Navigant Research Blog

As Commodity Prices Slide, Big Miners Seek a Sustainable Strategy

— August 22, 2014

Navigant Research’s report, Renewable Energy in the Mining Industry, summed up the state of the global mining business: “In the last decade, increased demand from countries such as China and other emerging economies pushed the price of many metals and minerals upward, which stimulated investment in the mining industry. More recently, the global economic downturn and the collapse in a number of metal and mined commodity prices forced the mining industry to scale back investment into new mine sites, reduce operating mine lives, and scale back their investment into more capital expenditure-heavy renewable energy.”

Since that report was published in the fourth quarter of last year, commodity prices have stumbled further, and the pressures on mining giants like Rio Tinto, BHP Billiton, and Vale Brazil have intensified.

On the surface, so to speak, it’s a great time to be an extractive company with worldwide operations in iron, copper, coal, and other minerals that are essential to the functioning of the modern industrialized economy.  The rise of China and India has created a seemingly bottomless well of demand, particularly for iron ore for steelmaking; technological advancements have cut the costs of large-scale mining operations (while eliminating thousands of well-paying jobs); and governments in places desperate for economic growth, such as Mongolia and Sub-Saharan Africa, have proven pliant to the demands of multinational mining corporations.

The Bottom of the Well

Rio Tinto’s profits in the first half of 2014 doubled from the same period a year before.  BHP Billiton made $13.4 billion in profits in the 12 months leading up to June 2014.  Brazil’s Vale, the world’s largest producer of iron ore, reported second quarter profits of $1.43 billion – slightly below Wall Street estimates but still a healthy increase over the year before.

A closer look, though, shows that big miners are playing a risky and ultimately unsustainable game.  The term of fashion in the mining industry today is “de-diversification” as mining companies sell off low-margin mines that they invested in during the commodities boom of 2002-2008, before the global financial systems crashed and growth in China ground almost to a halt.  To keep profits up, the companies are slashing costs and adding new production – a short-term strategy that could spell long-term disaster.

Rio Tinto’s results “showed that the strategy of carving into costs while ramping up volumes that are being pursued by the major miners has worked to offset commodity price declines,” wrote Stephen Bartholomeusz in the Australian business publication, Business Spectator.  “The key question – worth billions of dollars – is whether it will continue to work.”

Twilight in the Mines

Ultimately, the dilemma facing miners of low-margin commodities like iron and coal is that as economies like China’s and India’s develop, they need less basic stuff.  It takes less iron to make an iPhone than it does to assemble an airliner.  Despite slowing demand, Vale plans to double its exports of iron ore to China over the next 5 years.  Pumping more iron and coal into markets that need less of them is not a winning strategy over the long run.  Goldman Sachs analysts have estimated that the rate of growth in the supply of iron ore is 3 times the rate of growth in demand.  That’s a recipe for a glut and a price crash.  Already, iron prices are on a downward slide.

Asian iron ore spot prices have fallen 31% this year, according to Reuters, and “the consensus is that they will remain below $100 for the foreseeable future as big miners such as BHP, Anglo-Australian rival Rio Tinto and Brazil’s Vale ramp up output even as Chinese demand growth weakens.”

As with coal, iron ore could be entering a downward spiral that could overwhelm the major miners as they narrow their focuses:  “Iron ore risks becoming another coal,” remarked Reuters’ commodities columnist Clyde Russell, “where miners pursue output gains in order to lower costs, but in the end the resulting supply surplus just depresses prices even more, resulting in a no-win situation for producers.”

Like the coal era, the age of iron and steel is nearing its twilight.  That’s not good if you’re a multinational mining outfit.

 

Amid Global Turmoil, Oil Prices Oddly Stable

— July 18, 2014

The world has entered a zone of maximum upheaval.  From the Atlas Mountains of North Africa to the Hindu Kush, in Afghanistan, the Middle East is in flames.  The destruction of a Malaysian airline over Ukraine, almost certainly shot down by Russian-backed separatist rebels, threatens war in the Black Sea region.  Libya is being torn apart by competing militias, while parts of Iraq are under assault by the murderous Islamist force known as ISIS.  Syria remains a bloody horror show, and Israeli troops have launched a ground invasion of Gaza.  At no time since the terror attacks of 2001 has the world seen such conflict and instability.

So why aren’t oil prices higher?

Prices spiked briefly after the news on July 17 that Malaysian Air flight 17, en route from Amsterdam to Kuala Lumpur, was shot down by a surface-to-air missile fired from eastern Ukraine.  U.S. oil futures rose $1.99 a barrel, up 2% on the New York Mercantile Exchange, to reach nearly $104.  That was the largest one-day jump since June 12, when ISIS launched its offensive in Iraq, according to The Wall Street Journal.  But markets quickly calmed: the next day, benchmark crude had retreated below $103 a barrel on the NYME.  The shocks of recent days had caused a tremor across world petroleum markets, not a tsunami.

No Lost Sleep

“At any given point of time, global financial markets are always at risk from geopolitical disturbances, but this time around nobody’s losing sleep over it,”  wrote Malini  Bhupta in the  Business Standard, India’s leading economic newspaper, in a column headlined “Markets shrug off geopolitical risks as oil prices remain stable.”

Before the latest outrage in Ukraine, oil prices had actually been easing: in mid-July U.S. crude fell below $100 a barrel for the first time since May.  That’s not to say that prices aren’t high; as Steve LeVine, of Quartz, points out, geopolitical disturbances have removed around 3.5 million barrels of oil a day from world markets since last fall, and if the world were a more stable and peaceful place, oil prices would likely be well below $100 a barrel.  But given the current unrest, a price per barrel of $125, or higher, would not be startling.

The ability of the market to absorb multiple shocks and keep prices relatively stable is an indication of structural changes that have taken place in recent years.

Awash in Conflict, and Oil

According to Liam Denning, writing in The Wall Street Journal’s “Heard on the Street” column, the “forward curve” – the price of oil scheduled for delivery months or years in the future, based on the trade in futures contracts – has flipped in recent weeks, meaning that prices for contracts nearer in time are now lower than those further out.  When the curve slopes upward like that, it’s an indication that supplies are plentiful.  “The global oil market no longer looks quite so panicked about Iraq,” commented Denning.

More broadly, the world’s supply of oil has been climbing for years, and continues to do so despite the current crises.  What’s more, the sources of that supply have diversified; the Middle East no longer has as a dominant role in world production as it did 10 or even 5 years ago.

Defying “peak oil” predictions, world crude production increased roughly 50% over the last 30 years, rising from about 50 million barrels a day in 1983 to 76 million in 2012.  Regions that were negligible producers before the turn of the century are now significant oil suppliers: Africa’s production has doubled since 1983, as has South America’s.  Despite the current civil war, oil production in Iraq has soared, growing from about 300,000 barrels a day in 1991 to 3 million in 2012.  Driven by new drilling in the tar sands, Canada has more than doubled its production in the last 20 years.

And then, of course, there’s the United States, which in 2011 became a net exporter of petroleum products for the first time since the post-World War II era.  In  short, the world is awash in petroleum, and barring an all-out war between Putin’s Russia and the West, is likely to remain that way for some time.

 

Business Community Wakes to Climate Change Risks

— June 27, 2014

Attempting to reframe the climate change debate in terms of profit and loss, instead of politics, a bipartisan group of business and political leaders has released a report that says the United States faces billions of dollars in economic losses due to global warming.  Titled Risky Business: The Economic Risks of Climate Change in the United States, the study was produced by the Rhodium Group, an economic research firm, in association with a committee headed by former Treasury Secretary Hank Paulson, former New York City Mayor Michael Bloomberg, and Tom Steyer, the billionaire former hedge fund manager who has devoted his fortune to the effort to limit climate change.

Essentially, Risky Business makes the point, through an exhaustive database of the probable economic downsides of rising seas, drought, higher temperatures, and crop failures, that regardless of politics, it is irresponsible to ignore the risks of climate change – especially if you’re a businessperson, investor, or money manager.  With its high-powered lineup of Republican and Democratic financial heavyweights, Risky Business is the latest signal that the business community is awakening to the grave consequences of ignoring anthropogenic climate change, even as political leaders fail to act.

Ignored Rule

“Viewing climate change in terms of risk assessment and risk management makes clear to me that taking a cautiously conservative stance — that is, waiting for more information before acting — is actually taking a very radical risk,” wrote Paulson in a New York Times essay earlier this week.

In 2010, the U.S. Securities and Exchange Commission (SEC) established a rule requiring publicly traded companies to divulge their exposure to climate change risks in their reporting.  That rule has mostly been observed in the breach.  A February study by the Ceres Group, a Boston non-profit that looks at the financial implications of climate change, reported that, “A large number of companies fail to say anything about climate change in their 10-K filings. Forty-one percent of S&P 500 companies failed to address climate change in their 2013 filing.”

That is changing, as business leaders, driven by regulators and shareholders, have started to factor in likely climate-related effects on their businesses.  Large investors, meanwhile, have started to punish companies that produce or continue to rely on fossil fuels.  The announcement by Stanford University in May that it would eliminate fossil fuel investments from its $18.7 billion endowment portfolio is the most significant victory to date of the divestment movement.

Popping Sound

In an update to its 2011 report, Unburnable Carbon, the Carbon Tracker Initiative calculated that only 20% to 40% of the total listed reserves of the world’s fossil fuel companies can be burned if the world is to avoid catastrophic climate change.  Current fossil fuel company valuations represent a carbon bubble.  Eventually, the initiative stated, some form of price will be put on the carbon represented by those reserves, dramatically reducing their value.

“The scale of this carbon budget deficit poses a major risk for investors,” wrote the report’s authors, Jeremy Leggett and Mark Campanale.  “They need to understand that 60-80 percent of coal, oil and gas reserves of listed firms are unburnable … Capital spent on finding and developing more reserves is largely wasted. To minimize the risks for investors and savers, capital needs to be redirected away from high-carbon options.”

Politicians have utterly failed to come to grips with the environmental crisis of climate change.  Now, by framing it as an economic crisis, the business community is having a go.

 

Facing Change, Utilities Change Course

— June 16, 2014

Minutes after details of the proposed new U.S. Environmental Protection Agency (EPA) regulations on emissions from power plants were released, the coal industry made its reaction clear.

“If these rules are allowed to go into effect, the [Obama] administration for all intents and purposes is creating America’s next energy crisis,” declared Mike Duncan, the CEO of the American Coalition for Clean Coal Electricity, a trade group that represents suppliers, such as Caterpillar; mining companies like Peabody Energy and Arch Coal; and big operators of coal-fired plants, including American Electric Power (AEP) and Southern Company.

The responses echoed what some utility officials have been saying for years: limiting emissions of greenhouse gases from existing power plants will unravel the already beleaguered utility industry, send electricity rates soaring, and kill the shaky economic recovery.

“Under Attack”

“Electricity is under attack in our country,” said Tony Alexander, CEO of Ohio-based utility FirstEnergy, in a speech last April at the U.S. Chamber of Commerce, “and this battle is being waged through largely untested policies that will ultimately impact the reliability and affordability of electric service, and the choices customers now enjoy.”

Utilities and industry associations have spent millions trying, with limited success, to influence the EPA’s rulemaking decisions.  Utilities’ tactics, however, do not always match their rhetoric.  The umbrage of officials like Duncan and Alexander masks the industry’s more nuanced and responsive adaptations – not only to the EPA’s aggressive regulations, but also to the market forces that are driving power generation away from coal and toward cleaner sources like renewables and natural gas.  In fact, the EPA is only giving a shove to a battleship that’s already turning, however gradually, toward uncharted waters.

“The rule is going to speed the transition away from coal into natural gas and renewables and potentially increase the role nuclear electricity plays in the U.S.,” Christopher Knittel, director of the Center for Energy & Environmental Policy Research at MIT, told Bloomberg News.

Diversify, Already

AEP, for example, is the biggest owner of coal-fired power plants in the United States, and the Columbus, Ohio-based utility “could be among the most affected by the new rules,” according to Columbus Business First.  CEO Nick Akins has warned of plant shutdowns and the associated job losses because of the proposed regulations.  AEP is also, however, among the utilities that have already taken dramatic steps to reduce its carbon emissions and shift its generation fleet off of coal.  According to AEP’s 2014 Corporate Sustainability Report, the company’s generation fleet is “increasingly diverse,” and the company already had plans to retire 6,600 MW of coal-fired capacity before the new regulations were announced.

AEP’s 2013 environmental performance was “the best in company history,” a release summarizing the Sustainability Report said.  “AEP has invested about $10 billion in environmental controls and new generation over the past decade. Between 2005 and 2013, AEP reduced its carbon dioxide emissions by 21 percent.”

These reductions have hardly ruined AEP’s financial performance: the company earned $3.23 per share in 2013, comfortably within analysts’ projections, and its share price has nearly doubled since 2009.  “AEP’s total shareholder return for [2013] was 14.2%, compared with an average of 7.8% for the S&P 500 Electric Utilities Index,” the release noted.

Like newspaper publishers a decade ago, industry executives are watching a business that has persisted in more or less its current form for a century or so transform, virtually overnight.  Some of them are proving to be surprisingly nimble.

 

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