Mining outlook: volatility will force cuts to operations and jobs

It’s reporting season, and over the past few weeks some of Australia’s biggest companies have been releasing information on how they’re travelling. These reports reflect key themes of how things are going in key sectors of the economy. Over the coming days we’re going to report on the results a handful of major companies in key sectors, transport, construction, retail, mining, insurance and banking. Today we look at the mining sector.

The global economic environment has generated a number of significant challenges for the Australian mining industry. Slowing economic growth particularly in China has softened demand; while the oil price war involving Opec nations have resulted in lower prices than projected.

The mining industry’s contribution to the Australian economy is more than $121 billion a year. In terms of export income, it generates $138 billion per annum, which represents over half (54%) of total goods and services.

Australia’s two largest mining companies (and second and third largest in the world), BHP Billiton (BHP) and Rio Tinto, contribute a combined 79.4% of the Australian mining sector total revenue base (BHP at 44.6% and Rio Tinto at 34.8%).

But both Rio Tinto and BHP face a number of financial and operational challenges.

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BHP extract and process minerals, oil and gas from their production operations located primarily in Australia and the Americas. The company sells their products globally with sales and marketing activities channelled principally through Singapore and Houston, United States. In 2015, the company demerged a number of BHP’s alumina, aluminum, coal, manganese, nickel, silver, lead and zinc assets into a new company, South32.

Rio Tinto is one of the largest diversified resource firms in the world; the company locates, mines and processes various types of mineral resources across several continents.

Issues affecting the sector

The sector is facing one of the toughest periods in history, with 2016 being defined by weak domestic opportunities and falling commodities prices forcing companies to reexamine the costs structures of operations.

The Australian mining sector is under structural pressure largely due to its inability or unwillingness to adjust quickly enough to the changing market demand and circumstance. Its failure to change its operational and businesses practices developed during the mining boom has translated in 2015 in significant losses across the sector.

Typically in this stage of the industry cycle it would be expected that there would be significant industry consolidation either through strategic alliances or mergers and acquisitions. Risk adverse investors in global financial markets however are looking to avoid under performing commodities such as iron ore and coal, as well as some base metals like nickel.

The likelihood of raising equity or debt capital via bank loans to finance the merger and acquisition process is difficult. Given the volatility in the energy markets further reduce the strategic options available to mining companies. Industry experts project that a number of mining companies will go out of business and a huge number of assets will be put up for sale at bargain prices.

The recent strategic focus of management has been adopting a quick fix strategy, that is getting cheaper by cutting costs of their operations by reducing the head count of their workforce, rather than focusing on being more productive. Employment in the Australian mining industry decreased by 2.2% (4,170 people) between 2013 and 2014, so far in 2016 over 2000 mining jobs have been cut and many more are forecast to go in the sector.

Anglo American recently announced their intention to reduce their workforce by two thirds and Glencore has announced its closure of its zinc mines and implemented production and workforce reductions at its coal operations. Cost of labour however is only one aspect of the challenge when competing in a global market. The need for management to focus on the pursuit of operational excellence, via benchmarking and learning across industry boundaries processes remain imperative.

The key message for BHP and Rio is that the mining industry is at a ‘tipping point’ and their focus must be to identify strategies to make innovation deliver bottom line value.

BHP and Rio Tinto results

In 2014 BHP made a profit of US $4.26 billion however in 2015, following the collapse of commodities prices and BHP’s failed investment in the US shale industry, half year results showed its depressed financial performance of a net loss of US $5.67 billion.

Overall revenue fell to US $44.6 billion down from US $56.7 billion in 2014. Profit also decreased by 21% to US $8.6 billion and capital expenditure was reduced by US $4 billion to US $11.5 billion in 2015.

The company expects to incur significant costs from a dam disaster in Brazil at its Samarco joint venture with Vale, which killed 17 people. It made an after-tax charge of $858m relating to the accident. The adverse impact on BHP reputation and the direct cost of rebuilding a safe and sustainable operations are potentially significant.

While BHP has allocated A$363 million for the rebuilding project, had the appropriate preventative costs been incurred in advance, thereby ensuring safe and sustainably engineered dam sites the tangible (materials and labour) and intangible (reputational) costs would have been significantly lower.

Rio Tinto’s full year results showed revenue was down by 27% in 2015 to US $34.8 billion resulting in a reduced bottom line of US $4.5 billion down some 51% compared to 2014. Capital expenditure was US $5 billion.

Competitive threats from the companies' rivals have exposed both Rio Tinto and BHP to the risks of market share loss and the management have chosen to respond to their competitors threats by adopting price-cutting strategies. However as they increased production they contributed to an already oversupplied market and led to increased industry rivalry.

These strategic choices have further impacted Rio Tinto and BHP bottom line performance, cash flows, and dividend policy and subsequently their share prices. Given the volatility in their financial performances both companies have had to adopt a new dividend policy and capital allocation framework.

These companies are also spending less on maintenance and investing in less capital expenditure rather than investing resources in being more productive. BHP for example reduced their capital expenditure by US $4 billion between 2014 and 2015. RIO Tinto has also announced further cuts to its capital expenditure budget by US $1.5 billion over the next two years.

What’s in store for the sector

Continued development of emerging economies particularly, Chile and Peru, and the emerging markets in Central Asia and Russia are likely to provide a platform for long-term demand growth for commodities.

Industry insiders suggest that the commodities most likely to provide opportunities are nickel and copper because they have good medium term (5 - 10 years) prospects. Nevertheless weaker commodity prices and higher volatility will be the norm for the near future.

This observation seems to align with most commodities forecast reports, reflecting the current and immediate future state of the mining sector. The forecast of a weakening Australian dollar and late 2016 recover of the oil price provides some reasons to be slightly optimistic, however subdued investment throughout the industry will continue, as will financial pressures on many mining organisations.

Industry experts project that a number of mining companies will go out of business and a large number of assets will be put up for sale at bargain basement prices.

The Australian mining industry will continue to face many more economic and competitive challenges in the future. Mining companies need to find new and innovative ways to add value, whether through technology, innovation, or design thinking problem-solving approaches.

The Australian mining sector needs to recognise for it to achieve global competitiveness it is critical that they reinvest once more on making their assets more productive. In the intervening period retaining existing clients and broadening customer base; as opposed to even further, unsustainable cost cutting and market shrinkage; is critical for mining companies sustainability.