Softening commodity prices, rising costs and increased competition are challenging the boards of Australia’s energy and resources sector, but good governance and sound economics may help sort the wheat from the chaff, writes Domini Stuart.

    For over a decade, China’s appetite for Australian resources seemed insatiable. Year after year demand exceeded supply, forcing up the price of most commodities and creating an exceptionally buoyant environment. Then two things conspired to effect a change.

    “One is the flattening of growth in China,” says Keith Jones FAICD, chairman of Gindalbie Metals and Deloitte Australia. “There is still very strong demand but, over the last two years, the growth in that demand has tapered off. The other is that the major players have adjusted to the supply side of the equation. High prices encouraged massive investment in the sector, and increased capacity means there is no longer a dramatic shortfall.”

    As a result, the price of most major commodities has fallen sharply. Metallurgical coal, which was fetching more than US$300 a ton in mid-2011, is now selling for around US$113, while iron ore has dropped from highs of US$170 to around US$S80 a ton. Most of our other mineral exports are on a similar trajectory, which means that companies are now dealing with a very different set of challenges.

    “In the boom period, costs were less important to producers than getting the quantum of supply into the marketplace,” Jones continues. “If you could get the product mined and delivered you were going to make money. Today the opposite is true. Revenues have fallen dramatically, so reducing costs has become the primary focus.”

    Increasing the productivity of both capital and the workforce is also high on the boardroom agenda. Astute directors are continually reviewing both strategy and operations, scrutinising every link in the supply chain and calling for contracts to be renegotiated wherever they can.

    “What was good enough five years ago is certainly not good enough now,” says Jones.

    Mike Dunbar, managing director of Western Australian gold company Gascoyne Resources, believes that the boards of junior explorers should take a cold, hard look at their capabilities.

    “Many struggle or fail because they lack the skills to implement a development path,” he says. “We know that our expertise lies in exploration, and we have a number of advanced projects that warrant being developed. But we have also acknowledged that we do not currently have the necessary skills to push them into development, so the board is looking at bringing on a “big brother” — an operating gold mining company — to form a joint venture with us rather than attempting to do the development ourselves.”

    For some companies, the future may lie in diversification, or even a switch into a different area.

    “One example is a company called Karoon Gas,” says independent consultant Anuja Rao GAICD.  “It started out in the gas industry but, when the cost of mining and delivering gas proved to be unsustainably high, they decided to move into oil, where the overheads were a lot lower. The most resilient companies are prepared to consider every alternative.”

    A significant clean-out

    Capital that was readily available when prices were rising is now much harder to source. For the 800-plus companies at the smaller end of the market this could pose a serious threat to business.

    “The vast majority of ASX-listed resources companies are those focused on early stage activities such as feasibility studies and exploration of mineral resources and ore reserves,” says David Cormack MAICD, CEO of Snowden mining consultants. “As they are not generating their own cash flow from operations they are heavily reliant on regular raisings, so the fundamental risk for many of them is that they will not have enough working capital to stay afloat. Some will have to forfeit their leases and tenements as they struggle to meet the requirements for minimum exploration spend while others will inevitably disappear. I think there is a real risk that today’s 800-plus [smaller resources companies] will fall to a couple of hundred over the next few years.”

    Dunbar will not be sorry to see some of them go. “At the moment there are just too many companies,” he says. “There is only so much money available and, the more thinly that is spread, the less there is to be channelled into worthwhile projects. In my opinion, a significant clean-out would be good for the industry as a whole.”

    Finding a balance

    The resources industry is cyclical but, at the moment, it is impossible to predict exactly when the tide will turn. In the meantime, the board has the difficult task of finding ways to drive out costs without reducing production capacity.

    “Reducing capacity means that fixed costs have to be shared over a lower operating base, which is not a viable outcome for most organisations,” says Jones.

    “The real challenge lies in finding a balance between short-term benefits and the long-term strategic outlook,” adds Rao. “It is important for directors to spend time familiarising themselves with the sector’s growth potential and considering innovative technologies and processes. They will then be in the best position to formulate a strategy which will enable them to embrace sector growth when it occurs.”

    The government has the power to help by facilitating access, expediting the approval processes and providing support to both capital markets and investor confidence. It can also hinder by placing unreasonable limits on access to assets or opportunities.

    “Dealing with government is always a balancing act,” says Jones. “As a player in the sector, I would say the issue which has the biggest impact is the time it takes to get the appropriate approvals and to clear government regulatory oversight.”

    A need for different skills

    Directors may also be struggling to put the right skills in place. “Maximising the outcomes of assets without exposing the company to unacceptable levels of risk demands very good and very focused management,” says Jones.

    Even the biggest players have been replacing significant numbers of senior management as they rationalise and refocus.

    “Most of the major global miners have swapped out their CEOs in the last 18 months to two years,” says Cormack. “BHP, Rio Tinto, Anglo American, Barrick, Newcrest — they all have new people in the top job.”

    The board also needs people who understand the paradigm shift, particularly as many of today’s middle and senior managers have never experienced a downturn. But Cormack is concerned that even the best boards might be so distracted by matters of survival that they overlook the implications of the new Joint Ore Reserves Committee (JORC) code, which became mandatory on 1 December 2013.

    “In constrained times it can be tempting to window dress a mining project by overstating the value of resources and ore reserves — but, in an increasingly competitive environment, investor confidence is critical,” he says. “The JORC code aims to strengthen the integrity of Australia’s resources industry and enable investors to make better judgements.”

    The new code requires companies to disclose much more detail about the material factor, which could affect the investors’ understanding of the project.

    “One example is effective and timely disclosures of production forecasts,” Cormack continues. “A company’s credibility and reputation rests on the accuracy of this production guidance and any slip can very quickly destroy shareholder value. The board has to approve this along with every other public report and, under current law, directors are held personally liable for corporate fault. It really is imperative that the board gets across this and understands the ramifications, and non-technical directors are particularly vulnerable as they will inevitably have to put their trust in others.”

    While the major companies can, and do, commit significant effort and cost to ensure compliance, smaller companies might struggle to allocate resources. But, as Cormack points out, directors need to take all possible steps to ensure compliance, and to reduce uncertainty and guesswork around this critical part of the valuation process.

    “We see this as a very significant risk,” he says. On the positive side, high levels of scrutiny on the sector, high levels of transparency and relatively good governance practices mean that Australia is still widely regarded as a good place to do business. 

    “It would be unrealistic to say there is no such thing as corruption in Australia but, in my 30 years in the sector, I have very rarely encountered any sort of significant illegal activity,” says Jones. “It is vital that we maintain this good reputation as competition for capital increases.”

    Embracing innovation

    The companies most likely to ride out the storm are focusing on innovation as well as strategy. The latest technology can improve profitability and productivity by maximising resource recovery and de-bottlenecking in the value chain. Advanced data management software can provide a much clearer view of the underlying drivers in an organisation and provide a sound basis for decision-making. And improved exploration techniques are frequently able to identify previously overlooked resources and good-quality assets.

    “We are certainly hearing good news stories about exploration of new assets, and some companies are also finding smarter ways to deliver from the assets they have,” says Jones. “The continual drive to increase productivity is forcing people to innovate despite an inherent reluctance in some sectors to change tried and tested traditional ways. Organisations simply will not survive unless they find more creative ways to achieve the same outcomes.”

    The major players are leading the way. For example, Rio Tinto recently launched a new phase of its Mine of the Future™ technology and innovation programme, which is designed to optimise the performance of its key international copper and coal operations. And the mining sector as a whole has substantially increased research and development (R&D) activity over the last decade.

    “The industry is currently investing around $4 billion a year, which accounts for 22 per cent of all business R&D investment in Australia,” says Dr Gavin Lind, director of education and training at the Minerals Council of Australia. “This is central to the industry’s economic performance.”

    Rao also suggests that boards keep track of developing technologies such as three-dimensional printing.

    “Allowing companies to manufacture their own engineering parts and prototypes could reduce production downtime and result in substantial operational savings,” she says. “It is not just a case of it being handy to make your own washers. Three-dimensional printing could have an impact on the entire supply chain, creating a high-value skill set in Australia as it reduces imports and lowers the cost of production. It may not be the future of every operation but directors need to keep an open mind.”

    Getting it right

    As in any other sector, leading resources companies understand what drives business value, how the value is created and what can destroy that value.  They also create a culture of transparency and disclosure in order to build and maintain trust with shareholders.

    “It is not all doom and gloom,” says Cormack. “Companies with good projects, sound economics and sound governance will always be appealing to investors regardless of the overall sentiment in the market.”

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