Mike Elliott, Global Mining & Metals Leader from market analysts Ernst & Young (EY) discusses what the biggest risks in the resources sector will be as we move into 2015…
The need to address the decade-long decline in productivity due to the sector’s quest for growth during the supercycle has pushed productivity to the top of EY’s risk ranking. The effects of extremely weakened productivity across the business are now most obvious as commodity prices continue to soften, margins have been cut and there is nowhere else to look for profitability.
The supercycle altered the DNA of mining companies to adapt the processes, performance measures and culture solely toward growth. The transformation has occurred by stealth and the counter-transformation will need to be far more radical. Boards and CEOs are now realising that regaining lost productivity and gaining new ground is critical for long-term profitability and achieving an adequate return on capital employed, and requires a whole-of-business response. This broad transformational approach is essential and is yet to be applied effectively by any one sector participant. This huge step change is why this risk is top of the ranking.
Although the top risks have shifted around in the ranking, there has not been a substantial shift in priorities. The risks themselves have evolved greatly over the year with the prolonged commodity price dips which have thrown up many issues for the miners. Moving up into the top ten this year is access to water and energy, which is becoming an increasing issue as demand rises, costs increase and availability diminishes.
CAPITAL ALLOCATION AND ACCESS
DIVERGING AND UNIQUE CHALLENGES
The capital allocation dilemmas have fallen from last year’s top spot, reflecting progress made during the year in addressing this challenge. Steady progress has been made by the majors on capital management and optimisation following a spate of asset write-downs in 2013. Capital discipline is expected to continue, but the question now facing companies is what form the next phase of investment will take, and when stakeholders will begin pushing for this. However, little has changed in the past 12 months for many juniors and explorers and they remain cash-starved and focused on survival.
SOCIAL LICENCE TO OPERATE
ENGAGING POWERFUL COMMUNITIES
This risk has climbed the ladder to third position because the growing influence of communities to stop or slow projects, no matter how exemplary a company’s track record is with social engagement. The frequency and number of projects being delayed or stopped due to community and environmental activists continues to rise.
Organisations cannot rest on their laurels nor assume that acceptance provided by the community and its stakeholders will always be maintained. They should be integrating the activities required to obtain and maintain a social licence into the broader strategic plan of a more sustainable business.
RESOURCE NATIONALISM
BOTH RETREATING AND ADVANCING
Maintaining its spot in the top five risks, there remain waves of resource nationalism by countries keen to gain a greater share of shrinking returns from the sector. On the one hand, some countries have changed mining tax policies to become more attractive to mining investment in a lower investment environment. At the same time, other countries have introduced mandated beneficiation, invoked use-it-or-lose-it and increased state ownership.
Resource nationalism is very popular with the population of producer nations, and in many countries an increase in moves to instil mandated beneficiation has come in the same year as major elections. Emotive arguments promoting resource nationalism can only be overcome with meticulous and transparent revelation of the facts.
CAPITAL PROJECTS
A CONSERVATIVE APPROACH
This risk has moved into the top five due to the long trail of mega projects commenced during the boom that still need to be fully delivered, and with a view to the next cyclical upswing, mining and metals companies are beginning to plan the next wave of projects.
While the public capital markets still do not have an appetite for investment in new supply, mining and metals companies are beginning to quietly prepare for the inevitable investment as reserves need replacing and the cycle changes. Mining companies do not want to make the same mistakes they made during the supercycle, and boards will be demanding much more robust capital project management to avoid the failures of the past. In addition, with softening commodity prices, many companies are looking to extract more for less through increased productivity. As supply shortages for many commodities start to reappear in the next few years and investments get the green light, this risk will be high on CEO and board agendas.
“Mining companies do not want to make the same mistakes they made during the supercycle, and boards will be demanding much more robust capital project management to avoid the failures of the past.”
TOP 10 BUSINESS RISKS FOR MINING & METALS
1
PRODUCTIVITY
A case for broad transformation
The significant decline in productivity over the last 10 years was a by-product of a choice by industry participants to pursue volume growth at almost any cost during an unprecedented boom in commodity prices. Many companies have been attempting to deal with the resulting drop-off in productivity through a series of cost-cutting exercises or point solutions. However, the problem is too large for point solutions to solve on their own as they often simply move the problem further down the supply chain.
The need to boost productivity is threefold – to regain ground lost over the supercycle, to continue to innovate to recover lost competitive advantage and to counteract rising real wages. To put the issue into context, labour productivity in Australia has declined by roughly 50 per cent since 2001 and in the US coal sector, labour productivity declined by nearly 30 per cent from 2009 to 2012. The same is being seen globally, in both developed and emerging markets, and the issue has been escalated to the CEO agenda of mining companies.
The size of the entrenched nature of the problem is too large for conventional solutions, such as cost cutting, to deliver the sustainable improvements required. Real productivity gains will only come from a whole-of-business, end-to-end transformation.
Real and sustainable productivity improvements may require significant adjustments including changes to mine plans, reassessment of mining methods, changes to equipment fleet and configuration, and increasing automation. Most of these have been untouched by cost-reduction exercises.
The quest needs to be long term and requires a change in attitude across the organisation from the boardroom to the pit.
2
CAPITAL DILEMMAS
Allocation and access
The twin dilemmas of capital access and capital allocation encapsulate the diverging fortunes of the industry’s major producers and juniors in 2014.
Capital allocation: The majors have shown tremendous commitment to capital discipline over the last 12 months, positioning them well for future growth. Effective capital allocation is not a once-in-time reaction to changed market conditions, but a continuous cycle of review and action that informs strategy and impacts all areas of the business. A renewed focus on return on capital employed will be with the sector for many years to come. We see the sector now at various junctures along a path of capital transformation, one that can broadly be divided into capital management, capital optimisation and capital growth. Most importantly, the capital discipline lessons learned over the last couple of years need to stay front of mind and continue to be embedded in robust investment appraisal processes, regardless of where we sit in the cycle.
Capital access: Access to capital remains a critical challenge for junior miners. For many juniors and explorers, little has changed over the last 12 months, and they remain cash-starved and focused on survival. The juniors are still subject to widespread investor risk aversion which is impeding their ability to raise equity.
Consequently, cost and capital management remains essential. Mergers and acquisitions will continue to play an important role in financing the junior sector, albeit on a selective basis.
Acquisitions (minority or full takeover) or consolidation to pool resources may be the only realistic growth or exit option for many. For many early-stage companies, the only available scenario is to halt exploration, lay off staff, close premises and maintain only skeletal operations – a form of “corporate-induced coma.”
3
SOCIAL LICENSE TO OPERATE
Walking the talk with your stakeholders
Losing a social license to operate (SLTO) is a very real and potentially very expensive risk to a business. Research shows that community conflicts over environmental and social concerns can incur costs up to US$20m a week in lost value for large-scale operating mines.1 The challenge for operators is balancing immediate stakeholder demands and the inherent value in being a socially and environmentally reliable operator with controlling costs, lost production time, reputational damage and overflow impacts to other operations.
An additional challenge to an operator’s ability to gain acceptance is the increasing volume and variety of stakeholders plus a broadening definition of what it means to have a social licence to operate now that the concept has entered popular psyche. With growing public understanding of the wider impacts of extractive industries plus improved ability to access and disseminate information through technology, miners need to address criticisms and concerns about their operations on more fronts than in the past.
Of course there remains an obvious wider economic benefit in accepting these challenges. Miners have the opportunity to help create opportunities for social and economic growth through their investment into infrastructure, power and utilities, support for local businesses and contributions to schools, hospital and related social services.
This is a very powerful win-win opportunity to help sustain the community long after the mine has closed, in addition to being a fair recompense for the value the company derives from being in the community. Companies with the foresight to pre-empt, acknowledge and address community concerns stand in better stead than those that wait for stakeholders to raise concerns. After trust is broken, support can almost never be bought off.
4
RESOURCE NATIONALISM
Advancing and retreating
The new world of resource nationalism is a balancing act between promoting investment and maximising in-country benefits. With shrinking investment, some governments have begun to promote initiatives to attract mining investment into their jurisdictions. At the same time, despite declining commodity prices, we are still seeing waves of resource nationalism by countries keen to gain a greater share of shrinking returns from the mining and metals sector. The most dramatic example of recent resource nationalism activity has been mandated beneficiation and state ownership. Mandated beneficiation is very popular politically as governments seek to extract greater value from their resources by mandating that minerals are processed in-country prior to export. However, the long long-term fallout of this policy is unclear, and it can swing either way: significant investment can occur in downstream investment if the country invests to create competitive advantage or mining moves elsewhere.
Greater state ownership comes from the desire to take direct equity exposure to mining investment development and production. Mining and metals companies need to continue to educate governments on the impact of resource nationalism on investment decisions whether that is taxes, use-it-or-lose-it or in-country processing requirements.
Companies need to continue to demonstrate effectively the benefits of mining and metals to the broader community and enhance the understanding that raising the cost of doing business may scare away investment and jeopardise those benefits for the government and the community.
5
CAPITAL PROJECTS
Delivering value in the next wave
As new supply requires increasingly complex and large investments, the failure to keep them on time and on budget can cost a company their reputation and future ability to invest. Calls for greater capital discipline and greater return on capital deployed in the last two years ushered in an era of caution and restraint in capex. Numerous high-profile projects have been scrapped, shelved or sent back to the drawing board for replanning. Although total investment in the sector may have peaked, it must still deliver value on a large number of committed projects worth a record US$791b of investment, as of December 2013.
“Moving up into the top 10 this year is access to water and energy, which is becoming an increasing issue as demand rises, costs increase and availability diminishes.”
The next wave of projects are currently being planned — although quietly as the capital markets are highly resistant to new spending initiatives. Therefore, their success can provide a competitive edge and enhance an organisation’s enterprise value. Governments and local communities have a keen interest in such projects as they have the potential to drive a region’s economic development. Consequently, high levels of transparency and assurance will be required to ensure that these projects can be delivered on time and on budget.
Shareholders, capital providers and other stakeholders will all demand it. With a new understanding of better practices around these projects and knowledge of the consequences of bad management, it will be time for management to start putting these practices in place.
6
PRICE AND CURRENCY VOLATILITY
Diving for cover or riding the wave
Companies are now experiencing a time of extreme volatility created as the market tries to return to equilibrium following years of price stimulus which encouraged new supply. Mining and metals companies now realise that they can’t sit on the sidelines and wait for the volatility to pass as it will continue for a number of years. Working in volatility is the new normal and companies need to adapt. Primarily they need to place more emphasis on volatility risk management. The rise in volatility has also been accompanied by the increase in availability of derivatives that can be used to manage these risks.
As the sector becomes more customer focused, they are responding to customers who want to avoid this volatility. Changes in customer buying preferences have impacted the way in which this volatility has been tolerated by companies, with many customers seeking suppliers that can provide greater price certainty. As such, they are either directly or indirectly entering the derivatives markets to hedge those inputs. Many companies can appropriately incorporate physical and derivative trading into their core operations. Some of the larger producers are referring to this as a “revenue enhancement” strategy as they seek to extract some of the option value created by volatility and their naturally long position. This mirrors the convergence of traders that are increasing their exposure to commodity production.
We expect continued volatility in the sector in the medium term because of increased regulation, divergent central bank policies, geopolitical risk, provision of credit to traders and the withdrawal of banks from commodity markets. Living with volatility for long periods of time requires mining and metals companies to build in coping mechanisms that guard against the negatives of volatility, while taking advantages of the opportunities that only present themselves during this time, such as flexibility in varying levels of production
7
INFRASTRUCTURE ACCESS
A new world of ownership and financing
Current stakeholder attitude around infrastructure financing, ownership and access is leading to more fragmentation of the interest they have and the roles they may play in future infrastructure projects. In some cases, the cost of developing the infrastructure is almost 75% of the total project cost. Developing large infrastructure projects requires coordination among a number of stakeholders, such as users (miners, communities), government(s) and capital providers (financial institutions, customers). The divergent priorities of these stakeholders make it difficult:
- Mining and metals companies want integrated mining and infrastructure which ensures control of infrastructure but does not lower their return on capital employed (ROCE) by using their own capital.
- Governments prefer infrastructure to be developed on a shared-use basis to ensure maximum economic benefit.
- Capital providers want commensurate returns from risk taken in the project but avoid commodity price risk and construction risk.
The trend is toward shared access and shared value.
We see innovation in financing, and a change in the ownership model and the operation of infrastructure, as a large number of future projects will consist of a cluster of mines rather than just a single large-scale mine.
Companies should view infrastructure development from a sustainability perspective in that it provides social and economic benefit to local communities and businesses.
Infrastructure development leads to monetisation of otherwise stranded deposits and has a multiplier effect on the region.
8
SHARING THE BENEFITS
Managing expectations through the commodity price cycle runaway costs
The nature of the risk has changed and is focused more on skilled than unskilled workers. With the increased focus on improving productivity and a move toward automation, mechanisation, data analytics and contract negotiation, there is an increasing level of sophistication in the operations of mining and metals projects and the skills required. In addition, there has been a more proactive approach toward stakeholder management that has seen the introduction of roles, such as government relations and community engagement. Finding the right people to fill these roles is compounded by the high rates of employee turnover in the sector and the time it takes to fill jobs at middle and senior management.
The skills shortage risk has become more complex and is no longer a universal concept across the sector. It is now a matter of balancing the needs of an advancing industry against the skills that exist and investing in those of the future to avoid it becoming acute in the next cycle. A solution to the issue is beyond the control of an individual company, and it requires industry participants to think whole-of-sector when investing in future skills pipelines. The key is to learn from the last upswing and plan ahead, using a more holistic framework that involves all stakeholders.
9
ACCESS TO WATER AND ENERGY
Competing or depleting
Accessing water and energy is an essential part of operations for mining and metals projects, and is becoming increasingly difficult. Companies are up against unreliable power supply from the grid and rising energy costs. In emerging and frontier countries, the risk is amplified as companies compete with both governments and communities for these scarce resources, with failure to manage a mine’s use of water and energy likely to jeopardise the industry’s SLTO.
Managing costs sustainably is a priority. As the cost of renewable energy declines and conventional energy increases, the mining and metals industry will increase its reliance on renewables. The shift toward a resource efficient and low-carbon operation can ensure community acceptance, but this will come as the economics are proven. Water scarcity is an issue that demands a strategic and practical response from businesses to develop and implement solutions to benefit all stakeholders. This means assessing dependence on water and future supplies, and developing plans to cope with increased prices and possible shortages.
10
NEW ENTRANT
Access to water and energy
Accessing affordable water and energy is an essential part of operations for mining and metals companies and has become increasingly difficult, especially in countries in South America and Africa. Burgeoning energy costs and competing water demands in many mining regions around the world are starting to have a bigger impact on costs and the ability to operate. With global demand for energy expected to increase 36% by 2025, and with falling ore grades, this risk is compounding year by year, with the sector facing higher energy prices and volatility. Similarly, water scarcity is an issue demanding a strategic and practical response. The criticality of this issue in many countries has raised this risk into the top 10.
“The next wave of projects are currently being planned — although quietly as the capital markets are highly resistant to new spending initiatives.”
Profile
MIKE ELLIOTT
Ernst & Young
Mike Elliott is the Global Mining & Metals Sector Leader at EY, as well as the Sector leader for the Asia Pacific region. He has over 30 years experience working as a mining and metals assurance partner in the global EY network serving clients in the sector.
References
- “Cost of Company-Community Conflict in the Extractives,” Harvard Kennedy School, 2014.
- “E&MJ’s Annual Survey of Global Metalmining Investment,” Engineering and Mining Journal, 6 January 2014, http://www.e-mj.com/features/3674-e-mj-s-annual-survey-of-globalmetal-mining-investment.html#.U6AlmPmSx1Y, accessed 5 April 2014.
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