Capital allocation is No. 1 strategic risk in 2010, Ernst & Young reports

Cost management, consolidation and access to capital dominated Ernst & Young’s annual risk list for mining companies last year but this year it is capital allocation that is creating the most complex problems, according to the firm’s annual report, Business Risks Facing Mining and Metals.

Capital allocation has become the number one strategic risk for global mining and metals companies this year, leaping from seventeenth place in 2009.

“Despite a strong outlook for the sector and strong quarterly earnings, banks are still generally unwilling to lend, except when it comes to the very best assets,” Tom Whelan, national leader of Ernst & Young’s Canadian mining practice, said in a prepared statement. “As illustrated by recent transactions, a number of mining companies have decided the best way to allocate capital is growth by acquisition.”

Since the global financial crisis it has been harder for mining and metals companies to get capital and since capital is limited, companies have to be strategic in determining what to do with the money they do have. Most have chosen to use their capital for internal projects but the industry is starting to see transactions with some allocation for M&A. However the only M&A the industry is seeing are “friendly” transactions, which can present challenges of their own.

The opaque economic environment is challenging traditional benchmarks.  “The volatility of prices, cash flow, risk appetites and availability of capital during the recent global financial crisis have all made the decisions on how to allocate capital in mining and metals companies more complex,” the study elaborated. “Recent expectations of rates of return, level of gearing, and cost of debt and equity have all changed dramatically.”

Some of the key capital allocation challenges include: build or buy; greater equity financing; reduced appetites for risk; changes to expected rates of return; volatile costs of capital; how much infrastructure is tolerable; delivering the value of synergies; how big is too big; and what to do with cash flow.

In one example of some of the capital allocation challenges facing miners today, the study used a fictitious example of a company with US$100 million of available capital that wants to develop two projects. Project A requires US$80 million and Project B requires US$90 million. Prior to the financial crisis when securing debt finance was simple, the company might have chosen to develop both projects at the same time by borrowing US$70 million. Now, however, that US$70 million is not available at rates that would justify the investment. The management in this case would have to choose from a variety of options: turn down one of the projects because there isn’t enough capital to do both; raise the US$70 million of equity through a secondary issue; seek a strategic investor to share the costs in return for an off-take agreement (currently quite popular but a significant amount of ownership is transferred); or find a joint-venture partner to share the costs (usually the best partners are competitors and sharing sensitive information can make that quite difficult).

“Capital allocation is what keeps our chief executive officers awake at night and presents the most significant challenge for today’s management,” writes Lee Downham, leader of Ernst & Young’s U.K. Mining and Metals division.

Blake Langill, leader of Ernst & Young’s Toronto-based mining practice, noted in a telephone interview that there is an element of conservatism that has crept back into the process. “During the boom there was a lot of exuberance and investment and people were loading up with debt but now there’s a conservatism that is coming back…it seems to take longer to put deals together these days. People are being more disciplined about it. You can’t just go out and borrow millions of dollars from a bank.”

Langill pointed to BHP Billiton‘s (BHP-N) bid for Potash Corporation of Saskatchewan (POT-T, POT-N) as one example of how the landscape is changing. “Putting a deal together to counteract BHP is not something that is being done overnight,” he says. “I’m sure the other companies are being very careful in doing their due diligence.”

He adds that it’s interesting to watch companies arrive at decisions. Do they go out and try to build a project themselves or go buy some other company that has a ready made project. “No two companies will pick the same path,” he says. “They will have different philosophies and people are thinking long and hard about these things.”

Other issues ranking highly in this year’s report of strategic risks were skills shortages and resource nationalism. Skills shortages jumped from sixth place last year to claim the second spot this year, while resource nationalism climbed from ninth place in 2009 to this year’s fourth spot.

The report cited a study commissioned by the Minerals Council of Australia in 2008 that estimated the country’s mineral industry would need an additional 86,000 workers by 2020 to “maintain its current international market share”. It also pointed to statistics from Canada’s Mining Industry Human Resources Council that demonstrate there will be a labor shortfall of between 60,000 and 70,000 people by 2017.

A South African study two years ago noted that the country produced just 300 graduates from mining engineering programs in 2008, while only about 130 graduated from programs in Canada and Australia combined, and 35 in the United States, Langill says.

Labor shortages means some companies may have to deal with delayed project development and production — “conditions likely to contribute to another a spike in commodity prices,” Whelan warned.

As for resource nationalism, countries are trying to extract greater economic rent for their resources. The study cited several worrying examples of growing resource nationalism including South Africa’s new royalty regime that came into effect in March; Ghana’s intention to double royalties on mining; and Sierra Leone’s new Mines and Minerals Act that will boost royalties on precious metals. It also pointed to Venezuela’s decision to revoke a number of mining licences, Mongolia’s decision to freeze the issue and transfer of mining licences until the government brings in a stricter law on mining investment, and Brazil’s consideration of taxing shipments of iron ore in a bid to encourage investment in the country’s own steel industry.

The financial crisis certainly hasn’t helped. “It’s not a stretch to say that a lot of governments have run large deficits and will need to find access to revenues and the mining industry has been very strong for the last few quarters,” Langill says. “Historically people would pick on countries like the DRC and Mongolia but look at the proposed tax in Australia, which seems to have gone away, but was proposed by a developed country.”

The issue of cost management slipped to the number three spot this year from first place last year, but remains a serious risk because companies must continue to conserve capital and debt is not readily available, the report found. “Mining and metal sector input costs are increasing at a greater rate than normal inflation,” the study noted. “Mining consumables are linked to the price of oil and steel, both of which are increasing as at the global economy improves…transportation costs are also trending upwards – the oil price (Brent) rose almost 114% in 2009.”

Access to capital moved to the eighth spot this year from third place in 2009, but the study emphasized that while juniors are now managing to raise funds on equity markets, “transformational financing will be reserved for those with the best projects and potential. Debt is difficult to access for small and medium sized mining and metals companies.”

“The larger organizations have found that getting access to capital has become much easier over the last several months,” says Langill. “But the smaller you are the greater the
difficulty will be.”

The report forecast that the outlook for access to capital this year would be that “equity will play a greater role in the next wave of growth” and that the IPO market “will recover and spin outs will be more common.” It also predicts that the floating of individual mines will return and that a more diversified group of financing sources and investors will emerge such as sovereign wealth funds, multilateral development agencies, export credit agencies, private equity banks in the Middle East and Asia.