Looking into the future of mining


The remaining investors in miner and steel producer Arrium Limited (ASX: ARI) will be wondering where exactly the future lies for the debt-laden company after the board yesterday rejected a revised takeover bid of $0.88 per share. The subsequent hammering of the company’s share price, dropping 12% to close at $0.685, suggests shareholders don’t hold any illusions of another buyer fronting up in place of the Korean consortium behind the rejected bid.

In rejecting the offer Chairman Peter Smedley is quoted saying, “We believe that the revised proposal significantly undervalues Arrium and is not in the best interests of Arrium shareholders”. Although there were also issues surrounding the financing of the deal, it does beg the question — if Arrium is undervalued at $0.88, what is the company (or for that matter, any other listed mining company) really worth?

The valuation equation

The general principle of valuation can be applied to resource mining companies as with any other; the company is worth the present value of its future earnings (or more specifically, its free cash flows).  If we take this at face value, Arrium’s board is assuming the company’s future earnings are worth more than $0.88 today. For any resource company, whether a focused gold-mining company like Gindalbie Metals (ASX: GBG) or a diversified mega-producer like BHP Billiton (ASX: BHP) or Rio Tinto (ASX: RIO), these future earnings are a product of:

A) The quantity they produce,

B) The price being paid for the resource, and

C) The cost involved in getting the resource out of the ground.

Quantity and cost are somewhat within a mining company’s control. Price, on the other hand, is largely influenced by global supply and demand — the future of which is a source of vigorous debate between commodity analysts, politicians, and resource company executives.

Ore prices fall back to earth

Many have argued that iron ore prices have been caught in a spectacular bubble that has just gone ‘pop’. Just eight years ago, in October 2004, the price for a tonne of iron ore was around USD $16. For the financial year 2012, the average was around USD $151 per tonne, having hit a high of USD $191.90 in February 2011. The price moved on the back of huge increases in demand from China and India, which were undergoing surges in domestic construction growth, and supply was struggling to keep up. Naturally, huge mining operations were set up in Australia and around the world to fill the gap and capitalize on the opportunity. Locally, companies like Fortescue Metals Group (ASX: FMG) and Sundance Resources Limited (ASX: SDL) flourished. But as China’s growth slowed over the last 18 months, the huge future output potential of these mines is starting to look like surplus supply.

The future for iron ore demand

Supply is one side of the equation; demand is the other. The driver for iron ore in China was the result of demand for steel in construction projects to support the population’s massive urbanisation shift. This is now slowing. Research by Nomura analysts Matthew Cross and Ivan Lee suggests there will be no increase in the growth rate of China’s steel needs over 2012-2013. This, despite China’s expected urbanised population growth from almost 50% today to around 64% in 2025. Others suggest a more optimistic rate of 3-5%. Regardless, there is no debate that the rate has dropped significantly since the highs of the last few years.

Miners like Aquila Resources Limited (ASX: AQA) have already taken this on board — announcing plans to cut spending on its $6 billion Pilbara Iron Ore project — while Fortescue and BHP also have announced plans to cancel new projects and take on cost-cutting measures.

The Foolish bottom line

So, the huge demand for iron ore over the next couple of years is being supressed and supply is likely to remain high. The natural result of this situation is to place pressure on prices. We have seen this already with the price per tonne of iron ore easing back to the current level of USD $120. For miners like Arrium this implies lower margins on each tonne of ore mined and a necessity to sell larger quantities to maintain future earnings. With the chance of ore prices dropping further and a buyer now out of the picture, Arrium investors who have stuck with the company may question exactly when and how they will see the apparent fair value perceived by Chairman Peter Smedley.

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Motley Fool writer Regan Pearson doesn’t own shares in any companies mentioned. The Motley Fool’s purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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