Features : Miners Going Major

In the closing months of 2007, as investors fled equities and piled into commodities like gold en masse, spot gold prices in London at one point reached a 28-year peak of $845.40 a troy ounce. But it is not just recent events in the global credit markets that have sent metals prices soaring into the stratosphere. Gold, copper and zinc prices have risen steadily for the past five years, which is unusual given the historically high levels of pricing volatility in the sector.

This steady rise in prices is what has come to be known as the commodities “super cycle,” which has been attributed to unprecedented demand from rapidly growing economies such as China and India for metals, so much so that the mining industry was beginning to think it could put the traditional boom-and-bust cycle well behind it.

A consequence of the surging demand for commodities from rapidly industrializing countries is that it has put unprecedented pressure on supply. “Companies have underestimated demand and overestimated supply, which has led to high commodity prices,” says Tim Goldsmith, a partner at PricewaterhouseCoopers, Australia. “There has been a huge run on commodity prices in the last few years, and in my view it is sustainable. China and India are going through an industrial revolution, and demand is going to keep going up.”

According to Goldsmith, the lack of supply of essential metals is a holdover from the years prior to 2001 when the mining industry is generally considered to have underperformed. At that time commodity prices were in the doldrums, and, Goldsmith says, many mining companies did not put money into exploration and growth for the future. “That meant that when demand picked up, there was not a lot of new production,” he explains. And given that it can take an average of 10 years from starting exploration to getting a mine into full production, it is hardly surprising that supply is lagging demand.

But it is not just demand from China and India that is sustaining high metals prices. According to Gary Mead, an analyst with VM Group—which covers the precious and base metals markets, energy products and soft commodities markets—increased investment in metals mining in general has resulted in “terrific” price rises for most base and precious metals in the past two years. “Gold’s rise has been largely driven by investment demand based on dollar weakness and wider economic worries; the rise for lead partly on speculative interest, but partly on lower-than-expected Chinese exports; the rise for copper—until recently—very much based on supply shortfalls and continued strong consumption demand,” he says.

Goldsmith: “Companies have underestimated demand.”

Robert Brady, founder and CTO of UK-based Brady plc, which provides trading and risk management software for global commodity markets, says that with strong demand from consumers of metals and from investors seeking portfolio diversification, increased investment activity in commodities has resulted in money flowing into the mining companies. This is one of the main drivers behind the current wave of M&A; in the mining sector, he explains. Magnus Ericsson, chairman of Raw Materials Group (RMG), says, “Mines are making so much money, they don’t know what to do with it; the cash is burning in their pockets.”

One does not need to look far to discover where the money is being spent. With resources depleted at some mines, particularly in overmined regions such as South Africa, the race for assets is on. While some money may be going into exploration, a significant portion appears to be making its way to the Wall Street investment banks. According to RMG, persistently high metal prices and corporate profits have meant that mining companies have been more inclined to secure access to metallic mineral resources via acquisition, resulting in several giant mergers. “There has been consistent consolidation over the last 10 years in the mining industry, but in the last few years there have been some particularly big deals,” observes Goldsmith. “That is because of record profits.”

According to RMG, 2006 was a boom year for M&A; in mining, with the value of deals reaching almost $140 billion. The bulk of the consolidation, it says, is occurring in the aluminium, copper, gold, nickel and uranium sectors. Landmark deals include Brazil’s Companhia Vale do Rio Doce (CVRD) takeover of Canada’s Inco and the acquisition by Xstrata (Switzerland) of Falconbridge (Canada), each valued at $17 billion. Companies in the emerging markets have also become increasingly acquisitive, with Russian steel mill Evraz buying Oregon Steel Mills in Portland and India’s Essar Global acquiring Canada’s Algoma Steel and Minnesota Steel. That same year also saw the emergence of steel behemoths such as ArcelorMittal and Tata Steel’s acquisition of Anglo-Dutch Corus Group.

VM Group believes that the rise of China as a low-cost steel producer is likely to trigger more steel industry consolidation in the West. “Larger steel makers hope to establish a higher benchmark for steel via consolidation so that prices do not slump to the same extent as they have before,” it said in a joint publication with Fortis, adding that consolidation helps reduce volatility in steel prices.

In a bid to become the world’s leading aluminium producer, earlier this year Rio Tinto acquired Canada’s Alcan in a deal valued at $38 billion. But the deal of all deals would have to be BHP Billiton’s $145 billion bid for Rio Tinto in November 2007, which would give the combined company an enviable market position across base metals and commodities such as iron ore, copper, aluminium and coal. Anglo-Australian Rio rebuffed the bid, saying the price being offered was too low. In late November media reports suggested that Rio was distancing itself from any possible takeover, with the company’s CEO promising shareholders he would raise dividends in order to fend off a hostile takeover. The Chinese are also against a BHP/Rio tie-up for fear that it would monopolize iron ore supply in the Asia-Pacific region. “While it would make sense for BHP/Rio to merge some of their iron ore operations in Western Australia, they would have such a high market share it could be classed as an oligopoly,” notes Ericsson.

If the BHP/Rio deal went ahead, some believe it could trigger a fresh wave of consolidation across the entire mining industry. Competing providers like Brazil’s CVRD—which before the BHP bid for Rio was the largest metals company, with a 5.2% share of value of mine production (based on RMG estimates)—potentially could hook up with the likes of Xstrata, Alcoa or even Freeport-McMoRan in an effort to strengthen its position in base metals.

Mead of VM Group says that BHP’s bid for Rio is vast and costly and that it is difficult to imagine the entire mining sector being swallowed up, particularly given the current economic slowdown. That means such deals will become more difficult to execute, he explains. A deal of that size also poses potential credit risks and integration challenges. Either way, BHP’s bid for Rio has got the M&A; rumor mill working overtime.

China Edges Toward Top 10
Speculation at the time of the original bid was rife that a Chinese consortium including Chinese steel makers and the country’s sovereign wealth fund, China Investment Corp., may launch a counter bid for Rio to avert BHP’s takeover. A Chinese state mining company is also believed to be interested in bidding for a stake in India’s Vedanta Resources.

Vedanta Resources and Russia’s Rusal have made no secret of their global ambitions. With a weakened dollar, likely acquisition targets could include smaller US mining companies. As a significant amount of undeveloped resources in the mining sector can be found in emerging markets, companies like CVRD of Brazil and Grupo Mexico now feature alongside Australian, Swiss and American mining giants in the list of global top-10 mining companies. Ericsson believes a Chinese mining company will enter the top 10 soon if recent attempts by Chinese Minmetals to acquire Canada’s Noranda mining company are any indication.

As the smaller mining companies become successful and start having assets that are of interest to BHP and Rio Tinto, Goldsmith believes this will fuel further industry consolidation. “Given the sheer size of the big mining companies, nothing is off limits,” he says. “These companies generate so much cash on a monthly basis that when Rio bought Alcan, it was an all-cash offer.”

Yet while M&A; usually results in greater economies of scale, Brady says there can also be “diseconomies of scale” in terms of merged mining companies supporting a multitude of incompatible IT systems. Given the logistical and IT challenges of merging companies, Brady anticipates that, in addition to merger activity, there is also likely to be more “de-mergers” as big mining companies look to spin off some of their assets.

“Selective de-merging is also making its mark, as some companies streamline and focus operations in their given areas of expertise and strength,” notes Alex Herbert, director of corporate ratings at Standard & Poor’s. For example, following its purchase of Alcan, Rio Tinto is selling off a number of assets, including its packaging and engineered products divisions.

Mead does not see M&A; activity in the mining sector abating anytime soon, although he says the price of acquisitions may go up, even though the value of companies being acquired may fall as a result of the “paradox” of probable tighter credit terms matching falling metals prices. Concerns about the risk of a recession in the United States saw the price of industrial metals such as copper fall by 4% on the London Metal Exchange in mid-November. Zinc fell 5% in value at one point, reinforcing the view expressed by some that commodity prices may have peaked.

Price Rally Eases
If metal prices peak in early 2008, Ericsson anticipates that there will be less M&A; activity than in 2007. Yet he believes more M&A; in the mining sector is crucial in order to meet exploration and R&D; demands. “There is a need to create stronger companies, as financial strength is important because mining is a capital-intensive industry,” he explains. Mead says consolidation has tended to mean that the larger mining companies are less inclined to take risks. “In the platinum group metals mining sector, for example, most of the new resources are being discovered and exploited by juniors (hoping to be gobbled up at a handsome price once they have discovered some decent resources) rather than the large companies,” he says.
 

Pointing to the example of Apex’s investment in creating the San Cristobal silver-lead-zinc mine in Bolivia, Mead says mega-mergers have not stopped mining development altogether. “Mining exploration is happening on large and small scales all around the world,” he says. “More problematic are perhaps issues of resource nationalism, economic growth, metal prices going forward, and trying to figure out whether the capital cost of building a new mine is worth it.”

According to Ericsson, in Latin America, Africa and Russia there is increasing government intervention in the mining sector taking the form of profit sharing via the introduction of royalties. The recent proposal in Zimbabwe to nationalize 25% of all mining companies is another more drastic example, he adds. Although mining companies have tried to avert country risk by not putting all their eggs in one basket, Goldsmith says the problem is that they cannot choose where the resources are located.

Regardless of what happens in the credit markets, M&A; is likely to remain a means for mining companies to overcome increasing risks around resource access, particularly given growing concerns about sustainability. It is these concerns that led the World Bank to recommend a freeze on new lending for extractive projects in developing countries in 2004.

It may be cheaper for a mining company to acquire another company’s resources rather than develop its own. As Goldsmith points out, this requires local buy-in in terms of government and environmental approvals, and it can be years before a mine is ready for production.

Anita Hawser