Join our community of smart investors

FTSE 350: Miners over-reach and retrench

As we move into 2016, the FTSE 350 miners are struggling with surplus production across a range of commodities; the result of unfettered capacity expansion at the height of the mining boom
January 28, 2016

To characterise the share price performance of the FTSE 350 mining complex as abysmal might actually be understating the issue. As 2016 gets under way, prices for key industrial inputs are being undermined by a perceived economic slowdown in China, coupled with gathering US dollar strength. Judging by recent estimates from Macquarie Research, the weakened pricing environment is set to stretch through 2016. Macquarie's full-year forecast for copper is down 26 per cent on the 2014 average, while those for thermal coal and iron ore are down 31 and 49 per cent, respectively.

Every one of the FTSE 350 mining constituents has taken a drubbing since metals/bulk prices clicked into reverse, but the experience of Glencore (GLEN) provides a salutary lesson in the corporate tendency to over-reach during periods of capital expansion. Last year, the group was forced to launch a major debt reduction programme, including an equity offering and the cessation of dividend payments, which will contribute to a planned reduction in net debt to around $18bn (£12.2bn) by the end of 2016 - down from $30bn at the June half-year. While it's true that the Switzerland-based group carries more debt than 'pure' mining rivals in order to support its trading activities, housekeeping on that scale suggests that management's leverage risk assessments have gone seriously awry.

Admittedly, Glencore wasn't the only resource group to crank up borrowings to meet China's hitherto insatiable appetite for raw materials, but given the group's central function as a commodities trader - purportedly the world's largest - you might have thought that Ivan Glasenberg and the Glencore board would have an insider's perspective on demand trends. Apparently not. Nevertheless, the proposed scale of Glencore's retrenchment has played well with City analysts; in a recently published note, Credit Suisse said that the group's refinancing plans should prove sufficient to allay ongoing funding concerns.

Leaving aside industry hubris, perhaps the most telling move of late came from iron ore giant Rio Tinto (RIO). The group has not only frozen staff salaries, but has also put the screws on executive travel arrangements. The former measure is obviously substantive, but the cost of executive travel - no matter how seemingly extravagant - is a mere bagatelle where a FTSE 100 constituent is concerned. It seems that Rio's chief executive, Sam Walsh, is sending out a clear message to shareholders and the market: the group is battening down the hatches in anticipation of a prolonged spell of anaemic pricing.

Iron ore prices have fallen by a third from a year ago to below $40 a tonne, but Citigroup's head of Asia commodity research, Ivan Szpakowski, now believes that prices could fall below $30 a tonne in 2016. That could translate into an existential crisis for some producers. After all, Rio sits at the extreme lower end of the industry cost curve, so goodness knows what measures lower-margin producers are planning to underpin earnings.

It's worthwhile noting that new seaborne iron ore production from Rio and Anglo-Australian stablemate BHP Billiton (BLT), along with that of Brazilian rival Vale SA (NYSE:VALE), has undermined prices during a year in which Chinese imports of iron ore hit a record high of 953m tonnes. For the FTSE 350 miners, China's growth isn't in question; just the rate of growth expansion.

Meanwhile, copper prices, generally held as a bellwether on the health of the global economy, are nudging a seven-year low at the time of writing. Recent PMI data indicates that China's manufacturing sector remains under pressure; a problem given that China accounts for about 40 per cent of global copper demand. However, there are signs that recent tax initiatives from Beijing have reinvigorated the domestic automotive market - a big end user of copper. In addition, refined copper stocks in China's local market and bonded warehouses will be buying into a diminishing supply base, as it's estimated that around 10 per cent of planned production for this year has been lost to flooding in Chile, as well as mining companies shutting down unprofitable operations. The balance is tighter than recent price movements suggest.

NAME Price (p) Market cap (£m)PE (x)DY (%)1-year change (%)Last IC View
ANGLO AMERICAN                   239

3,348

2.524.0-78.1Hold, 295p, 15 Dec 2015
ANTOFAGASTA                   356

3,505

23.12.3-48.7Buy, 566p, 25 Aug 2015
BHP BILLITON                   627

13,234

8.212.7-50.8Hold, 810p, 03 Dec 2015
EVRAZ                     62    872 NA0.0-59.7Hold, 74.7p, 28 Aug 2015
GLENCORE                     79

11,369

5.80.0-68.0Hold, 88p, 30 Sep 2015
RIO TINTO                 1,657

22,768

6.88.9-42.0Buy, 2,485p, 15 Oct 2015
VEDANTA RESOURCES                   214    592 NA12.1-46.0Sell, 793p, 04 Nov 2015

Favourites

Even given the slump in valuations over 2015, market sentiment towards the FTSE 350 miners is at a nadir. It's conceivable that both Rio and BHP could eventually benefit from price-linked attrition in the industry - the so-called 'last man standing' argument. For now, Rio is the safer option of the two, given pre-emptive actions taken by Sam Walsh and his team to mitigate price weakness and help preserve operating cash flows.

Over the long haul, we're still optimistic over prospects for copper producer Antofagasta (ANTO), which has shown strategic clarity by cutting dividends, while snapping up a 50 per cent stake in the Zalidar copper mine at the low point of the copper price cycle. This shows that management is taking a long-term view, by prioritising growth and scale benefits over returning cash to shareholders, which include Chile's Luksic dynasty as majority owners.

Outsiders

There have already been worries that BHP Billiton would be forced to slash its half-year dividend due to mounting costs from the Samarco tailings dam breach in the final quarter of 2015. The payout is now under renewed pressure after the group announced a $7.2bn writedown on its US shale operations. BHP did not cut its dividend during the global financial crisis, but the group's energy division is also being hit hard by crude oil's demise - something has to give.