Irontrax Mining Industry Insight (Winter 2015)

Industry Overview

In early December, the angst among energy and mining producers worsened again, as one of the industry’s largest companies cut its work force by nearly two-thirds and Chinese trade data amplified concerns about the country’s appetite for commodities.  The current outlook for commodities prices is shaky, with a number of forces battering the markets.  China, the world’s biggest buyer of commodities, has pulled back sharply during its economic slowdown.  Still, the world is dealing with gluts in oil, gas, copper and even some grains.  “The world of commodities has been turned upside down,” said Daniel Yergin, the energy historian and vice chairman of IHS, a consultant firm.  “Instead of tight supply and strong demand, we have tepid demand and oversupply and overcapacity for commodity production.  It’s the end of an era that is not going to come back soon.”  The pressure on prices has been significant.  Prices for iron ore, the crucial steelmaking ingredient, have fallen by about 40 percent this year.  The Brent crude oil benchmark is now struggling to stay around $40 a barrel, down from more than a $110 since the summer of 2014.

 

A number of commodity-related businesses have either declared bankruptcy or fallen behind in their debt payments.  Even more common are the cutbacks.  These developments stem from the fact that between 2000 and 2014, companies invested hundreds of billions of dollars to expand their production capacity to satisfy China in a period of rapid economic expansion and much of their growth was fueled by debt.  But the situation has proved unsustainable as demand has fallen off.  Chinese copper imports are down nearly 3 percent from last year, while imports of steel products are down by more than 12 percent.  The country’s crude oil and iron ore imports are still up, but by rates that are slowing from previous years.  The weakening Chinese demand is hurting prices while production is overwhelming markets.  In the following months, China will continue to be a key factor in the commodities equation.

Hot Topics

Oil-Price Recovery Not Anticipated Until 2017:  The International Energy Agency (IEA) expects oil prices to remain low through 2016, but forecasts a rebound to begin in 2017 as the current oil glut recedes and demand rises.  At a December news conference in Paris, Fatih Birol, the executive director of the IEA, stated “Looking to 2016, I see very few reasons why we can see growth in prices.”  He added, “I think 2016 will be a year where we will have a lower price environment.”  There is an abundance of oil in the current market and we have the potential for a further increase if sanctions against Iran are lifted they come to the market.  Oil prices have been struggling to maintain a level of $40 per barrel.  The price of the world benchmark, Brent crude, fell below $40 in December for the first time since the global economic crisis in early 2009.  At the same time, a barrel of the U.S. benchmark, West Texas Intermediate, was under $37.  Mild pre-winter weather that has reduced heating demand and a volatile U.S. stock market ahead of the widely expected interest rate hike that occurred in December has added to the reduction.

 

The low price of oil has led the energy industry to slash investments in drilling and exploration, which could result in a tighter supply.  Birol noted that oil companies have cut such spending by about 20 percent so far this year, and may spend even less in 2016.  Although 2016 may well be another year with lower prices and implications for investments in the oil sector, this spending decline, combined with continued growth in demand, according to Birol, could eventually lead to “some surprises” in pricing.  Birol stated, “We have never seen, in the last 30 years, two years in a row of oil investments declining, and this will have an impact on production in the next few years.”  In the meantime, Birol fears that a protracted period of low prices for oil, gas and coal, could inhibit the move to clean, renewable energy, especially in developing countries, which may prefer to generate electricity by burning cheap, toxic coal rather than turn to more expensive energy alternatives.  While Birol didn’t say how low he expects prices to go in 2017, he does expect oil to rebound, albeit probably slowly, to about $80 per barrel in the next several years, specifically because reduced investment by oil companies should constrict supply significantly.  He expects the reduced investment by oil companies to cut non-OPEC production by more than 600,000 barrels per day in 2016.  But after that, he said, “we would expect to see upward pressure on prices.”

 

Crisis in the Coal Industry  It’s been a terrible year for the coal industry, particularly in the U.S., where nose-diving prices and tougher proposed regulation have pushed a number of producers to seek bankruptcy protection.  The U.S. coal industry faces not just overcapacity but crippling liabilities that will outlive mine closures.  In a recent report, McKinsey and Company suggests the U.S. coal industry should get “smaller” and “healthier” to avoid an even worse 2016.  The reason for this, as simply put by the analysts in a report published last month, is that while the U.S. has plenty of coal, the world just “doesn’t need it”.  “By 2020, the convergence of low-cost shale-gas supply, environmental regulation, and waning international demand is likely to push demand for US coal to at least 20% below what US mines currently produce—which is already almost 20% below 2008 levels.”  Aligning supply with lower demand would require closures across all regions of the U.S. coal industry.  McKinsey’s projections suggest that roughly half the capacity of the Central Appalachian Basin, in the eastern U.S., could be in excess of demand.  Years of pressure from climate activists are taking a toll, as a growing number of banks are now pledging to cut financing to the industry.  Such actions, along with crippling debt, could potentially sink the coal industry.  The analysts believe that even if miners cut capacity to balance supply and demand in 2020, they still will be unable to service most of the industry’s approximately $70 billion of remaining debt and liabilities incurred over the years.

 

The U.S. coal industry is still in the early stages of what could be decades of financial difficulty.  Beyond the pain to stockholders, debt holders, and employees, the industry’s giant liabilities are crippling its maneuverability and will limit its flexibility to rationalize capacity.  The coal industry faces some hard choices.  While harsh capacity cuts are normally viewed as the tough but certain way an industry can turnaround, that is not the case for the U.S. coal industry.  McKinsey and Company believes it is likely that many US coal companies will continue in business-as-usual mode, hoping for a rebound in the domestic and export market, while others will follow their competitors into bankruptcy or wind up in liquidation.  

 

Iron Ore Industry Hurt by Falling Chinese Steel Demand:  The pain for iron ore producers is not expected to let up anytime soon, as China’s demand for steel continues to drop.  Early in December, the price of iron ore had declined for nine straight weeks, marking the worst losing streak for the steel-making commodity since 2008.  According to a Bloomberg posting on December 10, China’s purchasing managers’ index for the steel industry fell to 37 in November from 42 a month earlier; a number under 50 signals a contraction.  Meanwhile more steel is being held at ports.  According to Shanghai Steelhome Information Technology Co. holdings have risen more than 2 percent to 89.5 million tonnes.  Weak seasonal demand, which is contributing to the mills’ financial difficulties, is likely the reason for the decline in steel production.  No doubt that will reduce demand for iron ore.  Where ore prices go from here will also depend on supply from the Big Four.  Vale (NYSE:VALE), Rio Tinto (LON, NYSE, ASX:RIO) and BHP Billiton (NYSE, ASX:BHP) have all been following a largely successful strategy of raising output and slashing costs to weather low prices and push out competitors.  At the same time, the glut of steel in China due to lagging economic growth is creating conditions for a trade war.  According to industry group China Iron and Steel Association, between January and October Chinese steel consumption fell by nearly 6 percent to 590.47 million tonnes.  The decline in consumption is affecting producers’ bottom lines, with China’s steel companies shedding $11 billion in the first 10 months of the year.  As a result, Chinese steel mills are looking to dump their product on the open market, a strategy which is alarming to China’s steel competitors in Europe and the United States.  Analysts at investment bank UBS figure that this year China will produce 441 million tonnes more than it will consume.  The country currently produces around half of the world’s annual steel output.

 

Trends in Used Equipment Values

The trend in values for used mining equipment has changed drastically over the past 2 years.  As recent as May 2013, the global mining equipment industry expected to witness steady growth with an anticipated CAGR of 7.5% over the next five years.  In fact, global commodity markets have declined.  During 2015 alone, supply surpluses have led to 20 to 30 percent decreases in the prices of most major commodities.  As a result, many companies within the mining industry continue to restructure their operations or worse, file for bankruptcy.  According to a December 2015 article published in the New York Times, London-based Anglo American, the fifth largest mining company in the world, is cutting its workforce from 135,000 to 50,000, and at least seven American coal companies have declared bankruptcy during 2015.
The above developments have, in turn, had an adverse effect on both new and used equipment values and orders, as well as related strategies employed by equipment manufacturers such as Caterpillar.  Last September the company announced plans to reduce its workforce by 10,000 by 2018, while closing a number of factories.  It is currently difficult to predict when the declining market for used mining equipment will hit bottom.  In 2016, commodity prices are not expected to see any material improvement as current over-supplied conditions will continue to strain cash flows for most mining companies.  Supply curtailments along with improving demand in some markets could provide some relief.  However, with most mining companies’ cash flows under pressure, industry capital expenditures are now expected to decline nearly 20 percent.  While reductions in capital expenditures and continued efforts to curtail operating costs may provide some advantage to the market for used mining equipment, sales in general will continue to feel the ill effects of supply surpluses.

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