Mining makes up more than 20% of the ASX 200 and nearly every Australian investor has exposure to the sector. To uncover attractive opportunities requires understanding the competitive forces that shape the industry.

The mining industry searches for, develops, extracts, and processes commodities including iron ore, metallurgical coal, copper, and gold, and ships them to customers. And when they ship these commodities it’s often not in its final form – it’s normally a concentrate.

People that buy the concentrates and products from the industry including include commodity processors such as steelmakers for iron ore and metallurgical coal, or intermediaries such as refineries and smelters for metals such as gold and copper. Prices vary based on the type of mineral produced, as well as the grade of their product compared with the standard for the benchmark price.

To understand the mining industry and how to find opportunities, it’s important to look at the value drivers of the industry. This article from Jon Mills explores the 7 value drivers of the industry.

These 7 value drivers provide a competitive advantage for companies against their peers – however, they’re not a sustainable competitive advantage, also known as a moat.
The episode goes through companies that come close to having a moat, and also run through the impact of China on the mining industry. It also discusses where Morningstar sees the best opportunities in mining.

Mark Lamonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

All right. So, Shani, picture this. Wild Friday night.

Shani Jayamanne: Yes.

Lamonica: I went to the pub for a couple of beers. I went back to my apartment. I was drinking a whiskey, trying to load stuff onto our website.

Jayamanne: Okay.

Lamonica: So, just crazy, crazy Friday night, and I get an email from you. And this occurred in April 2024.

Jayamanne: Yes.

Lamonica: And I received a request from you for leave on Friday night at like 9:30 in April 2025.

Jayamanne: Is this out of the ordinary for me? I feel like I always give you a lot of notice.

Lamonica: This was more than normal.

Jayamanne: Well, yeah, so I'm going on a trip. It's a milestone birthday for my husband next year. So, we're going…

Lamonica: 21?

Jayamanne: Yeah, 21. I like them young. No, not 21. But we are going to Edinburgh. And that's because my husband loves golf, and he wants to go play on the old course.

Lamonica: What are you going to do while he's playing golf?

Jayamanne: I'm going to caddie. I'm a good caddie. I always recommend the 8 Iron. That's what I do. If anyone knows golf, the 8 Iron is the best, in my opinion, and then Jordan. So, I've always really wanted to see Petra. So, I'll go there. I'll listen to Investing Compass and get the listens up in Jordan. I don't know if we…

Lamonica: Well, stay tuned. 14 months from now, we can hear an update on Shani's trip.

Jayamanne: Yes, but I would love some recommendations, especially if people have been to Edinburgh, which I imagine people have, and Morocco.

Lamonica: Okay. So, what's going to happen is because my email address is in the show notes, I'm just going to get emails about places that I'm not going to.

Jayamanne: Yes.

Lamonica: All right. Well, looking forward to that. Send along the recommendation. So, since you're not going on leave quite yet, why don't you talk about what today's episode is on?

Jayamanne: Okay. So, today we're going to speak about the mining sector and specifically how to find opportunities in the mining sector. This episode is based on the mining industry landscape by Jon Mills, who is part of Morningstar's equity analyst team.

Lamonica: And mining, of course, is an incredibly important sector for Aussie investors. Mining makes up more than 20% of the ASX 200, and nearly every Australian investor has exposure to the sector. So, to uncover attractive opportunities requires understanding the competitive forces that shape the industry.

Jayamanne: And the mining industry searches for develops, extracts, and processes commodities, including iron ore, metallurgical coal, copper, and gold, and ships them to customers. And when they ship these commodities, it often isn't in its final form. It's normally a concentrate.

Lamonica: People that buy the concentrates and products from the industry include commodity processors such as steel makers for iron ore and met coal, or intermediaries such as refineries and smelters for metals such as gold and copper. Prices vary based on the type of mineral produced, as well as the grade of the product compared with the standard for the benchmark price.

Jayamanne: Now, to understand the mining industry and how to find opportunities, it's important to look at the value drivers of the industry.

Lamonica: And by value drivers, what we mean are the factors that influence the worth of any product, service, asset class, or business. When we're speaking about mining, it is an interplay between seven factors, which is a lot. So, understanding those seven factors means that you'll be able to interpret the competitive position of companies in the industry.

Jayamanne: And that's very important to finding quality companies and therefore the right opportunities.

Lamonica: Okay. So, we have seven to go through. So, I guess we should go down the list. We'll probably finish right when you need to go to the airport to fly to Scotland. So, the first is revenue. So, sales are driven by the product of commodity prices and sales volume. The prices may be discounted relative to the benchmark if the commodities are a lower grade, so if they have impurities or if they're sold in intermediate forms such as concentrates, which we spoke about before.

Jayamanne: Then there's cost of sales. Labor costs, raw materials, and consumables are the biggest components of the cost of sales. And cost of sales is important because the lower that they are, the higher the profit margins.

Lamonica: So, there's depreciation and amortization. So, mines are and their associated infrastructure like processing facilities, machineries, railroads, ports cost money to maintain. They're very capital intensive. So, that means that depreciation and amortization tend to be a very large part of the percentage of sales.

Jayamanne: And income taxes are another one. The tax rates that apply really depend on the type of asset and the head office location. Some miners may also incur resource-specific taxes on top of corporate income tax.

Lamonica: Then there's royalties. So, mineral wealth typically belongs to governments or less commonly private landholders. So, in a lot of areas around the world where there are mines, royalties are typically paid to either a state government or a federal government or private landowners, including indigenous people in Australia.

Jayamanne: Okay, there's a couple more. There's minority interest. Mines are often developed with mining partners or customers such as steel makers in the case of iron ore or coking coal. Host governments can also have a share. And this expense is really incurred when their share of profits is given to other minority interests that don't flow down to the company shareholders.

Lamonica: And the last one – I can't believe we made it to the end. But the last one is capital expenditures. So, mines and associated infrastructure like processing facilities, railroads and ports are of course very capital intensive so they cost a lot to build.

Jayamanne: So, those are the seven value drivers that investors should look at when they're assessing companies in the mining industry. They provide a competitive advantage for companies against their peers, but they're not a sustainable competitive advantage.

Lamonica: And another name for a sustainable competitive advantage, of course, is a moat. And moats are very hard to find in mining.

Jayamanne: And as a reminder, there are five sources of moat – network effect, cost advantage, switching costs, intangible assets and efficient scale. The most common characteristics that a mining company can exhibit are cost advantage and intangible assets, but it's very rare and usually not sustainable.

Lamonica: Okay, why don't we talk first, Shani, about cost advantages. So, mining firms generally produce largely undifferentiated commodities. That's why they're called commodities. Companies can easily switch between one mining provider and another. So, the only real avenue to achieve a moat is persistent production at a cost well below the long-term marginal costs with high capital efficiency. And even then, it would be a narrow moat because wide moats are very rare in this industry. It would be rare because it would require miners to maintain decades of reserves and persistent low costs.

Jayamanne: And our moat ratings generally apply at the company level, and we typically do not have moat ratings on underlying assets. A case could be made that the Western Australian iron ore assets of BHP and Rio Tinto justify a wide moat, particularly as a large portion of investment was prior to the China boom when rates were much cheaper.

Lamonica: But moats are not easily assigned even to Western Australian iron ore, particularly when assessing the company level moat-worthiness. Cases like this, 20 years is plenty for large investment missteps, as happened in the China boom. Geological deposits are finite, and they deplete, meaning new resources must be acquired or found and then developed.

Jayamanne: And this is capital intensive. Mispriced acquisitions or developments can materially dilute future returns. Mining companies often develop or acquire assets when prices are high, only to find they overpaid when the cycle turned, diluting future returns.

Lamonica: So, moats are very hard to earn, and cost advantage can break down with demand changes, capital allocation missteps, new low-cost supply, process replication, scale replication, irrational competition, and disruptive technologies. This is the podcast of lists. So high value reserves, of course, also deteriorate and deplete as you mine them.

Jayamanne: Bleak.

Lamonica: Very bleak, Shani. Then there's intangible assets. And here we're talking about royalty assets. Royalty assets means payments made between two parties for the use of a particular asset. That sounds very vague, is basically paying one party for the use of a mine in this instance.

Jayamanne: And royalty assets can be valuable and moat-worthy, and this is that they are acquired at an attractive price, and they can be used for longer than a decade, and production from the asset underpinning the royalty will most likely persist. So, this really requires the underlying asset to have a long reserve life and production to not be substantially and durably loss making under reasonable commodity price scenarios.

Lamonica: So, a good example of this type of asset is Deterra Royalties, with the ticker symbol DRR. They have a perpetual royalty on iron ore produced from BHPs Mining Area C, or MAC. The intangible relates to the MAC royalty agreement between BHP, BHP's minority partners, and Deterra.

Jayamanne: A cost advantage stems from both the low cost to acquire the MAC royalty area and the low-cost iron ore production that underpins the royalty. The North and South Flank mines are expected to be close to the bottom quartile of the global cost curve at full capacity, and high-quality resources are sufficient to underpin at least 30 years of life at North Flank and 25 years at South Flank. And there are also additional development opportunities nearby.

Lamonica: We think production is highly likely to continue even if iron ore prices crater, given the low-cost nature of MAC. This underpins the value of the intangible. The royalty is based on revenue rather than profits, so it isn't directly affected by the margins BHP earns from MAC. If anything, the MAC royalty would likely benefit from inflation, assuming it ultimately steepens the cost curve and supports higher prices.

Jayamanne: Deterra has no operating costs and no capital costs but owns royalty rights on current and future developments in the royalty area. BHP is a primary counterparty, and BHP is in strong financial shape.

Lamonica: Okay. So, one of the largest trends that are impacting mining is the cyclical demand created by China.

Jayamanne: All right. So, let's start with a little bit of background. Many commodities commonly occur in the Earth's crust, but to be valuable, they must exist in sufficient concentration and quantity. Extraction, processing, smelting, and the transport are only possible if a deposit is economically viable.

Lamonica: Many of the large, shallow, high-grade deposits that are suited to open-pit mining have already been found, particularly in the developed world. Miners are exploring deeper to find new deposits, and as a result, there is a slow trend towards underground mining. This is particularly true in commodities such as copper and gold, where large-scale bulk mining techniques, for example, block carving, are increasingly common.

Jayamanne: Rarer forms of mining include in-situ recovery, where chemicals are injected into the ground via wells to extract commodities in solution. This is for commodities such as uranium and placer mine, where sand or gravel is mined and separated into the valuable parts, often using techniques such as gravity separation. With placer deposits, commodities such as gold or mineral sands, for example, are naturally concentrated in river, lake, or sea sediments.

Lamonica: I mean, this is the point where you're sitting there being like, I know more about mining than I probably need to know at this point.

Jayamanne: Actually, I'm sitting here being like, if there is anyone who is a miner that's listening to this, it's going to be like, who are these people?

Lamonica: Are you assuming that I could not be a miner?

Jayamanne: Yeah, I mean, have you ever gotten your arms dirty, Mark?

Lamonica: Not yet.

Jayamanne: No? Okay.

Jayamanne: But any minute now.

Jayamanne: All right. So over time, mining has become more capital intensive, and adding to this is that mining has turned more to automation, and that includes automated drilling at the mine face, automated trucks to transport ore, and remotely operated trains such as those that are operated by BHP and Rio Tinto at their Pilbara iron ore businesses.

Lamonica: So, most commodities markets are driven by demand from China. For example, China has accounted for nearly all the growth in global demand for copper and iron ore for the past decade. China has modest and generally poor-quality domestic iron ore reserves but consumes more than 50% of global steel and roughly 70% of traded iron ore.

Jayamanne: Almost all metallurgical coal is used with iron ore to create steel via the blast furnace, blast oxygen furnace method. China is the largest consumer of metallurgical coal, but large domestic reserves mean it accounts for roughly 20% of traded demand.

Lamonica: And as with steel, China's large construction and manufacturing sectors and significant infrastructure spending are a big driver of copper demand. China is relying on imported copper, accounting for less than 10% of mine's supplies, but more than half of refined copper demand.

Jayamanne: China's large construction and car manufacturing industries mean it also dominates aluminum demand. China also drives demand for nickel and zinc, given their primary use in stainless steel and galvanized steel.

Lamonica: And for any Americans listening, that word she said was aluminum.

Jayamanne: Yes.

Lamonica: At 370 metric tons in 2023, China is the world's largest producer of gold, accounting for about 10% of global supply according to Gold.org.

Jayamanne: Reputable.

Lamonica: Yes, exactly, and appropriately named. However, it is still a meaningful importer of gold with jewelry and investment demand totaling 910 metric tons in 2023.

Jayamanne: Okay, so let's get to the good part. What does this mean for investors? It means that investors need to be aware that the companies that they invest in are heavily reliant on China and the Chinese economy. Although these companies make up a large part of the ASX, the health of the companies are not dependent on our economies as much as they are on China.

Lamonica: Because we are so invested in these companies and most of us have outsized exposure to miners, we need to be wary that Chinese demand is intrinsically linked to the success of our portfolios.

Jayamanne: The report also includes an assessment of the current opportunities in mining. Most of the mining companies in our coverage list have large market caps, operate numerous mines and are exposed to multiple commodities. Moats, which indicate the ability to maintain a sustainable competitive advantage, are rare. So, the following stocks are considered materially undervalued.

Lamonica: Okay, so we're going to move on to the sexy part of the report, Shani.

Jayamanne: As sexy as a mining landscape report can get.

Lamonica: Yeah, exactly. I mean, there are countless people that will bring this out to the pub on Friday night when I'm at home getting leave requests from you and use this to meet people. So, we do call out a couple of the opportunities that are in this report. So, the first is Newmont, which is currently a 5-Star stock, and its primary commodity is gold.

Jayamanne: Newmont is the world's largest gold miner with a portfolio reflecting three major deals in recent years. First, it acquired fellow gold producer Goldcorp for a relatively mild premium in 2019. Not only did it avoid paying a high price, Newmont also extracted better performance at mines where Goldcorp struggled.

Lamonica: And second, it combined its crown jewel Nevada assets with Barrick Gold's in a joint venture called Nevada Gold Mines, once again, appropriately named or NGM. So, this also happened in 2019. With Barrick as the operator, Newmont owns 38.5% of the partnership, which reduced cost given the proximity of mines owned by the joint venture. Newmont also acquired Australian-based gold miner Newcrest in 2023.

Jayamanne: As a commodity producer, Newmont is a price taker. This means that they don't set prices, and they must accept the price the market sets. Newmont needs low-cost mines with long lives and a low installed capital base to support the longer-term excess returns needed to justify an economic moat. So, we don't assign it a moat.

Lamonica: So, the acquisition of Newcrest in November 2023 extended Newmont's lead over Barrick Gold as the world's largest gold miner, with 2023 sales of roughly 7.3 million ounces of gold from the mines in the Americas, Australia, PNG, and Ghana. The combined company also has material copper production of roughly 160,000 metric tons, as well as numerous development projects that we think are valuable and perhaps overlooked.

Jayamanne: We think Newmont's shares are undervalued given its weak sales volume in 2023, which have led to elevated unit cash costs. However, we think sales volumes will recover, helping lower unit cash costs and drive some improvement and enlarge enlarged Newmont's current position around the middle of the cost curve. Gold miners have also generally been out of favor due to concerns over rising real interest rates, which increases the opportunity cost to hold gold.

Lamonica: Okay. So, Newmont is roughly 30% undervalued, and that is when the report was issued, the 11th of March 2024, with a fair value estimate of 50 bucks. All right. So, let's do one more, just in case we want to keep the conversation going at the pub.

Jayamanne: Okay, and we'll do this one quick sticks. So, this one's Iluka. Iluka is diversified and does not have a primary commodity. It's currently a 4-Star stock.

Lamonica: Iluka is a global mineral sands miner, and their major mines are in South Australia and Western Australia. Relatively low operating costs for zircon are supported by the mine in South Australia, but its reserve life is less than a decade. Like the industry, Iluka is facing a declining grade profile at its mines, but a constrained outlook for supply should support prices.

Jayamanne: Mineral sand prices and volumes are the primary drivers of our fair value estimate. Iluka's focus is on maintaining and managing volumes and the resulting impact on prices. Efforts to maintain margins and prices mean sales volumes can fall in periods of weak demand, as Iluka shoulders part of the responsibility for balancing industry supply, but Iluka can also flex production to increase market share or liquidate access inventory as prices rise.

Lamonica: And we assign Iluka a no moat rating. So of course, as a commodity producer, Iluka is generally a price taker and needs low-cost mines with long lives and a low installed capital base to support the longer-term excess returns needed to justify an economic moat.

Jayamanne: Iluka was undervalued by 29% at the time the report was released at 11th March with a fair value estimate of $9.50.

Lamonica: Okay, we made it.

Jayamanne: We made it.

Lamonica: That was a lot of detail, a lot of technical detail around mines.

Jayamanne: Yes.

Lamonica: But I believe that is the first time we have used the word sexy on Investing Compass.

Jayamanne: I don't think it was.

Lamonica: Well, there we go. Just another episode. Anyway, hope you guys enjoyed all of that detail and all of those lists. And of course, if you have recommendations that you want to pass through me for a trip that I'm not going on, please send them to my email address along with any questions or comments you may have. Thank you.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)