October 16, 2008

Mining Tries to Dig Its Way Out

What goes up must come down. After a record-breaking 10-year boom for commodities, it was inevitable that prices would have to retreat -- especially in the face of global financial turmoil and sagging economic growth. And retreat they have: The prices of some metals are down by more than 50% since the start of 2008, dragging with them shares in mining giants such as BHP Billiton (BBL) and Rio Tinto (RTP).

Is it the end of the party for natural resources? "We're definitely seeing a slowdown in the mining sector," says Iain Armstrong, divisional director at investment firm Brewin Dolphin in London. "Company [share] prices will remain weak, as we're past the best of the current commodity cycle."

But the downturn may be only temporary. Although 2009 is shaping up to be a tough year on the back of the current slowdown, demand from emerging economies should pick up again in 2010, potentially fueling another commodities boom. "Strong fundamentals underpin high commodity prices in the long run," says Jason Burkitt, a director in the mining practice at consultancy PriceWaterhouseCoopers [PWC].

Capital Spending Slowdown That view is echoed by Tom Albanese, chief executive of Anglo-Australian mining company Rio Tinto, who briefed analysts Oct. 15 on the company's third-quarter results. "The Chinese economy is pausing for a breath," Albanese said. Although the company's iron ore production in the quarter rose 17% year-over-year, he conceded that future capital spending is now under review and production growth would be reduced "to fit current trends." Albanese remains confident of Rio Tinto's long-term growth prospects.

Analysts expect other companies, including Xstrata (XTA.L) and Anglo American (AAUK), to make similar statements about investment freezes when they announce third-quarter updates before the end of October. Aluminum giant Alcoa (AA) already said it would halt all noncritical capital expenditures when it announced on Oct. 7 a 52% yearly drop in third-quarter net profits, to $268 million.

It's unquestionably a new and different world than just a few months ago. For a decade, mining companies have ridden a wave of ever-expanding demand for natural resources from emerging economies, especially China and India. As prices for commodities -- everything from oil and iron ore to precious metals such as platinum and silver -- skyrocketed, so did profits and share prices. The SPDR S&P Metals & Mining stock index surged nearly 92% from the start of 2007 until its peak on June 27 of this year.

Now the economic turmoil is starting to bite, even in sizzling emerging economies. Analysts at UBS (UBS) expect gross domestic product growth in China -- the world's largest iron ore consumer -- to fall to 8% next year, compared with 12% in 2007. And Morgan Stanley (MS) recently cut its forecast for overall emerging-market GDP growth in 2009 from 6.2% to 5.5%. The slower-growing economies will need less metal to meet dwindling export demand and slackening local markets.

Rethinking Strategy The impact is already being felt by BHP Billiton, Rio Tinto, and Brazil's Vale (RIO), which dominate global iron ore production and are the world's largest mining companies by market capitalization. After negotiating almost 100% price increases with their Chinese customers earlier this year, all three now are likely to see a 30% decline in iron ore prices in 2009 as demand declines, particularly from the troubled automotive sector. Steelmakers, including giant ArcelorMittal (MT), already have announced production cuts for 2009. Tighter credit also is making it tougher for mining companies, especially smaller ones, to finance new projects.

Analysts say mining companies will have to rethink their strategies based on the new pricing environment. "Most of the miners will have to look seriously at which metals they focus on in future investment," says Charles Cooper, an analyst at stockbroker Evolution Securities in London. "High-cost production, such as nickel and zinc, may have to be cut." Nickel and zinc prices have fallen 54% and 42%, respectively, so far this year.

The uncertainty also is wreaking havoc on merger and acquisition activity. Xstrata recently abandoned an attempt to buy platinum producer Lonmin (LMI.L), in part because of falling prices for the metal. The biggest question remains BHP Billiton's ongoing all-share takeover bid for Rio Tinto [BusinessWeek.com, 8/26/08], which may have to be renegotiated. Thanks to its falling share price, BHP's offer for Rio is now worth only $84 billion, vs. $147 billion early this year. Analysts say that smaller deals now stand a better chance of going through, as companies with deeper capital reserves snap up players who are finding it difficult to fund their operations in the current environment.

Production Cut Pitfalls Companies must be careful not to cut production too much because it would undermine their long-term prospects. Unlike tapping oil and gas fields, extracting metals from the ground can't be easily stopped and restarted. That means any cutbacks over the next 12 months could slow commodity output over the next five years.

"Mining companies know they have to invest now to meet future demand," says Chris Thomas, a director on the metals and mining team at consultancy Deloitte. Most of the companies went through the commodity downturn in the late 1990s, which prompted a big cutback in capital investments. Many of them are still catching up from that freeze and don't want to suffer the same backlog this time around, Thomas adds.

That means mining companies must walk a difficult line between offsetting short-term falls in commodity prices and planning for improved metals demand from 2010 onwards. Those willing and able to invest during the slump could reap major rewards when the likes of China and India ramp back up again, says PWC's Burkitt. Companies that don't may see times even more difficult than today.