Pressure on hard commodities

This gloomy quote would barely be worth mentioning if it came from one of the many troubled mid-cap miners who are struggling now that commodity prices have softened. But it came from Tom Albanese, chief executive of one of the world's largest and lowest-cost diversified mining companies, Rio Tinto.

Barely a few months ago, Rio was aggressively pressing ahead with almost its entire development pipeline - this despite large capital expenditure (capex) cuts being announced by key competitors such as BHP Billiton. Now, Rio Tinto is toeing the line. This abrupt turnaround shows the speed at which market participants have come round to the idea that the so-called 'commodities supercycle' could finally be slowing down.

And while commodity prices oscillated wildly at times in 2012 - gold's stellar autumn run and iron ore's dramatic slide from $140 a tonne to $85 a tonne in just three months spring to mind - base metals emerged essentially flat for the year, with bulk commodities down 15 to 20 per cent and precious metals up 8 to 10 per cent.

The Age of Uncertainty

As we enter 2013, the outlook for commodity prices is as uncertain as ever. Growth in China is at its slowest for three years while economic recoveries in the US and Europe are stumbling. True, a new generation of Chinese leaders may soon try to put the country's economy back on the fast track, but a massive infrastructure-led stimulus package that would cause commodity prices to soar rapidly again seems unlikely. All in all, global industrial demand will likely remain subdued.

Worse still, mining equities are underperforming commodity prices. Not only are lower raw materials prices affecting miners' bottom lines, but so too are rising labour costs, higher taxes and royalties, longer environmental and permitting delays, declining ore grades and the growing burden of community obligations.

Yet 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. The balance sheets of some 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 will happen to most mining equities if commodity prices do 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.

Looking ahead

Admittedly, our general view on the mining sector is neutral to mildly bearish heading into 2013. We expect the early new year reporting season to be slightly disappointing for miners on costs, capex, earnings and dividends based on lower commodity prices and the well-publicised industry challenges experienced this year. Meanwhile, all eyes will be fixed on China to see whether positive early economic indicators in the fourth quarter translate into faster growth in the first quarter of 2013.

Nevertheless, there will still be opportunities out there. Some companies will have managed to keep operating costs low, cut their capital spending budgets and increased dividends, and the market should reward it. We generally favour those miners 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.

Our preferred picks are Yamana Gold, Central Asia Metals, Archipelago Resources, Antofagasta, Sirius Minerals and Silver Wheaton.