From McKinsey, November 2015:
Low equity prices may offer important M&A opportunities for the mining industry.
Where is the mining industry headed? Commodity prices are now far below their 2011 peaks—metallurgical coal by more than 70 percent, seaborne iron ore by more than 65 percent, and copper and gold by more than 30 percent—and the mining industry’s stock-market valuation has followed prices down. The big mining houses have been working hard on cutting costs, reducing capital expenditures, and boosting productivity. Still, the specter of a return to the bleak pre-China-boom period of sustained low profitability hangs over the industry.
Amidst this gloom, there is an alternative reading of the industry’s mid- to long-term prospects. Our commodity-by-commodity modeling suggests that stock-market sentiment may have overshot—once again. In many commodities, declining ore quality and limited accessibility of new deposits will squeeze supply in coming years, potentially driving a commodity-price rebound as global demand continues to rise. If lessons of previous cycles hold, mining equity prices could be expected to spike as well.
Such an outlook provides a moment of real opportunity. Growth is the big strategic conundrum in the mining sector. Exploration productivity has underperformed expectations for a full decade, project execution has been slow and costly, and government interventions to increase the take from new-project revenues has caused substantial slowdowns or outright withdrawal from prospective geographies. For mining leaders looking to grow or reposition their portfolios, current low equity prices could represent an important opportunity.
We do not know exactly when the mining sector will rebound, and our analysis suggests the outlook is not equally rosy for all commodities, but the recent sparks of M&A interest indicate that some industry participants have a similar view and suggest that more of this kind of activity is likely as bid-ask spreads narrow.
Building a picture of the industry’s prospects
Equity prices are down . . .
The metals and mining industry has a history of large swings in capital-market performance (Exhibit 1). From 1973 to 2000, industry total returns to shareholders (TRS) were low—below cost of capital in many years—and volatility was high.
This pattern changed dramatically in the first decade of the new millennium, the China-driven “supercycle.” TRS doubled, while volatility increased further. From 2012 onward, however, slower demand growth in China has triggered a steep fall in the mining industry’s TRS.
Mining and steel depart from comparable capital-intensive peers, overperforming in the boom periods and underperforming at other times, but always with substantially higher volatility than these other sectors.
Valuing cyclical companies is challenging, because swings in product price radically affect profitability.1 The mining sector is no exception; extreme commodity-price movements during the supercycle have made the sector very difficult to value. As a result, the market heavily weights the short term, and equity prices largely track commodity prices. Indeed, our analysis shows that the correlation between the two is significantly higher for mining companies than for similarly capital-intensive industries, such as oil and gas (Exhibit 2).
. . . but demand and production continue to grow