2015 Michael Birshan | Guillaume Decaix | Mark Dominik | Nelson Ferreira | Harry Robinson
Is now the time for mining acquisitions?
Low equity prices may offer important M&A opportunities for the mining industry
Where is the mining industry headed? Commodity prices are now far below their 2011 peaks and the mining industry’s stock market valuation has followed prices down. The big mining houses have been working hard on cutting costs, reducing capital expenditures, and boosting productivity—all aimed at improving profitability.
Our commodity-by-commodity modeling suggests that market sentiment may have overshot once again. However, in many commodities, declining ore quality and limited accessibility of new deposits will squeeze supply in coming years, potentially driving a commodity-price rebound as global demand continues to rise. If lessons of previous cycles hold, mining equity prices could be expected to spike as well.
We do not know exactly when the mining sector will recover and our analysis suggests the outlook is not equally rosy for all commodities. That makes it all the more important that company leaders are rigorous in their due diligence and analysis before they make any acquisition decisions.
Valuing cyclical companies is challenging, because swings in product prices radically affect profitability—the mining sector is no exception. Extreme commodity-price movements during the supercycle have made the sector very difficult to value. As a result, the market heavily weights the short term and equity prices largely track commodity prices. Indeed, our analysis shows that the correlation between the two is significantly higher for mining companies than for similarly capital-intensive industries, such as oil and gas (Exhibit 1).
A look at mining fundamentals offers a less gloomy view. Demand for metals is growing worldwide, as does production. For almost all commodities, production is at record levels. The slower rate of demand growth in China has let supply overtake demand in a number of commodities, pulling prices down – for now.
Our analysis suggests that the steadily deteriorating quality of accessible resources, combined with recent slowdown in mine investment, is likely to squeeze supply in the face of slow, steady demand growth, causing prices to rebound.
A different outlook
To get beyond generalizations, we have developed a new approach to modeling the industry (see Box 1: Modeling mining’s prospects). Our analysis suggests that after a six percent per year decline between 2011 and 2014, industry-wide mining revenues could grow at around four to six percent over the next decade. EBITDA performance for the industry overall is also projected to rebound over the same period, at a slightly lower rate of around three to four percent per year, held back by steady cost increases. So the mining industry will likely continue growing, albeit with lower margins.
The outlook for different commodities clearly varies significantly, but applying this modeling approach to 11 important metals and minerals suggests that several of them are well positioned to achieve attractive returns again (Exhibit 2).
Today’s relatively low share prices for metals and mining companies and the expectation of increased commodity prices over the medium to long term should encourage miners to pursue M&A now. The challenge for mining companies looking to strengthen or diversify their portfolios, however, lies in identifying strong players in the sectors and regions where they want to be active. Miners looking to make acquisitions should therefore make sure that they have fully identified the performance characteristics of any target company within a given sub-sector (see Box 2: “Uncovering operator performance”).
Modeling mining’s prospects
Our new modeling approach assesses the mining industry’s mid- and long-term potential by combining insights from three areas: drivers of supply and demand; mining cost and capital expenditure (capex) inflation; and pricing regimes and price premiums
Supply and demand: Projecting out both supply and demand drivers over the next decade, we conclude that geological shortage is likely to be a stronger determinant of future price movements than variations in demand. We examined geological factors such as grade erosion and depletion on a mine-by-mine basis, declining resource levels, and delays in new projects; all of which combined create the likelihood of severe shortages.
Cost inflation: In the 2000 to 2013 period, cash cost inflation has been close to 20 percent annually for copper, iron ore, and potash, while for coal it has been around 11 percent. This has primarily been driven by the geological factors just described. Even with new technology and productivity gains, these factors will continue to exert pressure, and our analysis suggests total inflation will average four to seven percent going forward.
Price regimes: Our modeling looks separately at two building blocks of commodity pricing. The first of these is the evolution of the cash cost of any industry’s marginal producer, explicitly considering geological inflation per commodity. The second is “price regime,” or the margin over cash costs that the marginal producers will earn, which marries a commodity’s historical price dynamics with our simulation of its future supply-demand balance. There are four basic price regimes:
- Cash cost—when price levels are close to the cost of the marginal producer and there is minimal incentive to invest
- Brownfield inducement pricing—when prices are high enough to prompt extension of existing capacity
- Greenfield inducement pricing—when prices rise to levels required to justify new projects
- Fly-up pricing—where demand grows so fast and capacity utilization is so tight that prices temporarily soar and project returns become exceptionally attractive
Our analyses show that while a single commodity can go through different price regimes, the price premiums (the commodity’s price minus the cost of the marginal producer) associated with each regime are much more stable than absolute prices in the commodity market.
Uncovering operator performance
What really determines the performance of a mining operation? How is that performance likely to evolve over time? How could it be improved? The operating costs of a mine depend on numerous interrelated factors, from the quality of the ore and the geological conditions at the site to the reliability of its equipment and the productivity of its workforce. In the past, that complexity made it hard for companies to compare different mines or to identify the (often significant) opportunities to reduce costs and improve output through capital investments or process improvements.
MineLens, a McKinsey Solution, is a new benchmarking approach that allows mining companies to compare the performance of their existing – and planned – sites with others in the sector and the industry as a whole. By accounting for structural differences between mines, regions and commodity types, MineLens allows
In the coming years, mining companies will continue to face real challenges related to prices, costs, and productivity. But the long-term fundamentals appear strong: geological factors, including depletion, could drive several mining commodities into more attractive price regimes in the medium- to long-term, creating potential benefits for miners with these assets represented in their portfolios. Some companies are already beginning to consider acquisitions and restructuring. But they must spend wisely, picking the right acquisition targets, making the appropriate portfolio changes and establishing strong operating practices now. Only then will they be in the best possible position when conditions improve.
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