel equity investors), we are fairly neutral in relation to this development.  One one hand, it will see returns to shareholders detrimentally impacted, certainly in the short term. 

However, running on a short term cost minimisation approach is usually not a sound proposition in the medium to long term, or even feasible in the long term. 

For example, easy access ore runs out, and eventually maintenance costs trump hanging on to the old piece of equipment.  Instead, resource companies need to operate on more of a NPV (net present value) basis - what creates the best long term value.

Conclusion

The mining capex downturn has reached, or is at least near, the bottom.  We expect mining investment spending to recover - although in the short to medium term this is likely to be in a moderate way (not many major greenfield mines for instance).