Capital shortage is number 1 issue

The capital strike hitting the resources sector risks doing long-term damage to the industry’s growth prospects.

One of the defining features of free markets is that they tend to overshoot, on the upside and the downside.

When times are good, investors indulge in “irrational exuberance”, to use a phrase made famous by former US Federal Reserve chairman Alan Greenspan.

In other words, investors will throw money at just about any alluring opportunity.

When markets turn, the result can be a drying up of investment capital. That is where we are at the moment.

There has been a dearth of funding and takeover deals this year and little sign the ‘capital strike’ will end any time soon.

The seriousness of this issue was highlighted by Ernst & Young’s annual survey of business risks facing global mining and metals companies, released this week.

Capital allocation and access to capital jumped to the top of the business risk list, up from number eight last year.

The report makes clear these “capital dilemmas” threaten both the long-term growth prospects of larger miners and the short-term survival of cash-strapped juniors.

These pressures were highlighted by news announcements released over the past week.

At the big end of town, gold miner Newcrest announced job cuts and big write-downs, leading to a savaging of its share price.

Among mid-cap stocks, Gindalbie Metals announced a funding deal that will deliver majority ownership of the giant Karara iron ore project to its Chinese partner Ansteel.

It was a prudent short-term step as Karara experiences commissioning issues but the long-term effect is a shift of control of one of the state’s major resources projects.

At the junior end, Gold Road Resources announced the resignation of two of its directors, illustrating the way in which such companies are striving to save every penny until the market turns.

Many of Gold Road’s West Perth peers have announced salary cuts, reduced exploration, staff cuts and office closures, and more of that is bound to follow, judging by data assembled by Ernst & Young.

Companies with a market value of less than $2 million – about 20 per cent of listed mining companies across the main junior exchanges – had on average less than $1 million in cash and equivalents on their balance sheets at December 31, 2012.

Ernst & Young’s global mining and metals leader Mike Elliott says the capital dilemma stems in part from the preponderance of investors with short-term investment horizons “who are not as comfortable with the (mining) sector’s longer-term, and often counter-cyclical, development, investment and return horizon”.

“This raises the question of how to balance the demands of short-term shareholders with those investing for longer-term returns,” Mr Elliott says.

“There is concern that the pendulum may swing too far, raising the possibility of another period of endemic under-investment in new supply and resulting in future price volatility.”

“There is a profound risk that the decisions taken by mining and metals companies today could damage their growth prospects, destroying shareholder value over the longer term.”

While it’s possible the capital strike will be long lasting, the reality is that nobody knows when the market will turn.

Just 12 to 18 months ago, fast-tracking production was top of the agenda for mining companies in the EY survey, and capacity constraints defined the key business risks.

Now the industry is focused on margin protection and productivity improvement.

Issues like skills shortages and infrastructure access have become much less prominent.

How to respond?

While markets may be imperfect, they are the best system we have for allocating capital and resources.

Governments may have a role in smoothing the adjustment process for industries going through change but they should not try to change or control markets.

As for the affected businesses, some of the factors squeezing margins, such as scarcity premiums for inputs or high currency values, will tend to self-correct as mineral prices fall.

But companies still need to address operating costs and capital allocation. The experience of the past few years, when the focus was growth at all costs, shows that business should always keep a close eye on efficiency and productivity.

That is the best way to deliver profitable results and attract support from investors.