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The mining cycle – booms and busts

Atlas Funds Management’s Hugh Dive details the five different points of the mining cycle and where commodities are currently positioned.

Hugh Dive | Atlas Funds Management

Unlike industrial companies such as Amcor or Transurban, mining companies' profits are inherently cyclical. The earnings from mining companies are subject to booms and busts, mainly outside the control of their management teams. This occurs as, ultimately, any company producing a commodity is a "price taker", not a "price maker", as there is no difference or brand premium between a ton of iron ore mined in Australia or Brazil.

Due to the nature of the cycle, we see that mining stocks should not be viewed as buy and hold forever. Instead, investors should choose their entry points based on where they consider minerals in the mining cycle.

In this week's piece, we will look at the five different points of the mining cycle and where Atlas perceives commodities as currently positioned. The travails of the nickel mining industry nicely illustrate the mining cycle. The non-corrosive metal used to make stainless steel and lithium-ion batteries has been one of the key mining stories of 2024. Nickel has gone from a boom in 2022/23 due to its inclusion in batteries for electric vehicles to miners asking for government subsidies and then closing mines in 2024.

1. Demand for commodities drives up prices

In the short term, supply is relatively fixed for most commodities as miners have optimised their mines for a specific production level, and minimal exploration during the lean times has run down ore reserves. At stage 1 of the cycle, memories of the previous bust are still pretty fresh, and there is likely to be an undersupply of personnel such as mining engineers. Additionally, the few surviving mining services businesses and contractors will likely have minimal spare capacity, which could allow production to expand quickly. Further, management teams in mining companies are unwilling to greenlight capacity expansions until they become convinced that higher commodity prices are permanent.

In recent times this occurred in 2020 as the demand for nickel as cathodes in lithium-ion batteries exploded with the demand for electric vehicles. This saw the price of nickel increase from US$11,700 per tonne in March 2020 to over US$32,000 per tonne in March 2022 as supply was reduced due to the COVID-19 pandemic, Russia halted commodity exports due to Ukraine war and the Indonesia government placed an export ban on raw nickel ore.

2. New Exploration undertaken to add to supply and Takeover activity surges

At stage 2 of the cycle, management teams at the mining companies are likely to run existing mines at full capacity and have developed some confidence that elevated prices will persist for some time. This incentivises new exploration, and capex is allocated to bring previously uneconomic discoveries into production.

At this stage, we also see surging M&A as companies use excess capital built up in stage 1 to buy growth, which can be delivered faster through a takeover than developing new mines. An example of this was the IGO's takeover in June 2022 of Western Areas for $1.3 billion in an all-cash transaction. This has since proven to be one of the poorer acquisitions in Australian corporate history in relation to the size of the company and the speed at which the loss was written off, with IGO $1.1 billion already being written off. BHP's misadventures in US shale gas and Rio's ill-fated takeover of Alcan were larger losses, but these took longer to develop and were smaller in the context of the wider company.

3. New mines start producing at the same time, supply shifts to being greater than demand

Due to the long lead times, in my observation, a range of projects hit the marketplace almost simultaneously. Additionally, from speaking to resource CEOs during stage 3, they are invariably convinced that they have the best project and that rival projects won't go ahead or get financing. Quite often, similar projects are developed, with banks falling over themselves to finance them. Before stage 3, these projects look to be quite low risk with short payback times if prices are maintained (which they won't be).

Furthermore, the costs of these projects are inevitably higher than originally forecasted due to the competition for scarce resources such as skilled labour and capital goods. A great example of this can be seen in the decision for Albemarle and Tainqi Lithium to construct two lithium hydroxide plants simultaneously in 2022 in West Australia.

Perhaps the greatest example of this was the decision of Santos, Origin Energy and BG to construct three LNG gas projects simultaneously at Gladstone in Queensland. Here, each of the CEOs believed that their rivals would capitulate, abandon their project, and allow their gas to be processed in their rival's plant, which was being constructed next door (see below). The total capital cost of the three plants was around $60 billion, and the opening coincided with a fall in the oil price from US$110/bl to US$55/bl.

The long lead times between development and first production can result in new mines coming online in market conditions quite different from when they were first conceived. A great example is IGO's Cosmos nickel mine, which was placed in care and maintenance in January 2024 before any nickel was even seen out of the mine. IGO acquired the nickel operation while acquiring Western Areas for $1.3 billion. At the time of the acquisition, the nickel price was nearly $30,000 per tonne, almost double that of the nickel ore price when Cosmos was put into care and maintenance.

In 2020, Indonesia implemented an export ban on raw nickel ore, which attracted foreign investment from three big Chinese businesses, including Tsingshan. These businesses each built a plant to manufacture battery-grade nickel, each taking three years to build, finishing in 2023, which over-supplied the world market with battery-grade nickel. The oversupply drove the price of nickel down from US$30,000 a tonne at the start of 2023 to under US$17,000 a tonne.

4. High-cost and less efficient mines close, and late-cycle projects are abandoned until the next boom

At this cycle stage, the canaries in the metaphorical coal mine are the contractors servicing the miners. In an effort to avoid the finality of shutting production, costs are pared back, and the services businesses serving the mines are the first to feel the pinch. Exploration budgets are slashed, and expansion plans are put on ice.

During the first months of 2024, we have seen operators of nickel mines plead to the government for subsidies to lower their cost base and compete with the Indonesian nickel price. Indeed, we have seen miners plead with the London Metals Exchange to exclude Indonesian nickel on the grounds that it is less "green" than nickel produced in Australia. When this was unsuccessful, the miners attempted to convince battery manufacturers and EV companies operating on very thin profit margins that consumers would pay a premium to have Australian nickel in their car batteries. Unsurprisingly, both of these moves were unsuccessful.

5. Capitulation

The final step in the mining stage is capitulation, where the higher-cost producers mothball their mines to conserve corporate cash and keep the company as a going concern. Often, we also see the lower-cost producers increase production despite lower prices in an attempt to maintain absolute profits. However, this invariably results in further downward pressure on prices and more pain for the higher-cost producers. In recent months, a range of nickel ore producers such as IGO, BHP, First Quantum and Panoramic Resources shut production at their nickel mines. In the case of the Ravensthrope mine in Western Australia is commencing a shutdown as of 1st May 2024; this is the third time that the mine has been placed on care and maintenance, with previous closures in 2009 and 2017.

The old adage in mining is "The cure for low prices is low prices". At stage 5, the supply is removed from the market due to mine closures. Additionally, companies are very unlikely to spend any money on exploring new mines, with exploration cash diverted either to find more attractive minerals or to conserve cash to keep the company solvent. Here, savvy operators often buy mines from companies desperate to offload assets at a fraction of the price they would have traded at in stage 2, assuming prices will never recover. Contracting supply from no new exploration and declining production from existing mines then lays the groundwork to move back to Stage 1, and the mining cycle continues.

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All prices and analysis at 1 May 2024 (unless otherwise stated).  This document was originally published in Livewire Markets on 1 May 2024. This information has been prepared by Atlas Funds Management (ABN 83 612 499 528 | AFSL 491395)

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