Investment Matters

The end of the small spending miners?

Mining companies have been constraining their investment spending in recent years.  This week's Investment Matters looks at (a) why, (b) when the situation may change and (c) examples pertinent to First Samuel's investors.

Background

As part of the upheaval in the resources sector in 2012, the prices of many commodities came under pressure - and it happened quite quickly and unexpectedly.  Furthermore, there was uncertainty in relation to the outlook - how long prices would remain depressed, and when a recover in prices would occur.  Therefore, miners took aggressive action to reduce their cost bases - so as to ensure that margins (and therefore profit) were maintained as far as was possible. 

The situation was, for many miners including the majors, compounded by quite high debt levels.  Thus there was a real focus on cash generation.   This created extra impetus to reduce costs and maximise cash margins.

The miners have been, overall, quite successful with their strategy.  For example, the graph below shows the very significant reduction in the cost base in relation to BHP's copper operations.

Source: BHP H1 FY-17 Results Presentation

Where are we now - costs?

The extreme focus on minimising cost and capital spend has continued longer than certainly we thought it would.  We thought there may have been a bit more of a measured approach - looking at mine optimisation in particular - given there has been a strong recovery in the price of most commodities.

Whilst the cost focus is fantastic in relation to cash return for shareholders (this may surprise some investors in the upcoming reporting season), it isn't sustainable.  There is only so long a mine can operate without, for instance, opening a new pit, replacing aged processing equipment, or minimising use of consumables (such as explosives).   Operating on the 'smell of an oily rag' for too long will eventually impact production, or even can cause safety issues.

Labour costs have also mostly been kept under control given the pressure on the sector since 2012.  Increases in the immediate term do not seem likely, though this is likely to change in the medium term.

Some costs can't be controlled

There are some costs that can't be controlled by the miner, with two notable examples being:

* Diesel - can account for up to 25% of a mines operating cost - more often in the 10-15% range depending on the nature of the mine and its location (e.g. ability to source power from the grid)

* Exchange rate - many miners have a functional currency (i.e. they report in) of USD.  In they have a mine in Australia for instance, most inputs are in AUD, and thus exchange rates influence the cost base.

Where are we now - volumes?

The following graph shows the production for two of Australia's key commodities - iron ore and coal (black thermal and met coal combined).  As can be seen, production didn't slow down after the 2012 upheaval.  In fact production ramped up for coal, and ramped up aggressively for iron ore.  Much of the investment to increase volumes had already been committed to.  In addition, maximising volumes maximised revenue. 

The fact that volumes have increased, yet cost bases have stayed under control is notable - normally volume increases put upwards pressure on the cost base.  

Coal iron ore 2

We see an environment where production volumes are not going to decline (for most commodities), and the controllable cost base is going to increase. 

The real question is when this will occur.  ABS data does show there has been a small uptick in equipment, plant and machinery spending in the mining sector. 

However, we do not expect a period of big spending from the miners - more that the underinvestment and stringent cost focus that have been seen recently, will start to ease.

mining equip

Implications for your investments

BHP and South32 are currently generating significant margins and cash flow, as a result of their strict focus on production costs. For many commodities, we expect margins will peak, or certainly be close to their peak, at the upcoming reporting season - when some market participants may be surprised about the amount of surplus cash generation (including from one of your investments South32).

Emeco is notable in that we expect to will see significant benefit as miners put effort into optimising their operations, rather than the current strict cost focus.  We have already seen some change, with utilisation rates improving over the last year.  The next step, and a significant change for Emeco, is when it commands increased margins from its contracts, thereby earning a more appropriate level of returns from its assets.