There is no doubt that 2015 has been a rather unpleasant year for the mining industry. A profit-deficient 12 month period has been experienced by company stocks in this sector as the biggest miners in the world are coming to terms with the painful reality of falling commodity prices. Worse still, the future remains largely uncertain for this once thriving sector.
So, is the mining industry a worthwhile sector to invest in come next year? Or should investors keep a safe distance? In this article we have compiled some of the reasons behind the mining industry’s poor performance in 2015. We have also outlined key drivers and themes that we think will help prices recover over the course of the next year.
Hopefully this will help you decide on whether to invest in this sector or not.
Reasons behind the Mining Industry’s poor performance
1. Decrease in China’s demand
A few years back, when growth in the Chinese economy was at more than 10 per capita annually, it was an insatiable raw materials consumer. A number of nascent mines were opened by miners all over the globe so as to cater for this vast demand.
A ‘super-cycle’ in commodity prices was thus created by the rapid development of the Chinese economy – but currently its growth has watered-down to around 6.5 per capita a year. This is largely due to the shift in its economy to a model which is more service-based and consumer-led.
As a result, China does not need as much iron, copper or coal like it once did. To make matters worse, unwanted stock is being pumped by its commodity producers into the market which pushes prices further down. For example, cheap Chinese steel is responsible for pushing the steel industry in UK into a crisis.
However, it’s not all bad news. The fact that the Chinese economy is still much bigger than it was a decade ago is a reassurance to some miners – and in the future, plenty of demand will be provided by the 6.5 per capita growths on a larger base.
The Chinese demand for metal is just slowing down when mines built to cope with it are at their peak. This has resulted in oversupply and consequently price falls that are dizzying.
Goldman Sachs says that a long period of hibernation for the iron ore industry is being ushered in by a maturing Chinese steel market; they also predict that next year a tonne of iron ore will go for $38 averagely while in 2017 and 2018 it will go for $35.
Rio Tinto’s chief executive Sam Walsh recently described a $30 for a tonne of Iron ore price as ‘fantasy land’ when its price was at $63 a tonne. Ironically, fantasy is now close to becoming the painful reality.
Rio Tinto is, nonetheless, to blame for at least some of this oversupply: It has continually increased the amount of iron ore it mines; by 2017 it aims for 360 million tonnes.
While this seems unreasonable, it is more effective for the likes of Rio cutting costs than stopping production.
If prices happen to rally and you have closed mines, you run the risk of being caught out. Furthermore, it is very expensive.
Rio together with Australian miner BHP Billiton have their bets on the ability of their efficient and cost effective model to force out smaller rivals in the game and sustain them throughout the downturn.
Even at these low prices, the biggest miners still say that they are making heaps of cash from their iron ore operations. But getting to boost the output hoping that soon the demand will return is a very big gamble.
3. Diversification is not the answer
Steps have been taken in recent years by miners aimed at diversification and selling of a variety of goods rather than putting all their eggs in one basket.
For example BHP has considerable interests in oil and gas in addition to its mining operations.
Glencore has assets in oil along with an agricultural division producing oils, sugar and grains.
The theory was that miners who had diversified could be insulated from a price fall in a single commodity by the others’ robustness. The problem is that price plunges have been seen in nearly all commodities in the past year which has hurt every big player to a greater or lesser extent.
4. Cost reduction is only a partial solution
With the sudden less profitability in their businesses, miners fall over themselves in the bid to cut costs.
Besides cutting capital expenditure, the money spent in the development of new mines and upgrading mines has seen them squeeze efficiencies out of the existent operations.
The strong US dollar has helped some miners as this makes it relatively cheaper running operations outside the US. Also helpful is the low oil price.
It’s unfortunate that suppression of prices is also helped by lower costs. Or as Investec analysts put it: Commodity prices that are falling are the stimulus for both the costs reduced and the natural consequence of the reduced costs.
There won’t be an improvement in the situation until there is no further lowering of costs and there is a drop off the curve of the marginal supply.
The Flip side
Distress will continually be experienced by mining companies in the coming months but while this happens, it is worth taking a long-term look at this scenario. In the coming years, a number of mining commodities will still be needed in many parts of the world. This is however with the exception of thermal coal which is being phased out in favour of cleaner energy.
For example, due to copper’s valuable transmission properties and use in electrical wiring and consumer gadgets such as smartphones, its demand is likely going to increase.
Key Drivers and Themes that should help prices recover over the course of the next year;
China gears up: The slowdown bulk feared by many to lie ahead has actually happened. It’s estimated that the actual growth this year was 4.5% or so, and economic activity is expected to pick its pace during 2016 again.
Dollar damage done: The greenback that is strengthening has given commodity producers with dollars in revenue and costs in local currencies an allowance to maintain a high level of supply and also lowered the price of the dollar that consumers (non-US) are able to pay.
Inflation returns: Finally the underlying price pressures are starting to pick up- notably in the US. The headline inflation rates in the coming months should rebound as the biggest declines in oil cost drop out in the yearly comparisons. In turn, this could see the revival of demand for inflation hedges, commodities included; gold is particularly likely to benefit.
More easy money: While in 2016 the Fed will continually raise rates, it would be due to higher inflation and a stronger economy keeping the real interest rates low. The quantitative easing programs by Japan and Europe will be continued or accelerated while more room to ease further is available for the People’s Bank of China through interest rates cuts and reserve requirements without needing a big renminbi fall as a resort.
Investor interest: While sentiments by investors towards commodities are at record lows still, plenty of room for money returning to the sector is available. Certainly, prices in commodities may increasingly look attractive to high valuations of bonds and equities. A rebound of prices on its own is not expected by investor demand. However, any recovery driven fundamentals of supply and demand which are underlying could be supported by the speculative flows.