Unusual Indicators
By Richard Walker
THE continent of Africa represents what is probably the biggest continental mining resource in the world. Africa is the second biggest continent, and even on the basis of known reserves it has about 30% of global mineral reserves. Africa has 40% of the world’s gold reserves, 60% of the world’s cobalt, and 90% of the world’s ‘platinum group’ of metals, plus half of the world’s chromite, half of all natural diamonds, and almost half of the world’s manganese. So why aren’t mining companies making money in Africa?
It is not as if there is no demand for the metals, minerals and gems that Africa produces. The global economy may look like it is in a mess following the Global Financial Crisis, with growth still low in the US and close to zero in much of Europe. But the bigger picture is different: the fact is the world is still in the midst of the biggest surge of economic growth ever recorded.
True, it is mainly emerging economy growth. But it is the emerging economies that need iron and aluminium, minerals for manufacturing, and coal for power. A large proportion of the demand for these commodities from developed economies is actually really emerging market demand, as infrastructure and industrial machinery providers in the US, Europe, Japan and Korea feed the endless appetite of China, India, and a host of smaller emerging industrial economies for their products.
So you would think that Africa’s miners – the companies that produce much of the world’s primary commodity output – would be in excellent health. Prices are still high for almost everything they mine. In the twenty years after 1983 the price of copper, which Africa has in abundance, averaged just over $2,000 a tonne. Today it is around $7,000. In that same earlier period the price of Nickel averaged around $7,000 a tonne. Today it is double that. Uranium used to average around $12 a pound. Today it is $40. Most aggregated industrial metals price indexes have more than doubled since 2003, while in the last ten years the price of African export coal has gone from $27 a tonne to over $80.
Indeed, it is difficult to find an industrial commodity that Africa produces in volume that is not worth at least double what it was worth ten years ago. Surely, the profits and share prices of the companies that mine Africa’s mineral wealth should have shot up too?
Unfortunately not.
Take African Barrick Gold, a profitmaking company with over $1 billion in revenue and a market capitalisation of over $900 million, Tanzania’s largest gold producer and one of the top five producers in Africa by revenues. Three years ago when gold fetched only $950 an ounce the company was worth $9.20 a share. Today, with gold up at $1,4000 an ounce, those shares are worth $2.30. Or take another African gold miner, AngloGold Ashanti, a much larger company with a market capitalisation of $4.6 billion which mines in South Africa, several countries in West Africa, and Tanzania, as well as on other continents. Over the same period Anglo’s shares have fallen from $44 to just over $13. Small mining companies suffer up-and-down share price volatility even in good times – but these larger companies should be more stable. Instead, their value has just gone down.
The smaller companies have often done even worse. Consider Sylvania Platinum, a South African miner of platinum group metals that are used in medical applications, jewellery and catalytic converters. Sylvania has a market capitalisation of $43 million, small enough for investors to expect some volatility as the price of its metals moved. But three years ago Sylvania was worth US75c a share – today after three years of repeated downgrades it is worth less than 15 cents a share. That is not volatility – that is a sign of something wrong with mining. The explanation is certainly not in the platinum price, which has risen from just over $1000 an ounce to almost $1500 an ounce over the same period, while palladium prices have doubled.
Very large diversified companies that mine a range of commodities in many parts of the world have not done quite so disastrously – they have just done badly. Australia’s BHP Billiton is the biggest mining company in the world, with extensive operations in Africa: over last two and a half years it has seen its share price fall by around 20%. British-Australian Rio Tinto Group with operations across Africa, has fallen by more like 35%. Brazilian Vale, a large investor in the coal mining industries of South Africa, Mozambique and Angola, has fallen by more than 50%.
One overall measure of mining performance worldwide is the HSBC Global Mining Index, which tracks a basket of global mining shares and functions as an overall indicator of the health of the industry. Last year the HSBC Index declined by 13%, while both the Dow Jones and the FTSE 100 gained 4%. 2013 has been worse – in the first quarter of the year the HSBC Index lost another 20%, while broader markets were rising sharply.
Falls in share prices do not always reflect company weaknesses: shares fall for all sorts of reasons, including market panics and crashes when everything goes down, the bad with the good, financial sector crises that may have nothing to do with an industry like mining, or just the mood of investors, something that can never safely be predicted or even explained. But the falls in the values of mining companies are so consistent across the industry, and also so consistent over several years, that it is reasonable to suspect that something more than just mood is at work. The mining companies are not doing well at making money from mining.
Total mining production from the ten biggest mining companies in the world was up 6% last year, according to PriceWaterhouseCoopers (PwC), a consultancy and accounting firm. But profits from those companies fell by half, to $68 billion. Most of that fall was not due to declines in operating profit, but to what are called ‘impairment charges’, which means that companies have had to write down the value of their assets. But impairment charges – especially when a lot of companies in one industry are being hit with those charges at the same time – are a strong sign of mismanagement. Companies that follow a ‘growth-at-all-costs’ strategy, or that just invest in what turn out to be the wrong kind of assets, are likely to have to make impairment write-downs sooner or later.
Many mining companies have come unstuck by underestimating the physical and political challenges of operating in Africa – and write-downs of supposedly good investments are the inevitable result. Sometimes the losses are the result of getting on the wrong side of politics, as happened in recent years to Rio Tinto Group in Guinea, when the government suddenly stripped the company of half of its iron ore mining rights in the iron-rich discovery area of Simandou, losing Rio Tinto $2.6 billion-worth of permits. Rio also had to pay the Guinean government another $700 million in 2011 to secure the remainder of its concession. Last year Rio lost at least as much again when it had to write down $3 billion of its $4 billion investment in coal mining in Mozambique, due to underestimating the cost of infrastructure development. And in August 2013 the recently merged mining and trading group Glencore Xstrata took a writedown of over $7 billion, mainly due to over-paying for assets in recent years.
These losses are a reminder that at the best of times it is always possible to lose money in the mining business, and in Africa it is possible to lose your money twice over.
But why is Africa so tough? One reason is to do with the long-term infrastructure deficit that is Africa’s biggest single economic challenge. Infrastructure is a particular challenge and often a huge cost for mining companies – in Mozambique, for example, Brazil’s Vale alone is spending $4.4 billion on building a rail link to export coal through Malawi, part of a $12 billion five-year infrastructure plan. Add to the infrastructure challenge the fact that many of the most resource-rich regions of Africa also happen to be Africa’s most unstable regions: instability and uncertainty are big disincentives for the kind of long-term investment that mining needs to be consistently profitable.
But the biggest single cause of losses is the mining companies themselves. Simply, they are not very well run. And they are not well run because they are not well-supervised from outside.
Mining companies are not like technology companies, or utilities, or consumer goods manufacturers. They don’t attract the sort of investor scrutiny and consumer interest that other companies live with every day. Miners are more secretive, their operations are often difficult to get close to (not least because they are guarded by well-armed security forces), and most of their assets are underground, invisible, and only estimated in value. When Apple releases a new product (or even when it doesn’t release a new product), the investment and consumer worlds buzz with the debate about what the company is doing, whether it is the right thing, and which way the share price is going. When a mining company makes a massive new investment or buys a competitor for billions of dollars, few pay much attention, let alone ask whether it makes any sense at all. The managers of mining companies are free to be as incompetent as they like.
This history of impairments and write-downs (or in plain English, bad decisions) is only one sign of the poor quality of mining company management. There are other indicators too, should anyone care to look at them.
One is the falling return on capital employed, or ‘ROCE’ in investment jargon. ROCE is a measure of how efficient a company is: it is the ratio of net profit to all of a company’s plant, property, equipment and ‘current assets’, less ‘current liabilities’. And ROCE is now at a decade low in the industry. Return on capital rose steadily during the early years of the last decade, reaching 23% in 2006. It is now at 8%, or around half of what investors expect of a healthy company.
That is one reason why today equity investors do not like mining companies – profits may not be falling in absolute terms, but the amount of capital required to produce those profits is steadily increasing.
Mining companies have to find their capital somewhere, and if equity markets won’t give it to them, then they raise debt directly, by borrowing from institutions and from ‘debt markets’, which is where corporate bonds are traded. In fact, most of the mining industry’s financing now comes in this form of debt: last year the mining industry raised $108 billion in new debt, and 96% of that was in corporate bonds and institutional borrowing, not in stock market equity. Whatever else this means, it certainly suggests that companies do not expect stock market investors to take a liking to them any time soon.
One more indicator of the strength or weakness of mining management is the ratio of exploration expenditure to mineral discoveries. Put simply, if companies are run well, then they will find more mineral deposits for every dollar of expenditure than if they are run poorly. And here the figures are not encouraging.
A decade ago the industry was spending less than $3 billion a year on exploration. By last year, after an unprecedented commodity price boom, the annual worldwide cost of exploration was ten times that amount. But the returns from all that money spent have been very disappointing. According to MinEx Consulting, the value of western world discoveries was roughly more than double the costs of exploration in the ten years to 2000 – a good return on investment. But since 2000 the discovery rate has plunged, averaging less than a third of the cost exploration. In Africa, says MinEx, discovery rates have been volatile, but in 2011 (the last full year for data) the number of discoveries was around half the ten-year average, and preliminary data for 2012 show fewer discoveries still – and still Africa was the best performing region in the world for discoveries per dollar of exploration spend during 2003-2012, with 14% of global expenditure but 22% of discoveries.
With relatively low costs of exploration (in part because African minerals are still being discovered closer to the surface than anywhere else except Latin America), African miners should be in much better financial shape than they are. But that is without factoring in mining companies’ tendency to waste money in most other parts of the world.
What has it been wasted on? Remember, there is nothing that a mining company executive likes better than a big exploration budget. Exploration is the exciting, Wild West side of the mining business, and with it comes lots of flights to exotic locations, nights in expensive hotels, and a diary full of expense account meals, limousines, and nights on the town. Whether you find any copper, or diamonds, or gold is not really a primary concern. No wonder investors are taking a dim view of what mining companies have been up to over the last ten or fifteen years.
However, the industry is not entirely to blame – and there are signs that the last two years of relentless share price falls and stagnant or falling profits have begun to change the way that companies operate. By knocking anything from 20% to 90% off share prices, stock markets are saying that they don’t believe that mining companies are in good enough shape to be profitable in the foreseeable future. And companies are beginning to agree with them.
For one thing there is management change. According to PriceWaterhouseCoopers, half of the chief executives at the top ten mining companies in the world have been replaced since April 2012. The latest instance came just weeks ago in August 2013, when CEO Greg Hawkins of African Barrick Gold was suddenly replaced. Along with this round of new faces has come a new concern with costs. It is widely accepted within the industry that mining is very inefficient compared to many other businesses, due in part to historic under-investment in technology, and in part due to overspending fuelled by the boom in commodity prices over the last decade. That now seems to be changing.
Mining investment overall is set to be down sharply in 2013. PwC reports that after spending $140 billion in 2012, the plans for this year call for a reduction to $110 billion. The fall may turn out greater than that. Kerfalla Yansane, Finance Minister of Guinea, said recently that he estimates that mining investment in Guinea (which has one of the world’s richest unexploited reserves of iron ore) will fall by 33% this year.
Companies are also demanding more from the investments they do make. PwC reports that many of the largest companies are increasing what they call their ‘hurdle rates’ – that is, the minimum return they are willing to accept in new investments, and several of the top 40 companies have stated that 25% is the minimum return required.
One important reason for this change of mood is that African attitudes towards mining have also changed. Labour negotiations have proved tougher than ever for African companies, particularly in South Africa following fatal clashes over mining pay and conditions (and one of the effects of the industry’s poor record in technology investment is that it remains a hostage to labour costs).
The industry also sees Africa as a bigger risk than before – and for industry, risk equals cost. African governments are setting tougher terms and conditions, with new mining taxes or tighter ownership and exploitation rules announced in countries like Zambia, Zimbabwe, Ghana and Guinea, and companies fear more, especially in South Africa.
What do these changes mean for Africa? Clearly, less exploration and investment in existing resources means less money spent in Africa. Less mining company profit means less tax revenue. In the long term this may all be for the good: it is good that companies finally face the fact that they are overspending and underperforming, because that will eventually translate into better profits.
But for the next few years, there is going to be a squeeze – and the biggest losers will not be the big mining companies, who have the resources to weather the storm. The losers will be the ‘juniors’, the small companies with just a few tens of millions of market capitalisation, who don’t have the resources to borrow on capital markets, and who cannot raise new capital through stock market equity because their share prices have been hit even worse than the majors. Companies like East African explorer Nyota Minerals or Zimbabwean gold and nickel miner Mwana Africa, both of which have seen their values drop by over 90% over the last couple of years. These juniors are the companies that do most of the new exploration in Africa, and provide the next generation of discoveries for the major companies to buy out when the time is right.
The next year or so will see more exploration rigs packed up and put into storage, and more small companies file for bankruptcy – drilling reports from Africa have already fallen by about half since mid-2012, according to IntierraRMG, a mining data provider. There will be more labour strife as the big miners struggle to force down their costs, and some of the biggest infrastructure projects that mining companies are currently bankrolling will be put on ice. Mining profits will eventually rise, but before that happens the mining economy – including thousands of suppliers and support staff not directly involved in the mining business – will take a severe battering.
The African mining business is all about hope, risk and reward. Right now hope and reward are taking a back seat, and risk is driving.
First published here. http://unusualindicators.wordpress.com/2013/09/18/whats-wrong-with-mining/
