Mining stocks: fool’s gold?

Mining stocks: fool’s gold?
Hi ho...hi ho
Paul Allison, CFA
June 21, 2022

Normally it would be ‘off to work they go’ for mining companies at this stage of the cycle. 

Firms like Rio Tinto and BHP make their money by extracting minerals from the ground for as little cost as possible and selling them for the best price.

When prices rise, miners tend to use windfalls to dig more materials out of the ground. And the opposite is true when prices hit rock bottom. Production is reigned in and cash is conserved. These are the supply forces that self-regulate commodity cycles and those price ups and downs are as old as the hills the metals spring from.

So, with metals like copper and aluminium sitting at all-time highs, you’d expect picks and shovels to be doing overtime, ripping as much out of the ground as possible. 

Supply up, prices down. Let’s move on. 

But this time it’s different

Ah, the most dangerous saying in investing. 

It’s true every cycle is different and the reasons for high or low prices are rarely the same. But in any market nearing record highs, optimists always grasp for explanations as to why high prices will stick around. 

Danger lurks, though, because regardless of the different reasons for high prices (the bubble in 1999, a commodity supercycle in the 2000s, web 3.0 in 2021) the outcome is usually the same. Bust follows boom like night follows day.

Of course, over the long term, growing demand tends to lead to higher peaks and shallower troughs, but in the short and medium term, cyclical industries like mining usually can’t escape the gravitational pulls of supply and demand.

But really, something does look different

The best way to gauge a mining firm's digging efforts is to look at its capital expenditure, or capex. Capex measures the amount of cash being spent on long-term mining projects and associated equipment.

2011-12 was the last time metals prices were molten hot. This came on the heels of the China-led commodity supercycle through much of the noughties. 

Back then, mining company bosses were fully paid-up members of the supercycle club, pouring vast amounts of money into projects, believing prices would stay high forever. 

In 2012 BHP and Rio Tinto spent around $40bn on projects and equipment, a whopping 30% of combined sales. And guess what? Yep, metal prices collapsed as the extra capacity led to oversupply.   

Fast forward to 2021 and the world’s two biggest miners spent just $14bn, less than 10% of their sales. So does this mean miners have finally found supply discipline? Maybe. 

After nearly 10 years in the doldrums, commodity companies have rediscovered their swagger, but this time it seems the message from management is different. There will be no returning to the hedonistic spending days of old, so they say.


If metals prices stay where they are the temptations to loosen the capex purse strings will grow of course, and spending is likely to pick up, but miners also have a large ESG guillotine hanging over their heads. 

The ESG crowd has quietened this year but the theme is evergreen (pun intended). The hurdles for approving large, dirty mining projects have risen in recent years, and this should keep supply shackled to an extent.

So with supply constrained, at least for now, demand becomes the key factor. 

Demand is marginally more predictable than supply but still a tough thing to forecast. If we slip into recession this year or next, it’s likely the associated demand drop-off will hurt commodity prices. But that’s a big if.

It’s raining cash

All this means the cash coffers at large mining companies are overflowing. 

Last year Rio and BHP both produced around $20bn in free cash flow (cash after all expenses and large products). That equated to roughly one third of their respective sales or a 33% free cash flow margin. 

That’s a level of cash practically unheard of for a capital intensive industry like mining.

For dividend investors, the yields on commodity stocks look too good to be true. And if history is anything to go by, this might well be the case.

Miners always tend to make bundles of cash during the good times only to see the wells run dry when the bust inevitably arrives.

But maybe this time really is different. It’s possible that we never return to the boom and bust supply cycles of old, due to ESG constraints or new-found capital discipline.

Either way, mining firms look set to continue raking in cash for now, as even a big bump in capital spending would take time to translate into new supply. 

The path of economic growth looks like the most immediate risk to the bull case for mining stocks, and for that, we’ll just have to wait and see.  

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