Anatomy of a disaster

AS the world’s top miners’ market capitalisations have plummeted along with their popularity, veteran Queensland resources lawyer Robert Milbourne of K&L Gates ponders where it all went wrong, and offers a way forward.
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Robert Milbourne

Staff Reporter

The international mining and resources sector accounts for about 11.5% of global GDP, and its indirect contribution is far higher. Extracted natural resources enable the creation of cars, buildings, smart phones, and all other aspects of our modern life, yet, the industry remains vilified by some as debasing our common natural heritage.

At the same time, given its enormous financial footprint, the sector provides a major source of national income for developing economies throughout the world. Even some of the most developed countries rely heavily on the sector's tax contribution, as seen in Australia over the last decade.

Why is there such a contradiction – between dependence on its products but popular opposition to the sector?

One can argue that the sector suffers from a profound misunderstanding of its fundamentals from all stakeholders – governments, NGOs, consumers and even the mining industry itself.

In 2004 the global mining sector and its stakeholders were caught off-guard by the phenomenal growth in demand from China and other BRIC nations.

Year after year growth in demand eclipsed the best efforts of the industry to increase production, leading to a misalignment between supply and demand, and a rapid increase in pricing.

After eight years of consistent growth, in 2012 governments finally caught on, and hoped to "get their fair share", through the imposition of a super-profits tax in Australia that was quickly emulated around the world.

Yet the timing of such legislation was eight years out of date, and more worrisome, was introduced at precisely the time the industry began its decline in profitability and commodity demand growth, in effect accelerating a decline in the sector when it most needed support for sustainable operations.

To make matters far worse, senior mining executives arguably also misunderstood the dynamics of the market, and approved unprecedented expansion in capacity.

In 2013, Vale approved its massive 90 million tonne per year S11D iron ore project. Rio Tinto approved expansion of about 70Mtpa of capacity in the Pilbara. BHP raised its production of 187Mt in 2012 to 270Mt in 2014. Similar stories occurred in thermal and metallurgical coal, copper, and other commodities.

Given its incredible importance to the wellbeing of the global economy, and given the relatively stable global consumption curve (which has not fundamentally changed from 2012), it is astounding that the sector can continue to be so profoundly misunderstood.

Investors are clearly among the first to have lost. BHP Billiton went from a market cap of $US270 billion ($A349.03 billion) in mid-2011, to $115 billion in June 2015.

Vale went from $170 billion in mid-2011, to $38 billion now. Rio Tinto went from about $140 billion in 2011 to $82 billion now. This represents a loss in these three companies alone of about $350 billion in market capitalisation.

Further, over this period of time each of the majors expended enormous amounts of capital – Vale for example invested over $70 billion from 2010 to 2015. Similar numbers were expended by Rio and BHP Billiton. Despite such investments, their market capitalisation plummeted.

Have we learned anything? Are governments, mining executives, consumers, investors and NGOs any wiser after such a dramatic boom and bust – all during a period of gradual increase in demand and a tapering off to a stable global consumption level?

This industry enables the products that support our way of life, and support the emergence of impoverished countries to rise into a global middle class.

One might think that some of the world's leaders would meaningfully address the sector's regulation for the maximum benefit of all.

Unfortunately, governments and the private sector seem determined to continue their misunderstanding of the sector and its contribution, and now even more importantly, the opportunities present in the sector.

Mines throughout the world are being sold by the major mining houses, often at nil cost. Even more mines are being moth-balled.

Further, exploration expenditure, necessary for identifying the mines of the future, is at a 10-year record low this year in Australia.

What does this imply? Well, for a start, with exploration stopping, mine development left unfunded, and mine operations being closed, it is reasonable to expect that for many commodities supply will fall lower than demand and commodity prices will rise again.

Many analysts struggle to identify the "top" or "bottom" of the mining investment cycle but many argue we are close to or have already passed the bottom.

Failure to understand demand and supply is making havoc with national and state budgets in Australia and throughout the world, so getting this analysis right is critical. Yet global analysts often come to fundamentally different valuations on the same asset.

Let’s take an example of the New Saraji coking coal deposit in Queensland. In 2008 BHP Billiton bought the mine for $US2.5 billion, twice what many estimates valued it at.

Five years later, BHP admitted the project was unlikely to deliver an economic return. If anyone should understand the mining sector – shouldn’t it be the executives in the sector?

Yet BHP was not alone, Rio Tinto wrote off almost all of its $22 billion worth of acquisitions including a coal project in Mozambique and the aluminium producer Alcan. Vale has also written off large sums with respect to its coal and nickel operations.

There is an assumption by stakeholders that the industry is subject to the fate of a "cycle" and valuations and commodity prices will rise and fall accordingly. But there does not appear to be a demand cycle – demand for Iron ore in fact increased robustly in China from 2013 (820Mt) to 2014 (932Mt) at the same time commentators declared the "end of the boom".

How is that demand increased by 110Mt and yet the cycle was over?

The only thing that happened was unprecedented additional supply capacity, all of which should have been easily foreseen and understood by the market – a major mine cannot suddenly "appear", but rather it often can take over ten years from exploration discovery to fully commissioned mining operations.

The whole world knew Vale, BHP and Rio Tinto were increasing supply. And yet, when they all announced their expansion plans the investors and governments trumpeted their ambitions, only to have these same stakeholders abandon the sector after seeing Chinese growth fail to match the unprecedented expansion in supply capacity.

Had anyone actually predicted Chinese supply would continue to grow by 100Mtpa indefinitely, to justify these expansions? If they did, it has been hard to find those predictions in my research.

So what can be learned?

Well, first, the entire industry should have a laser focus on demand. Investors must improve their understanding of the supply/demand equilibrium. Boards should quantify their understanding of market fundamentals and be held to account.

Governments should consider the impact to the broader community of workers, infrastructure, and economic returns when regulating large scale projects if they run the risk of leaving stranded assets in the hands of governments to manage.

In Australia, many large infrastructure projects for ports and rail capacity sit languishing as a result of the poor decisions all stakeholders made at the height of the froth in the market.

Finally, greater understanding may be merited to recognize what the sector actually provides to the world – mining in Australia accounts for less than 0.2% of landmass – all of which must be rehabilitated, while agribusiness accounts for a massive 53% of Australia's land mass.

This trend is replicated throughout the world. Yet despite its comparatively small impact, the sector provides disproportionately high wage paying jobs, government revenue, and public infrastructure.

The world can ill-afford to continue with such a poor record of planning and decision making for such a critical sector.

The time is now to assess global demand and ensure that investors, banks, governments and other stakeholders align exploration, project development and operations to a reasonable connectivity to current and future demand requirements, ending once and for all the damaging assumption that the industry is bound to continue to repeat its "cycle" of boom and bust.

This cycle is entirely man-made and should end, now.

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