Jul 27, 2020
The COVID-19 pandemic is likely to have a material impact on commodity demand, which is hard to quantify and will not uniformly affect all commodities. Depending on one’s view of the shape of the economic recovery post COVID-19 and the effectiveness of the monetary and fiscal support, one can only at best map out various commodity demand to GDP growth scenarios over varying recovery periods. What is clear however is that the pandemic has exacerbated or accelerated recent key themes in mining such as declining mine production supply and heightened environmental, social, and governance (ESG) risk. The response to the pandemic also informs our bullish stance to gold.
SA underground mine supply, already exhibiting a multi-year structural decline, came to a complete halt during the initial Level 5 of SA’s lockdown. This month-long supply disruption dove-tailed with the complete cessation of global industrial demand, and allowed PGM prices (of which SA is the primary producer) to remain well supported. These mines have since reopened but are not yet operating at full capacity. New social distancing measures, as well as enforced screening and testing, will result in a ‘new-normal’ period where SA’s precious metals mines operate at reduced levels. This period could last for the rest of this year.
Gold mines should be the worst affected as they have deeper, older shafts, which rely on workers being carried underground in groups using cage lifts. Gold mining employees mostly still live near the mines in communal hostels, which also complicates social distancing. This contrasts with platinum mines, where workers mostly live in their own accommodation. Additionally, most listed South African platinum companies have operations which were less affected by the restrictions imposed as a result of the pandemic, such as AngloAmerican Platinum’s Mogalakwena open-pit mine, which is mechanized, and Sibanye Stillwater and Impala, which both have offshore operations.
The risk of sporadic COVID-19 outbreaks will also continue to provide significant uncertainty around whether previous production levels will be reached, at least until some form of virus elimination through a vaccine or herd-immunity is attained. This does provide some longer-term support for PGM prices, as supply will remain constrained even as demand recovers. Figure 1 demonstrates the extent to which supply has been disrupted for the PGM sector thus far.
Figure 1: Identified/estimated ongoing supply disruptions, annualised
Data as at 14 April 2020. Source: Citi Research, Media Reports, Company Reports, Wood McKenzie, IHS, Metals Focus;
Identified losses include price related closures.
1 = Citi estimates of cumulative losses from ongoing and year to date disruptions.
2 = assessed as share of mined supply.
3 = estimated losses in regions supply is deemed highly likely to be restricted (including from logistical bottlenecks.
4 = Mined PGMs losses only (excludes Anglo refinery disruptions).
5 = Nickel losses counted as impact on refined supply.
6 = Mined lead losses only (excludes secondary and refineries).
Any financial results presentation, mine site visit or management meeting often includes a robust discussion on how investments in technology are being used to reduce costs, improve productivity and efficiencies and progress towards “greener mining”. While shareholders loathe to see mining companies spend capital on large growth projects, mining executives have had to focus on increasing the quality of their operating systems to drive costs down whilst incrementally adding to saleable volumes through better processes. Figure 2 indicates the cumulative productivity gains for BHP as a result of technological advancement driving costs down while improving output.
Figure 2: BHP cumulative productivity gains (US$ billion) as a result of technological advancement
Source: BHP company results presentation, 2018
Apart from the earnings enhancing benefits, technology is a key tool for combatting some of the ESG issues which plague the industry. It is a growing imperative for mining companies to pursue sustainable strategies for reducing water intensity, reducing carbon emissions and reducing fatalities, amongst other things. As company disclosures continue to improve, progress on ESG factors is visible to investors and has an impact on valuation multiples.
The COVID-19 pandemic has the potential to accelerate the trends towards increased automated mining and to reduce the labour intensity of the industry. This pandemic has once more highlighted the challenging working environment for underground miners, necessitated by the very nature of deep level mining, and the potential cost to human life. The risk of a COVID-19 outbreak is an added concern to a long list of other dangers such as exposure to toxic gases, seismic fall of ground and collisions with moving equipment.
We have seen increased tensions with threats of labour strike action as infection and fatality rates have increased in the South American mining regions and here at home the implementation of no-work no-pay policies will negatively impact labour relations going forward. This should be an opportunity for mining companies to invest some goodwill with its workers and communities. Interestingly, it is the companies with better profitability and balance sheets who have responded with care, in terms of subsidising worker incomes and providing community relief during this time.
The challenge therefore is to see technology used in an integrated manner to improve productivity and to mine sustainably whilst protecting human life. As investors we should pay careful attention to the capital expenditure budget allocated to technological advancement for a sustainable profit stream and less attention to cost-cutting strategies to simply meet the next year’s profit targets. Figure 3 depicts how much more natural resources are required currently to produce less metal than a century ago and points to the reality that for a sustainable future, innovation is required to reverse this trend.
Figure 3: Far more natural resources are required to produce less metal than a century ago
Source: AngloAmerican Smart Mine conference, Bank of America Merril Lynch, June 2019
Gold has once again shown its status as a safe haven and diversifier within portfolios this year. After an initial sell-off when the markets fell in early March, gold prices rapidly recovered later that month and now trade up around 14% year-to-date. Economic uncertainty has clearly risen sharply in the wake of the pandemic and central banks have responded with an unprecedented amount of fiscal and monetary easing. Past crises, notably the Global Financial Crisis, have shown that gold prices perform well during the recovery. With central banks, in particular the US Federal Reserve, concerned about slower growth leading to deflation, we would expect them to target higher inflation in order to keep real interest rates low and even negative. In this environment, we believe the gold price should be well supported and this will prove a very constructive environment for gold equities.
Figure 4: The high negative correlation to US real rates means gold is attractive in a low to negative real interest rate environment
Source: Bloomberg, 31 May 2020. Time period selected for contextual and illustrative reasons.
* The yield on the US 10 Year TIPS represents real rate of return guaranteed by the US government which is the interest rate that would be charged in a world where there is no inflation.
Gold equities provide investors with diversification for their portfolios as well as leverage to the gold price itself. This leverage is good if gold prices are rising but not if they are falling and does add to volatility, particularly as the equities are less liquid than gold itself. However, in the current environment, we believe that gold equities are generally in their strongest position for over twenty years.
After the steep falls in valuation between 2011-2015, many management teams have changed, and debt has been cut drastically. Companies are now focusing on improving returns on capital and returning cash to shareholders rather than prioritising volume growth (see Figure 5 below). With the falls in oil prices as well as rising gold prices, margins for most companies have improved this year from already good levels and even if gold prices fall back, we are still well above the $1100/oz average breakeven cost.
Hedging is much reduced from 15-20 years ago, as companies have less debt and lower costs. Disruptions to production due to COVID-19 have, overall, been relatively light and, with strong balance sheets, companies have been able to manage these sensibly and protect workforces. Investors are beginning to be attracted by the sector as companies demonstrate their ability to deliver free cashflows and the promise of sustainable dividends. This is being enhanced by mergers and acquisitions, which are active but being conducted at reasonable valuations with a number of zero premium mergers conducted recently. As long as gold prices remain well supported, we see the equities continuing to deliver good returns as well as diversification over the long term.
Figure 5: The quality of gold companies continues to improve
Source: Ninety One, 31 March 2020.
*Simple average of Barrick, Newmont Goldcorp, Newcrest, Franco Nevada, Buenaventura, Kirkland Lake Gold, Evolution Mining, Anglogold Ashanti, Wheaton Precious Metals.