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Ernst & Young's Global Mining and Metals leader, Mike Elliot, discusses some of the key points found in the group's Business Risks Facing Metals and Mining for 2012 Report.
GEOFF CANDY: Welcome to this week's edition of Mineweb.com Metals Weekly podcast. Joining me on the line Mike Elliott - he is the Ernst & Young global mining and metals leader. Now Mike Ernst & Young has just released its Business Risks Facing Metals and Mining for 2012 Report and its interesting because almost out of nowhere resource nationalism suddenly reappeared I suppose on the radar about 18 months to two years ago. It was the biggest risk according to mining companies in the previous survey that you guys did. It's still number one although one gets the sense that the nature of it has changed somewhat.
MIKE ELLIOTT: That's correct and thanks for the opportunity again. What we're seeing is that resource nationalism has held its number one position because we've seen it become much broader, both in terms of geographical coverage, but also the nature of resource nationalism has changed. Geographical coverage - when we talked about this probably a year ago - we were talking about some 20 countries that had either announced or implemented changes to their mine taxes and royalties arrangements, whereas now that count is well over 30 and a number of those original 20 have even gone back for a second bite of the pie. What we've also seen is that it's not just about royalties and taxes now, during the year we saw an increasing trend around countries looking to increase the amount of value that they were seeking to retain out of the raw materials they were producing and therefore there's this increasing trend of requiring raw materials to be further processed in-country. And we've seen that in large countries like Indonesia, and it's also been promoted in countries such as South Africa and Brazil. Also it's taken the nature of limitations on foreign investment and again, Indonesia has been having its policies released earlier this year, where it's looking for no more than 49% after 10 years for foreign ownership of mining assets.
GEOFF CANDY: In terms of the rest of the list and I want to come back to resource nationalism issue in just a bit, but before we get there, what are the other risks that are highlighted?
MIKE ELLIOTT: Well one of the things we've seen overall is that the top five risks or so have been pretty comparable to what they were last year, but while they may be not changed relative to one another that much, they've increased overall in intensity. We've already mentioned what's happened with resource nationalism, but some of the capacity constraints that we're seeing which is impacting skills shortage to the pressures on expanding supply through new infrastructure that's required, these are still even more present now because they're pushing up against some of the historic infrastructure and skills capabilities and as the supply response starts to come onto the market now, we're pushing further up against those ceilings. So that's starting to bite. One that has actually come into those top four or five risks has actually been cost inflation and while that's been around for a number of years, it's not as high as what it's been this year. And as we've seen the softening of prices for metals and minerals, it's obviously put pressure on margins at the same time that mine based cost inflation, a lot of these currencies are still very, very strong currencies - they're putting pressure on costs, revenues softening, and so overall margins are being squeezed. This is causing companies very much to start looking at costs a lot more than some of their strategic priorities.
GEOFF CANDY: It's interesting, and coming back and linking that to the whole notion of resource nationalism, you talked about the fact that companies are wanting to beneficiate more in their own countries, and one gets the sense almost that there's a move - and this was noticeable particularly in the steel sector where you were seeing perhaps a lot more of a focus of building the mills next to the mines almost, that perhaps there's a trend emerging to almost have self-contained mining sectors that don't necessarily rely as much on moving the raw materials out of the host country. Is that not likely also to add cost pressures as well?
MIKE ELLIOTT: Absolutely and in fact it's challenging whether be it the mine or the beneficiation plant are being built at all, because if there was such a value in putting the beneficiation plants right next to the mine, then companies would already be doing that. If that was the lowest cost as far as return option, that's the choices that the market allocation of capital would actually achieve today. But it's not and those beneficiation plants are often placed where there may be access to particular skills of labour, access to energy, access to other inputs into the process, that's what's working most economically. So if government policy starts to require that to happen in a non-market sense, then they're lowering the overall rates of return of that vertically integrated supply chain and that makes investment that much harder to do. In the report we quoted an example there of when Indonesia announced its new policy changes, we've actually seen examples that we've been involved with where people who are prepared to invest in mining operations no longer made that investment because it came with the additional price tag of beneficiation and they just weren't prepared to commit that amount of capital into an operation in Indonesia.
GEOFF CANDY: And of course as well it comes down to skills if you're particularly focusing on one specific country. Either you have to have the skills in-country or you need to import them, and that comes with its own set of challenges as well.
MIKE ELLIOTT: Exactly and in an environment where part of what the skills shortage is... one of the reasons its increased, is that it's not just a problem for Western Australia or British Columbia now - it's becoming much more of a universal problem within the sector and while there may be national shortages which are focusing the problem increasingly we're going to be moving that towards global shortage of these particular skills and if skills are short on a global basis it's going to be even harder to require them to go into an area that's just looking to have these people operate because they're executing government policy rather than that's where you can generate the highest value.
GEOFF CANDY: Looking at the moves in the rankings, you mention cost inflation. It went from issue number eight to issue number four in this survey. Is there a sense that people are worried that this is a structural change that these cost bases have moved higher and are likely to stay higher long-term, or is this a blip almost, or something that's a fairly short-term concern?
MIKE ELLIOTT: Well I think there are two parts to that - on one sense there is an acknowledgement that broadly cost bases have increased and to the extent that cost bases have increased for all producers, that starts to fall under the price of these commodities. And we've seen that somewhat what you might have seen in gold where the average or even the lowest quartile producers of gold have cash costs that are much higher now than what they were three or four years ago and hence that's probably going to put somewhat of a floor on the gold price. What also producers are now focusing in on is that when cost has been probably less a priority in a rising market and being able to get production out there, and get production to chase the premiums that have been available in the market the last couple of years, that's been the priority. That prioritisation is now changing as those margins are being squeezed and so with that change of prioritisation, companies are now looking at their relative cost performance to their peers. So it's always this quest to get down to the lower two-three quartiles of producers because they're the ones that are going to sustain the longest period of profitability. So we've actually seen a period of shift away from maximising production and schedule and cost coming second, to now seeing cost ranked much higher particularly on a relative basis, is that something that nearly all miners are subject to that's probably less targeted as part of this focus on cost.
GEOFF CANDY: It's interesting you say that because it very much speaks to the sense that we're getting - there seems to be a subtle shift going on from an almost total focus on the demand side concerns over the last few years, to at least an increasing awareness of the supply side issues as well.
MIKE ELLIOTT: I would agree with that. I think there is a rebalancing of that... for a long period, just the premiums that were available in the market just meant there was all haste to try and get a supply response to that and cost did come secondary in that context. Now I don't think that the sector broadly would see the outlook in demand being negative, but the rate of growth that we've experienced in the last few years will probably not be there. We'll see this lower level of growth probably for a number of years but the expectation is that we'll still see positive growth in most years during the rest of this decade which looks very, very good for the sector. So they will still be challenged on the supply response but it won't be such a heady race for an increase in that supply.
GEOFF CANDY: One that came in number eight and one that caught my eye was the concern about sharing the benefits. Maybe if you could just explain briefly what that concern means...
MIKE ELLIOTT: It's an interesting collection of things that mining companies are now dealing with, and this is really looking at the fact that this sector has been successful for so long, that its major stakeholders - and we really see five major groups of stakeholders there - you've got governments, you've got shareholders, you've got the workers, you've got the local communities and you've got the suppliers and all of them look at the wealth that's been created by the mining and metals sector and really are seeking to see how they can get a bigger share of that. And that creates competing claims over some of that wealth and that manifests itself in different ways. Even beyond resource nationalism for governments - we're increasingly seeing governments looking to mining companies to actually undertake some of the social programmes that are normally the domain of government, whether that be health and education in remote communities, whether it be indigenous training and development - these are traditional areas of government but because they see the wealth being created by miners, that's becoming a de facto responsibility of the mining sector. When you look at workers, we've just been through a period of very high industrial disputation as workers seek to increase their wages and salaries in this environment. So each of these, and if you go through each one, the shareholders want greater dividends, communities want a larger dividend to the local community which actually hosts these disruptive activities, and suppliers are obviously looking to improving their margins on the products that they sell which are also in some degree of scarcity, so each of them have this particular claim. What the challenge from the mining companies is, is how they balance those particular claims and what do they get as trade-offs. If there's going to be an increased distribution to each of those groups, what are the trade-offs - so for instance with the workers what productivity trade-offs are there in order to justify a higher return to the workers. So it's that area that mining companies are finding quite difficult - not just one stakeholder group, its multiple stakeholder groups with competing claims.
GEOFF CANDY: It very much speaks to the whole sensibility of the "Occupy Wall Street" movement as well and very much a case of the fact that the mining companies have had a very good period of time from an outsider's perspective in that commodity prices have been doing very well and the expectation was that well if prices are so high, surely you must be making money and we'd like to see a piece of that, and that's not just the government, its investors, it's the workers etc. etc. and there must now clearly be a concern about how do we perhaps explain the difference between the prices of the commodities and what actually does come into the bottom line.
MIKE ELLIOTT: And in chasing that higher return, the sector has been prepared to take on much greater risk and whether that be political risk, whether that be geological risk there has been greater appetite for risk chasing this. The mining companies themselves have held that particular risk and if they're looking to transfer greater returns to these stakeholders, then what they will probably also be looking to see is how they can actually lay off part of this risk as part of doing that. So there needs to be a risk reward transfer at the same time. It's not a free take, it may be a take but it's a take that comes with also a transfer of risk. The second part I think that needs to be done as part of that education is that these businesses need to retain large amounts of capital because the whole business model is they have to invest in that next project - because if they just do what they do today, every shovel full of dirt that they pull out is a shovel full closer to their extinction. So there's a large amount of capital which is required to be retained in these businesses and as we go to the next era of the next range of projects, they are going to be more capital intensive than what we've seen in the past. So it's part of the sustainability model of mining, sustainability of their business model that actually says that there needs to be an education about what level of capital also needs to be retained in these businesses.
GEOFF CANDY: And very much that speaks as well I think to the social licence to operate in that it is a concern that mining companies can't just come in and take the resources out and do with it what they want - they do need to get that permission from government, from the various people and also then, if they understand that, and all the stakeholders understand that, one gets the sense that perhaps they'll be able to do it for longer.
MIKE ELLIOTT: Yea and what we hear from that in our discussions around these points, is around maintaining those social licences to operate, it is increasingly difficult to do that because community attitudes continue to change at such a rapid rate, and that rate is obviously aided and abetted by the modern technologies we have, social media, the new role of NGOs, the different political processes that are opening up. While greater democratisation of some of these frontier countries is great in eliminating one sort of political risk, it also opens up the amount of community debate there, and so the challenges of maintaining that social licence to operate, and keeping ahead of the curve of those changes in community expectations, is really, really tough for mining and metals companies at this point in time.
GEOFF CANDY: Just quickly to close off with, coming in at number seven was price and currency volatility. Its dropped a notch from position six - are companies concerned about where commodity prices are going and what is their level of concern about a drop in prices?
MIKE ELLIOTT: Well I think that one of the reasons it has dropped is that the whole issue of dealing with volatility while threatening to companies is starting to become a little more business as usual. When it was there a year ago, companies were still... their first reaction was to sit on the sidelines and volatility was occurring. If they were to do that they'd be still sitting on the sidelines from last year. The sense is that volatility is going to be with us for a number of years and so what they're doing is adapting to volatility, building greater flexibility in their operations to be able to change levels of capacity with moderate cost changes in there as well and that increase in flexibility can actually add value into their operations. So the concerns are probably how quickly the movements are from up and down. What we've seen and what we were talking about earlier around the cost pressures that are in the business is one of their reactions of what do they need to do to build greater flexibility into the business, take costs out to be able to handle a situation if commodity prices were to be lower for any particular period of time. But I think there is genuine confidence there that the outlook would still be positive enough that on average there's going to be still strong prices, they're going to be above the historic averages and while we might live through a period of softness, even prices now for most commodities are still relatively good by historical trends and companies are building their businesses based on that understanding.
GEOFF CANDY: In the press release you spoke about the fact that the issues facing the mining sector are more complex now than they were 12 months ago. Is there a sense that perhaps we're likely to see a diminishing of that complexity over the next 12 months, or are things likely to get even more complex from hereon in?
MIKE ELLIOTT: Well I think we've got two parts of complexities that will have to work themselves out in the next 12, 18 months, two years. The first is you do actually have some contradictions in these risks so that we have at one point struggling to meet some of these capacity constraints like skills and infrastructure and energy and things like that. But on the other side there are cost pressures which are causing capital programmes to be re-evaluated and slowed down and so forth. Those are inherently contradictory in the long-term. In the short-term you have this pipeline of things which are putting the capacity constraints and then you've got these concerns over the next generation of projects about how economic it is to bring those on. That needs to be rationalised over the next 12 to 24 months and in doing so there'll be a clearer view as to whether its policies mainly still around pro-growth and dealing with the supply side, or whether it's reacting to a soft demand side and therefore being much more cost focused.