The top four diversified miners have shown a huge improvement in earnings in the space of just 12 months. After reporting losses of over US$22b last February, this season they have reported a combined profit of nearly US$14b. While improved prices resulted in some of the windfall, it can also be attributed to initiatives to improve productivity, better inventory management, cost reduction and lower capex.
Shareholder returns are back as miners report better earnings
For example, Rio Tinto announced $3.6b total shareholder returns, including a final dividend of US$1.25 per share1, and Fortescue increased its dividend to 20c per share as compared to 3c per share last year.2
Debate over the sustainability of price increases
There has been a lot of debate regarding the sustainability of price increases — in particular the prices of bulk commodities. Much of the increase in prices is dependent on China.
- Will Chinese demand for iron ore continue at current levels?
- Will Chinese steel production ease off?
- At what point will China reduce coal production once again?
As Glencore CEO Ivan Glasenberg said at the earnings conference last week: "As I've always said, China, we don't understand China, exactly what may or may not happen from one day to the next, and we all saw it in coal last year."
We believe that iron ore prices are unlikely to return to the lows of $40/t we saw last year but they will not stay as high as they are.
“Demand is being bolstered by Chinese infrastructure spend and environmental policies favoring imported high-grade ore, but they will realistically retreat to the $60-$70 range as new supply from S11D enters the markets.”
Focus shifts to growth rather than survival
A number of miners have indicated that they won’t be looking at divestments and will instead be considering what next in terms of growth options. Our view is that capital allocation and portfolio strategy are critically linked.
Five actions for mining companies:
- Complete regular and rigorous portfolio reviews to determine the highest performing investment projects and identifying where to focus capital.
- Understand that the embedded optionality and capital intensity of individual projects is a key determinant in deciding what assets form the optimal portfolio to achieve growth aspirations.
- Examine underlying liabilities associated with assets to protect against unforeseen risks that may have been previously underestimated, or remain beyond their control without any financial limit. An example would be non-operated joint-ventures.
- See that projects previously considered core may become best suited for divestment if growth opportunities are limited and do not fit with new strategic direction of the company.
- Focus on optimizing the performance of assets that are kept through portfolio improvement and cost control measures.
EY Global Mining and Metals Transaction Leader, Lee Downham, discusses portfolio planning and financing in this video.
1. “Rio Tinto announces cash generation of $8.5 billion and $3.6 billion of shareholder returns,” Rio Tinto Media Release, 8 February 2017
2. “‘Resurgent miners supercharge their dividend payouts,” The Australian, 27 February 2017
3. “Glencore 2016 earnings results presentation,” Glencore, 23 February 2017
M&A and capital raising - 2016 trends, 2017 outlook
Although the year ended on a high, 2016 started with serious distress and a very bleak outlook for the sector. Increasingly, we noticed corporate strategies being tailored to the particular commodities and markets in which participants played. The resulting divergence between commodities is set to continue this year, ending the “one-size-fits-all” mentality - companies must now carve their own path.
In 2017, we expect a more positive industry outlook, improved transactions activity and access to capital, though not without caution. It will be an interesting year, with many different strategies being put into action.
Miners must have the right mix of capital with optimal financing to secure future growth. Investors should consider the company and not just the sector broadly. It’s time to lay foundations for sustainable growth, create resilience and drive future shareholder returns.
Aluminium prices ended 2016 at a high of US$1,730/t, driven by stronger demand, supply discipline in China and an increase in raw material prices.
- Aluminium prices are expected to average US$1,650/t in 2017 providing Chinese producers do not restart idled capacity. Prices may also be supported if China follows through on plans to cut 30% of its smelting capacity in Henan, Shandong and Shanxi during winter to alleviate air pollution. This may result in a market deficit of 1.5mt to 2.5mt.4
- Global aluminium production was up by 3% to 59mt in 2016. The surprise has been the slower- than-expected rate at which Chinese capacity has restarted after substantial closures in 2015 – only ~2.1mtpa of the roughly 4mtpa has been restarted. Production is forecast to increase further to 61.2mt in 2017 and 64mt in 2018.5 Much of the new production is coming from Russia, the Middle East and India. In China, while production growth is slowing, we will see additional supply come online from its new low-cost smelters.
- Robust global aluminium demand with forecast growth of 5% in 2017. Demand will be supported by stronger demand from the automotive and construction sectors in China, North America and Western Europe. In the US, the ambitious infrastructure program pledged by US President Donald Trump, will boost demand for aluminium.6
- Increasing focus on downstream assets and value-add products as producers seek to increase margins, expand product portfolios and their geographical reach. For example, Zhongwang USA LLC proposed acquisition of Aleris Corp. for US$2.3b, marks the largest entry of a Chinese company into the US aluminium industry.7
- Trade restrictions against China: The US filed a new complaint with the World Trade Organization against China over the alleged artificial expansion of the latter's share in the global aluminium market via cheap state loans and energy subsidies.8
4 “Aluminium: Sit up -> China cuts could be a big deal,” UBS, 25 January
5 “Commodities Quarterly,” Deutsche Bank, 15 December 2016 via ThomsonOne
6 “Commodities report: Aluminium update,” Natixis, 10 March 2017 via ThomsonOne
7 “Aleris To Be Acquired By Zhongwang USA LLC,” Aleris Corp. website, http://investor.aleris.com/2016-08-29-Aleris-To-Be-Acquired-By-Zhongwang-USA-LLC, accessed 08 February 2017
8 “U.S. launches WTO complaint over Chinese aluminum subsidies,” Reuters.com, http://www.reuters.com/article/us-usa-china-trade-aluminum-idUSKBN14W1ZV, accessed 08 February 2017
China’s control of the thermal coal market will reduce price volatility and thus provide a price floor and a greater sense of security for coal miners seeking to bring production back online.
- China has dictated a price range of US$73/t-US$83/t for thermal coal and will intervene when prices at northern ports fall outside this range.
- The price floor has already seen India’s International Coal Ventures’ moving to restart its 5.3mtpa Benga mine in Mozambique.
- China will continue to control the domestic coal sector through regulatory and operational interventions and indirectly lift the profitability of its heavily indebted miners until 2020.
- However, the long-term price outlook remains weak on dwindling demand, as demand for cleaner forms of energy increase. China has cancelled more than 100 coal power plants, and reiterated that 10% of power will be from natural gas by 2020 while announcing a US$360b spend on renewable energy.
- There is almost no thermal coal project pipeline and financing is increasingly difficult to get with banks, including Deutsche no longer grant new financing for greenfield thermal coal mining.
Metallurgical coal prices have moderated from a peak of more than US$300/t in November 2016 to a more realistic US168/t in February 2017.
- Seaborne mettallurgical coal spot prices are now at a significant discount to the 1Q17 HCC contract price of US$285/t, an incentive for steel mills to defer cargoes into 2Q on expectation of lower prices.
- Metallurgical coal prices will remain linked to Chinese regulation of its domestic coal sector and will therefore largely follow thermal coal prices.
- Chinese supply cuts of around 50mt in 2016 will not quite be matched by new or idled production brought online in other countries.
- It is likely that the Chinese ban on North Korean coal will remain in place, although this will depend on whether it receives sufficient coal from other seaborne producers.
Copper prices have increased more than 26% since October, largely due to the possibility of increased infrastructure investment under the new Trump administration, but also accelerated by the possibility of supply disruptions amid healthy demand.
- Copper supply grew in 2016 on efficient project ramp and minimal disruption. However, this ”wall of supply” was offset by higher-than-expected demand from China, up 4.1% to 10.5mt in 2016.
- Higher demand led to a 28% growth in China’s mined copper imports to 19.63mt. However, this did not directly translate to increased domestic refined production and higher refined exports as the increased output was consumed domestically in light of higher demand for copper in China.
- The market is likely to be balanced or even somewhat in deficit in 2017. Fewer mines are due to come online this year and there are likely to be possible disruptions to production due to:
- Expiring labor contracts: BHP Billiton has stopped production at the Escondida mine, after unionized workers went on strike. This is impacting 3,400 tonnes of output per day. Labor negotiations at Rio Tinto’s mine in Bingham Canyon, Utah, may also cause disrupted production.
- Power issues in Zambia: After an increase in fuel prices in October 2016, the Zambian Government plans to raise electricity tariffs to cost-reflective levels by the end of 2017, impacting miners’ unit costs.
- Freeport-McMoRan cut production at its Grasberg mine in Indonesia as it has been unable to export unprocessed ore since mid-January.
- The Indonesian Government has relaxed its ban on partially processed mineral exports but the new law increases the risk substantially for miners operating in Indonesia to secure fair value in meeting the divestment rule, e.g., Freeport-McMoRan, which will need to sell 41.6% of PT Freeport Indonesia to comply with this law.
9 “Zambia Targets 7% Budget Gap in 2017 as IMF Talks to Start,” Bloomberg, 11 November 2016
Gold prices remained elevated for most of 2016 but fell by almost US$100/Oz after the US elections in November to close at US$1,146/Oz. Gold prices have recovered in the first 6 weeks of 2017 due to growing global geopolitical and economic uncertainty and in particular, US policy.
- The possibility of increased government debt and inflation in the US are both positive for gold prices but expected increases in the Federal Reserve interest rates will be negative. Trump’s pro-growth policy and restrictions on immigration could lead to an increase in US Government debt and wage inflation. The Federal Reserve is expected to increase interest rates two to three times in 2017.10
- Miners will increasingly develop large projects through joint ventures to realize operational and financial synergies. For example, GoldCorp President and CEO David Garofalo recently reiterated that the company is seeking partners to develop greenfield projects.11
- M&A activity in the gold sector is expected to increase in 2017 as miners seek to replenish their aging portfolios. Gold miners will acquire ounces by investing in junior miners and by paying premium for large and quality projects.
- Margins and cash flow have improved in 2016 and therefore several miners may decide to return capital to shareholders as dividends. For example, Randgold recently increased its full year dividends by 52%.12
10 “Wall Street stands with two Fed-hike outlook for 2017,” Reuters, 3 February 2017; “Cashin on Fed rate hikes: 'I don't think they're going to be able to do 3,'” CNBC, 6 February 2017.
11 “Goldcorp to Focus on Partnering With Peers to Develop New Mines,” Bloomberg, 13 January 2017.
12 “Randgold increases dividend after record year,” The Telegraph, 6 February 2017.
Iron ore prices hit US$92.23/t on 13 February 2017, the highest since July 2014 and double the price in January 2016.
- Although unexpected, the increase in prices appears to be sustainable in the short term as increased Chinese demand and new supply coming onto the market more slowly than expected will keep the market balanced in the first half of the year.
- Chinese policy remains the key driver of demand. The planned closure of all induction furnaces (which use scrap) by June bodes well for increased imports of raw materials for blast furnaces. There is also optimism that there may be further economic stimulus in China that will result in new infrastructure projects thus increasing demand for steel and therefore iron ore.
- At current prices, some higher-cost miners will be incentivized to continue production, although previously discontinued production has been slow coming back online.
- It is likely that 2018 will be the turning point for the iron ore market, as this is when the remaining additional seaborne supply will enter the market and drive prices lower.
- Short-term average price forecasts have been upgraded by between US$5 and US$10 to between US$55 and US$65 for 2017. Expectations for a longer-term drop in prices have not changed. However, as additional supply continues to outweigh expected demand growth.
In January 2017, the Indonesian Government lifted the ban on the export of nickel ore that was imposed in 2014. This is likely to boost nickel supply and keep the already inflated inventory of nickel high.
- The lifting of Indonesian mining ban could result in 50kt of nickel ore onto the market.13 This could create negative pressure on nickel prices, which only just started recovering in the last quarter of 2016.
- However, the ongoing environmental audit in the Philippines, which is affecting around 50% of domestic nickel production, may create a temporary deficit in market, providing support to nickel prices. Exports from the Philippines tumbled 16.8% to 327kt in 2016 and the Philippines Department of Environment and Natural resources plans to keep the ban on non-compliant nickel producers in 2017.
- Global stainless steel production increased by 8.3% in 2016 mainly due to particularly strong growth in Chinese production of 13.4% y-o-y. This was largely due to restocking after a weak 2015 as well as some stimulus creating stronger demand than the year before. However, the Chinese production is only forecast to be 4.1% in 2017 as sluggishness remains in the Chinese property market.14
- Nickel prices surged by 15.5% to US$10,005/t in 2016 but this is unlikely to be repeated in 2017 as there will be higher supply from Indonesia and slower growth in stainless steel demand.
13 “Commodities Compendium,” Macquarie Research, 19 January 2017
14 “Indonesia upends our positive H1 thesis,” Deutsche Bank, 13 January 2017
Steel prices have been resilient with the world export HRC price up 27% to US$528/t over the 3 months to late January. Any correction in raw material prices will, however, put pressure on prices in 2017.
- Metallurgical coal prices have declined from a peak of over US$300/t in November 2016 to a more realistic US168/t in February 2017. There was little change in fundamentals and much of the increase was driven by Chinese Government mandates to restrict supply.
- US policy decisions on infrastructure spending and border taxes are going to be important factors influencing US steel demand if implemented.15 While fundamentals were stronger in 2016, US sheet volumes rose just 3% in 2016 despite attempts to restrict imports through anti-dumping duties.
- Chinese steel demand may be flat or weaken during 2017 as the there is little incentive for new residential construction in China as the Government has imposed measures to cool the housing market and is expected to withdraw stimulus from the market.16
- During 2016, Chinese steel production increased by 1.2% y-o-y to 808.4mt,17 despite the removal of more than 45mt of steel capacity. 18Chinese capacity cuts will not have an effect on the global market until the Government implements policies to restrict output.
15 “2017 steel sector outlook,” Credit Suisse, 12 January 2017
16 Resource and Energy Quarterly December 2016, Australian Chief Economist, February 2017
17 “World crude steel output increases by 0.8% in 2016,”World Steel Association, January 2017
18 “Eleven China provinces finish cap cuts, exceeding 45 mil mty,” Steel Business Briefing, 5 December 2016
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