The mining sector is going to destroy itself; that’s the view of Edward Chancellor an award-winning financial journalist, who has written for the Financial Times, Wall Street Journal and is a former member of the asset allocation team at GMO.
The July 28 issue of Goldman Sachs’ Fortnightly Thoughts magazine contains an interview with Edward, which was first published in February this year. In the interview, Edward discusses the factors that drive a boom-bust cycle in an industry, and why the mining sector is digging itself into a hole, it may never be able to escape.
These are the highlights of the interview.
Edward Chancellor: The mining sector is eating itself alive
There have been many instances in the past where market booms have generated excessive of capital spending, which then drives mean reversions. Monetary policy or speculative euphoria can create a capital boom, and when the boom collapses, investors can get locked into permanently low returns as the industry has changed for good. This trend is particularly damaging in sectors where assets have a long shelf life and don’t disappear; the mining sector is a perfect example.
“A similar story is now unfolding with respect to China. People have woken up to the overinvestment in mining and the supply side developments in the energy sector only in the last couple of years. Anyone with a capital cycle framework should have realized that measures like capex to depreciation were becoming very high for the miners… analysts spend too much time thinking about the P&L statement and traditional valuation measures for their companies, but they don’t spend enough time looking at the balance sheet and cash flows, which are often negative when capital spending is booming. Take the classic case of homebuilders. Even in boom periods, while they generate high profits, they tend to bid up the price of land, and so, their cash flow is actually quite weak. Back in 2005-06, quite a few well known value investors thought that buying home builders was a good idea as they were trading close to their trough levels on price to book. What they missed was that the book itself had been increasing at around 25% a year for five years straight. This is what I call ‘a fundamental bubble’; i.e., the valuations may look cheap, but the asset itself is a bubble. “
There is a massive capital concentration in China after around a decade of booming credits and capital flows. A lot of money has been invested in building logistics for the resource sector, as well as building production capacity for the resource sector. And China isn’t the only culprit, Brazil has also succumbed to this capital boom and so has the US tech industry. Unfortunately, miners are only exacerbating the problem by showing absolutely no capital discipline.
“It is an extremely concentrated industry with a handful of big companies like Vale, Rio and BHP controlling supply. So theoretically, we should have expected the big miners to show some capex discipline at the time of the disruptive entry of a fourth player, Fortescue. But instead, what we saw was an increase in production last year. And the miners are spending similarly this year too. BHP even said that the lowest-cost producer has the right to continue producing.”
Returns on capital are driven by changes on the supply side if miners want to increase their returns on capital they are going to have to decrease output. However, it seems as if the sector has no desire to adopt this more sustainable way of doing business, a decision which will guarantee low returns for the foreseeable future.
“The BHPs, Rios and Vales of this world will carry on digging because the supply cost curve has flattened. i.e. they can produce more at a lower cost. And so, they’ll carry on bringing more supply which will eventually bankrupt the industry. It’s tempting to catch falling knives, but you can be fairly bearish on the miners today even if you didn’t account for the impact of China’s rebalancing. This is the trouble; as investment strategist Russell Napier commented “analysts spend 90% of their time looking at demand, and 10% looking at supply. And, it should be the other way around.”