The Trouble with Mining - Management or Structural Issues?

Rio Tinto boss Tom Albanese recently became the latest CEO of a major mining firm to be relieved of his duties.  His departure came in response to a $14 billion write-down that resulted from the 2007 purchase of Alcan, then a leading aluminum company.  He joined a growing list of departures that includes the top executives of Anglo American, Vale, Barrick Gold and Kinross Gold.  

Before 2008, the rising tide of the commodities "supercycle," propelled by infrastructure-heavy economic growth from the developing world, was enough to lift the earnings and share prices of many resource producers.  But as Warren Buffett has warned, when the tide goes out, you find out who's been swimming naked.  Today's unforgiving daylight reveals repeated cost overruns, rampant technical setbacks, and a pattern of overpaying for acquisitions.  Investors are left to wonder whether this is a management problem, which is solvable, or a more structural situation, which may not be?

Part of the blame lies squarely on management.  It's well known that around two-thirds of acquisitions fail, largely because acquirers routinely overpay.  The burden of proof, then, falls on senior executives and board members to demonstrate that their own prospective purchases are an exception to the general trend.  Even without the easy judgments of hindsight, the Alcan deal was always risky, given that aluminum is abundant and thus never in short supply.  Managers in the mining industry tend to be particularly poor at allocating capital: not only do they overpay for assets, they often have a soft addiction to issuing new equity, whatever the price; they rarely pay dividends; and they almost never take advantage of weak share prices to repurchase shares. Out-of-control costs and technical failures reflect mismanagement, as well.  Too often, managers have failed to halt development, even when added expenses push the rate of return to dismal levels, and executives have been unable to deliver on production or schedule-related promises.  

Still, many of the problems in the resource extraction industry are structural.  It is telling, in fact, that the names appearing on the casualty list above are managers from the strongest mining firms in the world.  As such, they have built-in advantages over competitors, including the resources to attract the best managers in the industry - in theory, at least - assets that are diversified both by geography and by mineral, and a lower cost of capital.  

Nonetheless there's a long and daunting list of enduring challenges in the mining industry: the difficulty of operating many mines reliably and profitably; unsteady demand; a lack of skilled technical labor, and shortages of general labor; ore grades in permanent decline; and a litany of political, regulatory, legal and environmental obstacles.  As if all that weren't enough, the largest problem is the "hole-in-the-ground" conundrum: every ounce, pound or tonne a producer sells leaves it one unit closer to being out of business.  These challenges surely contributed to many the mistakes and failures noted above.

This doesn't mean that there are no attractive mining investments.  The surest way to get an edge in a commodity business is to be a low-cost producer.  Most importantly, this means owning low-cost mines with long lives, as BHP Billiton does, for example.  As noted, size typically ensures large companies access to cheap capital, as well as a strong balance sheet that can withstand volatile commodity prices.  In addition, vast resources typically allow companies to better navigate the political, regulatory, legal and environmental challenges that exist in the global resource industry.  And a world-class management team is not only desirable, but flat-out necessary.

Potash Corp may be one of the few mining companies that’s worth investing in, despite the general difficulties of the industry.

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