Lessons on investing in miners

Mining makes up more than 20% of the ASX 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, often in an intermediate form, such as a concentrate.

Customers 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.

Mining industry value drivers

Value drivers are the factors that influence the worth of any product, service, asset or business. In the case of mining the interplay between the following 7 factors are key to understanding the competitive positioning in the industry. 

1. Revenue: Sales are driven by the product of commodity prices and sales volumes. Realized prices may be discounted relative to the benchmark price if products have impurities, or are sold in an intermediate form, such as a metal concentrate.
2. Cost of sales: Labor costs, raw materials, and consumables are the biggest components of the cost of sales.
3. Depreciation and amortization: Mines and their associated infrastructure, such as processing facilities, machinery, railways, and ports, are capital intensive. Depreciation and amortization tend to be material as a percentage of sales.
4. Income taxes: Global tax rates vary by asset and head office location. Some miners may incur resource-specific taxes on top of corporate income tax.
5. Royalties: Mineral wealth typically belongs to governments or, less commonly, private landholders. Miners typically pay royalties to provincial and/or federal governments, and/or private landowners, including indigenous peoples.
6. Minority interest: Mines are often developed with mining partners, or customers, such as steelmakers in the case of iron ore or coking coal. Host governments or indigenous peoples may also have minority shares in mines. This expense reflects the share of profits from those mines not due to company shareholders.
7. Capital expenditure: Mines and associated infrastructure, such as processing facilities, tailings storage facilities, railways, and ports, are capital intensive.

Why moats are so hard to find in mining

A moat is a sustainable competitive advantage. The imaginary of moat as a body of water to protect a castle is apt as a moat protects a company from competition. To offer effective protection the moat must be sustainable.

A company may benefit from a first mover advantage but without the protection of a moat those advantages will be eroded over time by competitors eager to get a piece of an attractive opportunity. A company that our analysts believe will sustain a competitive advantage for 10 years receives a narrow moat rating. A wide moat rating denotes am expected 20-year sustainable advantage.

Our analysts have identified 5 sources of competitive advantage – network effects, cost advantage, switching costs, intangible assets, and efficient scale. Companies that exhibit one or more of these sources of competitive advantage have a moat. For more on moats read our overview here.

Mining companies can exhibit the moat sources of cost advantage and intangible assets. However, mining companies with moats are rare.

Cost advantages

A durable low-cost advantage is the primary potential source of an economic moat. As mining firms generally produce largely undifferentiated commodities that are often highly fungible, switching costs, network effect, and efficient scale aren’t moat sources. Outside the rare case of a royalty asset, persistent production at a cost well below the long-term marginal cost with high capital efficiency is the only way to earn a moat.

Wide moats are very rare, requiring decades of reserves and persistent low costs. 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 proportion of investment was prior to the China boom when rates were much cheaper.

However, moats are not easily assigned even to Pilbara iron ore, particularly when assessing the company-level moatworthiness. Here, 20 years is plenty for large investment missteps, as happened in the China boom. Geological deposits are finite and deplete, meaning new resources must be acquired or found and developed. This is capital-intensive. Mispriced acquisitions or developments can materially dilute future returns, potentially precluding a moat. Mining companies often develop or acquire assets when prices are high, only to find they overpaid when the cycle turned, diluting future returns.

Cost advantage can break down with demand changes, capital allocation missteps, new low-cost supply, process replication, scale replication, irrational competition, and disruptive technology. High-value reserves can also deteriorate or deplete.

Intangible assets

Royalty assets can be valuable and moat-worthy if 1) acquired at an attractive price, 2) in effect longer-term, that is, at least a decade, and 3) production from the asset underpinning the royalty will likely persist. The latter condition generally requires the underlying asset to have a long reserve life and production to not be substantially and durably loss-making under a reasonable commodity price scenario.

Deterra Royalties (ASX: DRR) holds just such an asset, with a perpetual royalty on iron ore production from BHP’s Mining Area C, or MAC. The intangible relates to the MAC Royalty Agreement between BHP, BHP’s minority partners, and Deterra.

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. High-quality resources are sufficient to underpin at least 30 years of life at North Flank and 25 years at South Flank, with additional development options nearby.

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, and so 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.

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

Cyclical demand driven by China

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 transport are only possible if a deposit is economically viable.

Many of the large, shallow, high-grade deposits amenable 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 toward underground mining. This is particularly true in commodities such as copper and gold, , where large-scale bulk mining techniques, for example, block caving, are increasingly common.

Rarer forms of mining include in-situ recovery, where chemicals are injected into the ground via wells to extract commodities in solution, such as uranium, and placer mining, where sand or gravel is mined and separated into the valuable parts, often using simple 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.

Over time, mining has become more capital-intensive. Continuing this trend, miners are now turning to automation. This includes automated drilling at the mine face, automated trucks to transport ore, and remotely operated trains such as those operated by BHP and Rio Tinto at their Pilbara iron ore businesses.

Most commodities markets are driven by demand from China. For example, China has accounted for nearly all 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.

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.

As with steel, China’s large construction and manufacturing sectors and significant infrastructure spending are a big driver of copper demand. China is reliant on imported copper, accounting for less than 10% of mined supply but more than half of refined copper demand.

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, respectively.

At 370 metric tons in 2023, China is the world’s biggest producer of gold, accounting for about 10% of global supply, according to gold.org. However, it is still a meaningful importer of gold, with jewelry and investment demand totaling 910 metric tons in 2023.