How Miners Will Fall Off the Wagon
The world's miners went on one hell of a binge five years ago, and they've been dealing with the hangover ever since.
Even the worst overindulgence passes into memory eventually, though, and last week the industry emerged blinking into a bright new day.
At BHP Billiton Ltd., Vale SA, Rio Tinto Group and Anglo American Plc, 1 combined net debt fell by almost $15 billion between June and December, compared with a $3.7 billion reduction across the previous three-and-a-half years. Free cash flow in the December half rose more than sevenfold from a year earlier, to its highest level since 2011. Capital spending dropped to the lowest point in a decade.
Executives rolling out these results did their best to project an ascetic air. Having set fire to a mountain of capital during the boom, they were keen to remind shareholders they were now reformed characters.
Here's how Rio Tinto Chief Executive Officer Jean-Sebastian Jacques put it:
And his BHP counterpart, Andrew Mackenzie:
Or, indeed, Anglo American's Mark Cutifani:
Notice a pattern?
The executives undoubtedly are sincere. But make no mistake: Should commodity prices remain buoyant, this party will be back on in a year or so.
The reason is embedded in the nature of the industry. If you were trying to think of a recipe for the undisciplined allocation of capital, you'd probably design a business with vast expenditure needs combined with highly variable but frequently extraordinary profits. Like a mining company.
While digging up rock may not seem glamorous, it can be fantastically lucrative. On long-term average operating margins, the world's big miners are often more profitable than the owners of Cartier, Gucci, Givenchy and Tiffany:
Unlike those luxury-goods companies, though, they're exploiting finite resources. Kering SA can keep churning out Gucci handbags for as long as there's leather to make them, machines to stitch them and customers to buy them. BHP Billiton, on the other hand, can only mine the world's biggest copper pit for another decade before it needs a costly mega-upgrade to access fresh parts of the ore body. Occasional capital splurges come with the territory.
Right now, the giant spending machine that characterized the mining boom has fallen almost silent. Combined capital expenditure by the big four was $8.4 billion in each half of 2016, the lowest level since 2006. Vale's immense S11D iron ore mine started up in the December quarter, and outlays at Anglo American's colossal Minas-Rio iron ore project is winding down as production ramps up. The last significant chunk of spending from the years-in-the-making $7.6 billion upgrade of BHP's Escondida copper mine will happen within weeks.
What happens next will depend on the direction of commodity prices and the attitudes of the miners' investment committees. But it would be foolish to rule out the possibility that the companies will return to their old ways.
Thanks to those great margins, mining debt can plummet when prices are favorable -- just look what happened between 2007 and 2010 in the first chart above. If free cash flow keeps coming in at the $25 billion-a-year pace of the past six months, as analysts expect, then even if half of it is paid out as dividends, the big four will be back at cyclically low debt levels by the end of 2018. By that point, they'll want approval for the next big round of project spending for fear of being left behind by their competitors.
The current vogue is for clearing the overhang of debt on the balance sheet and rewarding long-suffering shareholders with dividends and buybacks. But the former is a finite task, and the latter can get old pretty fast. The allure of expensive projects has dimmed of late, but it will inevitably shine again.
There already are signs that the dam is breaking. Back in 2015, Rio Tinto gave the go-ahead to its $5.3 billion Oyu Tolgoi copper mine expansion project, and last year approved another $1.9 billion for an Australian bauxite mine. This month, BHP Billiton signed off on $2.2 billion to develop an oil field in the Gulf of Mexico, and by the end of the year it will decide whether to spend the same amount on expanding its Spence copper mine.
Expect more such lapses from sobriety if commodity prices remain healthy. Miners have been in recovery from their debt addiction of late, but there's no real cure.
We've mostly excluded Glencore from these comparisons because its initial public offering in 2011, the merger with Xstrata in 2013 and its mix of trading and mining businesses makes it look a bit different to other miners over the span of the past decade.
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