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The impacts of COVID-19 on the Mining Sector

Outlook for Commodities

The new year brought with it a new sense of investor optimism and purpose. Global equities were trading near all-time highs, and commodity sensitive metrics like Industrial Production, Fixed Asset Investment and the Manufacturing PMI were moving in the right direction. This optimism proved resilient in the early stages of the COVID-19 as the virus spread from Hubei province but appeared to be coming under control.

The past three months have proven this optimism to be misplaced. The global economy has dropped into a recession that will be as severe, if not more than the 2009 Global Financial Crisis. Fortunately, severity is one of few parallels. The root cause of the GFC was a huge, unaddressed expansion and misallocation of credit, the structural effects of which continue to stifle economic growth today. While COVID-19 has created more pervasive economic disruption through curtailing movement of workers, consumers and goods and services, there is an end point to the crisis if a vaccine is developed and widely distributed (an upside scenario is that this occurs rapidly). On the downside, prolonged shutdowns can reduce the productive capacity of the economy - capacity that can take some time to bring back. How likely or soon this might happen remains unclear and, sadly, further disruption within and between economies is almost certain before this point is reached.

The near-term threat posed by coronavirus has prompted a collective fiscal stimulus from the Federal Government totalling about 6% of global GDP, focussed on supporting the incomes of millions of newly unemployed and moderating the impact of widespread business closures. Public infrastructure spending - the doyen of recession-busting packages of the past - is rightfully taking a back seat until control over the human cost can be established. Until then, the focus of government economic policy must be on managing the unintended consequences of preserving public health.

The outlook for the world’s major commodity consumer, China, is perhaps one source of good news. New cases appear to have been successfully contained - for now. China’s Government is moving to restart the economy. The People’s Bank of China has lowered interest rates and cut the reserve requirement for banks to stimulate new lending which is likely to flow into domestic infrastructure investment rather than new factories or equipment, given weak demand in export markets. This bodes well for iron ore prices (which have moved back to the US$80-90 range following sharp falls at the end of January) but less positive for trade exposed industrial metals. On the downside, the impact could yet prove muted. The desire of Chinese authorities to preserve containment means projects that require large onsite workforces will be difficult to get off the ground.

On the supply side, commodity exporting countries face a series of challenges that will shape their own domestic economic policy responses. One of the limited benefits of restrictive civil liberties in many countries appears to have been the levers in place to contain the domestic spread of the virus. However, this can be offset in economic terms by the impact of falling prices, and revenue and capital outflows. Even prior to COVID-19, the collective impact of countries in financial distress such as Argentina and Turkey served as a greater drag on global growth than changes in US momentum. Capital flight from emerging markets has accelerated during the crisis, with US$83bn leaving emerging markets since the crisis started - the largest capital outflow ever recorded. This highlights the paramount importance of global coordination to maintain economic and financial stability.

Commodity outlook

Energy commodities, particularly oil, have experienced significant declines over the past month as the COVID-19 disruption married with Saudi-Russian price competition driving the price of Brent Crude down 53% in the month of March to reach US$23/bbl, a 17-year low. At least a tenth of global oil production is uneconomic at these prices and this proportion will increase as prices tumble further. Many US shale producers, facing breakeven prices in excess of US$45/bbl, will be forced to shut down production.

Industrial metal prices have also fallen over the last month. Copper is down 20%, nickel down 13% and zinc down 14%. The permanency of these declines will be tied to the duration of the crisis. A lot of metals are building surpluses due to demand weakness and supply growth. Previously strong physical fundamentals are being eroded with commodity exchange inventories growing rapidly.  Copper has been supported by a future supply shortage outlook for a long time. Now that shortage narrative is changing. Surprisingly, the precious metals are also tanking. Big month declines for palladium (-38%), platinum (-35%) and silver (-30%). Only the classic ‘safe haven’ gold is doing ok, but still lost ground with a 6% price decline in the past month.

Falling costs are generally positive but coupled with falling demand creates the “prisoner’s dilemma” game among mining firms. The crash in oil prices and the weakness of producer currencies (including the AUD) has driven down the marginal cost of production. A strong US dollar reduces mining companies wage bill in local currency terms, lowering their break-even costs. More production adds downward pressure to the price, leading to sub-optimal payoffs for those involved.
The fear is that this inventory overhang will extend the downturn and cap any price recovery. The expectation is that equities (essentially forward-looking assets driven by sentiment) will bounce back before spot market-based commodity assets given the size of the stockpiles.

Thanks to all the cost discipline and operating excellence programs, the big diversified miners are in much better financial shape compared to the GFC in 2008 and the last commodity market downturn in 2015. Much lower debt levels, stronger cash-flows and no toxic investments on the balance sheets means they are better equipped to weather the downturn. Most companies should be able to weather the storm without having to tap shareholders for cash or fire sale assets.

The impact of COVID-19 on supply and production operations may partially offset downward pressure on commodity prices. Mines are typically in remote locations characterised by FIFO operations. This makes them highly vulnerable to a transportable and highly contagious virus like COVID-19. Efforts to contain the virus by restricting the flow of labour and transport will inevitably have a production impact, particularly for those commodities where supply is highly concentrated in a particular region and where transportation is a big part of the value chain like the bulk commodities.

Fears of reduced supplies of key commodities are growing due to measures to contain the virus at key mine operations across the globe. Several of the world’s biggest mining groups have announced delays to production and development projects because of travel and other restrictions imposed in response to the global pandemic.
We’ve seen that dynamic play out in Peru recently where production has come to a halt after the government declared a state of emergency. Bear in mind that Peru produces 12% of the world’s copper. Removing supply on this scale is likely to have a price impact.

In Australia, keep a close eye on iron ore developments. Given the sheer remoteness of the operations in the Pilbara, iron ore is one of those commodities seen to be most at risk of major disruption. About 60% of the world’s seaborne iron ore is produced in the Pilbara, a two-hour flight from Perth.

Further delays to production around the world should provide some support to commodity prices, choking off some of that excess supply we’ve seen reflected in exchange inventories. With the number of operations announcing restrictions to production increasing, the risk to supply for several key commodities will ratchet up.

Supply developments aside, the main challenge for commodities is lack of investor confidence. Until we see an end to panic selling in the markets, it’s hard to build a strong case for a commodity market recovery.

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