Will the good times continue for the mining sector?
Following the recent round of company reporting, the numbers confirm that the mining sector is quickly rebounding from the lows of early 2016. Iron ore miner, Fortescue metals (FMG), was in a very sticky situation in early 2016 with a multi-year low in the iron ore price and high debt. The situation was so bad that the company was even at risk of insolvency. BHP Billiton (BHP), the largest mining company in the world had many problems of its own, not least of which was the failure of a tailings dam in Brazil that destroyed a large area and caused numerous casualties. The share price responded accordingly, falling to levels not seen since the early 2000’s. Finally, Rio Tinto (RIO), like many other miners, had a large amount of debt and severely restricted cash flow with which to pay interest. The slump in commodity prices didn’t just affect the miners, it also impacted related mining service companies, such as Monadelphous (MND), whose share prices fell as quickly as the miner’s.
In order to stay in business, most miners cut dividends and implemented cost saving programs to reduces expenses. FMG was perhaps one of the most successful companies in this regard, managing to reduce cash costs per tonne to just $12.50 compared to an amount well over $20 in the March quarter of 2014. BHP cut its dividend drastically from around $1.68 per share in 2015 to just $0.40 in 2016 in order to save cash. This was a significant departure from BHP’s steadily increasing dividends over the prior several years and it contributed to strong pessimism in the market regarding the prospects of all mining companies.
What a difference a year makes. Reading the half yearly reports just released by these same companies, they are now flush with cash and are using it to aggressively pay down debt. BHP reported a rise in profit to US$3.2bn from just US$412m in the prior corresponding period and cash flow was a whopping US$5.8bn. BHP was able to settle claims relating to the Samarco Dam disaster for a cost of $2.2bn, not a small cost but manageable for BHP.
FMG is also reaping the benefits of its cost saving program as its margins skyrocket due to lower costs and higher realised iron ore prices. The FMG share price is now up over four-fold and talk of insolvency a distant memory. The share price rise has been so strong and consistent that it is currently the highest momentum stock in the Rivkin momentum portfolio where it has been since June of 2016.
Like the saying, a rising tide lifts all boats, the mining services companies have also rebounded from their lows. Although revenue for many of these companies for the recent half hasn’t climbed off the lows, optimism for the future pipeline of work is driving share price gains and there is a noticeable change is sentiment for these companies.
Whether or not the good times will continue for these companies mostly depends on the trajectory of commodity prices. Most miners would be very comfortable if prices stayed where they are without increasing any further however the increased production as a result of high prices will eventually put downward pressure on prices and again compress margins. If companies then respond by cutting production, the cycle will be complete and ready to start again. This is the, almost inevitable, cycle of the mining industry. Investors in this field certainly face higher than average volatility although this brings with it the potential for higher than average returns.
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