Tim Goldsmith PwC Global Mining Leader South Australian Chamber of Mines & Energy Gala Dinner Speech 30 April, 2012, Adelaide Ladies and gentlemen, good evening. It s an absolute pleasure and honour to be able to speak at the South Australian Chamber of Mines & Energy Gala dinner here in Adelaide. Throughout my 25 years of living in Australia I have worked with many companies in the mining sector and devoted my focus purely to mining. I have a great love of the industry and being asked to talk on where I think the future is heading is something that I will very much enjoy. Over a period of only 10 years the mining sector has changed dramatically. It is only 10 years ago that it was deemed to be the sunset industry, the old industry, one which did not have a future. What a difference a decade can make! What I want to do tonight is talk a little bit about what occurred, but more importantly, what we can expect from the future. Before I go any further let me raise the topic of China. No one can ignore the impact that China has had on the mining industry over the last 10 years - and the major impact it will have in the future. One of my roles within PwC is assisting Chinese enterprises to invest in Australia, primarily into the mining sector. This work started approximately 10 years ago and I have been a frequent traveller to China throughout that period of time, typically spending one week a month in China. Nowadays I seem to be primarily focused on tier 2 and tier 3 cities, so I see what is happening throughout China and have a good insight into what I think it will mean for the future. I will touch on some of this as I go through this talk but I will try not to get too much into the facts and figures and detail of China as that topic alone is one I can talk about for hours. When we consider the outlook for the mining sector there are only really two areas that need consideration. The first is future demand for the products and the second being the supply. Simple economics tells us that when demand equals supply we get equilibrium. In the real world this rarely happens and we tend to have situations where demand exceeds supply which tends to lead to high commodity prices or periods when supply exceeds demand which leads to lower commodity prices and diminished outlook. I will briefly touch on where I see demand and supply moving in the years ahead. Then let s touch on what equilibrium means for commodity prices. Demand has been in a period of rapid growth over the past 10 years. It is really quite phenomenal when we consider that during that period we have had 4 years of the Global Financial Crisis (GFC), yet demand has continued to increase. What do we learn from this? I think the main item here is that industrialising parts of the world have a significantly more intensive usage of minerals than those countries that have already industrialised. Put simply, building a country like China for the first time uses significantly more minerals than maintaining a country like the US. By way of example, it s not many years ago that the US was the largest steel
producer and consumer in the world. Now China is an 8 times larger maker and user of steel than the US. This happened almost overnight! Consider the growth in production that the companies supplying the minerals had to achieve, and you get a picture of the impact on demand. So let s dwell on China for a second. The first point I always raise is that the initial view most of us have of China has been determined based on the economic performance and political situation in China from 1950 to 2000. This totally ignores that 100 years earlier China was 25% of the world s economy and had been for 1,800 years. No doubt that the 50 year period from 1950 was a time when the country economically underperformed but we all need to move our mindsets away from that thinking and consign it to history. When we look at the future we need to be thinking in a very different way. Contemplate what has happened in the last 10 years, and the rapid growth that we have seen in China, more than 8% per annum GDP growth. Indeed, when I first went to China 10 years ago, the economy at that point in time was half the size that it is today. It is quite remarkable to contemplate that the Chinese economy has doubled in 10 years. Whilst remarkable, as long as China continues to grow at 7.5% or greater per year, we will see the economy double its current size in another 10 years. This is truly when we start seeing the mind boggling nature of how growth upon growth moves the entire pendulum rapidly. This is the true demand story for the mining industry. As I analyse China to work out how I can best assist their companies in their ambitions, I am hugely comforted by the fact that the economy is managed. This is something that the West seems to struggle with. Daily you can read in the Western media questions of whether China will have a hard landing and whether the party is over and we should all be running for the hills because China s growth is unsustainable. The people who write these stories have very little understanding of how the Chinese economy works and how well managed it has been. When I make presentations I utilise graphs, one of which highlights that over the last 25 years the Chinese Government has set five year goals for GDP growth (in their 5 year plans). Each of those five 5 year plans growth figures has been exceeded when the actual numbers have been calculated at the end of the 5 years. What do we learn from this? Simply that growth is an important facet of China s industrialisation and that the economic managers in China have become very good at ensuring their predictions are met. I find it remarkable that the 5 year plan that completed in 2010 was still able to beat forecasts after the GFC happened in the middle of it. Clearly the Chinese Government put a massive stimulus package in place which enabled them to turn what was looking like a very challenging position into business as usual. We should be recognising that the Chinese Government was able to achieve this goal and can do it again. The bottom line here is their ability to fund another stimulus package is not in doubt and should there be a need they will not hesitate to do it. My personal feeling is that there won t be a need given that there has been such careful economic management and that the current reduction in growth has been managed, primarily to ensure inflation was in check. The Chinese leaders are certainly trying to change the Chinese economy from being export orientated to one which is more domestic orientated. This reflects the early stages of maturing of the Chinese economy and has been underway for many many years. My starting premise here is that this transition will occur. But it won t occur overnight and once again the Western media often seem confused by this as they tend to think that exports will be closed off tomorrow and China will start an import race. This is not at all likely, and instead, we 30 April 2012 2
will end up with something which is far more gradual and more managed and has little impact on exports and imports on a period by period basis. So my outlook, from all I see in China, is that this remains a very positive growth region for the world. I see very little risk in a landing (hard or soft) that will significantly change mineral demand. I do see clear blue skies ahead when thinking of China for many years to come. There is one aspect of China that I want to raise here that I hope will cause you to think a bit. This is in relation to the political transition which occurs this year. This is a once in a 10 year event when basically the top guys stand down and are replaced. From a personal perspective I think there is actually very little risk in relation to this political transition, but don t be surprised to hear increasing media fear as 2012 rolls on. The last time this political transition occurred was 10 years ago. I think of myself as one of the early guys who got into China and started trying to understand it. 10 years ago I met very few people who had been to China let alone had any real understanding of how the system worked, or anything like the knowledge which we as a nation have of China today. I can barely remember the last transition and I believe that very few others who now have a good understanding of China really remember the last transition. We have very poor knowledge of what will occur, and this will provide much fodder for naysayers. So, don t take the transition too lightly, but my overarching view (based on the information I have seen and delved into through my trips to China) tells me that this is low risk, but not without some potential grandstanding along the way. Inevitably you can t help but talk about China when you consider demand for minerals but we mustn t ignore the fact that it is not going to be a China only game and increasingly we are seeing impacts from other emerging regions. Another message I am increasingly trying to highlight to executives in the mining sector is to increase your knowledge of India, and also other countries such as Indonesia and other fast emerging regions. Understand what is driving those economies and what minerals they are long in and what minerals they are short in. I, for one, will admit that my detailed knowledge of how India works and what minerals it s going to need, in what quantity, and when and what they can supply themselves, is frankly, not at the level that it is in relation to China. It s easy to be an expert on something when everyone else is an expert, those who really gain are those who get ahead of the curve and get into it early, so please contemplate furthering your understanding of India and other nations. So my summary on mineral demand is that industrialisation of the world has been underway for the last 20 or so years and will continue at pace for the next 50 years. This is a period of time which is particularly metal intensive and I strongly believe that the general demand for commodities will remain exceptionally strong throughout that period. There will obviously be some years which are better and some that are worse but the general trend is very strong and that leads me to be extremely bullish about the future for the global minerals industry. Focusing now on the supply side and I find myself getting even more excited. I used to think that supply could quite easily meet demand as long as there was a small time lag whilst people got their act together. I no longer believe this to be true and think that the supply of minerals is in real danger. We have already seen in the early 30 April 2012 3
years of Asia s industrialisation that the speed of response has been extremely slow and should be a cause for concern. Supply constraint was initiated in the 1990 s, a period of time which those of us who were involved in the mining industry will happily forget as it was a very dark and dirty period for the industry. Mining companies did not generate acceptable returns and found shareholders and debt lenders were negative towards our industry. This led to a response whereby non-essential expenditures were cut, and in particular exploration. Ultimately when you reduce exploration, at some stage you are going to pay for it and the lack of supply response over the period since shows this. Having noted that supply was slow to catch (or try to catch) demand we now sit here 10 years after the real kick up in demand started and can see that there is a clear reaction that has occurred around the mining world (some good, some not so good) that has changed our outlook on future mining supply. Lets outline a few of the key risks that I see to supply: Successfully building mines on time and on budget is a challenge anywhere around the world Increasing government intervention through fiscal regimes and resource nationalisation Declining grades and rising cost of production for all mineral commodities. There is currently a massive capex programme underway all around the world. This will clearly bring a lot of new product to market when projects are successfully built. Mine construction is a very tricky game and is unlikely to get much easier. The challenges vary from location to location but consist of issues such as skill shortages, material shortages, information shortages and cash shortages. Further, the resources are increasingly being found in more remote regions of the world. The remoteness of the locations adds to the capital expenditure costs as there is a lack of infrastructure. Governments no longer provide this infrastructure and look to mining companies to fund this as well as public infrastructure in many cases. All of this is without contemplating some of the resource nationalisation issues prevalent in many parts of the world. The bottom line here is it is exceptionally difficult to build projects on time and on budget anywhere in the world. Mining has always been a place for entrepreneurs, and for those of us that love this type of excitement, mining really is the industry to be in. Look back to 2002 (the start of the boom) and you will see that there were very few junior iron ore or coal companies and consider how that has changed so dramatically and how many projects have come through these companies. As a nation we really should applaud this sector far more than we do. The world leaders in this regard are undoubtedly Australia and Canada and it is vital to me that one of Australia s great advantages is our entrepreneurial spirit in the mining sector and we should do all we can to encourage this sector. I have highlighted iron ore and coal and it would be remiss of me not to also mention how entrepreneurial Australians have been in exploring beyond our shores, Africa springs directly to my mind, as do many other locations. I also would say the Canadians are exceptionally good in this regard as well. As I travel around the world (often to emerging markets) it is rare that you don t get to hear Australian and Canadian accents very quickly. 30 April 2012 4
The Miners have made good money recently and this is something which I celebrate. I have analysed the profitability of the mining sector over more years than I care to consider and it is only the last 7 or 8 that I have been able to put my hand on heart and say that these are the kinds of returns which investors (taking the risk they take when they invest in mining) should be expecting to see. This is great news but with it, it also brings challenges. The starting risk here is that there are many people out in the world who believe that if someone is doing well then that means they can share their good fortune with them. Governments all around the world are displaying this attitude as many struggle under budget deficits and falling taxation revenues and are looking at the mining sector as an area where they can raise extra funds. That s a tax discussion, but we could equally have a discussion around wages and in fact around ownership. Resource nationalisation is undoubtedly alive around the world and based on my views that we will have long term demand growth I do not expect it to go away anytime soon. So my general summary of the supply side is that it is very constrained. Mines have been chugging away at full speed for the last decade as they try to meet the market demand. Increasingly we see regular occurrences of production targets not being achieved because of a variety of reasons such as weather incidents, industrial relations issues, break downs and other shortages. There is a very clear trend here which when we look at products such as copper highlight that we probably lose 8% of forecast production every year by disturbances (this is one month in each year!). Add on top of this the challenge the lack of exploration success (most incremental production is expanding existing projects) and I see very real concerns that supply growth is not sustainable and will not be able to meet the real needs of the world going forward. One of the most important aspects of the last decade is what has happened in relation to cost of production. Cost of production for all mineral commodities has risen dramatically. To use an example, global production of iron ore has doubled in the last 10 years. The cost of producing that iron ore has tripled. That is not just the highest cost producers and neither is it the lowest cost producers, it is a statement which fairly accurately reflects every producer. There are many reasons why we have seen costs grow faster than supply has grown and many of these will be well known to you and we often talk about them as mining inflation (which exceeds CPI). This ignores the most significant driver for increasing costs, which is the reduction in grade which we have seen across all minerals. If grade halves then we end up moving twice as much rock for the same product. As a starting point, this is likely to see costs double. Therefore as grade diminishes it s very logical that costs will increase dramatically. When cut off grades are raised, this almost certainly leads to higher cost of products. Again, I could talk for hours on this subject but rather than do that, I just want to highlight the fact that costs have dramatically increased and what that actually does more than anything else is help underpin commodity prices. This brings me back to a topic I referred to earlier, namely equilibrium commodity prices. There is a view that in equilibrium (when supply matches demand) the mines in the lowest 80% of the cost curve will be able to survive whilst those higher cost mines will be in trouble (this is a very brief comment and simplifies elasticity of demand and many other factors!). Were this equilibrium to occur today we would see a reduction in commodity 30 April 2012 5
prices but only to 80% of the cost curve. If prices fall further, mines will close. As closures start occurring that will dry supply up and therefore put pressure on prices to go upwards. In short, the increased cost of production has substantially underwritten the price of commodities for the long term ahead. One of the most misquoted aspects of Western media is the constant view that commodity prices are at all time highs and therefore are almost certain to plummet. This is the thinking of the old paradigm and ignores the demand position described earlier. It is not going to be the case or at least if it were to occur (as it did in September 2008) it will be very short lived because we will have a very quick supply response with product coming off market which will serve to increase prices very rapidly. I am conscious that I have been talking for longer than I should, but I can t help to get excited when I start contemplating the future of the global mining industry. I think the demand/supply equation looks very robust and we can expect to see strong growth for mineral products for many, many years to come as the industrialisation of the world continues. The real bonus for the mining industry is that the ability to increase supply will be very hard to achieve and will be far less likely to be successful. This will lead to longer term high commodity prices and we have the benefit that they are underwritten by the increased cost structures of the industry. Overall this is a very bright picture. Let s not get too carried away though. For every winner there will be many who will not be successful. The real winners here are those who have low cost mines and are in operation and have long life mines. I think we have a number of companies in Australia that meet this scenario and are very well placed. Those companies who do not have operations or have very high cost operations will not necessarily find life so easy. This is part of the reason why their share prices don t react even though commodity prices remain high. In essence the world knows that their costs of production are very high and they have little margin. So let me bring this all to a close by saying that I do see a very positive outlook for the global mining sector. The clouds are more around how management and Boards are able to navigate through to ensure that they get quality projects in quality locations with quality people delivering quality production costs. Those who succeed will do exceptionally well. Just before I close let me touch on Australia and South Australia. Australia is an excellent mining country. It has been for a number of years and it s very highly thought of throughout the world. Having said that, we mustn t be complacent. We have excellent minerals in this country and we are blessed with those that are of particular importance in the early stages of industrialisation such as the bulk commodities of coal and iron ore. But we have many challenges around the infrastructure, the people skills and the cost of production. Australia is not seen as a low cost producer anymore. Some of this is because of our higher standards of living but some of this is also because of exchange rate movements and increased regulation. We are still seen as a stable country and we are still seen as a country which cannot be ignored in a mining context. I look around the world as I travel and I see other mining countries that equally have excellent attributes similar to what I see in Australia. I would say that the general view I see in Canada is a population that is far more positive about the mining industry than I see here in Australia. To think of another very positive country and 30 April 2012 6
one which I am spending increasing amounts of time in is Chile. The Government in Chile is doing what it can to encourage the industry and has recently established soft loans to assist explorers in the junior section in their mining sector. As far as Australia is concerned, there are different mineral mining models in the different states. I hear frustration from abroad when dealing with Australia that they need expertise not just in Australia but in the individual states, such as Western Australian laws being very different to South Australia. I believe that there are increasing similarities but also many differences and I think it is something as a country we would be sensible to take heed of. Notwithstanding this, I think it is appropriate to acknowledge the role that the South Australian Government has taken to its mineral industry over the last decade. I regularly hear people praising South Australia as a friendly and positive state to work in the mining sector, and I hope this continues and other states follow suit. In closing, let me once again highlight what I believe to be an exceptionally positive period ahead for the global mining industry. But there are no free drinks here and for Australia to maximise its potential it will need to ensure that it remains competitive. Our resources are excellent but that can be said of other countries as well and we do live in a very competitive world and competition over capital is particularly fierce. Thank you for your attention For further information, please contact: Tim Goldsmith PwC Global Mining Leader +61 (3) 8603 2016 tim.goldsmith@au.pwc.com Andrew Forman Partner +61 (8) 8218 7401 andrew.forman@au.pwc.com Jock O Callaghan PwC Energy, Utilities & Mining Industry Leader +61 (3) 8603 6137 jock.ocallaghan@au.pwc.com 30 April 2012 7