The sub-mine crisis of 2016
From its peak in 2011 to the beginning of 2016, the global mining sector has gone through a wrenching 90% reduction in global market capitalization, wiping out an estimated US$1.5 trillion. Following the sub-prime mortgage crisis, the International Monetary Fund estimated that financial institutions around the world ultimately lost US$1.5 trillion directly or indirectly from their holdings of subprime mortgage backed securities. Has the collapse of the global mining industry already resulted in a "sub-mine" crisis of global economic importance? If so, have the widespread repercussions throughout the world been felt already, or is it possible that the real consequences are about to come?
The collapse of the global resources stock market capitalization will have severe consequences. Pension funds which have a diversified portfolio have now lost perhaps 9% of their valuations from the mining sector collapse alone (assuming mining makes up 10% of their portfolio) – leaving less capital to reinvest into other areas, and making further investment into the mining sector less likely due to perceptions of greater risk given the sector's tremendous fall from grace. Hedge funds, private equity, and other sources of institutional investment must all have lost similarly large sums.
Banks and other international financial institutions, which bankrolled the astounding development of the mining sector around the world, even if not directly exposed to mining firms – are often now facing exposures to major infrastructure – ports, rail, ships, power stations, many built to service the global minerals sector – and some of that infrastructure may now have little remaining market value. Mines once developed with hundreds of millions of dollars in capital are now being shuttered, or sold for a dollar. Those mines that are being shuttered had been expected to export bulk commodities through rail, port and shipping lines – many of which had been project financed, and now face consequential loss and potential default, which can trigger follow on financial defaults by those overexposed to such risk.
Global bulk shipping rates have plummeted, placing further strain on financial markets. Bulk commodities like iron ore, coking coal, nickel and copper, are being traded at historic lows, forcing intermediaries – such as refineries and smelters, into economic collapse. Steel mills throughout China have been facing economic ruin for the last year. In tandem with the mining sector in free-fall, the collapse of global oil and gas pricing only multiplies the complications to the global commodities sector. With crude trading at under US$30 a barrel, the same market risks facing the mining sector are undoubtedly being faced in the energy sector.
Who else is exposed? Employment in the sector has followed the collapse – with Anglo American announcing a record plan to reduce workforce by 85,000 people. Communities are clearly impacted, with lost employment now unwinding local economies. Government revenues of commodity rich countries are experiencing the sting that comes from the "resource curse", with consequential reductions in government services in some of the poorer parts of the world. Sovereign bonds issued by such countries may now be rapidly downgraded as a result.
There must be a bright side and there is: low energy and commodity prices can lead to reduced costs for cars and white goods and other costs throughout the economic system (provided countries do not rapidly devalue their currencies – a related risk to the fall in commodity pricing). There may also be an opportunity for those not yet exposed to the sector to acquire assets at record low valuations and wait for the inevitable return to a "new normal". This bright side might have a negative aspect to it – global deflation. When global commodities are trading at (or occasionally less than) cost of production, then a downward spiral of deflation can spread through the system, deepening the financial crisis of those who have high debt liabilities
A free-fall in commodity prices will create great strain in the financial system as hedge positions are unwound and lending institutions balance sheets come under strain. Thoughtful market observers have worried about the risk that derivatives markets in Australia and abroad might magnify the economic effects described above and create a contagion of financial instability radiating throughout the world. This is a pressing question because of the huge extent to which derivatives are used by producers, shippers and users of physical commodities of all sorts, in most cases to hedge risks and in many cases in order to speculate on price direction or volatility. This worries people who consider the role of derivatives in the last global recession. The Subprime Crisis of 2008 began in the United States housing market but rapidly morphed into the Global Financial Crisis in part because over-the-counter derivatives markets fostered unperceived financial interrelationships that upset stability in financial markets around the world.
It is unlikely that derivatives will play the same destabilizing role in the coming energy and commodities recession that they played in the Global Financial Crisis. In part this is because the role of derivatives in physical commodity markets is different than it was in pre-crisis credit markets, with a wider role for legitimate hedging than there was in pre-crisis credit markets, which used credit default swaps not so much to hedge risk as to create additional leverage and liquidity. Second, the derivatives regulatory framework is much more robust today than it was at the dawn of the Global Financial Crisis, with systematic regulation of over-the counter swaps markets in all developed economies.
However, an energy and commodity recession may provide the first global test of the effectiveness of the efforts that have been made since 2008 to create more transparency, better regulation and ultimately improved financial stability mechanisms. Three areas of concern include whether cross-border regulation will be effective to rein in a global contagion of closeouts. A second danger area is whether the diffusion of hedging and energy risk is well-enough understood or whether we will discover that some obscure fund or institution has unwittingly taken on all of the risk of Australia’s mining sector. A third concern is whether the regulatory responses to the crisis have indeed ended the phenomenon of “too big to fail” or whether new sources of instability have been created in clearing houses.
What might be done? Government tax and royalty policy might be reconsidered to enable marginal operations to remain in operation – saving employment and the supply chains dependent on such operations – but this risks of course slowing the correction of reducing capacity from the market. Surprisingly, demand for resources has not subsided – the challenge has been on the supply side. Darwinian forces will shut down over-supply which will eventually increase pricing. Until then, governments and major institutional actors should take a look at how regulations and market based interventions can assist to decrease commodity supply while increasing commodity demand, bringing equilibrium more rapidly to the market and reducing the ripple effects into the global economy. Regulators, and indeed all participants, should hold on tight, and get a steel eye on understanding the consequences from the global capital markets losing US$1.5 trillion from the mining and metals sector. Now may be the time to call for a new round of stress-tests for resources exposed institutions. Redoubled investigations into intermediary exposure may be critical. Resources participants across the board should rethink counterparty risk, and review their contractual and financial arrangements in light of possible cascading counterparty defaults.
What else should be considered? Here is a "top six" list of points to keep in mind:
(1) Sale/Lease back of Assets: Miners have significant capital allocated into rail spurs, crushing or washing plants, and related infrastructure. These assets could be sold and leased-back, taking cash out now in exchange for a leasing structure that could help restructure the balance sheet toward "core" assets.
(2) Take or Pay Renegotiation: In the event of voluntary administration, creditors will often need to negotiate their position. Port and rail operators are analogous to creditors to mining firms – investing capital for major infrastructure essential for mining operations, but with little value if such mining operations are closed or put into care and maintenance. Infrastructure firms heavily exposed to rail and port "take or pay" arrangements may be willing to restructure such contracts to ensure viability of operations of the mining firms prior to administration.
(3) Streaming. We have seen the emergence of streaming structures where financial intermediaries "pre-purchase" future production (of gold or similar precious commodities). The financial injection is used for cap-ex necessary for such production. It may be that streaming investors could inject capital into suffering mining operators, in exchange for discounted long term off-take, this time rather than to bring mines into operation, but rather to ensure mines continue in operation during the current commodity collapse.
(4) Renegotiation with Regulators Clive Palmer famously sought Queensland state government support in various forms – alleged to include support for remediation bonds and other obligations the Queensland Nickel operation had to issue in favor of the state. While he was apparently unsuccessful, there appears to be a window in which some assets might be able to seek government support temporarily to ensure ongoing operations, if such assistance could stave off insolvency and the consequential layoffs. Options could include renegotiating the quantum of state mandated rehabilitation bonds, or seeking other financial support through alternative state mechanisms, including for example suspending expenditure obligations on exploration tenure.
(5) Innovative Joint Venturing Joint Ventures are certainly not new to the industry, but innovative structures may be useful to consider. For example, given that port, rail, water, power and other infrastructure players are essentially all exposed to the same risk, but with different balance sheets and access to capital, it may be that rather than two mining firms joining in a joint venture, a mining operation opens equity to a port or rail provider in exchange for reduced take or pay costs for a period of time.
(6) Agriculture – Finally, many mining houses purchased significant amounts of land, including in some cases large blocks and stations. This was important to secure consents quickly and reduce interference by local land owners. In the current depressed market, reconsidering such assets could be helpful in reconstructing balance sheets. Rural agricultural firms are placing premiums on large properties with prime grazing or agricultural values. Sales could include protection of off-set obligations, easements, and put or call options in the event a mine is developed in the area of the land holding. Such deals (many already under negotiation) provide the possibility to dispose of such land without impacting resource development and operational rights.
The challenge for participants in the market now is around valuation – at what point should they sell or acquire – and what are future fair market valuations. How does an investor in a port, rail, or mine invest in this part of the cycle – what take or pay contract structures are appropriate for this new world. How might new sources of capital joint venture with current owners to recapitalize and prepare for the next stage of the cycle? In a world of increasing volatility finding solid ground may only become harder, and traditional contractual terms for acquisitions, joint ventures, financing and off-take arrangements must be reconsidered. One small part of the solution is that we all must become far more conversant in the economic forces that are at play – which have repeatedly taken even the major mining firms by surprise.
The world does not function without mineral resources – and the market will return to some form of profitability to ensure production continues. Until that new normal returns, we must prepare for even more volatility.
-Robert Milbourne is a partner in the Brisbane office of K&L Gates and an adjunct professor at the University of Queensland. Anthony Nolan is a partner in the New York office of K&L Gates and a Lecturer in Law at the Columbia University School of Law. K&L Gates is a full service global partnership of 2000 lawyers operating in all major jurisdictions around the world. A version of this article was originally published in the Australian Financial Review.