Commodity prices have finally risen to the point that miners can start new development projects, but the rally in metals prices also brings higher costs for producers.
Both operating and capital costs tend to climb sharply during cyclical rallies for metals. However, some companies have proven more adept than others at generating returns in the face of this challenge.
Stephen D. Walker, head of global mining research at RBC Capital Markets, found that returns on invested capital (ROIC) for base metals companies exceeded those of gold miners during the recent commodity cycle.
Both groups have similar operating margins, yet senior gold producers posted an average ROIC of 4.4 per cent between 2001 and 2017, compared to 7.1 per cent for base metals companies.
“This appears to be a result of gold companies being impacted to a greater extent by rising operating and capital costs, and not benefiting from a more broadly diversified commodity portfolio,” Walker told clients.
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Another factor base metals miners have in their favour is longer mine reserve lives – an average of 24.6 years for North American producers, compared to 10.5 years for gold companies. While large projects require significant upfront capital investments, greater economies of scale are achieved at mines with longer lives, which results in lower per unit mining costs.
There are plenty of factors pushing costs higher in the mining sector, including the rising level of turnover of skilled employees. Labour costs are also on the rise, as higher levels of exploration and project development lead to more consulting and contractor activity.
Larger North American operators with multiple mines can transfer employees from one project to another, or use their internal training programs, but most smaller miners don’t have those advantages at their disposal.
Walker also pointed out that energy price assumptions are as much as US$10 per barrel higher this year, which will put pressure on the 25 to 30 per cent of related operating costs.
If the mining industry sees similar capital investment growth to what was seen in the 2005-2008 and 2010-2013 cycles, the analyst cautioned that there is a risk of meaningful cost escalation.
Shareholders have made it clear that they prefer companies that expand existing projects rather than acquire new ones, take on little or no new debt, return excess capital through dividends, and only pursue M&A when synergies are relatively easy to achieve.
However, the positive supply and demand fundamentals for copper, which includes the growing electric vehicle and power infrastructure markets, should result in more early-stage projects.
It’s also worth noting that the zinc market is in deficit, and changes to the Chinese steel industry have provided a boost for coal and iron ore prices.
Based on global spending trends for copper and gold projects for the next few years, RBC found that that potential budget for copper is as much as four times the size for gold.
Walker believes this indicates that mine expansion for gold companies is in a steady state, whereas copper producers are more in growth mode.
“The risk for gold producers and any late cycle development projects is they are ‘caught on the back foot,’” the analyst said. “As copper projects are sanctioned and copper development projects move forward, and new gold projects are caught in a rising capital cost environment…the gold producers once again deliver below average returns for investors.”