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    Deleveraging Tightens Metals Supply and Supports Prices: Part 2

    Charl Malan ,Senior Analyst
    December 21, 2016

    Part two 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 Part 1 we focused on how the metals mining industry has tackled deleveraging by reducing capital expenditures ("capex"). In Part 2 we ask the question, "Are metals miners cutting costs too deeply?" We also explore the additional measures miners are taking to reduce debt, including cutting or restructuring dividends and selling or closing unprofitable assets.

    Are Cost Reductions Cutting Too Deeply?

    Most metals producers are well into the process of reducing overall costs, and the industry has experienced, on average, an approximate 26% decline in costs over the three-year period from 2013 through the end of 2015. At the World Copper Conference that we attended in Santiago, Chile, this past April, the case was made that costs could fall by another 15% or more, driven by efficiency improvements and large-scale layoffs (such as those announced in early October by the Chilean copper mining group Antofagasta, which is trimming 7% of its workforce, and Polish mining company KGHM Polska Miedź S.A., which is letting go of 12%).

    Cutting too deeply into the cost structure is already having repercussions on future supply. The "supply chain" has experienced a structural shift and a massive destocking has occurred in terms of equipment, consumables, and labor. A dearth of key skills during the 2000s plagued the industry (Chart A), and as a net result, many mining projects experienced schedule over-runs (Chart B). Both factors will likely have an impact on the supply response in the short- to medium-term.

    Chart A: Metals Mining Labor Supply is Not Meeting Demand
    Labor Supply and Demand Growth (%) CAGR* 2005 - 2011

    Chart A: Metals Mining Labor Supply is Not Meeting Demand

    Source: Xstrata (from McKinsey).
    *CAGR is compound average growth rate.

    Chart B: Many Mining Projects are Experiencing Schedule Over-Runs
    Estimated %

    Chart B: Many Mining Projects are Experiencing Schedule Over-Runs

    Source: Xstrata (from McKinsey).

    Cost cutting may also have an impact on future supply by impacting other areas including the availability of consumables such as explosives, equipment such as trucks, shovels, and parts. This could especially be the case with equipment where lead times could expand rapidly as demand for new equipment increases.

    Restructuring Dividends to Help Reduce Cash Flow

    Among the industry's "Big Six" diversified mining companies (BHP Billiton, Rio Tinto, Glencore, Anglo American, Vale, and Freeport-McMoRan) cutting or restructuring dividends has been a core method of reducing cash outflow. In February this year, BHP Billiton slashed its dividend by 75%, its first reduction since 1988, as it ditched its progressive dividend policy (a steady or higher dividend at each half year) for a payout ratio based on earnings (payout of 50% of attributable profit). By cutting dividends in 2016, BHP Billiton is expected to reduce outflows by $6 billion, Vale by $5 billion, Rio Tinto by $4 billion, Glencore by $2 billion, and Anglo American and Freeport-McMoRan by $1 billion each.

    The effect on long-term supply from cutting dividends relates directly to future capital allocation. It appears that shareholders are demanding that excess cash be returned via dividends and/or used to reduce debt in order for businesses to be managed more efficiently in a potential down cycle. We believe this demand for capital will mean that any growth spending will be carefully scrutinized and expected hurdle rates will be significantly higher than the historical average, and this means that less money will be allocated to growth. This is likely to have a medium- to long-term impact on supply response.

    Closing and Selling Assets to Help Reduce Debt

    As Chart C illustrates, asset sales have been a very popular strategy among miners in order to help reduce debt, not only because it represents a potentially significant cash inflow, but also because these assets are typically a drag on EBITDA and, therefore, on net debt/EBITDA (EBITDA represents a company's earnings before interest, tax, depreciation and amortization, and is a measure of a company's operating performance). This strategy has been extremely successful, and we continue to be surprised by the full price buyers are paying for second-tier assets. For example, Freeport-McMoRan has inked a deal to sell a 13% stake in Morenci to Sumitomo for a cash consideration of $1 billion, which equates to 13x EV/EBITDA (the industry trades around 7x EV/EBITDA).

    Chart C: Overview of Potential Assets for Sale
    Estimated %

    Chart C: Overview of Potential Assets for Sale

    *"N/A" includes assets with variable interests or where interest details are unavailable
    **"Other" includes agriculture, energy, industrial or refractory metal assets

    We believe that selling assets will have a medium-term impact on metals supply and it will be more severe than the market anticipates. The reason is that, once an asset is sold, its entire operational infrastructure is reconfigured to process only "profitable" tonnes, which in normal course of business means that capacity is generally reduced by approximately 10% to 20%.

    Although the industry's long list of potential asset closures has been well publicized, it has only been when the industry started to close assets that the reality of what was about to happen has struck home.

    Zinc Provides A Case Study in Supply

    A classic case study remains zinc. Although we have written about it earlier this year (Zinc's Year to Remember, A Supply Side Story), it is important to recall that it was only in June 2016, when global supply had contracted by about 12.5%, that people started to take note. This reduction was a truly global phenomenon, with Europe cutting production by as much as 10.1% and India by 39.5%. At the same time, China the world's largest zinc producers reduced supply by about 6.9%.

    Closing loss-making assets has a short-, medium-, and long-term impact on metals supply. Although these assets could again become operational, it normally requires much higher and, more importantly, sustainable commodity prices for that to happen. The reason is that the cost of reopening mining infrastructure (especially underground) is lengthy and expensive, not to mention there are typically issues associated with ramp-up and product quality.

    "The Cure for Low Prices is Low Prices" Speaks the Truth

    As we concluded in Part 1, 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 costs structures, high cash flow, and the desire to return capital to shareholders.