Lack of capital forces junior miners to fight for survival—E&Y

“The dramatic and continuing sell-off in equity markets has starved the junior end of the market of capital at levels we have not seen in 10 years,” says a new Ernst & Young report.

Author: Dorothy Kosich
Posted: Tuesday , 11 Jun 2013

RENO (MINEWEB) -

Capital allocation and access, which tops the business risk list for mining and metals companies, not only threatens the long-term growth of larger miners, but has forced junior miners to fight for their survival, says Ernst & Young’s latest mining and metals report.

“For the larger mining and metals companies, the dilemma is how best to allocate capital,” said E&Y’s Global Mining and Metals Center in the report, Business risks facing mining and metals 2013-2014.

“The pullback of investors from riskier investments in the junior end of the market has created a capital desert for this segment of the market that has not been seen in a decade,” said the report.

“The price-driven, seemingly indiscriminate support that speculative juniors received from retail equity investors prior to the financial crisis in not on hand today,” E&Y observed. “Investors instead are looking for low-risk, near-term, high-yield opportunities, which the early stage junior mining sector simply cannot offer.”

“Furthermore, providers of risk capital have not yet adjusted to a new environment where a scarcity premium may no longer drive exponential growth in commodity prices,” said the report. “Instead, they are taking a step back, wait and see approach, opting to stay absent from the sector in the short-term rather than make long-term adjustments to their return expectations.”

“The damaging impact of this is amplified because junior mining companies cannot afford to take the same wait it out approach.”

The second highest-ranked business risk highlighted by E&Y is margin protection and productivity improvement. “A decade of higher prices has concealed the impact of rampant inflation, falling productivity and poor capital discipline in the sector,” said E&Y. “A weak external environment and the lack of investor confidence have heralded an industry-wide directional change from growth for growth’s sake towards long-term optimization of operating costs and capital allocation.”

However, the report suggests that the slowing expansion now taking place within the mining industry “will mean some relief in terms of rising costs, although cost pressures are unlikely to abate in a hurry.”

“Margin protection, via better management of containable costs, and a renewed focus on operational productivity will be two critical factors for companies to return profits to levels experienced in the last five years,” E&Y suggested.

Resource nationalism, which ranked first in E&Y’s 2012 business risks report, has dropped to third place in the latest version. “Resource nationalism remains prolific in resource-rich countries, and while it continues to be a major sector risk, it appears to have reached a tipping point where it no longer is the surprise it once was, and companies are getting better at managing this risk,” said Andrew Miller, E&Y Global Mining & Metals Tax leader.

Mining companies are now factoring country risk into pricing models, building strong relationships with government, building brands and effectively communicating on the positive impacts of mining, increasing the transparency of their payments to government, and implementing arm’s-length valuations of risks and functions through sophisticated transfer pricing, according to the report.

The social license to operate ranked fourth on E&Y’s list of business risks “as activists become more powerful and vocal through the use of social media around concerns over climate change, competition for water and the impact mining has on communities.”

“Companies need to find better ways to demonstrate shared value in their projects to all stakeholders in a manner that draws attention to the benefits of their initiative,” said Meg Fricke, senior manager, climate change and sustainability services, Ernst & Young Australia. “Every organization should look at decisions through the lens of share value. This will lead to new approaches that generate greater innovation and growth for companies, as well as greater benefits for society.”

While the availability of skilled labor remains one of the key long-term challenges for mining, E&Y suggests the slowdown of new mining investment might see some short-term relief for construction and development jobs. However, skills shortage is ranked fifth on E&Y’s business risk list as “longer-term demand for labor is expected to continue to trend steeply upwards.”

“Skills shortage is expected to remain one of the biggest risks facing the mining and metals industry,” said the report. “Such an acute shortage of skills can be somewhat mitigated if the sector is able to adapt to automation of various activities, tap into newer sources of talent, and effectively manage the migration and mobility of its workforce.”

Price and currency volatility is ranked sixth on the list as “unprecedented price and currency volatility will continue to test mining and metals for the next few years as the sector approaches supply demand equilibrium in many commodities,” observed E&Y.”As supply and demand now approach equilibrium, longer lead times in changing production are leading to overcorrection and undercorrection in supply, causing increased price volatility.”

To mitigate this risk, E&Y suggests companies can document the volatility of critical cash flow elements and improve mine planning to match volatility. Mining companies can also better integrate mine and financial planning, and increase the flexibility of costs to vary production levels.

Capital project execution risk ranked seventh on the list of E&Y mining risks as over the past 12 months, “the profile of capital project execution risk has increased significantly.”

“This shift has been driven by the market’s focus on short-term return on investment plus recognition of the project impacts if budgets and timelines are out of sync with stakeholder demands,” said the report. “Poor management of capital project risk can not only comprise the schedule and cost budgets, but also have a profoundly negative impact on a company’s profitability, growth prospects, social license to operate and overall financial health.”

“While the time of project failures is certainly not behind us, many large and spectacular ones have already occurred with detrimental consequences for some CEOs of major mining and metals companies,” E&Y noted. “In an environment of volatile commodity prices, low profitability and mounting pressure from shareholders, it stands to reason that future mega projects be approved as programs with multiple projects to provide executives with more options for reassessment throughout the project life cycle.”

Sharing the benefits is ranked eighth on E&Y’s list as mining companies try to balance more vocal stakeholders with increased demands with falling commodity prices and higher costs. “Stakeholder expectations need to be reset to the new market conditions and lower base of distributable value,” E&Y recommended, “however, those expectations lag the new reality.”

“While stakeholder demands will naturally rebalance over time…those mining and metals companies that can best communicate with their stakeholders to bring that rebalancing forward will create greater value,” E&Y advised. “It is vital that the next reset does not sow the seeds of stakeholder discontent for the next recovery in minerals prices.”

E&Y ranked infrastructure access the ninth highest business risk as “economic growth in rapidly developing economies continues to put pressure on mining and metals companies to increase supply through the development of new or existing mineral deposits. Increasingly, new deposits are found in the so-called frontier countries where development is challenged through the lack of infrastructure.”

“Organizations are torn between shareholders’ desire for short-term gains and restricted capital spending, with the need to maintain a healthy pipeline of projects in the long term,” said the report. “Development of these projects, a significant part of which is infrastructure development, will require increased coordination and collaboration between mining and metals organizations and other organizations. For their part, mining and metals companies will have to look for innovative commercial solutions and be willing to share control of the infrastructure.”

A newcomer to E&Y’s top 10, the threat of substitution has the potential to be a gamer changer for single commodity organizations or companies where one commodity dominates the product mix/profit share. “It has already dramatically transformed the US coal market and has the capacity to irreversibly change other commodity markets should the right conditions prevail,” E&Y warned.

“It is critical to respond to early indicators of a commodity threat—such as new or increasing environmental concerns, advances in technology, competing products with low profit margins and less dependence on quality and performance,” E&Y advised. “Building risk management to deal with this risk into current strategies can help prepare the organization for these events. The risk of substitution also highlights the importance of monitoring interdependent sectors.”