By Robert Milbourne, Partner, Registered Foreign Lawyer, K&L Gates
FOLLOWING the global divestiture movement to abandon fossil fuels (while continuing to consume them), it appears that there is a growing contradiction between dependence on the sector and opposition to its products. One can argue that the sector suffers from a profound misunderstanding of its fundamentals from all stakeholders – governments, NGOs, consumers and even the mining industry itself.
In 2004 the global mining sector and its stakeholders were caught off-guard by the phenomenal growth in demand from China and other BRIC nations. Year after year growth in demand eclipsed the best efforts of the industry to increase production, leading to a misalignment between supply and demand, and a rapid increase in pricing.
After eight years of consistent growth, in 2012 governments finally caught on, and hoped to ‘get their fair share’, through the imposition of a super-profits tax in Australia that was quickly emulated around the world. Yet the timing of such legislation was eight years out of date, and more worrisome, was introduced at precisely the time the industry began its decline in profitability and commodity demand growth, in effect accelerating a decline in the sector when it most needed support for sustainable operations.
To make matters far worse, senior mining executives arguably also misunderstood the dynamics of the market and approved unprecedented expansion in capacity, and multi-billion dollar acquisitions. In 2013, Vale approved its massive 90 million tonne per year S11D iron ore project and Rio Tinto approved expansion of approximately 70 million tonnes per year of capacity in the Pilbara. BHP raised production of 187 million tonnes in 2012 to 270 million tonnes in 2014 while similar stories occurred in thermal and metallurgical coal, copper and other commodities.
It is astounding that the sector can continue to be so profoundly misunderstood. Investors are clearly among the first to have lost. BHP Billiton went from a market cap of US$270 billion in mid-2011, to US$115 in June 2015. Aggregate losses from Vale, Rio Tinto and BHP have reached approximately US$350 billion in market capitalization in the last five years. Moreover, while market values plummeted, the mining houses each expended enormous amounts of new capital – Vale for example invested more than US$70 billion from 2010 to 2015 with similar numbers expended by Rio and BHP.
Have we learned anything? Are stakeholders any wiser after such a dramatic boom and bust – all during a period of gradual increase in demand and a tapering off to a stable global consumption level?
Mines throughout the world are being sold by the major mining houses, some at nil cost. Even more mines are being moth-balled. Exploration expenditure, necessary for identifying the mines of the future, is at a 10 year record low this year in Australia.
What does this imply? Well, for a start, with exploration stopping, mine development unfunded, and operations closed, it is reasonable to expect that for many commodities supply will fall lower than demand (assuming demand remains the same) and commodity prices will rise again. Failure to understand demand and supply is making havoc with government revenue in Australia and throughout the world, so getting this analysis right is critical. Yet analysts often come to fundamentally different valuations on the same asset.
Let’s take an example of the New Saraji coking coal deposit in Queensland. In 2008 BHP Billiton bought the deposit for US$2.5 billion, twice the value of some estimates. Five years later, BHP admitted the project was unlikely to deliver an economic return. If anyone should understand the mining sector – shouldn’t it be the executives in the sector? Yet BHP was not alone, Rio Tinto wrote off almost all of its US$22 billion of acquisitions including a coal project in Mozambique and the aluminium producer Alcan. Vale has also written off large sums with respect to its coal and nickel operations.
There is an assumption by stakeholders that the industry is subject to the fate of a minerals industry supply ‘cycle’ and valuations and commodity prices will rise and fall accordingly. But there does not appear to be a demand cycle – demand for iron ore in fact increased robustly in China from 820 million tonnes in 2013 to 932 million in 2014 but at the same time commentators declared the ‘end of the boom’.
What can be learned? The industry should have a laser focus on demand. Investors must improve their understanding of the supply/demand equilibrium. Boards should make public ever more detailed assessments of macro market fundamentals and be held to account if they are wrong.
The world can ill-afford to continue with such a poor record of planning and decision making for such a critical sector. The time is now to assess global demand and ensure that investors, banks, governments and other stakeholders align exploration, project development and operations to a reasonable connectivity to current and future demand requirements, ending once and for all the damaging assumption that the industry is bound to continue its ‘cycle’ of boom and bust. This cycle is entirely man-made and should end, now.