The inflationary environment hitting the miners and their procyclical-commodity linked cost bases is clearly here, but what is the potential impact? Tyler Broda, Head of European Metals and Mining Research at RBC Capital Markets discusses the possible risks to the sector both from costs and revenues. Listen to the podcast for more.

(upbeat music)

- [Michael] Welcome to the Industry's in Motion podcast

from RBC Capital Markets

where we'll be exploring what's new and what's next

in today's fast moving markets and industries

to help you stay ahead of the curve.

Please listen to the end of this podcast

for important disclosures.

I'm Michael Hall, head of European research

here at RBC Capital Markets in London.

And today I'm joined by Tyler Broader.

Tyler's nearly 19 years experience working

across major banks, both in banking positions, but in sales.

And for the last nine years

he's actually headed up the European research team

focusing on the metals and mining sector.

And Tyler you recently published a report

outlining inflation and how that's impacting

or likely to impact the cost outlook for the mining sector.

Can I ask you to kick off actually what inspired you

to write that note?

- [Tyler] Yeah thanks Mike for having me.

The Anglo-American, when they came out

with their cost guidance recently, there was a big uplift

in its cost for 2022, and that's absolutely fine.

It's an inflationary environment.

We expect that to be happening.

What then happened is as updating the model,

I realized that, well actually our 2023 costs are lower now.

And when 2024 is even lower than that.

And you start to realize that the numbers

when you go through an inflationary environment

you reach that point where you move to inflation.

It really does cause a pivot in terms of your expectations.

I mean, it is very hard to model cost

for the diversified minors.

You've got so many different variant assets

that have different cost profiles.

A big open pit would be very heavy in diesel,

underground mine would be very heavy in labor.

So it all really depends on where the mine is, et cetera.

So it makes it very hard an aggregate to model

which I think leaves consensus and us

basically hugging towards medium term guidance

but that's all historical now

and we're in a much different environment.

And so after we changed our changes for Anglo-American

which saw us raise costs for the next couple of years

I was expecting to see more downgrades come through

and they didn't, which led us to doing the work

around this note where we basically took a look

at all of the company's cost profiles in consensus,

and each one of the big five major diversified miners

that we cover sees a declining cost profile

over the next five years which in today's environment

with CPI running at 8% and the inflationary forces

facing industries from energy or labor

being potentially higher than that

this leads to quite a large disconnect.

We didn't even look as well in this note

at the implications for capital expenditure,

but there would be a lot of the same forces impacting there.

- [Michael] Okay, interesting.

So we're basically resetting 10 years

of lower cost base and cost cutting

into a different environment

and elaborating on that then how is this inflationary period

different from other cycles?

- [Tyler] Yeah, in the note, we took a look as well

at the historical inflation since 2002 in the space.

And it was actually quite interesting to look

at the inflation we saw in 2006 through 2008

where it reached up to 40% year over year on a unit basis.

And that's actually even higher

when you think about how much production

was being delivered from a growth perspective

over that time, we don't have that this time,

the mining companies, the last six seven years

have been under investing and holding back

giving back capital instead of investing that

which means that this inflation potentially

could be even more impactful.

And I think as well, this inflationary environment

following 10 years of easy monetary policy

and then the build up sort of tension

leads to potentially us being

in a more inflationary environment

than that pre global financial crisis period

which is quite worrying when you look at where

the cost based forecasts are for the the space.

We also went through a phase in 2012 or 2017

where you largely saw deflation come through.

And that is something that we think

could potentially happen again over time.

But at this point what that's done

is effectively reset everything lower into what is we think

potentially unrealistic expectations and costs.

- [Michael] Okay actually sounds relatively daunting

and scary.

I mean, where could we actually be wrong?

Where could the benign effects be more benign

than we're expecting?

- [Tyler] Well, I think that there is an element

that companies could push through

more technological savings.

There are some innovations coming through

but I think actually that this might actually

be a better outcome than the other side,

which would be most of the time we've seen in the past

big periods of inflation has been followed

by big periods of deflation.

And the reason for that is

is that the inflation tends to happen late cycle.

So it's actually an economic decline

which we are potentially seeing the start of right now

that is potentially going to usher in maybe a scenario

where we are wrong on inflation.

But unfortunately that would lead

to a much bigger compression in the margins

would actually be a worse outcome for the equities.

So it does leave us in a relatively cautious position

in the short term.

- [Michael] Okay.

And thinking about the pricing side

if you've got inflation going up

and this is the commodity prices

why wouldn't higher cost higher inflation

support higher commodity prices?

- [Tyler] And normally it does.

I think there's a couple of things to mention on this

as to why the support may not be there the same

as in history you have in theory in a commodity,

if you're priced to the top end of the cost curve

and then inflation starts to move higher

then the prices need to move up to keep that supply online.

What we've had since,

especially since the the response to COVID

and all of the liquidity in the markets, we've pushed up.

And it was in a recent note,

but we've pushed up to being trading at,

for commodities somewhere around 120 to 160%

off the top end of the cost curve.

So unfortunately there's a bit of a catch up happening here

whereby the commodity prices of the mind commodities

have moved up higher but with energy catching up

that means the inflation is gonna backfill behind it.

But unfortunately, because we're so far off

that cost support there's a lot of room

for cost to go up before it starts supporting the prices

at least from the current levels.

- [Michael] Okay I understand.

So look, it's not our agreement to talk

about individual stocks here, but at a sector level,

you are portraying strong high margins, revenues at risk,

potentially from a deteriorating demand environment.

That's not what we're forecasting, but that's the potential.

And obviously the scope for costs and CapEx

cost from the P and L CapEx and the cash flow to go up.

What does that mean for a sector view?

- [Tyler] Well, I think that's why

we've moved increasingly cautious as the year has gone on.

In the note as well there's a chart showing

the historical EBITDA margin because oil prices lagged

in 2020 and 2021 we saw the margins for the minors,

go up, the revenues go up faster than their costs went up.

And that's led to a point where we're at 54% EBITDA margin

in 2021.

The average over the last 20 years has been about 38%

across the sector.

What that means is,

is that we are potentially at peak margins

and consensus actually has the margins coming back.

The problem we would see is that that might happen

a lot faster if costs need to be adjusted

as part of this process.

There's also the fact that we've seen the equities perform

as well as they have.

You know, you've seen the balance sheets getting fixed.

You've seen the companies

increase their business capabilities,

dividends have gone up all these things though

have pushed the share prices up.

And if you take a look at most of the share prices

in the sector at the moment they're up near

their all time highs.

And so we think that at this point

there's a very strong outlook for a lot of the sector

in terms of things like decarbonization,

things like copper, some of the battery metals

there's gonna be some very interesting times ahead of us

but at this point, we think just in terms of the ability

for this sector to withstand a cyclical downturn

into what we think is rising inflation

is going to be very challenging.

- [Michael] Okay, understood.

Great, thank you very much for your time, Tyler,

obviously, a sector we need to keep a close eye on

over the coming months.

What else lies ahead in today's ever evolving markets

and industries.

We'll be keeping track right here on Industry's in Motion.

Make sure you subscribe to Industry's in Motion

wherever you listen to your podcast.

Thank you for listening to today's episode.

- [Narrator] This content is based on information available

at the time it was recorded

and is for informational purposes only,

it is not an offer to buy or sell or a solicitation

and no recommendations are implied.

It is outside the scope of this communication

to consider whether it is suitable for you

and your financial objectives.