ROB Insight is a premium commentary product offering rapid analysis of business and economic news, corporate strategy and policy, published throughout the business day. Visit the ROB Insight homepage for analysis available only to subscribers.
Global mining giants BHP Billiton and Rio Tinto are caught in a trap of their own making. Commodity prices and demand remain sluggish, yet both companies are locked into aggressive investment commitments. The task for Canadian investors is to determine the extent to which Canadian miners suffer from the same issue. Free cash flow analysis is not encouraging.
Summarizing a report from the Goldman Sachs mining team, the Financial Times's Alphaville blog summarizes the dilemma thusly:
"The big miners won't generate much cash over the next three years because of massive capex budgets, which are by and large locked in.
Rio, for example, will spend $13-billion this year and possibly more if it approves a second phase of Oyu Tolgoi in Mongolia or the South of the Embley project in Australia. BHP, meanwhile, will splash out $22-billion on sustaining capital and growth projects in the year to June 2013.
There is a big wave of iron ore supply about to hit the market while Chinese demand for the steel making ingredient is about to fall. Deutsche Bank estimates 80 million – 100 million tonnes of additional supply is coming down the slipway in the second half of the year – most of it from the Australian trio of Rio, BHP and Fortescue Metals Group."
Canadian mining companies, particularly those in the iron ore sector, are undoubtedly in the way of this approaching crisis. Labrador Iron Ore stock has entirely ignored a recovery in the commodity price and remained at bargain basement prices.
The news is no better for the Canadian mining sector as a whole (see chart). Free cash flow yield is heading steadily lower, toward financial crisis levels. In most cases, commodity prices have been stable but higher capital expenditure is eroding profits for the sector.
The mining sector is currently playing a game of chicken with global commodity prices. Firms continue to invest in new mines, in the hope that when new production comes on stream in the years ahead, higher profits and cash flow will resume. In many cases, it's an all or nothing bet – and one that's not fully supported by global economic prospects. Until cash flow improves, investors should remain highly skeptical.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.
Scott Barlow