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  • Natural Resources

    Deleveraging Tightens Metals Supply and Supports Prices: Part 1

    Charl Malan ,Senior Analyst
    December 13, 2016

    Part one of a two-part series by Senior Analyst Charl Malan.

    Overview: VanEck's natural resources investment strategies span the breadth of raw materials commodities sectors, and base/industrial metals play an important role. As of November 30, 2016, base/industrial metals-related holdings accounted for approximately $1.5 billion of the firm's assets under management.

    Miners Take Multiple Steps to Deleverage

    In this two-part series, we explore how the industry has tackled deleveraging by reducing capital expenditures (“capex”) and overall costs, cutting or restructuring dividends, and selling or closing unprofitable assets. Part 1 focuses on capital spending, or capex reductions (capex generally refers to a company expenditure used to purchase, upgrade, improve, or extend the life of a long-term asset).

    For some time, the base/industrial metals industry has been overly leveraged given the correction in commodity prices. The industry’s higher debt levels resulted from a combination of poor capital allocation, acquisition activity, and weaker corporate earnings over the last several years. The industry has responded in the past 12 to 18 months by making its key theme capital preservation and debt reduction. This has shifted the industry’s focus away from simply growing supply (we also address this supply theme in earlier posts, including Coking Coals Rally Driven by Supply Contraints and Zinc’s Year to Remember: A Supply-Side Story).

    We believe all these actions will have a dramatic impact on supply and will ultimately support metals prices. In effect, the industry has canceled most growth projects and, therefore, the difference between supply and demand should tighten. We believe that the lack of growth capital is the single most important factor likely to support future prices of base metals.

    A Significant Decline in Capex

    The industry’s “Big Six” diversified mining companies (BHP Billiton, Rio Tinto, Glencore, Anglo American, Vale, and Freeport-McMoRan) have slashed capital spending from a peak of approximately $80 billion in 2012 to an estimated $25 billion in 2016, and this has been critical in reducing cash outflow.

    Chart A illustrates actual and expected capital spending for the Big Six firms, showing incremental six-month updated figures. At VanEck, our current capital spending projections of $25 billion for 2016 and $22 billion for 2017 are 15% to 20% lower than what was projected in December 2015.

    The repercussions of cutting capex will have both short- and long-term impacts on supply response. In an industry where assets are depleting, it is critical to maintain a reasonable level of capex. Upon closer analysis of capital spending trends, it is also noticeable that both sustaining and growth capex were significantly reduced (Charts B and C). “Sustaining capital” refers to when mining companies use capital to maintain production and operations at existing levels. By contrast, “growth capital” is considered expansionary as its goal is to grow production and operations.

    Big Six Capex Spending Has Declined Dramatically Since 2012
    Charts A, B, C:

    Emerging Markets Have Significantly Lower Debt-to-GDP Ratios versus Developed Markets

    Source: VanEck, Company Reports as of 10/31/16. The Big Six Diversified Mining Companies are BHP Billiton, Rio Tinto, Glencore, Anglo American, Vale, and Freeport-McMoRan. These are not recommendations to buy or sell any security. Sectors and holdings may vary.

    As can be seen in Chart B, sustaining capital spending has been reduced by nearly $8 billion from its peak in 2012. The direct impact of this is that current mining capacity/supply is at risk, as not enough capital is being allocated to maintain or sustain current supply levels. Therefore, current production forecasts are most likely overestimating production levels and, thus, production in the short- to medium-term may be lower than expected.

    The outlook for growth capital spending, Chart C, is equally concerning and is expected to have an impact on long-term supply. Growth capital has declined from about $60 billion in 2012 to approximately $10 billion currently. This represents more than an 80% reduction, and effectively means that the industry has canceled most growth projects. As we said earlier, this is likely to tighten the difference between supply and demand. At VanEck, we believe the lack of growth capital is the single most important factor likely to support future prices of base metals.

    “The Cure for Low Prices is Low Prices” Speaks the Truth

    In summary, the old saying of “the cure for low prices is low prices” really speaks the truth. We do, however, think prices will be more sustainable over the medium term, as the existing supply base has been significantly reduced and there are virtually no signs that it will change, even now that we are experiencing some higher commodity prices. We believe this creates an ideal environment for commodity equities: sustainable commodity prices, low cost structures, high cash flow, and the desire to return capital to shareholders.

    In Part 2, we ask the question: Are metals miners cutting too deeply? We also explore in more detail the additional measures that miners are taking to reduce debt, specifically cutting or restructuring dividends and selling or closing unprofitable assets.