Dr Copper’s diagnosis is not upbeat. The red metal, long seen as a measure for the pulse of the global economy, is struggling to break above $2.75 a pound, having traded as high as $3.30 in 2017. Even supply disruptions in Chile, the largest copper-producing nation, have failed to boost prices. This indicates the market is unconvinced about the outlook for demand, which has been weakened by slowing global growth, sluggish manufacturing activity and the US-China trade war.
It seems unlikely that the supply-demand balance will boost the copper price in any meaningful way. The International Copper Study Group (ICSG) expects the market to deliver a surplus of 280,000 tonnes in 2020, as China adds new refining capacity – the amount that can be produced each day – and other smelters and refineries ramp up production after operational setbacks this year. The ICSG also forecasts that consumption of refined copper will only grow by a tepid 1.7% in 2019.
Ignoring the warning signs
As cyclical businesses, the health of mining firms has traditionally been correlated with that of the world economy. Given the signals from Dr Copper, it should follow that investors should take a similarly pessimistic view. Yet the credit spreads of several major mining firms are now trading at the lowest level in a year (see figure 1).
Figure 1: Copper compression: squeezed credit spreads of large miners
Source: Bloomberg, as at November 2019.
Spreads have been compressed by the fact that many miners have taken creditor-friendly moves to strengthen their balance sheets over the past few years. But spreads seem to have become dislocated from the signals given by the copper price, as shown by that of Freeport McMoran, a copper miner (see figure 2).
Figure 2. Freeport McMoran’s credit spread and the copper price diverge
Source: Bloomberg, as at November 2019.
Optimism that a US-China trade deal can be reached has probably also pushed down spreads. But we believe that the probability of achieving a wide-reaching solution has been overestimated. President Trump will likely try to shore up his support base in advance of the 2020 US Presidential elections, which might well involve acting tough on China. Credit spreads seem only to have responded to recent positive news, ignoring the unclear longer term picture (read more about this in the August edition of Ahead of the curve).
Far from rude health
Going forward, slowing growth in China – the world’s largest consumer of metals – does not bode well for mining firms. Chinese steel production dropped by 0.6% in October, the first decline since 2016. China’s manufacturing Purchasing Managers’ Index has hovered around 50 since May (a reading below 50 indicates that activity is contracting) and industrial-production growth is at a 17-year low (see figure 3).
Figure 3. In the doldrums: Chinese growth
Source: Refinitiv, as at November 2019.
One-off factors that supported miners’ margins this year are also unlikely to resurface in 2020. One of these was a higher iron-ore price, which benefited miners like Rio Tinto. The price of iron ore was pushed up by the Brumandinho dam failure in early 2019 but has since come down from its mid-year highs and could fall further as supply comes back online.
The dam failure is a reminder of the environmental, social and governance (ESG) costs that miners face, including increased pressure to meet safety requirements. Our stewardship arm, Hermes EOS, has engaged with mining firms on tailings issues over the past year and has participated in the Investor Mining & Tailings Safety Initiative, an investor-led forum that aims to improve disclosure standards around tailings management.
The Global Tailings Review, an initiative convened following the tragedy, has also launched a public consultation on safety standards, which should improve scrutiny of mining firms but may increase costs. Some companies are considering using dry stacking – a method where tailings are dewatered and then stacked – rather than dams for waste management, which could incur operation costs in the short term.
Although many miners have improved their balance sheets since the commodity-price crash, share buybacks have not been scarce this year. Glencore announced a $2bn share buyback in February, while Anglo American followed suit with a programme worth $1bn in July. Glencore has since announced disappointing operating performance and an additional $1.1bn lease liability on the back of accounting changes, which has pushed net debt to the higher end of its $10-$16bn target range.
Given the poor outlook for the sector, we think there is an opportunity to invest defensively in the credit-default swaps (CDSs) – insurance contracts against a bond default – of selected miners. Downside protection is a central part of our flexible approach to credit investing and we recently bought the CDS of miners that seem expensive relative to their fundamental value, or that have large ESG risks that credit spreads have not fully accounted for (read our piece on pricing ESG risks into credit markets).
We have purchased protection on both Rio Tinto and Glencore through our Absolute Return Credit capability. In addition to facing the challenging economic conditions indicated by the copper price, Rio Tinto is heavily exposed to the downward trend of the iron-ore price, while Glencore has faced governance issues.
Hermes EOS has engaged Glencore since 2018 and we have integrated the resulting insights into our analysis of the company. EOS has engaged with the company on bribery and corruption issues in light of ongoing investigations into Glencore by the US Department of Justice, the Commodities Future Trading Commission and, as of last week, the UK’s Serious Fraud Office.
Glencore and – to a lesser extent – Rio Tinto clearly face considerable headwinds. Because of this, we think that both issuers’ CDSs should serve as preventative measures against any deterioration in conditions, helping us to preserve investors' capital.
Looking for the upside
We still believe that certain mining companies have attractive fundamentals – particularly those that have strengthened their balance sheets over the last five years – and have invested accordingly. Yet investors seem to seem to have ignored Dr Copper's prognosis and priced in a healthy macroeconomic outlook, while ignoring ESG issues and a rise in share buybacks. We have exercised the flexibility in our investment approach to take on defensive positions in issuers whose CDS offer the chance to secure superior relative value.