Inflationary pressure on the global mining industry - Transcript

Michael Hall:

Welcome to the Industries in Motion Podcast from RBC Capital Markets, where we'll be exploring what's new and what's next in today's fast moving markets and industries, to help you stay ahead of the curve. Please listen to the end of this podcast for important disclosures. I'm Michael Hall, head of European research here at RBC Capital Markets in London, and today I'm joined by Tyler Broda.

Michael Hall:

Tyler's nearly 19 years experience working across major banks, both in banking positions, but in sales. And for the last nine years, he's actually headed up the European research team, focusing on the metals and mining sector. And Tyler, you recently published a report outlining inflation and how that's impacting or likely to impact the cost outlook for the mining sector. Can I ask you to kick off actually what inspired you to write that note?

Tyler Broda:

Yeah. Thanks. Thanks Mike for having me. The Anglo-American, when they came out with their cost guidance recently, there was a big uplift in its cost for 2022, and that's absolutely fine. It's an inflationary environment, we expect that to be happening. What then happened is as updating the model, I realized that, well, actually our 2023 costs are lower now and 2024 is even lower than that.

Tyler Broda:

And you start to realize that the numbers, when you go through an inflationary environment, you reach that point where you move to inflation. It really does cause a pivot in terms of your sort of expectations. It is very hard to model cost for the diversified minors. You've got so many different variant assets that have different cost profiles. A big open pit would be very heavy in diesel. Underground mine would be very heavy in labor.

Tyler Broda:

So it all really depends on where the mine is, et cetera. So it makes it very hard in aggregate to model, which I think leaves consensus and us basically hugging towards sort of medium term guidance. But that's all historical now, and we're in a much different environment. And so after we changed our changes for Anglo-American, which saw us raise costs for the next couple of years, I was expecting to see more downgrades come through and they didn't, which led us to doing the work around this note where we basically took a look at all of the company's cost profiles in consensus.

Tyler Broda:

And each one of the big five major diversified minors that we cover sees a declining cost profile over the next five years, which in today's environment with CPI running at 8% and the inflationary forces facing industries from energy or labor being potentially higher than that, this leads to quite a large disconnect. We didn't even look as well in this note at the implications for capital expenditure, but there would be a lot of the same forces impacting there.

Michael Hall:

Okay, interesting. So we're basically resetting 10 years of lower cost base and cost cutting into a different environment. And elaborating on that then, how is this inflationary period different from other cycles?

Tyler Broda:

Yeah, in the note, we took a look as well at the historical inflation since 2002 in the space. And it was actually quite interesting to look at the inflation we saw in 2006 through 2008, where it reached up to 40% year over year on a unit basis. And that's actually even higher when you think about how much production was being delivered from a growth perspective over that time.

Tyler Broda:

We don't have that this time. The mining companies in the last six, seven years have been under investing and holding back giving back capital instead of investing that, which means that this inflation potentially could be even more impactful. And I think as well, this inflationary environment, following 10 years of easy monetary policy, and then the build up sort of tension leads to potentially us being in a more inflationary environment than that pre-global financial crisis period, which is quite worrying when you look at where the cost based forecasts are for the space.

Tyler Broda:

We also went through a phase in 2012 through 2017 where you largely saw deflation come through. And that is something that we think could potentially happen again over time. But at this point, what that's done is effectively reset everything lower into what is, we think potentially, unrealistic expectations and costs.

Michael Hall:

Okay. Actually sounds relatively daunting and scary. Where could we actually be wrong? Where could the benign effects be more benign than we're expecting?

Tyler Broda:

Well, I think that there is an element that companies could push through more technological savings. There are some innovations coming through, but I think actually that this might actually be a better outcome than the other side, which would be most of the time, we've seen in the past, big periods of inflation has been followed by the periods of deflation.

Tyler Broda:

And the reason for that is, is that the inflation tends to happen late cycle. So it's actually an economic decline, which we are potentially seeing the start of right now that is potentially going to usher in maybe a scenario where we are wrong on inflation. But unfortunately, that would lead to a much bigger compression in the margins would actually be a worse outcome for the equities. So it does leave us in a relatively cautious position in the short term.

Michael Hall:

Okay. And thinking about the pricing side, if you've got inflation going up, and this is the commodity prices, why wouldn't higher cost higher inflation support higher commodity prices then?

Tyler Broda:

And normally it does. I think there's a couple of things to mention on this, as to why the support may not be there the same as in history. In theory, in a commodity, if you're priced to the top end of the cost curve and then inflation starts to move higher, then the prices need to move up to keep that supply on line. What we've had, especially since the response to COVID and all of the liquidity in the markets we've pushed up, and it was in a recent note, but we've pushed up to being trading for commodities somewhere around 120% to 160% off the top end of the cost curve.

Tyler Broda:

So unfortunately, there's a bit of a catch up happening here whereby the commodity prices of the mind commodities have moved up higher, but with energy catching up, that means the inflation is going to backfill behind it. But unfortunately, because we're so far off that cost support, there's a lot of room for cost to go up before it starts supporting the prices, at least from the current levels.

Michael Hall:

Okay. I understand. So look, it's not our remit to talk about individual stocks here, but at a sector level, you are portraying strong high margins revenues at risk, potentially, from a deteriorating demand environment. That's not what we're forecasting, but that's the potential. And obviously the scope for costs and CapEx, cost from the P&L, CapEx and the cash flow to go up. What does that mean from a sector view?

Tyler Broda:

Well, I think that's why we've moved increasingly cautious as the year has gone on. In the note as well, there's a chart showing the historical EBITDA margin. Because oil prices lagged in 2020 and 2021, we saw the margins for the minors go up, the revenues go up faster than their costs went up. And that's led to a point where we're at 54% EBITDA margin in 2021.

Tyler Broda:

The average over the last 20 years has been about 38% across the sector. What that means is, is that we are potentially at peak margins, and consensus actually has the margins coming back. The problem we would see is that might happen a lot faster if costs need to be adjusted as part of this process. There's also the fact that we've seen the equities perform as well as they have. You've seen the balance sheets getting fixed.

Tyler Broda:

You've seen the companies increase their business capabilities, dividends have gone up. All these things though have pushed the share prices up. And if you take a look at most of the share prices in the sector at the moment, they're up near their all time highs.

Tyler Broda:

And so we think that at this point, there's a very strong outlook for a lot of the sector in terms of things like de-carbonization, things like copper, some of the battery metals. There's going to be some very interesting times ahead of us, but at this point, we think just in terms of the ability for this sector to withstand a cyclical downturn into what we think is rising inflation is going to be very challenging.

Michael Hall:

Okay. Understood. Great. Thank you very much for your time. Tyler. Obviously, a sector we need to keep a close eye on over the coming months. What else lies ahead in today's ever evolving markets and industries? We'll be keeping track right here on Industries in Motion. Make sure you subscribe to Industries in Motion wherever you listen to your podcasts. Thank you for listening to today's episode.

Speaker 3:

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