The mining industry is at an inflection point. Softening commodity prices and a slowdown in China have led to suggestions that miners' best days are behind them. Others still believe that rapid industrialisation in emerging markets presents a huge long-term opportunity. Nowhere is this better reflected than in the veering stances of two of the world's largest diversified mining companies, BHP Billiton and Rio Tinto.
Whereas BHP has delayed or shelved more than A$30bn-worth (£19bn) of projects in recent months in response to falling prices and rising costs, Rio Tinto continues to aggressively press ahead with almost its entire development pipeline. That's not to say both companies don't retain relatively bullish views on commodity prices - they certainly do - but their diverging views underscore the belief that returns on mining investment may not be as good in the future as they have been.
The last decade has been a rare period where prices for raw materials have risen dramatically due to soaring demand from emerging economies, most notably China, as they industrialise and urbanise. Meanwhile, the long lead times required to put new mines into production, coupled with a dearth of good-quality discoveries, have kept new supply coming into the market low and prices high.
Yet demand has started to cool off, and commodity prices with it. As the government-engineered slowdown in China shapes up to be larger than first anticipated, and economic recoveries in the US and Europe fail to materialise, there have been steep falls in the prices of steelmaking ingredients such as iron ore and coking coal. A growing number of market participants are coming round to the idea that the so-called 'commodities supercycle' could be entering a less intense phase.
Consequently, mining companies' margins have shrunk, and with them share prices and returns on equity. But it's not just lower raw materials prices affecting miners' bottom lines. In their search for new supply, miners have been pushed into riskier jurisdictions than ever before, often into impoverished nations whose governments have unexpectedly raised royalties and taxes - or resorted to outright expropriation (see 'The red flag of resource nationalism'). Even in stable western democracies, such as Australia, governments have been quick to make a grab for a larger slice of the profits. Meanwhile, labour costs have soared, environmental and mine permitting is taking much longer, community involvement has become more necessary and costly, and even the best of projects are being built way over budget. Worse still, grades for many long-life, flagship mines are coming down as they age, and new deposits of significant size are becoming more difficult to find.
True, additional stimulus from central banks to encourage economic growth - such as the latest round of quantitative easing, or QE3, from the Federal Reserve - is likely to drive commodity prices (precious metals especially) higher in the short term, as it's done in the past. Extra government spending on large infrastructure projects in China would no doubt help, too. Yet these are both temporary measures, and it will take a great deal more growth in organic demand to sustain the level of price increases seen in recent years. That demand could still come from China, where new leaders take power in October. One assumes they will act assertively and quickly to keep the country's economy growing strongly. Whether that means Chinese gross domestic product will grow at 10 per cent a year or 6-7 per cent a year, however, is more difficult to predict - and that means the direction and magnitude of future commodity price moves are also uncertain.
But it would be a mistake to argue the decade-long party for miners is all but over - especially when most commodity prices remain near historic highs. Balance sheets of major miners are robust, dividend payouts are becoming larger and cash flows are still strong for the better-quality companies that have managed to keep costs low. The market also already appears to be bearishly pricing in further falls in commodity prices, which could be artificially depressing valuations.
But what would happen to most mining equities should commodity prices not increase considerably from here? In a deteriorating or flat commodity price environment, investors would have to seek alpha to generate the bulk of their returns - meaning they will need to turn their hands to stock-picking to find outperforming companies within sub-sectors that can post superior returns. That won't be easy. Some commodities will fare better than others, and higher-cost miners that have previously provided healthy earnings growth due to their exposure to hot commodities could suffer. Yet there will also be ample opportunity. Mining and mineral exploration by its very nature is a high-risk, high-reward venture, and nimble investors will be able to take advantage of what's on offer.
In this special report on mining, we assess the sub-sectors and commodities that are most likely to outperform based on supply and demand fundamentals, while also assessing the implications for profitability and investment throughout the industry. Where applicable, we will also provide our preferred stock recommendations for each sector or what we view is the best exposure.
■ We favour mining companies that can drive earnings growth without relying on higher commodity prices. We view emerging producers and mid-cap miners with high potential to grow output as most attractive, followed by companies exploring or mining high-grade, low-cost deposits in safe jurisdictions - as these will always be in demand and will be able to withstand price shocks.
