Through-cycle investment in mining

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Cyclical commodities pricing has historically driven financing challenges for mining companies: volatile valuations, reflected in an average 1.4 times price-to-book ratio, compared with 2.5 times for the S&P 500 and 1.7 times for the FTSE 100,1 as well as cyclical capital expansion, reflected in “peaky” expansion cycles, which are 73 percent correlated with commodities prices.2

The impact of this is highly variable valuations, as well as underinvestment during downcycles and overinvestment during upcycles—especially for junior mines and exploration projects.

The COVID-19 crisis has the potential to exacerbate these challenges, with prices under pressure in many commodities, driven by demand and supply disruptions. There is a critical need to address the industry’s financing challenges to avoid underinvestment during the COVID-19 crisis, which could affect production for years to come (for an example, see Greg Callaway and Oliver Ramsbottom, “Can the gold industry return to the golden age?,” April 2019).

By taking a disciplined approach to capital planning and diversifying financial portfolios, miners can make better long-term-investment decisions, maintain stronger balance sheets, and likely see more consistent returns and valuations.

What: The challenge of investment in mining

Commodity prices are notoriously cyclical—mining has seen five cycles since 2000.3 Going forward, we can expect to see similar cyclicity and greater volatility within cycles, as declining ore grades and deteriorating mine conditions cause operating costs to rise and the cost curve to steepen.4

Cyclicity creates related challenges for mining companies when it comes to financing: volatile valuations and cyclical capital expansion.

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Volatile valuations

Historically, mining valuations have been closely correlated with spot prices. This is true even compared with other capital-intensive industries. Mining market capitalizations are 93 percent correlated with commodity prices, compared with 84 percent in oil and gas, 64 percent in steel, and 60 percent in pulp and paper.5

We also see a consistent gap between industry-wide enterprise value when calculated using discounted cash flows (reflecting intrinsic performance) versus when calculated using market capitalization (reflecting investor confidence)—on average, 1.4 times higher since 2008.6

This is also reflected in low price-to-book ratios for mining relative to other industries: 1.4 times median ratio for mining companies from 2008 to 2018, compared with 2.5 times for the S&P 500 and 1.7 times for the FTSE 100.7

Mining’s volatile valuations reduce the financial attractiveness of public equity for miners, contributing to volatile investment cycles.

Cyclical capital expansion

Perhaps as a consequence of the strong correlation between prices and valuations, mining companies tend to go through highly “peaky” capital-expansion cycles, as the ability to raise funds is correlated to price levels. The correlation between price and investment spend is high—73 percent over the past decade—and is expected to continue going forward, based on anticipated capital-expenditure-expansion plans (exhibit).

Mining companies tend to go through ‘peaky’ capital-expansion cycles.

As a result, many companies fail to capitalize on high pricing when it occurs because they have underinvested in the downcycle. This is especially true for junior mines and exploration projects. In the downcycle, by contrast, companies may find themselves overextended because of excessive expansion programs at the top of the cycle. This is a strategic challenge as much as a financing one, though financing can help increase the strategic “degrees of freedom” for mining companies.

Why now? Mining industry outlook and context

The mining industry’s current context creates a need and an opportunity to address the sector’s financing challenges. Prices have sharply declined since January 2020 in many commodities, including thermal coal, zinc, steel, copper, aluminum, lead, nickel, iron ore, and metallurgical coal.8

We are already seeing an increase in debt, auguring a return to the industry’s boom-and-bust financing cycle.9 Without structural change, the downturn that the COVID-19 crisis looks poised to precipitate would mean another cycle of capital flight, overextended balance sheets, and falling valuations.

Leading companies have a clear perspective on use of cash and capital returns through the cycle, including risk-based views on the sources and uses of cash.

How to address: Taking a disciplined approach to capital planning and using the full range of financial levers

Leading companies have a clear perspective on use of cash and capital returns through the cycle, including risk-based views on the sources and uses of cash. They evaluate where they are in the cycle against their long-term capital-expansion plans to develop through-cycle-financing plans:

While through-cycle-mining returns are attractive, investors have historically been discouraged by near-term fluctuations in commodity prices. This, in turn, has driven volatile valuations, capital expansion, and balance sheets.

The current environment—rising prices propelling investment—creates a window of opportunity for mining companies to address these challenges through disciplined capital planning and use of an extended range of financial levers.

While capturing the opportunity requires work, organizations that take up the challenge and succeed in changing their investment strategies might just beat the cycle.

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