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Acquire, distribute or hoard. That is the choice facing global mining companies such as Rio Tinto and Xstrata. High commodity prices may be providing them with a lot of cash. But what are they to do with it?
The right answer depends on how long prices are likely to stay high.
Xstrata and BHP Billiton are giving cash to shareholders, but perhaps only temporarily. If prices stay high for much longer, acquisitions are likely to gain favour.
Mining is a usually a pretty tough business. Investment is huge, competition is global and demand grows more slowly than GDP – the service economy does not need a lot of steel and copper. It is possible to prosper – Rio Tinto has reported a return on equity of 17% or more for the past decade – but only by having low-cost resources and doing nimble work when it comes to acquisitions and divestitures.
Prices reach record highs
This year has been very unusual. The price of almost every commodity has risen to a record level. There is even a shortage of coal, when there is usually a massive oversupply.
The result has been tremendous cashflow. For the first half of 2004, BHP Billiton reported an increase of 46% in ebitda. The 40% rise for Anglo American and 29% for Rio Tinto were equally impressive. Xstrata, which has lower-quality assets and more financial leverage, posted a remarkable 164% rise.
Now managers have to decide what to do with their cash. Their thought process must go something like this. "We could use all this money to make the company bigger. But if prices fall, buying now would be a disaster. So maybe we should give the cash to shareholders. Or just hold on to it and see what happens."
The key variable is prices – just how unusual is 2004? Few observers expect the current boom to go on for ever but there is a growing current of opinion that it could last for many years.
On the supply side, investments have been relatively low for several years and tougher regulations and greater political risk are making it difficult to accelerate them now.
Demand looks stronger than it has in years. Global economic growth is increasingly centred in China and India, which need a lot of commodities to build up their physical infrastructure.
But the fine balance that supports record prices could easily tip. Higher prices often concentrate the minds of regulators and accelerate capacity-increasing investments. And global growth rates are never assured.
For the moment, companies have held off on big commitments. Xstrata has found a good way to straddle the fence. It has paid down debt and is now planning a share buy-back of up to 10% of the shares. But the debt could easily be raised again, and the buy-back has a twist.
Thanks to a clever legal structure, the repurchased shares can be issued again without any delay or problem with pre-emptive rights. So the company seems to be favouring a distribution to shareholders but is ready to jump in the other direction.
So for now, the miners are hoarding, in financially shrewd ways. But cash in the cupboard tends to influence judgements. And industrialists tend to be optimistic about their own companies.
So it is not surprising that mining executives are starting to sound a little less cautious. A few more months of high prices could be enough to get deals flowing.
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