From S.A. Creamer's Mining Weekly.
miningweekly.co.za
Global commodity-price boom 'unstoppable phenomenon'
It's an unstoppable: That's what R30bn South African investor says of global commodity-price boom
South African Mick Davis is nothing if not acquisitive. Under this former Eskom executive director, the London-listed Swiss-based Xstrata plc has...
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Xstrata thinks commodity boom has legs
X marks the spot
By: Martin Creamer
Published: 16 Mar 07 - 15:44
South African Mick Davis is nothing if not acquisitive. Under this former Eskom executive director, the London-listed Swiss-based Xstrata plc has seen its share price soar following flurry of acquisitions in the past five years, his latest scalp being that of Canadian nickel giant Falconbridge.
His confidence to acquire – and even be tipped by some analysts as a possible Anglo American plc suitor – is based on his deep insight into the confluence of two phenomena that have created enormous opportunities.
Phenomena One: On the demand side, commodities prices are being lofted by what he defines as the “unstoppable phenomenon” of infrastructure investment in urbanising China and India, which, he has no doubt, will continue to be “unstoppable” for years to come.
Phenomena Two: On the supply side, mining companies are unable to catch up with demand, which, he has no doubt, will also persist for years to come.
The commodities boom con- tinues, in his view, to have legs aplenty. After all, he reminds, it was he who coined the phrase “stronger for longer” in describing the longevity of the global commodities super cycle.
On demand from China and India, he says: “This is an unstoppable phenomenon that is going to continue for years.
On supply, he says: “You have to bear in mind that the risk is on the supply side.”
Little wonder then that he remains mining’s most voracious acquirer.
This is his three-pronged thesis:
* Commodity prices have been so high because of the confluence of the two phenomena;
* commodity prices will continue to be high because China is financing its urbanisation-infrastructural growth from its own domestic savings and not from foreign borrowings, while India – though orders of magnitude behind China – has also entered that same urbanisation phase; and
* the long range cost of production will remain high because of the length time it takes for mining companies to respond to the previous decade’s sharp fall-off in mining expansion – coupled to the fundamental that the cost of production always sets commodity prices.
“The combination of normal growth in the rest of the world with extraordinary growth in China and India has created the current sustained period of demand, which is going to go on for years,” Davis forecasts.
Importantly, this is taking place against the background of China being a creditor nation and not a debtor nation, with the cash to fund its growth arising from its own domestic savings; this is shielding it from the choking effect that other rapid-growth developing countries suffered when trying to finance rapid growth from the savings of foreigners.
Provided China’s domestic savings ratio remains high, it can continue to finance its growth, which Davis sees as the “very important difference” between the China phenomenon and what has happened previously.
“Clearly China will go through its own growth fluctuations and I should imagine that the Chinese authorities are going to be very conscious about over-heating, but because of China having more central control, it will be better able to manage it,” he predicts.
Phenomenon number two is the much-reduced supply side. Davis recalls that a similar surge in demand for raw materials and consequent price step-change took place after the Second World War as a result of the reconstruction of Europe, Japan and other areas of the Far East.
That resulted in an explosion of exploration activities in areas that had hitherto not been a major source of raw materials, including South America and Australia. That exploration investment found very substantial deposits, which were then brought to market.
But as Europe and Japan matured, the intensity of metal usage began declining as a percentage of gross domestic product and a huge funnel of supply began feeding into shrinking outlet of demand, resulting in the world price of commodities declining by one percent and two percent a year.
As a consequence, during the late 1980s and early 1990s, very few mining companies were covering their cost of capital and returns to investors were poor. This resulted in the era of engineer-dominated asset focus giving way to one of accountant-driven return-on-investment focus, and opportunities to expand supply were not taken up for a prolonged period.
The upshot was a vastly reduced supply side, which, in the early part of this decade, collided head-on with explosive Chinese growth, and the prices of raw materials were sent soaring once more.
“I knew about the supply side, and that was the basis on which Xstrata began acquiring com- panies, but not about the immense demand side,” Davis confides. “People said you’re mad, you’re overpaying, but I knew that, at some point in time, the market had to respond to the tightness of supply, which is still with us right now,” he says.
While there has been a supplier response, Davis points out that it can take up to seven years to turn a large mine to full account. “We are now in the stage of people trying to respond and in my view it is going to take years,” he says.
However, has never argued that the current high price levels are sustainable. But what he does postulate is that prices will remain “higher than the long-term averages” for a “reasonably long period of time”, owing to the time it will take for supply to catch up with demand “on a sustained basis”.
Astoundingly, he says that current risk is on the supply side. This is because mining operations are being run “at 110%” to optimise production, which means that there is little scope for breakdown. “The smallest event in the operation means a curtailment of production. That is the scenario,” he says.
While he believes that nobody should labour under the delusion that the price buoyancy will last for ever, or that some prices, even in today’s terms, will be sustained, he is adamant that they will “certainly remain for quite a long period of time above long-term averages”, and that those long-term averages will ultimately reflect the long-on cost of production.
Which leads to the question of what has happened to costs in this period. “There is no doubt that operating costs have step-changed up. If you follow any of the mining companies, you will see that there has been a dramatic impact on their cost base. There has also been a step change in the cost of establishing mines. The long-on costs of production have undergone a step change and thus our notion that long-on prices are different to what they were before this phenomenon started and that people have to set their long-term price assumptions at high levels,” he says.
But is the diversified mining model efficient in such buoyant circumstances?
Xstrata, like BHP Billiton, Anglo American and Rio Tinto, espouses the diversified model, mining chrome, coal, vanadium and platinum in South Africa and copper, zinc and nickel globally. Is such a model not more appropriate for commodity downturns? Would it not be more capital efficient to provide a range of single-commodity opportunities for investors, who are increasingly against commodities being packaged for them?
Davis remains a firm believer in the diversified model. “First of all, commodity prices don’t all rise and fall at the same time. Last year we had a slight fall off in chrome and vanadium prices, but we had a rise in nickel prices, even though both metals supply the same stainless-steel market. Coal was slightly weaker last year, but up this year, which is where the diversified model comes in, to dampen the vola- tility of all this, which is very positive.
“The second point is that a single-commodity producer has no option other than to invest his cash flow in building more mines – or sending it back to shareholders. But you find me a management team that wants to send money back to shareholders every year, which means that there is a high likelihood of single-commodity mining companies investing inappropriately,” he says. By contrast, the diversified model develops a whole range of opportunities and can manage cash flows across those opportunities. “Quite honestly, there is no way in the world that a fund manager can replicate the range of asset investment at the same quality of management. Yes, you can company pick, each with a different quality of assets, management and options, but the fund manager won’t be able to replicate what the diversified manager is able to do,” Davis insists.
But is there a limit, then, to the extent of diversification?
Of no-go areas, he says: “We don’t focus in on gold as a primary commodity to be in and there may be some countries at a point in time that we wouldn’t want to invest in because we don’t believe that we can manage the risks associated with operating there. But beyond that, I don’t actually think that there is a limit to diversification,” he says.
“You should have a very clearest of criteria of what creates value for shareholders and thereafter be able to respond very quickly to opportunities. We don’t think that investing in very small markets where he only way we can build up a business is to dominate that market and become the market. Although it sounds an interesting position to be in, when that happens, rival investors hold on to your coattails when the market is bullish and take market share away from you. When the market begins to depress, the dominant company is saddled with the job of cutting prices to keep the market solvent,” he says.
What is the value of Xstrata’s South African investment?
“It’s between R25-billion and R30-billion. Since 2005, we have been in a substantial expansion phase, firstly in chrome and soon in coal. From 2005 – when we started the R1,67-billion Lion ferrochrome project – to 2009, Xstrata will have invested R6-billion-plus in chrome and the Goedgevonden coal project, which is at a rate of R1,5-billion a year. This speaks volumes for our willingness to invest in South Africa in the right conditions of certainty, fair play and integrity in the system. If we have those three, there is no reason why investments cannot be made in decent opportunities,” he says.
Do you have that certainty, fair play and systemic integrity?
“We wouldn’t be making these investments if we didn’t. But, given the history and the huge potential that exists for misunder- standings off of the perspective of history, we are all prisoners of our past and we all define our relationships with others by virtue of that past. In South Africa there is still a huge potential for people to mis-understand the motivations of other people. Both the industry and the Department of Minerals and Energy (DME) have to work very hard to make sure that we don’t misunderstand one another. When somebody has a disagreement, nobody should automatically assume that the one party is out to screw the other party. People are entitled to disagree and we should work hard to understand the real motives behind what people are doing. The system itself has to have integrity, be objective and be transparent and that requires both the DME and the industry itself to behave in that way. Provided those elements are in place, there is no reason why you can’t have a very good relationship. At the end of the day we all want to see the development of the mineral potential of South Africa. The issue of having empowerment partners is not an impediment. We have local partners in many places around the world and having an empower- ment partner is like having local partner. The sooner the DME and the industry can move through this phase of new-order rights, the better it will be for everyone. We need to ensure that the climate prevails where entrepreneurs and people of capital are inclined to want to invest their money in South Africa. As a South African, I feel immensely proud that the trans-ition has taken place since 1994, but then I am equally concerned about the level of crime and the remaining income distortions, the need to invest more in education and achieve greater reach and delivery in healthcare. Xstrata will this year invest R100-million to develop communities around its mines and another R103-million to develop skills,” he says.
What is your view of the upcoming Royalties Bill?
“I think that the Royalties Bill is very unfortunate. Royalties are just another form of tax and I don’t understand why an additional tax burden should be introduced. We had a tax system that worked and I think it is very unfortunate, but South Africa is not alone in doing things like this. There are many other countries that do it and I will say the same about them. If everything is defined upfront it is fine. For instance, in Peru, with Las Bambas, we have negotiated a royalty and we have no problem in doing that. We are not against the principle of paying royalties, but when you have bought something and built something on the basis of a tax regime, then over and above that tax regime, a royalty is imposed, I think that is very unfortunate, because that does not create certainty. Once you have established a royalty, then the rate of that royalty can change – just like that – and so there is uncertainty. While I am sure corporate tax rates could change as well, tax systems tend to have a certain stability inherent in them. So I don’t understand the need for this royalty. I was totally in favour, personally, of striving towards the empowerment objectives and, as Xstrata, we did our best to meet those in a very productive and cooperative way. But I am equally opposed to the introduction of royalties. This exogenous tax that comes in after the event is not good for business and quite honestly nobody signalled to me in the past that there was a lack of tax off-take from the industry into the revenue coffers. But it is there and we will live with it,” he says.
And what of windfall tax?
“I think it is crazy that we build in things like windfall tax. When the industry suffers nobody comes back and says give them a windfall subvention. Nobody says here is a windfall subsidy for the industry that is making losses. During the periods when we have lost money, I haven’t, in any geography, witnessed any government saying, sorry chaps, here is a subsidy. It must be recog-nised that mining is a cyclical industry and, yes, it is doing well now, but it makes its profits and it pays taxes on those. Windfall tax does not do certainty and the system any good. It is great to meet short-term objectives and sometimes it is great for meeting political objectives, and again other countries around the world are tempted to introduce it. Gordon Brown did it with North Sea oil. There are many precedents for it. But is it a good thing? Absolutely, not. I hope that more measured heads prevail over this issue,” he says.
Do you see opportunities for more investment?
“Project Lion is the first of potentially three phases. If the chrome market grows sufficiently, we will expand the Lion Project into phase two and phase three and there are opportunities further down the line in the coal business. We are interested in platinum as a commodity, which we are only in tangentially in a joint venture with Anglo Platinum, at Mototolo, and we would like to expand that and clearly South Africa is the home of platinum resources. Mototolo is linked to Xstrata’s chrome reserve up-dip and Anglo Platinum had an extension of a reserve down-dip. It would have been very expensive for Anglo Platinum to initiate the mine, but not expensive if we initiated our mine. Our reserve wasn’t large enough on its own and their reserve was too expensive. Economic viability was reached in allowing Xstrata to deploy its low-cost mechanised mining techniques and Anglo Platinum to build and run the concentrator plant. Essentially we get our share of the UG2 “waste”, which is effectively feed for our chrome plant, and we buy Anglo’s 50%. Anglo processes the platinum group metals (pgms) and we get our share of the pgm content. It is a very virtuous joint venture and shows you that mining companies can cooperate for the greater good. By that cooperation, we created the viability of two significant reserves, which, in themselves, were going to be quite difficult to bring to fruition from an economic perspective. We are not only mining those reserves, but also beneficiating the ore from them by producing ferro-chrome from them. Lion is our base producer now and the beauty of its Premus technology is that it reduces dependence on power and reductants. We are getting to a situation of bringing back all our furnaces. Demand has picked up quite significantly this year and demand for ferrochrome from China is up fourfold. The economics of China beneficiating ore has moved in favour of imports,” he says.
How is Xstrata advancing transformation in South Africa?
“Even before the change to South Africa’s minerals legislation, which made transformation an imperative, we have been very concerned about moving away from single-sex hostels. We saw them as major contributors to the breaking up of families and therefore society and contributors to Aids and the pro- liferation of HIV. We have invested a lot of time in trying to get people into their own homes and living with their families and we have been very successful in doing that. For a long time we have also been investing in the communities and in education and again we continue doing that. My view on transformation is that it is untenable as a general pro- position that the majority of people in the country don’t have the ownership and managerial access that drives economic growth. Clearly that is wrong and is unsustainable and one can understand why the government felt the need to intervene. But, as we have gone along that way, mistakes have been made in how that has been done and that has caused people to be concerned. By and large, I don’t think anyone can disagree with the process of trying to readdress imbalances and that is why we have cooperated with that. We have achieved our black economic empowerment (BEE) objectives in quite a painless way (with Merafe, ARM and Kagiso). We set up a transformation committee that I chaired. We didn’t rush into BEE transactions. We wanted long-term partners who could bring some capital to the table. We weren’t shy in assisting them with financing, but we wanted them to also make a commitment. We wanted a business case to exist for BEE, because that would make it sustainable. If we look at historically disadvantaged South Africans in managerial positions, we are somewhere between 28% and 38%, depending on whether or not you should include white women, which is far off where it should be, but a lot better than where it was five years ago. We have seen the unfortunate phenomenon of a chase for this managerial capacity as it emerges and matures. It is almost like when you have ten golf courses and nine green-keepers. There are ever-spiralling salaries, which is a danger. People should invest time in jobs because it is only through experience that you become effective. Forty-two percent of our procurement is done through BEE companies and our target for this year is to get that up to 50%. We have been very happy in doing that and our managerial team has found that to be a rewarding experience. From that point of view it hasn’t phased us. But the issue of consistency and integrity in the system of conversions is obviously important and I am comfortable with where we are at the moment.
Are you looking for opportunities in Africa?
“Everybody has to look in Africa, which is rich with mineralogy and prospective. It is very challenging geography. The political risks are high and there are issues of security of tenure and living with wars, which is why Africa has not seen any significant mining investment since the mid-Sixties. Juniors play a very important role in greenfields exploration and were use juniors a lot in high-risk preparatory explor-ation. We have a very philosophical view on where we can add value and where juniors can add value, but there are many known deposits in Africa that are clearly going to become more interesting to the majors, as companies become more comfortable with managing the risks. Everybody has noted the aggressive way in which China Incorporated is attempting to establish a foothold in Africa. That, I have to tell you, is another hurdle. What mining companies do best is buying and getting a lease on reserves, mining in the most effective way possible, investing in the communities around the mines, generating revenue and paying tax. That is a model that has served most major mining regions around the world, in Australia, South Africa and South America. We have the potential in Africa for a different model to be established with a concerted effort by a country to establish a foothold and I am not sure that on that basis the Chinese can do what major mining companies have proved they can. That is a challenge both for us and the governments of Africa in terms of what they believe will be the best value-add for their communities. I still think that the way mining companies do it is best, but then I am talking my own book,” he says.
What of power adequacy for your operations?
“The power shortages in this country are a very significant issue. In the discussions I had with the authorities six years ago, I signalled to them that I thought (he is a former executive director of Eskom) that the issue of returning the mothballed power stations to service was not the correct solution because they represent very old technology and are expensive to run and they are fundamentally challenging. For the benefit of the system, I expressed the view that they should build new power stations rather than try to bring back the mothballed power stations. But returning old stations to service is what is being done and, in the next three years, I hope that we will be able to muddle through, but I think that it is going to be very tough. Clearly major power users can play a role in assisting in the management of the demand load and we will be working with Eskom to do anything we can to ensure that the system is kept as strain free as possible. We have load-shedding agreements, we have had to shed load and we view this as a partnership to make sure that we don’t end up in any crisis,” he says.
As an acquirer of note, do you see opportunities arising from Anglo American plc’s disposal of assets?
“All I have seen is Anglo making a decision to dispose of some non-core assets and these are not assets that are of interest to us. Anglo American remains one of the premier mining companies in the world and, if there is anything we can do with Anglo to create value for both sets of shareholders, we clearly would. We have joint ventures with Anglo American and BHP Billiton in Colombia and we have a joint venture with Anglo in copper at Collahuasi in Chile and a joint venture with BHP Billiton on the Douglas-Middelburg coal project in South Africa. Joint ventures are common place in the industry,” he says.
Is the pace of corporate activity hotting up?
“It has been hot for some time and there has been a lot of consolidation taking place. It is too early to see whether it is going to settle down or not, but there are always opportunities,” he says.
Edited by: Liezel Hill |
