Digging Up Results – 2007 Explored7 January 2008
David Binning looks at mining highs and lows throughout 2007, and how these will impact on 2008 and beyond.
It's the boom that many thought had to come to an end. But the relentless appetite for commodities in China and India has ensured that the mining sector will continue to defy gravity for some years yet.
While specific economic data for 2007 is still being compiled, a quick look at 2006 will remind people of the sort of trajectory the industry is still travelling on. According to data from PricewaterhouseCoopers, the total net profit reported by the world's top 40 mining companies grew a staggering 64% over 2006.
Although growth was not as frenzied throughout 2007, the outlook for 2008 remains strong. Most key commodities finished up in 2007.
The exceptions were zinc, nickel and aluminium, the latter falling sharply from just above $1.30/lb to $1.10 and the worst performer among commodities.
"Some of the commodities have had the lustre come out of them," says Keith Jones, managing partner at Deloitte WA and leader of mining and resources group. Yet the outlook for growth remains strong.
2007 was also the year that uranium returned to favour after several years in the wilderness. The climate change issue forced a change of mood regarding nuclear power and pushed yellow cake up to a record price of $130 per ounce in June. It has since come way back down but remains a key commodity to watch. Alternative energy and the previously infeasible concept of 'clean coal' started to gain traction.
According to Gavin Wendt, mining analyst with Sydney-based consultancy Fat Prophets, the commodities boom has lasted much longer than anyone had expected. "This one really has legs," he says.
He predicts that gold will finally hit the magical $1,000 price in 2008, with oil climbing to $125 a barrel. Over the last few years some analysts suggested that gold was losing its safe-haven status after the US invasion of Iraq failed to push prices to expected levels.
However, Wendt feels that continued instability in the Middle East and elsewhere, as well as the likely softening of the US economy, is expected to restore some of gold's traditional role next year. China may edge out South Africa to become the largest gold producer, while Australia is likely to claim third in front of the US.
TO CHINA AND BEYOND
Driving most of the demand in the mining industry is China, with India fast catching up. Both countries have served as a vital buffer for an industry that would otherwise be tilting with the declining fortunes of the US.
A number of the world's biggest iron ore producers have flagged a doubling of production to keep up. The global ore market has also been responsible for one of the more remarkable success stories in corporate Australia. Andrew 'Twiggy' Forrest, CEO of once iron ore upstart, now global contender Fortescue Metals, is now in the running to be Australia's richest man.
INVESTMENT ISSUES REMAIN
But behind the stories of stratospheric profits, there lies a dimmer tale of exponentially rising exploration costs, dire skills shortages, and ageing transport and other infrastructure splitting at the seams. Lack of investment in the 1990s is to blame.
Big mining companies with iron ore and coal operations have even had to initiate strategies to deal with severe rubber shortages as China's consumption continues to increase. In 2007 Rio Tinto opened a multi-million-dollar tyre retread and driving/roads research facility in WA.
"The cost of infrastructure is growing rapidly because of extra costs of labour and equipment; companies are trying to capitalise on a once-in-a-lifetime opportunity," notes Deloitte's Jones.
But investments over the last few years may yet take five or more to produce notable results. "It will probably take another five years before we see enough skilled people and it [the skills shortage] will probably get worse in the short term," says Wendt.
Even though China and India certainly aren't going anywhere, there are still negatives from the global economy.
"You have to say market sentiment is pretty positive, demand is high, but there are obvious concerns with the US economy and its effect on the world economy," says Dr Sandra Close, director of Melbourne-based mining consultancy Surbiton Associates. "This will all feed into the basic commodities that mining provides."
SAFETY IN NUMBERS
Continued strong growth in commodities was the main impetus to mergers and acquisitions activity throughout the sector. In particular, BHP Billiton's audacious takeover offer for Rio Tinto dominated the headlines. The union would create a colossal mining giant.
Whether it will go ahead remains to be seen. Comments from Rio CEO Tom Albanese in early December 2007 stated that BHP's offer of $125bn was "ballparks away".
Nevertheless, BHP has been reported as considering a number of options to make the union more palatable to competition regulators. These include divesting its uranium assets, given Rio's strong assets in this area.
China-owned Baosteel recently entered the fray with a significantly higher offer of $200bn. Observers see this as an unlikely marriage, but the various courtships are helping to lift the value of the entire sector.
The coming year is likely to see even more M&A activity than 2007 and analysts also expect to see further consolidation among the small to medium caps. 2008 and beyond will be the true test for a number of major mergers. Many in the coal and oil industries have failed to impress analysts. Part of the reason may be the fact that the scale of M&As today is entirely unprecedented.
Wendt notes that many of the large mining companies are finding that their profits have remained fairly static, despite sharp increases in revenue. "Have these mega mergers been a great idea?" Wendt ponders. "I don't think they have been. Certainly in the gold sector there hasn't been a lot achieved."
As Surbiton's Close notes: "Whenever you get mergers and acquisitions companies believe they're going to save lots of money; but it doesn't always work out like that."
However, she observes that the point at which consolidation reaches critical mass is the point at which the new generation of minnows is typically born. 2008 will be a year to watch activity among the small players.
Another important development for 2006/7 was the emergence of new world mining companies, including new players from Asia, but most notably the new Brazilian powerhouse of CVRD. CVRD was responsible for one of the biggest takeovers for 2006, after absorbing 76% of Canadian rival Inco for $15bn; making it the world's second largest mining company.
HEDGING A WAY FORWARD
A key trend throughout the mining sector for the past few years has been hedging. High commodity prices means that takeovers are often transacted with cash (69% of transactions were conducted with cash in 2006) which encourages alternative investments.
However, hedging has been blamed for causing instability in commodities markets. Alison Kitchen, national chair of energy and natural resources, KPMG, feels that the practise is on the way out. "My expectation is that big players will prefer to stay unhedged," she says.
THE NEW INDUSTRY CLIMATE
2007 was the year in which the issue of the environment loomed large for the mining industry. 'Climate change' suddenly became two words the industry was forced to take onboard. PWC reports that during 2005, utilities surveyed mentioned wind and uranium only 17% and 19% respectively. By 2006 those proportions had increased to 48% and 45%.
This year also saw the value of the uranium sector skyrocket as people faced up to the reality that nuclear power might be the greener route to coal. Uranium prices exploded, as did the stocks of companies involved in exploration. Australia's uranium miner Paladin Resources is one of the country's outstanding resources performers for 2007.
Bi-partisan support to increase the number of uranium mines in Australia from three has huge implications for the world's second-largest producer of the metal, although the governments in the uranium-rich states of Queensland and WA are yet to be persuaded to play ball.
Fetching around $60/lb at the start of 2007, uranium blasted up above $136/lb by June. In December 2007 it was hovering just over $90/lb. But compared with the 2000 average price of $6.90, things still look positive.
"The heat went out of the uranium market, but there's still good demand in the long term," says Deloitte's Jones.
However, Fat Prophets' Wendt doesn't quite share the same enthusiasm. "Looking forward, I doubt whether all those [nuclear] power stations slated for construction will actually get built," he says.