Why invest in mining equities? One commonly held view – that, for example, a share in a copper miner is a bet on rising copper prices – is not backed by historical evidence. In fact, while commodity prices are mean-reverting, they are neither stable, easily predictable on a short-term horizon, or consistently inflationary. That’s despite being steered by two powerful inflationary forces: demand growth, and steady depletion of geological resources. In other words, while growing populations and economies are consuming ever greater quantities of metals, discoveries have slowed, and metal grades have thinned. And yet there's no guarantee prices will climb.
To return to our initial question then, why, other than a charitable inclination to fund primary economic activity, should anyone invest in mining shares? The answer can be found between the basic drivers of supply and demand: productivity growth. Without it, those inflationary forces would have upended the global economy. Were it not for the advances in mining productivity and innovation since 1950, analysts at research firm Bernstein have calculated that a tonne of copper would cost around $25,000 (£19,600) a tonne. That’s around four times’ the current price.
This deflationary effect has sometimes been boosted by the discovery of world-class deposits such as Escondida, first mapped in the early eighties and which still accounts for 5 per cent of today's global copper output. But the phenomenon has largely been thanks to the gradual introduction of better technology, expertise and processes, and the falling cost of capital goods. Together, they have kept profit margins steady. Indeed, such incremental improvements have allowed Escondida operator BHP Billiton (BLT) to keep the mine in the bottom quartile of the global cost curve.
And for much of the 20th century, this was the warrant for investment in supply: new output, in the shape of a new or expanded mine, which could compete with the lowest-cost operations already in production.
What next for productivity?
Yet by several measures, that long-term trend appears to be breaking down. Though expectations for growth in population, urbanisation and infrastructure all prop up demand growth projections for base metals, miners are struggling to grow supply with the same overhead restraints. Discoveries are lower-grade, smaller and costlier to find, geopolitical risks are unpredictable, and local environmental standards are usually (and thankfully) higher.
Such an impasse explains why Rio Tinto (RIO) appears content to gift billions back to investors through share buy-backs and dividends, rather than build new mines. Chief executive Jean-Sebastian Jacques confessed as much this week, reportedly telling an Australian resource conference that “maybe there needs to be a new way of funding mining projects”.
It also helps to explain why much of the capital expenditure Rio is committing to its portfolio is focused on productivity improvements. The prize, the iron ore heavyweight has stated, will be "additional cumulative free cash flow of $5bn from the start of 2017 to the end of 2021", and an "annual exit rate from mine-to-market productivity improvements of around $1.5bn from 2021".
Such a strategy, while hardly catnip to growth-oriented investors, might at least buttress the income case for London’s largest miners. It’s also a trend evident among Rio’s peers.
Take, for example, Anglo American (AAL). The group’s third-quarter results show that production per employee is 5 per cent higher year on year – as measured on a copper-equivalent basis. This has helped to make up for lost iron ore earnings from suspended output, and weakened diamond and copper prices.
Indeed, recognising doubts over the ‘tier-one’ status of its mining assets, Anglo is working hard to move its portfolio to the left of the global cost curve. The results have been impressive: by its own calculation, Anglo’s costs have moved from the 52nd to the 46th percentile in five years, despite the shake-out of unprofitable operations elsewhere in the period. Its copper, metallurgical coal, diamond, platinum and nickel divisions are now more resilient to price shocks, while only iron ore and thermal coal output is less competitive.
Over the same timeframe, Anglo's mining cash profit margin has climbed 11 percentage points, and the group believes up to $2.5bn (£2bn) of efficiency and technological improvements could help to almost replicate that feat by 2022.
Automating the iron age?
While metal extraction is sometimes characterised as a backward or slow-moving business, mining is not structurally predisposed to continuous disruption, as productivity improvements over time suggest. But when billlions of dollars are at stake, tried-and-tested solutions to mining problems will always be favoured over innovation.
"As such, firms need smarter ways to extend the life and utility of assets at lower costs, not innovations that upend existing operations and create shorter cycles of capital replacement," argued hedge fund Massif Capital in a recent note.
But that doesn’t mean innovation is impossible. Anglo is currently trialling technology that precisely targets ore via a process known as coarse particle recovery, and which helps to retrieve minerals while minimising waste and energy and water use. In terms of capital intensity, Anglo believes it could reduce operating and capital expenditure by more than 30 per cent, and cites "outstanding results" at a pilot operation at the Los Bronces copper mine in Chile.
The FTSE 100 group's other initiatives include the potential application of artificial intelligence in exploration, and the use of so-called 'digital twins' – virtual models of the mining process, which can help to predict maintenance ahead of time. Such a tool will not be lost on Anglo, after pipeline leaks at its massive Minas Rio iron ore operation have kept production suspended since March.
