- The mining industry faces a number of negative factors that are squeezing earnings
- Concern that "supercycle" is drawing to a close after years of surging Chinese demand
Anglo American set the sombre tone. Falling prices and rising costs enfeebled the mining group's businesses in the first half of the year, halving earnings.
First among its diversified cadre to report, the miner last month pruned its spending plans on high-profile growth projects. It is now -- as earnings season approaches its conclusion -- a familiar tale.
The mining industry faces a number of negative factors that are squeezing earnings, curtailing cash flows and forcing management teams to make tougher choices.
The backdrop to the lacklustre results is the concern over whether the so-called "supercycle" is drawing to a close after years of surging Chinese demand combining with supply constraints from decades of under-investment to send prices higher for commodities such as copper, coal and iron ore.
The debate is crucial to mining companies and their investors. Over the long term, the performance of mining equities is largely correlated with commodity price fluctuations. Increases in costs, especially wages and payments to governments, tend to lag behind booming profits as prices rise, putting severe pressure on the sector's profitability.
Mining chief executives argue that China's hunger for steel-producing commodities, iron ore and coking coal, as well as copper and other metals will remain robust.
"The bull run can't last forever," says Rachael Bartels, managing director of Accenture's mining industry group. "But the underlying demand for commodities is not going to go away. China and India are not finished with urbanisation and Africa hasn't even started yet."
Yet mining companies face a dramatically more challenged outlook than even a year ago -- and their latest earnings underscore the issues to watch in the sector.
Miners including Xstrata, Anglo and ENRC have reduced their spending on growth projects this year, many pledging to review future plans as well.
BHP Billiton, more dramatically, took its $20bn Olympic Dam expansion project off the table, arguing it no longer made economic sense.
"Six months ago, [the miners] were like bulls at a gate in terms of trying to see who could spend more money," says Rob Clifford, analyst at Deutsche Bank. "Now there is a lot more caution."
The real story behind the pullback, argue executives and analysts, is the collapse in the industry's cash flows. Underlying earnings before interest, tax, depreciation and amortisation -- a proxy for cash flow -- fell between 20 and 40 per cent from the second half of last year to the first half of this year.
Rio Tinto's earnings per share fell about a fifth year on year, note analysts at Citigroup, who say its operating cash flows fell 60 per cent -- close to levels not seen since the 2009 financial crisis.
Some miners' first-half cash flows did not cover their capital expenditure and dividends. The industry's debt levels are expected to keep rising. "We are likely to use a little bit of balance sheet capacity if current conditions prevail," said Marius Kloppers, chief executive of BHP Billiton. "This is what balance sheets are for."
Most miners are only pushing back expenditure or shelving as yet unapproved projects. So increasing debt levels around the sector could raise concerns that the industry may again be caught short, as it was in the 2009 crisis when Xstrata and Rio Tinto among others had to seek additional funds from shareholders.
Deutsche Bank's Mr Clifford says the miners are entering this downturn with strong balance sheets and rising indebtedness was expected this half. "But the pace of it was a little faster than expected," he says.
Myles Allsop, analyst at UBS, notes: "In the current uncertain macro environment, you would expect investors to prefer more defensive diversified names, rather than pure single-commodity plays. No one expected iron prices to fall as far as they have over the last six weeks, just as happened with thermal coal in the first half."
Despite the tough outlook, the biggest mining groups increased their dividends in the first half, while less diversified companies, such as Kazakhmys, the copper miner, cut their payouts.
Big mining groups aim to build a portfolio that balances exposure to swings in any individual commodity, meaning they should fare better than companies focused on one product in times of volatility.
"There is a reason BHP is considered defensive," notes Mr Clifford. "It has got a nice mix; it's the most diversified of all the miners, with a hedge against energy and a good play into copper."
BHP, with a portfolio spanning iron ore, coal, copper, aluminium, energy and potash, argues that it will also benefit as China's economy moves from its steel-intensive investment phase into consumption-driven growth, requiring more copper, aluminium, nickel and zinc.
Anglo, with iron ore, copper and coal, also boasts diversity but is exposed to the troubled South African platinum sector and has increased its presence in diamonds by taking control of De Beers -- a segment linked to luxury spending that BHP and Rio are trying to exit.
The recent collapse in the iron ore price, down by almost a quarter in the past three months to $101.5 a tonne, its lowest level since December 2009, raises concerns for Rio Tinto and Brazil's Vale, both heavily dependent on the commodity.
Analysts, however, argue that Rio's low-cost operations in the Pilbara region of Western Australia, where a tonne of iron ore is estimated to cost $40-$45 in total to produce, should protect it from further falls in price.
"I am completely committed to a diversified strategy," said Tom Albanese, Rio's chief executive. "But I also recognise we should be allocating capital to where we are going to get the highest returns -- right now and for the foreseeable future that will be in the Pilbara."
Accenture's Ms Bartels notes: "For the top diversified miners, finding and developing long-life low-cost assets is fundamental to your ability to ride the wave of rising and falling commodities prices."
One sliver of positive news from the miners was that rampant cost inflation, which has eaten into earnings and pushed up the cost of major development projects, seems to be abating.
Anglo expects costs to rise about 2 per cent in the second half of the year -- down from 4 per cent in the first half and 8 per cent in 2011 -- as price rises for inputs such as oil, rubber and chemicals start to ease.
"There is definitely a sense that cost inflation is now moderating, as raw materials prices have eased, and that self-help measures are stepping up as well," says Mr Allsop at UBS, referring to job cuts and closing higher cost operations.
"Brazilian and South African producers are also benefitting from materially weaker currencies, though the Australian dollar remains strong which is a problem for miners with operations there." The Australian dollar has stayed close to parity with the US dollar, rather than weakening in line with commodities prices.
Labour costs present another problem, with shortages of skilled engineers and operators persisting and workers demanding higher pay in markets including South Africa, Australia and Kazakhstan.
Ms Bartels argues that management teams' ability to control costs will become more important given the subdued price outlook. "Mining groups may not be able to control their revenues but they can control their costs," she says.
The danger is that miners -- as they did in the prolonged downturn of the 1990s -- cut too drastically leaving themselves short of manpower and growth opportunities come the recovery.
"Cost control is not about slash and burn," says Ms Bartels, "but being smarter about what they chose to do and how they do it, whether they are riding commodity highs or lows."