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Legacy of the supercycle

Mike Elliott, EY Global Mining & Metals Leader

Congreso Nacional de Minería, Abril 2015

Cartagena, Colombia

Legacy of the supercycle – Mike Elliott

Overview

► What was the supercycle?

► Products of the supercycle

► What are implications of the supercycle?


What was the supercycle?


Supercycle: a sustained period of rising demand and prices

► The supercycle was steeper, bigger and longer than normal cycles

► Driven by China and other rapid-growth economies and under-investment in 1990s

► Supply was always chasing demand

► But has the mining supercycle ended?

► Analysts remain divided over the end of supercycle

► The supercycle is likely to continue, or is it just less super?


Legacy of mining supercycle: need for reassessing profitable growth strategy in the post-boom period

► The global financial crisis caught companies overinvested - growing for the sake of growth

► The supercycle fundamentally changed the sector and intensified risks

► Miners need to learn from mistakes and reformulate their strategies

► How to exit the supercycle?

Source: EIU Annual data from 413 companies with more than 100 employees from mining and associated industries


Reasons for optimism: continued Chinese growth with ongoing urbanization

83

132 129

66

130 145

164

23%

30%

22%

9%

17% 16% 16%

0%

5%

10%

15%

20%

25%

30%

35%

0

20

40

60

80

100

120

140

160

180

2009 2010 2011 2012 2013 2014 2015

%

00

0 t

Chinese nickel demand growth

Demand increase in absolute volume % Demand increase

► Even if Chinese growth slows, demand is off a bigger base

► China is 50% urbanized right now and 65% in 2025

► About 2/3rd as much of Chinese already urbanized during the last decade will do so over the next decade


Reasons for optimism: higher energy intensity in extraction

► Energy use by mining continues to increase

► Drivers: deeper and more complex mines and lower grades

► Desalination operations in dry regions are especially energy-intensive


Reasons for optimism: higher energy intensity in extraction


Products of the supercycle


Products of the mining supercycle

1. Ongoing commodity price volatility

2. Focus on return on capital employed (ROCE)

3. Margin recovery – through productivity

4. Margin recovery – through sales and marketing

5. Higher resource nationalism

6. Greater community demands

7. Greater product substitution


Imbalance in the demand/supply equilibrium has led to higher volatility in commodity prices

Source: EY Analysis; Thomson Datastream

Price volatility: the violence of the exit from the supercycle

will see an ongoing period of volatility

0%

5%

10%

15%

20%

25%

30%

Gold Oil Copper Platinum Aluminium Iron ore Nickel

Annualized volatility in commodity prices (1H 2014) Driving volatility in the market

• Exiting the supercycle

• Commodities as an asset class Increased

regulation

• Divergent central bank policies

• Geopolitical risk

• Provision of credit to traders

• Banks withdrawing from commodity markets

Volatility will continue for years to come, and mining and metals

companies must learn how to transact and invest in volatility

1


Commodity volatility challenges confidence in planning business models

► Increased volatility = increased decision risk

► Forecast ranges are wider and more conservative

Source: Thomson Datastream, EY analysis

1

12.000 13.000 14.000 15.000 16.000 17.000 18.000 19.000 20.000 21.000 22.000

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LME-

Nic

kel C

ash

US$

/t

Annual nickel spot price volatility

44%

41%

58%


► How to invest

► Role of hedging

► Trading = revenue enhancement

► Flexibility of operations

What to do with volatility?

1


Measuring growth and returns

► Supercycle generation

► Expectations of semi-permanent growth exceeding

demand

► Heavy investment in projects

► Eight of the top 10 mining companies saw leadership

changes mostly based on past

► Impact on available capital and sector trust

2


Measuring growth and returns: what has changed?

Supercycle metrics

► Production growth

► Revenue replacement

► Expansionary capex

► Lazy balance sheets

► Rerating projects through M&A

Post-supercycle metrics

► ROCE

► Free cash flow

Return = ↓ Cost ↑ Productivity

Capital employed = Capital discipline

For instance: Anglo American 2016 plan

• Miners are defining and measuring

goals in terms of ROCE

• Projects are being planned and

monitored to deliver desired results

2


“Effective capital allocation is a continuous cycle of review and action that informs

strategy and impacts all areas of the business. The capital discipline lessons of

recent history must stay front of mind, regardless of where the industry sits in the

cycle.”

Optimization

Best-in-class

portfolio review

Management

Flexibility

Creativity

Responsible,

disciplined growth

Innovation

Growth

Focus on ROCE: increased focus on productivity and

smarter capital allocation 2


Focus on ROCE: Efficient capital project execution is decisive for ensuring long-term profitability

2

Record US$791b of investment

currently in the pipeline

69% are facing

cost overruns

50% are

reporting

schedule

delays

• Pressure to deliver

• Planning to avoid failure

142

127

108 96

81

63

2012 2013 2014 2015 2016 2017

Global yearly mining investment

forecast (US$b)

Source: "Riding The Rising Tide of Global Growth," Deutsche Bank research, 19

February 2014, via Thomson One


Margin recovery: increased focus on productivity

Focus on production growth at any cost during the supercycle meant

diminished focus on productivity, which has been on the decline since 2000

Productivity transformation: A long-term view

3


Margin recovery: sales and marketing

► Sales and marketing offers significant value for little investment

► Exploiting option value from volatility

► Converging producer/trader model

► “For a handful of skilled companies, commercial excellence has delivered EBIT margin

increases of as much as 8 percentage points” - McKinsey

4

Source: McKinsey


Fallacies raised by miners

► We sell at spot, so no need to market

► If true, traders would make not profits

► Our competitive advantage is mine operations

► But are they producing what, where and when the market is buying?

► We already price our products at a premium

► Tactical marketing only captures modest upside

► The end of long-term contracts removes the need to invest in

customer relationships

► Understanding “value in use” is key to identifying capacity for premiums

4


Increase in resource nationalism

Trends in numbers

US$12.5b & US$6.5b

World Bank projected impact on net trade loss in

fiscal revenue for Indonesia between 2014 and 2017,

respectively

Expected annual impact on South Korea’s coal

imports following the introduction of a coal

import tax

Fall by 3% to 5%

45.5% Fall in production in chrome the year after the

introduction of an export ban in Zimbabwe

Mandated beneficiation Indonesia, South Africa and

Zimbabwe

Use it or lose it Jamaica, Indonesia, Bolivia

State ownership South Africa

Seeking Trends

Higher value-add

Higher employment

Earlier or

uninterrupted cash

flow

More participation in

upside

• Perception of super profits saw resources nationalism become supersized

• Cannot return to pre-supercycle levels

• Threat to investment

5


The trends in trading

Producer/Traders

(e.g., Glencore)

Producer

(e.g., BHP Billiton)

Banks

(e.g., Morgan

Stanley)

Asset heavy Asset light

Value

heavy

Value

light

Traders

(e.g.,

Trafigura)


Greater community demands: the new reality

Economic

► Two-speed economy with uneven wealth creation and insufficient job creation

► Skills shortages

► Prosperity exceeds inflated costs

Social

► Housing availability/affordability

► Managing a FIFO workforce

► Compensation for a loss of a way of life

Environmental

► Land-use conflict

► Water

► Cumulative impacts of multiple mining operations

6


With empowered local community, gaining social license to operate is more challenging than ever

Even in a capital constrained environment this is an area requiring continued

up-front investment. Lack of investment now will result in possible

irrecoverable project loss or delay.

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Revenue Capex Payments to stakeholders

Revenue, capex and payments of top mining companies

While the mining boom has peaked, expectations have not

6


Drivers of

substitution Environmental

concerns

Products with low profit margins and less dependence

on quality and performance

Environmental concerns

Advances in technology

Reduction in dependence on

imported material

Products with low-profit margins and less

dependence on quality and performance

Regulatory change

Market drivers

Monitoring the drivers of substitution is an early-warning system

Greater product substitution 7


Substitution hits hard

… and single-commodity companies will be hardest hit

Loss of

markets Challenges to

business

continuity

Value in long-

term assets

will erode

Increased

acceptance of

risk

R&D costs

Lower prices

Greater product substitution 7


What are implications of the supercycle?


What needs to be done?

►Transform business models

►Embrace volatility

►Reset metrics for long-term success

►Redefine how governments and communities benefit

►Invest in downstream R&D


Realtime insights

Connect with us

@EY_MiningMetals

@MikeonMining

linkd.in/15wlTox

ey.com/mining

[email protected]

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About EY’s Global Mining & Metals Center

With a volatile outlook for mining and metals, the global sector is focused on cost

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