A recent study by Ernst & Young has revealed that, despite the high level of expertise found among metals analysts, "the accuracy of outcomes for the recent metal price forecasts has been consistently disappointing."
Meanwhile, study authors Lee Downham and Tim Williams also noted that "the pace of consolidation in the mining industry shows no signs of slowing. The continuing, robust levels of metal and minerals prices are fuelling the drive for growth through acquisition."
In their study, Downham and Williams found that US$70 billion in transactions took place in 2006 and that this year "may well see even more, particularly if BHP Billiton's recent offer for Rio proves successful."
"All of these transactions have taken place in an environment where commentators speak of the sector being near the ‘top of the cycle' and analysts predicting huge declines to current metals prices in the long term."
The analysts asserted that the market "is undervaluing mining assets by not fully appreciate how long demand will outstrip supply" Meanwhile, they advised, "Low EV/EBITDA multiples and high cash flows potentially allow for ungeared balance sheets to be leveraged and that the mining sector has decided that production can most effectively increased through aggressive acquisition."
"The implications of consolidation are wide-ranging, from the arrival of private equity, to the role to be played by the new order mining companies, to the risks faced by the winners who will need to integrate significant new assets quickly and manage heavy debt burdens," Downham and Williams said.
The Ernst & Young paper, EYeSight on Consolidation: Backpedalling on the cycle, examined three key themes:
Looking further back than the usual 5-10 year timeframe, how cyclical is the sector, and, in real terms, how high are current metal prices? Given the huge number of variables to consider, what chance do metals analysts really have of accurately forecasting metals prices even 12 months forward? What could this mean for the sector going forward as the consolidation seems to continue apace?
HOW CYCLICAL IS THE SECTOR?
Ernst & Young said: "It is our view that current metal prices are actually a return to sustainable price levels following an extended period of artificially depressed prices, rather than the conventional wisdom that the industry is near the top of a cycle."
The report analyzed cycles of metals prices over a century in real terms. The analysts concluded that "there have been specific reasons behind most of these cycles which are unlikely to be repeated in the near future. For example, we believe that the weak prices in the 1990s were in large part a reflection of the collapse of the Soviet Union. This simultaneously triggered the release of 50 years of accumulated stockpiles of minerals alongside a sharp reduction in domestic demand in the Commonwealth of Independent States (CIS). Those metal stocks, which had been mined at, quite literally, any cost during the Cold War may have forced down the traded metal prices to artificially low levels until those stocks were eventually depleted-at exactly the time that the demand return."
"It should also be recognized that the availability and the use of so many of the metals that we take for granted is actually a relatively recent phenomenon, partly drive by technology," the analysts explained.
FORECASTING CHALLENGES
Ernst & Young suggested that the mining sector "looks to the metals analysts to provide insight and foresight on some complex markets-to predict the future."
However, they added, despite the high level of expertise, the accuracy of metals analysts forecasts have been "consistently disappointing.
This has been, not coincidentally, at a time of sustained market strength and rising metal prices over the last three years. Analysts, almost universally, have been predicting a sharp decline in metals prices to return to the average levels of the previous 10 years."
"It is only when the mining companies are really convinced that future revenue from operations justifies the commitment of significant capital outlay that they will accept the risk, resulting in further capacity," Downham and Williams suggested.
"Investing just before prices plummet is a far harder mistake to survive that going along with cautious market sentiment and not making an investment," they said. "As a result of underinvestment over the last 20 years, the level of additional capacity that the mining industry has planned appears to be, in many cases, simply inadequate to satisfy demand."
Nevertheless, the analysts found that "predicting the nickel price during the last few years has been clearly, challenging. As with copper, the accepted view has been that the price would fall sharply back to its average at the turn of the century. The nickel price rose steeply in mid-2007, which is demonstrated by the sharp return to accurate forecasting of the 1-year-out price that actually prevailed in the third quarter of 2007. The historic predictions for the price for 2007 have risen from US$.00/lb to US$18/lb-as the price itself has done."
HOW HAVE VALUATION ERRORS DRIVEN CAPACITY?
Ernst & Young asserted that metal price forecasts are the most critical factor driving valuation. However, their reading of equity research notes determined that metals analysts did not foresee price increases in the key industrial metals-copper, nickel, steel and aluminum-as they rose sharply over the past three years. Metals analysts also did not predict that the "price rises would endure as long as they have," according to Downham and Williams.
Noting that as industrial metals prices have risen, so have the forecasts of the near future prices, the Ernst & Young analysts said, "Our research has shown that analysts' short term metal price forecasts since the beginning of 2005 have been significantly adrift of where prices have actually settled, invariably on the pessimistic side, which leads to undervaluation of mining and metals equities."
SO WHAT DOES THIS MEAN?
Ernst & Young asserted that, by their actions, mining companies "have made a clear statement that they believe in medium-to long-term metals prices-a key drive of valuation models used to support the prices paid during this consolidation phase."
"By contrast, the stock markets are still catching up. Even though confidence in the sector increases with each acquisition announced, our analysis has shown that historic predictions of metal price forecasts have lagged actual spot prices by significant margins."
The analysts suggested that "time and again, significant premiums have been paid over market price." They noted that more than US$100 billion has been spent on the recent takeovers of Falconbridge, Inco, Phelps Dodge, and Alcan "as the key players fight it out for control of low-cost production across the globe."
"With a near impossible task of predicting future prices, it is no wonder that metals analysts are keen not to stray too far from the comfort zone of historic averages-history has proven that the mining companies, not wanting to miss out on key strategic assets, are taking a far more realistic view.
"While the size and these transactions have only been increasing, we do not believe that they mark the end of the consolidation era. Ernst & Young would expect further strategic acquisitions to occur in the sector, while investment analysts underprice commodities relative to the corporate themselves," Downham and Williams concluded.
