November 2009

Cost containment a rising risk for mining companies

A report by Ernst & Young says that the financial crisis and global recession have changed the environment that Canadian players face

By P. Diekmeyer

The global financial crisis created or exacerbated risks that threatened the near-term survival of a number of mining and metal companies. However, opportunities have also emerged for well-capitalized companies to position themselves for the upturn. Those are key conclusions of Ernst & Young’s Strategic Business Risk Report 2009 released in August.

The report notes some of the major changes that have beset the industry. It also highlights risks that mining sector players face and assesses how those risks have evolved during the past 12 months.

Not surprisingly, the 40 per cent drop in the London Metal Exchange Index that occurred between July 1, 2008 and July 1, 2009, has made things much tougher says Tom Whelan, Ernst & Young’s Canadian leader for the mining and metal industry. “Access to capital has been choked off for most companies, with the rare exception of those in the gold sector and maybe a few others,” he says.

Tightening the purse strings

The upshot is that producers are now increasingly focused on cost containment, which the Ernst & Young report lists as the biggest risk that the sector faces. “We went through a period during which commodity prices rose rapidly to unprecedented levels,” says Whelan. The desire by operators to produce and sell as much product as possible while the prices were so good led to bottlenecks in the supply chain for basic inputs ranging from skilled labour to energy and delivery infrastructure. “This ‘produce at all costs’ mentality led to sloppiness and cost overruns, which are totally unsustainable at current price levels,” says Whelan.

Many mines responded to the drop in commodity prices by shutting down production. However, others that continue to produce will need to get their costs back into line. The key, says Whelan, is that cost reduction activities need to be implemented in a way that does not lead to value erosion.

The Ernst & Young report recommends several steps that mining and metals companies can take to respond to cost containment risks. These include focusing on areas that provide maximum value, embedding cost optimization to make sure that the savings achieved are sustainable, and ensuring that company leadership is visibly committed to achieving a single definition of success.

Some risks have decreased… temporarily

Of course not all risks have increased. In fact, slowdowns or shutdowns at many mines, sparked by shrinking demand, have given companies slack in several areas once judged far more critical. For example, skills shortages, once a major threat due to the rising average age of workers in several key job categories, are not as prevalent as they once were.

In a similar vein, reduced or halted production by many operators has meant that a lot of those mines will be around longer. That means that pipeline shrinkage is less of a concern. Getting access to scarce infrastructure is also easier now.

Reduced demand has also weakened the hand of many countries and regions that were seeking to attract investors willing to develop local deposits. As a result, resource nationalism and the ability of miners to obtain or maintain social licenses to operate no longer provide the same “bargaining chip” incentives they once did. “The discussion of risks as required in the management discussion and analysis (MD&A) tends to be generic and typically does not provide a detailed description of the likelihood of the risk occurring or the magnitude of the impact,” says Whelan. He counsels clients not to succumb to the pressure to cut spending on initiatives to build bridges with local communities where mines operate.

Much discussed, not always fully reported

Reports like the Ernst & Young document provide particularly useful information for mining sector stakeholders. The long life cycles inherent in almost all mining projects means that correct risk profile assessments of current and planned initiatives are crucial. 

“At the end of the day, the mining industry is full of risks,” says Whelan. “[As a result] risk management is one the top topics of conversation at board levels.” Despite this, Whelan points out that risk reporting is not formally mandated under current accounting guidelines.

“The MD&A sections of company financial statements do include a risk section. But the information there is kept fairly generic,” says Whelan. The upshot is that to fully assess the risk that the mining industry operates under, stakeholders will generally have to do research of their own.

Whelan also made interesting observations regarding the effects that consolidation has had on the industry. “Our research shows that companies that are emerging out of the crisis fall into three categories. They are either opportunists, innovators or survivors,” says Whelan.

The key, says the mining sector expert, is to stay focused on the big picture. “Tougher access to financing means that the short-term investment picture may indeed look grim,” says Whelan. “The IPO market has essentially been closed down. As a result, we are telling our clients that if they have a chance to get a hold of capital, they should seize it.”

The tough times, however, are not expected to last forever. “The demand for resources will rebound,” says Whelan. “Lack of available financing has created fabulous opportunities for those who have a longer term horizon such as the Chinese companies who recently took positions in Consolidated Thompson Iron and Teck Resources.”

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