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Light at the bottom of the mine?

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Light at the bottom of the mine?.

Over February iron ore prices staged a recovery, reversing some of their 80% fall since late 2011. Long-suffering shareholders in mining heavyweights BHP Billiton and Rio Tinto enjoyed a reprieve from relentlessly falling share prices, with both shares ending the month up. Has the mining sector finally turned a corner?

Mining companies have faced savage falls in prices of the commodities they produce. Their response has been to reduce their cost per tonne of output by cutting expenses, and by spreading costs over greater production volumes. Both these measures, ironically, are likely to further weaken commodity prices, aggravating the very problem they seek to address.

Mining bosses seem to be aware that they are locked in a race to the bottom. BHP Billiton CEO Andrew MacKenzie recently advised shareholders to expect a prolonged period of weak and volatile commodity prices. Last month, both BHP Billiton and Rio Tinto broke with long-standing policies and cut their dividend payments. With some urgency Fortescue Metals Group is paying down a multi-billion dollar debt load. Junior miner Atlas Iron Ore significantly restructured its debt. Last year, Anglo American announced large staff cuts and axed its dividend.

All players are sharply reducing investment. The singular objective is to save the most cash for the longest time; in short, to survive expected hardship.

If commodity prices recover in the near term, everyone who has survived wins. If prices remain weak, eventually the very lowest cost producers win, as they are ultimately the only survivors and have the market to themselves. Along the way the cash rich outlast the cash poor, and get to buy high quality assets cheaply from distressed competitors.

While strategically sound, this would be a very hard won victory, involving earnings contraction and insolvency risk. For share investors, picking the ultimate winner could still mean further losses, and perhaps be likened to having backed the tallest pygmy. We prefer to see the underlying commodity markets stabilise before risking our investors' capital in the mining sector.

 

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