Miners to lag commodity recovery

By Mark Noble | June 2, 2009 | Last updated on June 2, 2009
4 min read

A run-up in commodity prices will heal a lot of the damage sustained by the mining sector, but a study by PricewaterhouseCoopers (PwC) says it will take some time before mining companies deliver the type of results they did before the downturn.

If you’re a Canadian investor, mining is a big deal. Canada is one the world’s most important mining markets and home to a number of the world’s largest mining companies — particularly gold mining giants, such as Barrick, Kinross and Goldcorp.

The difficulty in investing in these companies is that while their earnings are directly correlated to the price of the resources they extract from the ground, they are businesses with overhead costs that greatly detract from earnings.

Revenue in 2008 was still 3.7 times that of 2002, with the industry obtaining a robust profit of $57 billion. This coincided with a rapid increase in production costs, such as increased energy and labour prices, which could be sustained by high corresponding prices for base metals.

When commodity prices fell miners saw their earnings plummet, and debt to revenue ratios from a wave of consolidation soar.

According to the PwC study, which was a review of global trends in the mining industry, 2008 saw the market capitalization of the top 40 mining companies in the world decrease by 62% from 2007. The necessary market capitalization to be included in the top 40 dropped to $2.3 billion from $9.0 billion in 2008.

There is expected recovery to occur if base metal prices continue their current trajectory, but unfortunately most of the world’s producers have overhanging capital costs incurred when commodity prices were at record highs, the study says.

“Operating costs continue to rise at a greater speed than revenue, further eroding margins. Costs continue the upward trend of the past six years with the current rise consistent with the 19% annual average,” the report says. “Adjusted EBITDA increased to a record $141 billion, seven times the result achieved in 2002. Higher costs eroded the percentage growth in EBITDA to the lowest levels experienced.”

Success during an economic recovery will require mining companies to reduce debt and reign in their operating costs, says Bob Bosshard, a mining partner in PwC’s Toronto mining practice office.

“Profit margins will be lower than they have been over the last few years as company’s move to right size their costs. To get margins back in line, operating costs will have to get back in line,” Bosshard says.

One hurdle to this is the fact that many minors are locked into hedging contracts on costs such as energy prices, which are higher than the current cost of these commodities.

Miners were unable to take advantage of lower asset prices during the downturn to acquire new sources of revenue. Some companies like Rio Tinto have huge debt loads — the result of making acquisitions at the height of the market.

“Investing in resources during a downturn has the potential to generate significant value as asset prices will be lower relative to commodity prices. Nonetheless, few companies and investors apply this rationale as investing during a downturn requires a different investment mindset,” the report says. “Most investments in capital intensive industries will require a positive economic environment, which is why investment is heavily cut back where bad news is the norm.”


Bosshard says if prices for the commodities that miners produce continue to rise, he expects there to be at least a two to three month lag in miners being able to transfer those higher prices into earnings.

Canadian gold glitters

Canada and its group of globally dominant gold producers has done well in the downturn. The study suggests that gold producers are well positioned to capitalize on an economic recovery.

Gold companies only saw their market capitalization decrease by 20%, compared to the overall market sell-off of roughly 40%. Gold remained a safe haven during economic turmoil, as investors viewed it as a stable source of wealth protection. There are now 14 gold companies included in the top 40 mining companies, up from ten in 2007. Gold companies now comprise 26% of the total market capitalization, more than double the 2007 level, the report notes.

“Gold has weathered the storm reasonably well,” Bosshard says. “Four Canadian Gold companies made the top 10 list of the world’s largest mining companies. We’ve seen developments, such as Kinross taking a stake in Harry Winston, which is a new direction in strategy. As well, there has been lots of equity raising. Canada raises about 50% of the equity for global resource sector. This is a good for the economy in Canada.”

Indeed, a separate global mining research paper authored by BMO Nesbitt Burns, is titled Canadian Gold Renaissance. The report suggests Canada is set to reverse a decade of decline in gold production. By 2015, the country is expected to produce 7.2 million ounces of gold, a 132% increase over current production levels.

“The forecasted growth in production is expected through a combination of brownfield expansions, mines under construction and development of new projects,” the report says. “Underground [extraction] is expected to be the dominant source of Canadian gold at a projected 60% of total production. Sustained interest in underground production is based on the potential grade of these deposits driving lower quartile operating costs and superior cash flow.”


Mark Noble