Will the giants inherit the earth?

Grim as the economics of mining and minerals are for everyone right now, looking ahead, things are lining up strongly in favour of the industry’s biggest players. Expect them to dominate increasingly large swaths of the business for years to come
By Ian McGugan

After four years of relentlessly bad news, the one bright spot for the mining industry in 2016 is that there are no high hopes left to disappoint. The compelling question that hangs over the sector is no longer how bad things will get—they’re already horrific, thank you very much—but how miners can adapt to today’s bleak conditions.

One common line of thought argues that big companies will dump unwanted assets, voluntarily cut production and reduce their operations to bring supply back in line with demand. This would seem to create an environment in which small companies can seize on the opportunities being opened up by shrinking giants.

That scenario appears reasonable at first glance. Think about it more closely, though, and its logic is full of holes. In today’s environment, where all-in costs for many metals are below spot prices, it makes no sense for a small company to buy mediocre assets from a big one. And there’s no way to acquire a trophy mine—one that can produce positive returns even at current prices—except by paying healthy sums. Recent deals, such as Barrick Gold Corp.’s (TSX:ABX) mine sales, have put a healthy price tag on middling assets despite low metal prices.

Meanwhile, the case for giants to reduce output voluntarily seems even weaker. A big miner that cuts back on production simply opens up market share for others to grab. That’s what happened last year when Glencore plc, the huge miner-cum-trader, shuttered some of its zinc output. Rivals immediately expanded to fill the gap.

Given these trends, the likeliest course for the mining industry is the exact opposite of what many expect. Watch for the industry to become increasingly dominated by large players who will set out to dominate entire swaths of the business and drive costs to new lows by boosting volumes. The next few years are more likely to be an age of heavyweights than an era of welterweights.

Money, as always, will be the determining influence. Investors who have lost fortunes over the past few years aren’t lining up to lose more. The big-risk-big-payoff allure of betting on junior miners is exactly what potential shareholders don’t want at this point. Far more attractive will be investments that allow them to reduce risk, even if it means lower payoffs in the long run.

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The case for de-risking grows more compelling if you think this commodity downturn is likely to last for a long time. That, unfortunately, looks quite likely. Economists who study past commodity cycles, such as David Jacks of Simon Fraser University, caution that the boom-and-bust pattern of commodity prices have typically moved in decades, not years.

Wall Street observers, including Barclays and Credit Suisse, agree that this downturn will be with us for a while. They predict that the malaise in metals prices that began in 2011 is not going to substantially ease until 2020 or so. To be sure, some raw materials—zinc is a possibility—may recover before then, but others, notably iron ore, are caught in a downdraft that shows no signs of relenting.

There’s no great mystery as to what’s behind this long swoon. It’s a case of surging demand meeting a slowing Chinese economy. Mines take years to develop and many projects were launched to meet the galloping demand of 2010. They’re only now coming into production, at a time when China’s appetite for raw materials is on the wane. Barring an unexpected U-turn in Chinese demand, it will take some time before supply once again matches demand.

For the most part, big companies are in a better position to navigate a prolonged period of low prices than are smaller businesses. Among other advantages, large miners can benefit from diversification—the ability to spread risk over multiple commodities and several projects.

To be sure, diversification has not paid off in recent years, as the price of every commodity has sunk pretty much in tandem. It is still an attractive attribute, however. A company that mines several raw materials has a greater chance of producing whatever commodity happens to be enjoying strong demand right now. It also has the flexibility to shift resources from its losers to its winners.

In addition, big companies have the size to take on big logistical challenges. As deposits of many minerals become harder to find, it’s becoming more and more common for miners to have to operate in hostile environments and construct their own infrastructure to get products to market. Look at Agnico Eagle Mines Ltd.’s (TSX:AEM) projects in the Canadian arctic, or Gina Rinehart’s (Hancock Prospecting) massive new iron ore mine in western Australia. These are projects that smaller miners would not be able to undertake.

Of course, the obvious objection to the notion that big is good in today’s mining industry is to point out that the very biggest companies in the industry—such as BHP Billiton Ltd., Rio Tinto Group, Vale SA and Glencore—have also been hard hit by the downturn. They’re all trading for a fraction of their peak highs.

Remember, though, that this is a relative comparison. For all their woes, the biggest companies in the industry (with the possible exception of Anglo American plc) appear to be in a better position to chart their future than does the average junior miner struggling to raise financing in an increasingly skeptical market.

This is not forever. At some point—and let’s hope it’s by 2020, if not earlier—metal prices will start to climb, demand will rebound and small, aggressive juniors will once again be in favour. For now, though, the advantage lies with the industry’s established majors, not its up-and-comers.

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