The Business of Mining

“China remains the biggest driver of base-metals demand and, hence, prices. Fiscal tightening later in the year will dampen demand for resources, putting a ceiling on prices. At the same time tight credit for Western producers will hamper their ability to expand capacity, limiting supply and supporting prices.”

Observations:

• The Economist identifies strengthened fiscal policy in China and credit shortage hampering capacity increases in the West as the most important drivers for metal prices in 2011.
• Gold price is expected to rise approx. 10% and copper price approx. 7%, while aluminium price stays stable and steel price drops 17%.

Implications:

• It is unlikely that the credit shortage will have significant impact on the commodity prices in the short term. As capacity expansion projects typically have long lead times the availability of credit does not impact the available capacity in 2011 much.
• Tax rate hikes in China are planned to limit the growth to ‘sustainable levels’, which could reduce the Chinese demand of construction materials significantly and reduce steel, copper and aluminium prices. However, even at moderate Chinese growth levels demand increases will force miners to add capacity.

©2010 | Wilfred Visser | thebusinessofmining.com

“Canada’s impending decision on the fate of Potash Corp. of Saskatchewan has ignited a fierce national debate in a country known for its championship of free trade and laissez-faire attitude toward foreign takeovers.

Observations:

• The main reason for the provinces to resist the acquisition is the loss of tax revenue, estimated to be $5bln over the next 10 years.

Implications:

• A secondary argument used by the provinces is that BHP Billiton would gain a too large share of the market by the acquisition. However, as BHP doesn’t currently own a significant fertilizer business, this argument doesn’t hold for regulators. Furthermore, the potential changes to the pricing system that BHP would like to introduce would promote free trade rather than keep the current cartel system (from which the provinces are benefiting) in place.
• Rumors of an increase of the bid by 10% in order to win over the required threshold of investors were smothered by other rumors that BHP would not increase its bid before the Canadian government would give its approval to the deal. In this way BHP manages to increase the pressure on the government via the shareholders of PotashCorp, that would get a good deal.
• Most likely Harper will try to find a compromise by giving a conditional approval, with conditions including job security and arrangements to secure income for the provinces. In this way he will be able to defend the acquisition to the political audience while not setting international markets up against Canada.

©2010 | Wilfred Visser | thebusinessofmining.com

“Mongolians were until recently wont to describe themselves as “beggars sitting on a huge pile of gold”. The country has vast but largely untapped mineral deposits. Until recently wages were low and jobs scarce. Shoppers in Ulan Bator, the capital, were not spoilt for choice—unless they were in the market for dried meat, vegetables or furry hats.

Observations:

• Mongolia had a GDP of of $9.4bln in 2009. The benefits for the country from the Oyu Tolgoi copper deposit and the Tavan Tolgoi coal deposit will add many billions to the GDP, turning the trade deficit into a significant surplus.

Implications:

• The natural resource curse implies that the abundance of natural resources in a country hinders the development of stable government organizations, as it provides a reason for corruption and promotion of weak legislation. Mongolian government is trying to escape from this curse by strengthening anti-corruption legislation, taxation policies and by improving transparency of the dealings with foreign companies.
• Foreign mining companies investing in Mongolia (Ivanhoe, Rio Tinto and potentially Chinese partners) clearly need political stability. Key part of their entry strategy will have to be a non-market strategy: aiding the government to institute legislation, penalize corruption and build infrastructure. Reducing the risk of the projects in the long term is worth a good deal of money, given the foreign capital expenditure of over $4bln.

©2010 | Wilfred Visser | thebusinessofmining.com

“The Canadian province of Saskatchewan is at odds with BHP Billiton over the Australian miner’s $39bn hostile offer for PotashCorp, raising the prospect that the deal might be rejected by the federal government.

Observations:

• Although the province does not have the power to veto the acquisition, the opinion of the local government will influence the national regulator and government when they decide about the deal’s ‘net benefit to Canada’.
• BHP has announced it is willing to locate the global headquarters for potash in Canada; a logical move, as the acquired assets would be much larger than anything BHP already owns in the business.

Implications:

• Losses to the Canadian government are reduced tax revenues and the potential loss of managerial jobs (which is covered by BHP’s intent to establish a potash HQ). Benefit to the country would be higher stability of operational jobs and increasing investment power in the national potash industry, which could increase tax revenues in the long term.
• It is unlikely that the national government will support Saskatchewan’s opinion, as the tax loss on which the opinion is based is only a relatively small and one-off temporary loss. The national government might decide to compensate the province for the reduced tax income.

©2010 | Wilfred Visser | thebusinessofmining.com

The Economist published a strong article describing the rise of Vale:

“It is perhaps the biggest firm you have never heard of. The Boston Consulting Group says it has created more value than any other large firm in the world over the past decade. Yet few people know how to pronounce Vale’s name (it’s “vah-lay”).

Where the Economist is right:

• Vale has grown steadily organically and by small acquisitions from a state-owned local player to a state-backed global player.
• The company is still heavily depending on its iron ore production (65% of revenues, at times an even larger part of profits), diversifying into other metals mainly to hedge risks. Only the fertilizer business is set up to become a future star performer, but this might be frustrated by BHP’s Canadian plans.
• The capital expenditure of the company in the coming years will by far be superior to the competitors’ investments. Rio Tinto is bound to a $5bln capex for this year, while Vale is said to invest around $100bln in the next 5 years.

Where the Economist might be wrong:

• The vertical integration into transportation is more a necessary evil than a strategic asset. The company started the railway expansion because it could not trust the government to provide the infrastructure required for its operations and it bought bulk tankers mainly because its geographic locations makes ownership of the ships a better option than contracting the shipping. However, the ownership of a fleet might make Vale an interesting partner for various commodity trading houses that are looking to strengthen their upward ties.
• The pressure of the Brazilian government for local investments is certainly not on top of the management’s mind. Although the government should be kept satisfied to keep te current royalty structure, expansion abroad is crucial for the company’s success, which leads to increased international prestige and tax income for the government.
• The strong presence in the Brazilian iron ore market is a strategic asset rather than a hinderance. In the shadow of China, Brazil is developing an enormous appetite for steel. Vale is not only the most suitable cultural supplier; its domestic production ensures it is by far the lowest cost supplier to the developing Latin American market too.

©2010 | Wilfred Visser | thebusinessofmining.com

“A spate of cross-border acquisitions in Australia’s mining and energy sectors was announced on Monday partly in response to the new government’s revised minerals tax and also because of China’s continuing thirst for commodities.

Leading bankers and fund managers forecast a dramatic rebound in takeover activity, saying the resolution of the tax dispute between miners and the government will trigger further overseas investment in Australian mining and energy assets.”

Banpu, Thailand’s biggest coal producer, on Monday launched a A$2.5bn ($2.1bn) takeover bid for Centennial Coal, a thermal coal producer. Its offer of A$6.20 a share for the 80 per cent of Centennial it did not already own was at a 40 per cent premium to Centennial’s pre-bid trading levels.

Source: Financial Times, July 5 2010

Observations:

• The super profit tax proposal by Kevin Rudd has been significantly changed. Changes will only occur for iron ore and coal operations and effective rate increase is much lower than originally proposed.
• Banpu has reacted swiftly to the increased certainty about feasibility of projects by bidding to acquire all shares of Centennial. Analysts expect the offer to succeed.

Implications:

• Banpu was only producing coal in Thailand and Indonesia until now. The step towards production in Australia emphasizes the growing influence of “Eastern” miners in the developed mining areas.
• Other companies have restarted development projects in Australia as business goes “back to normal”. However, especially for the large iron ore projects in Western Australia project economics will be significantly less comforting than in the “old” tax regime.

©2010 – thebusinessofmining.com

“Chalco, the second-largest aluminium producer, has pulled out of a A$3bn (US$2.4bn) deal to develop a bauxite refinery in Australia, blaming a drop in aluminium prices and difficult global conditions.

Observations:

• When Chalco, a Chinalco daughter, won the permit for the bauxite deposit aluminium prices were $3,000 a tonne compared with below $2,000 today.
• Condition for the development was the construction of a smelter in Australia, to prevent the ore from being shipped directly to China. In this case the benefit for the Australian citizens would be significantly lower than with domestic smelting.

Implications:

• The Australian government is likely to reopen the permitting process for the deposit, giving other firms a renewed option to develop the deposit. However, only few firms currently have the funds to undertake the project.
• Today’s announcement by the new Australian prime minister that the super profit tax will only cover coal and iron ore operations does increase the feasibility of the project.

©2010 – thebusinessofmining.com

In the series of specials on the priorities of the CEOs of the world’s leading mining companies we analyze Rio Tinto this time. What is top of mind for Rio’s CEO Tom Albanese?

Tom Albanese

An analysis of Rio Tinto’s latest annual report; financial reports, investor presentations and the news about the company in the last months yields a list of 10 issues that are likely to be at the top of Albanese’s list of priorities. The list holds strategic, operational, financial and relational activities, each of which are scored in terms of importance and urgency. Priority 1 on the list is the lobby on the new Australian mining tax. Number 2 is restoring the operating margin of the company. The list closes with resetting the focus of the exploration program. Read on for the full list of priorities.

Priority 1 – Lobby against Australian mining tax

Although prime minister Kevin Rudd has been replaced by Julia Gillard, the negotiations about the reformation of the Australian mining tax system stay the top priority for mr. Albanese. If the super profits levy proposed by mr. Rudd would be implemented without changes (which is very unlikely at this point), Rio’s profits would take a hit of approx. 20%. As part of the tax discussions Rio Tinto is re-assessing its portfolio of development projects in Australia, as the feasibility of many projects is endangered by the tax.

Priority 2 – Restore operating margin

The operating margin of the company has decreased most of the large diversified miners, down at less than 20%. Especially in the diamonds and minerals unit major cost cutting needs to take place. Furthermore, the transformation of the aluminium business is to continue to take out more costs.

Priority 3 – Achieve ‘A’ credit status

The balance sheet has been strengthened significantly in 2009, but achieving the ‘A’ credit status remains top priority for the CFO in order to ensure access to capital in the near future. “Prudent balance sheet management” and a “complete review of trading security practices” are mentioned as key issues for 2010.

Priority 4 – Sell Alcan packaging food

Rio undertook a major divestment program of non-core assets to strengthen the balance sheet. It did succeed in collecting $8bln already, but still wants to bring more cash in by selling the remainder of the packaging food division of Alcan for some $2bln.

Priority 5 – Complete Pilbara Iron ore JV

The enormous Western Australian iron ore operations, for which a Joint Venture with rival BHP Billiton has been designed, are getting ready for large scale production. However, the JV is still subject to competition authority analysis. The Australian watchdog will decide end of July, but other countries will be investigating much longer. Getting the Pilbara operations on steam is crucial for Rio’s iron ore supply position to China.

Priority 6 – Develop M&A Decision scenarios

The share price of his company will be a major concern for mr. Albanese. The market capitalization has not really recovered after the first hit of the crisis. The low prices in the industry enable many strange merger and acquisition moves. Albanese survived the acquisition effort by BHP Billiton started late 2008, but will need to be prepared for potential new moves.

Priority 7 – Strengthen relationship with China

A revolutionary deal with Chinalco involving $20bln investment by the Chinese collapsed in June 2009 as shareholders did not support the board’s intentions. With China being the single most important country for development of Rio, which is very dependent on iron ore exports, Albanese will have to find other ways to build relationships with the key decision makers in the country.

Priority 8 – Manage capital projects portfolio

Rio is planning to invest only some $5bln in 2010. However, the projects on which the money will be spend are of strategic importance to the company. Extension of Diavik diamond mine, Building of the AP50 aluminium plant, and development of Oyu Tolgoi Copper mine in Mongolia are the most important capital projects in the development phase.

Priority 9 – Improve operational delivery

Where cost cutting is one of the top priorities, increase output volumes is another key issue. Especially the output of the aluminium operations has been disappointing in recent years. Albanese will be closely monitoring the delivery excellence programs in Madagascar (new industrial minerals asset), Queensland (Clermont thermal coal and Kestrel coking coal) and the aluminium business unit.

Priority 10 – Focus exploration program

Finally, Rio’s exploration program needs renewed focus, mainly in the areas of iron ore and copper. The new Mongolian asset and a potential Bingham canyon extension could secure copper output for some time. The difficult relationship with Guinean government very much increases the need to find new iron ore, as the Simandou development can not be expected to be finished quickly.

Sources: Rio Tinto annual report 2009, Rio Tinto annual review 2009, Rio Tinto investor presentation February 2010

©2010 – thebusinessofmining.com

“Australia’s government signaled it will consider changing the way its planned new mining tax is applied to some parts of the resource sector, but mining giants BHP Billiton, Rio Tinto and Xstrata PLC said little headway has been made toward a compromise despite fresh talks.

The planned resource-profits tax has met with furious opposition from the mining sector since it was unveiled May 2. The government has been eager to show progress in talks with industry, but comments from the miners themselves suggest Canberra isn’t near delivering what they would consider an acceptable compromise. The tax still must be approved by lawmakers ahead of its planned 2012 introduction. “

Source: Wall Street Journal, June 17 2010

Observations:

• The Australian government is continuously meeting with top executives from Australia’s mining companies in order to draft a tax proposal that is supported by the miners.
• Key issue for the mining companies is the impact on the cash flow of existing projects, which might not be able to pay back the investment (sunk costs) due to the increase in tax. The government is considering ‘transition arrangements’ to tackle this problem.

Implications:

• The government wants to apply a one-size-fits-all tax to natural resources companies. Although many companies (among others petroleum, sand/gravel) complain about this approach, making exceptions would create a system that rivals the current Australian tax system in lack of comprehensiveness.
• Low value commodity producers are protected in the tax proposal by the fax that the 40% levy is only applied above a rate of return of 6%. Most likely, the government will be persuaded to increase this threshold to a level more aligned with the industry, thus ensuring the companies they will be able to pay back future investments.

©2010 – thebusinessofmining.com

“Xstrata, the Anglo-Swiss miner, said it had “suspended” A$586m (US$498m) in spending on coal and copper projects after reviewing operations in Australia in the weeks since Canberra announced plans for a new 40 per cent resources super profits tax.

It comes as the world’s biggest mining houses battle the Australian government over a tax that is scheduled to come into force in just over two years, provided it clears the legislative process. Miners have waged a high-profile campaign to warn that the tax will damage Australia’s international competitiveness and jeopardise mining projects and jobs.”

Source: Financial Times, June 4 2010

Observations

• Until now only a limited number of companies have announced suspension of development. $0.5 bln by Xstrata, $15 bln by Fortescue (on very early stage projects) and a withdrawn takeover bid of Macarthur by Peabody.
• The tax proposal is unlikely to be passed before the Australian elections, making the actual implementation very uncertain.

Implications

• Mining companies and investors fear that other countries may follow Australia’s example and take a larger part of miner’s profits.
• The government has various options to get a deal on reforming mining taxes:
  • Increase the “tax-free” rate of return of 6% to a threshold percentage more common in mining investments (12-15%)
  • Only apply tax to new projects that didn’t start development. In this way current developments are not threatened. However, this will not solve the miner’s problem in the long run.
  • Combine tax proposal with cut in state royalties (paid per ton of product instead of over profit). Only paying when making a profit reduces risk for the miners significantly. However, ideologically this is not in line with giving the locals a part of the value of the extracted resources.

Further reading:
Overview of implications of super profits tax

©2010 – thebusinessofmining.com