Published Date: 2021-02-23 | Source: INCE|Connect | Author: Gary Booysen | Rand Swiss | Director and Portfolio Manager
Mining, in its simplest form, is an industry dedicated to the exploration and extraction of metals and minerals around the world. In economics these basic resources form part of the one of the four factors of production. The majority of the world's goods and services thus would not exist without the location and unearthing of these primary resources.
When looking at the mining industry you can broadly separate the resources into Minerals and Metals. Metals can further be divided into Precious Metals and Industrial Metals. Precious Metals include gold, platinum and silver and they're considered rarer and have a high value-to-weight ratio. Since transport costs are less, you often have internationally set prices. An ounce of gold for example is worth more or less the same in London as it is in Tokyo.
Industrial metals (e.g. Copper, Tin, Zinc) and minerals (e.g. Coal, Bauxite, Phosphate, Gypsum) usually have a lower value-to-weight ratio and as such have very different prices depending on where they're extracted compared to where they're consumed. The prices are set in different parts of the world by direct contracting and there is no ruling price.
For example, Iron Ore prices will differ depending on the proximity of sale to the extraction services. When a mining company like Kumba Iron Ore (JSE:KIO) is delivering Iron Ore to China, it will be competing with Australian operations which are geographically much closer to the final delivery point. The price of Kumba's "lump" when measured for delivery in China, must include the cost of transport (which is higher than the mines in Australia). Many traders watch the price of Iron Ore Futures on the Dalian Commodity Exchange to get a sense of what the iron ore markets are doing but there is no internationally recognised Iron Ore price. This is just not possible.
Oil is another commodity that is more formally priced on exchanges but also has no single ruling price. As such, there are a multitude of oil prices across the globe: Brent Crude Oil, West Texas Intermediate, Dubai Crude, Urals Oil, Western Canadian Select, Tapis Crude, Bonny Light to name just a few. Not only do the different oil contracts represent the differing prices in specific geographies, it also represents the price of specific grades of oil.
Not all barrels are created equal. For example, Wyoming Asphalt Sour, which was the first contract to trade negative in the chaos of 2020, is a thick US oil used mostly to produce paving bitumen. This is very different from low sulphur, light oils like Tapis, the Malaysian crude benchmark traded in Singapore, which has, for a long time, been considered the world's most expensive grade.
Characteristics of the mining sector investments
Typically, the mining sector goes through Boom-and-Bust cycles, which are tied to the overall economic performance of global economies. The very cyclical nature of mining can be best explained through the required balancing of the supply and demand of the commodities discussed above.
Firstly, it's important to understand when a commodity price is set in the international markets, the individual mining company often becomes a "price taker" (i.e. they have no control over global prices and the profitability of their operations can swing dramatically depending on where international markets are trading). If a junior gold miner has an All-In-Sustaining-Cost (AISC) of $1,000 per ounce and the gold price happens to spike to $2,000 an ounce, at the time of sale of the production, they become incredibly profitable. If, however, the gold price collapses the opposite will be true.
You see, typically finding ore bodies, getting mining permits approved, sinking shafts and processing and refining the final product is incredibly complicated. It takes many years from the discovery of a deposit, to the successful construction of a mine, to the final sale of the underlying commodity. The fact is, it's almost certain the gold price will be very different by the time the mine's metals come to market from the time the deposit was first discovered.
There are exceptions though...
South African platinum miners, as well as Opec+ countries, have some control over their commodity price, thanks to the dominant portion of their output. They can curtail supply to ensure the markets are in deficit and that prices are supported. In general, however, this is not the case.
Typically, the cycle goes as follows...
Prices are low, so there are few feasible projects and big mining houses cannot raise the capital to invest. Often this is a period in which mines are putting shafts on care and maintenance and taking supply out of the market. Investors have most likely seen stock prices fall as the commodity prices themselves fell. As the miners continue to close mines, lay off staff and remove supply, the market moves from a surplus to a deficit. The prices naturally start to rise. (I'm assuming in this example that demand remains unchanged). As prices rise, the mine's profit lines explode. Suddenly, previously unprofitable projects become viable at higher commodity prices and investors, seeing record mining profits and high commodity prices want to cash in on the boom.
In this environment, it's easy to raise capital and expand operations. Naturally, the sector over invests. The commodity price is uncertain, and they must make hay while the sun shines. It is now conceivable to min previously unprofitable deposits thanks to the higher commodity prices. More supply comes to the market. As supply floods in, prices start to fall. The now profitable ounces are suddenly unprofitable, and all the new half-built mining projects start to look like terrible investments. The share prices collapse, and the mines start laying off staff and putting projects on hold. Supply contracts, prices start to rise, and the cycle starts again.
For resource and mining investors, it's very important to understand where you are in the commodity cycle.
Generally mining companies are considered riskier because of the high volatility in earnings (and the high volatility in share prices).
Mines also typically have a finite life span. The longevity of a mining company is almost always linked to its ability to source new mining projects. And while there are some mining houses (like Anglo American) with a long tradition of success, the JSE is littered with the corpses of bust cycles that saw smaller mining companies fall apart. Often the junior miners make fantastic returns over a shorter period of time and then fade into obscurity. The budding mining sector investor should carefully consider the time horizon of the investment.
• What is the nature of the company?
• How is the company planning to return the profits to shareholders via a set dividend policy?
• What do the pipeline of projects and the current mineable reserves look like?
A word on regulation
The regulatory environment for South African mining has come under a huge degree of scrutiny recently. Not only is mining dangerous and the safety of operations is key, but remember when a mining company extracts resources from any country it needs to compensate the country itself for the extraction and sale of its resources. The mining company may bring the engineering expertise and raise the capital to build the mines, but they are taking value from the land. As such, they're often heavily taxed and in some cases can face changing regulatory requirements to be able to access the unmined resources. These companies most often need to compensate the communities, promote government agendas (like full employment) and did I mention they often need to pay super-sized tax bills to ensure operations are allowed to continue.
Since these companies are making huge capital investments (often with capital raised from you the shareholder) it's important to understand whether or not the territory you're operating in will honour its agreements. Many resources are found in less politically stable parts of the world and it's very attractive for governments to simply wait until the mine has sunk significant capital into a project, before changing the terms of the deal.
Can I say this sector certainly isn't for the widows and orphans?
The true cost of mining
In addition to the standard regulatory costs of mining, there's an upswell of regulation aimed at protecting people from the often-hidden environmental and social costs of mining. Historically, these costs haven't been seen on the income statement, but they are most certainly present. Across the world, mining companies have been responsible for incredible levels of pollution, massive social destruction and often the total annihilation of ecosystems.
You may think of BP's Deepwater Horizon oil spill or a major disaster like the 2015 collapse of the BHP Vale tailings dam in Brazil, an accident which killed 19 people, poisoning all life along the Rio Doce and went down as one of the largest ecological disasters in Brazil's history. But it's not only the major disasters that should be added to the bill. The mining industry has incrementally racked up an incredible death toll over the years via smaller accidents and poor operating practices.
Fortunately, ESG regulation is tightening and mining companies are more focused than ever on improving the safety and environmental costs of doing business. For example, Sibanye-Stillwater, the world's largest producer of platinum, aims to be carbon neutral by 2040.
As these environmental and social costs are more tangibly included in the cost of mining, it's worth considering how green your selected mining company is, when you do decide to invest. In the 21st century, investors should be aware that being environmentally friendly and socially responsible makes business sense.
So, to invest or not to invest?
You need only look at the spectacular returns being generated by the mining houses to understand the appeal of a mining investment. But, as with most investments, it comes down to the specific counters, projects and operations you get involved in. Over the next week we'll be exploring the investment cases behind some of the most exciting JSE listed companies.
If you'd like to take advantage of any of the upcoming ideas, you can get your stockbroking accounts set up with South Africa's number one online broker Rand Swiss. As an Share360 reader you can access our special group rate by setting up your account here.