2016 REVIEW: Miners back on track after disciplined year

Mining companies have radically overhauled the case for investment this year.

Gone are the days of growth at any cost; the focus now is on running assets for a return on capital.

The shift in strategy is reflected in the share prices of the world’s mining firms as well as in various related indices.

The FTSE 350 Mining Index, for instance, started the year at levels last seen in June 2004, which is before the commodities super-cycle began. At the time of writing, the index looks set to have more than doubled over the course of 2016.

The rise of around 117% in the index from its January low is a relief to the world’s largest mining companies, which were plagued by balance-sheet issues few can deny required immediate attention.

Several of those firms were viewed by market participants as balancing precariously on the edge - of potential bankruptcy in the worst-case scenario, and of forced M&A in the best.

Those same miners are now ending the year with significantly improved outlooks. The focus of management for the year has been on cutting costs and reducing debt, with very few firms failing to escape the need to divest, close or curtail operations.

A key reason why the sector got itself into such a mess is that, during the super cycle, productivity fell to its lowest in more than 30 years. The mining sector focused on production at any cost because of an unprecedented boom in commodity prices, a situation that consultancy EY says made productivity the leading operational risk for mining companies for the past three years.

The dire situation at the start of 2016 also gave miners a reason to focus on their portfolios following several years of irrational exuberance during which some arguably seemed willing to give any commodity a try.

Anglo American, for example, is now focusing the group on diamonds, platinum group metals and copper; BHP Billiton is focused on iron ore, metallurgical coal, copper and uranium, and also has an energy business. Rio Tinto is concentrating on copper, iron ore and bauxite, while Glencore remains the most diverse in terms of both its commodity and geographical split with a lucratively cash-generative marketing business.

These four companies represent almost 6% of the FTSE 100 Index, with the others – Antofagasta, Fresnillo, Polymetal and Randgold Resources – boosting that figure to 7%.

To a certain extent, many firms in the broader mining community got lucky, seeing their fortunes improve amid recovering sentiment towards commodities, a renewed interest in the asset class from investors, and currency factors that moved in their favour. Falling energy prices and weakening exchange rates in commodity-producing country have also been a boon, albeit for reasons out of rather than within the miners’ control.

To be fair to the corporates, they have addressed their past excesses and bad capital allocation head on. Companies have become far more streamlined, both in terms of assets as well as staff, and cash costs have been aggressively trimmed.

Expenditure in 2016 for the four large diversified FTSE 100 miners – Anglo American, BHP Billiton, Glencore and Rio Tinto – is likely to be around 25% of their collective peak spend of $62 billion in 2012, HSBC analyst David Fleming estimates.

The collective asset write-downs of these four mining companies over the past five years has been more than $80 billion, which amounts to around 30% of their combined current market capitalization, he also notes.

But miners are not yet out of the woods. The FTSE 350 mining index is still roughly 45% below the peak levels seen at the end of 2010, after which China’s voracious appetite for commodities started to wane.

One problem miners now face is that those assets they were willing to sell have started to improve in value, meaning reluctance to part with them has increased along with the respective price tags of the operations for sale.

The easy productivity cuts have been made, meanwhile, making it harder to make real inroads via future cost-reduction initiatives, whether in terms of capital or operational expenditures.

Similarly, while the commodity markets have seen an improvement in futures prices of late, the physical market is yet to catch up. Many commodity markets are still in surplus and/or with significant inventory levels, which China – or, indeed, the rest of the world - is unlikely to eat into, for now at least.

There’s also production still to come to the market from the boom years, when companies overinvested in growth for growth’s sake.

With all of this in mind, two elements will be critical for the performance of mining firms in 2017: first, whether miners have learned their lessons and can retain growth, cost and productivity discipline; and second, whether miners have picked the right commodities to focus on in their respective portfolios.

Discipline is within the control of management, but commodity prices, broadly speaking, are not.

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