Can commodity producers resist the temptations of the up-cycle?

ANYTIME you hear the mantra “this time it will be different,” it’s probably best to assume the same old cycle will repeat itself.

This is especially true for commodity producers, who often appear to lurch from boom to bust and back to boom with little regard for learning from past mistakes.

Perhaps this is because commodity cycles can take decades to play out, meaning institutional memory is lost over time, allowing executives to repeat the mistakes of their predecessors.

But more likely it’s because most chief executives in listed commodity majors are either forced by investors to be seen doing something to boost growth, or by nature are driven to build and buy new mines.

The strong gains in many commodity prices last year, including a doubling of iron ore and coal, have given rise to optimism within the industry that the down cycle in commodities is finally over after five long years of falling prices.

Assuming this optimism is justified and prices are at the start of new up-cycle, how should commodity producers respond? In the down cycle that started in 2011 most companies responded by cutting costs to the bone and curtailing exploration, while also boosting output to lower the outlay per unit produced.

This did lead to a dramatic lowering of the cost curve, but the tactics also likely deepened price declines as they resulted in more lowcost supply reaching well-supplied markets iron ore, coal, aluminium and crude oil being good examples.

If we are at the start of a new cycle of stronger commodity prices, the prudent thing for companies to do is to remain focused on costs, while also paring debt and steering exploration spending towards markets with the best long-term prospects for supply constraints or strong demand growth.

Global consultancy Deloitte captured the essence of the challenges in its “Tracking the Trends” mining report earlier this month, with the top issue being how companies should focus on “understanding the drivers of shareholder value.”

The report said mining companies delivered poor total shareholder returns (TSR) in the period of falling prices from 2011 to 2015, in contrast to strong returns in the earlier period of higher prices and significant investment.

While this seems obvious at first glance, Deloitte said the main issue is that miners shouldn’t rely on rising prices to boost shareholder value.

“There are numerous levers and metrics management can use to influence TSR, such as costs, gearing, capex and portfolio composition,” the report said.

“However, to generate greater value to shareholders by improving return on invested capital and return on equity, miners must exercise financial discipline.” Put another way, commodity producers should resist the temptation to embark on an open chequebook approach to new projects just because they are now generating large cash returns as higher prices boost revenues.

Reasons for optimism

So far the signs are somewhat encouraging, with major miners expressing caution in their recent results presentation.

Top miners BHP Billiton, Rio Tinto and Anglo American all committed to boosting shareholder returns through higher dividends, and in Anglo’s case by reinstating dividends.

They also all committed to using their extra cash to pay down debt and maintaining a focus on keeping operating costs low.

Perhaps this is because the company executives aren’t quite yet convinced about the sustainability of the current rally in prices, but it’s also to be hoped that this generation of leadership can resist the temptations of embarking on marquee projects or overly-ambitious M&A deals.

The main risk is that the longer the price rally does go on, the greater the pressure will become from equity analysts for plans to boost growth over the longer term, a situation that in the past has resulted in massive commitments of capital that has not delivered its promised returns.

BHP’s shares trading in Sydney have rallied strongly recently, gaining 82% from the post-2008 recession low of A$14.21 reached in January 2016 to Wednesday’s close of A$25.78.

But even with these gains, the shares are still more than 40% below the April 2011 peak of A$44.89, hit just as commodity prices started their extended losing run.

What this shows is that there is still some way to go for BHP to deliver the returns to shareholders promised by the billions of dollars spent boosting its production of top earners such as iron ore and crude oil, if you use the share price as the main method of judging the success of management.

While I am always wary of saying this time it will be different, there are some good reasons as to why this might be the case.

Firstly, the massive spur in investment that helped drive the oversupply of commodities and the resulting declining prices doesn’t really exist anymore.

Much of the optimism behind the last investment boom was that China would simply buy everything that commodity companies could produce.

While China remains the world’s top commodities importer, it’s become apparent that its appetite isn’t unlimited, even though there are still areas of robust demand growth, such as in crude oil.

This alone should make companies more wary of re-starting an investment cycle, but it’s also worth noting that the current chief executives of most of the top miners tend to be more focused on operating rather than building.

For example, BHP’s current boss Andrew Mackenzie sounds very different from predecessors like Marius Kloppers and Brian Gilbertson, and not just because of his Scottish accent.

Mackenzie tends to focus on BHP’s achievements in driving down costs and running operations as efficiently as possible, while Kloppers and Gilbertson liked to talk about deals and building new mines.

Yes, the times have changed, but at this stage of the cycle where cautious optimism abounds, it’s probably better to have an operator rather than a deal-maker in charge. — Reuters

# At the time of publication Clyde Russell owned shares in Rio Tinto and BHP Billiton as an investor in a fund.