De-risking did not start last week in the mining markets.
Copper prices have stayed around $6,000 a tonne for the last few months, well below the $8,800 peak last May. Zinc, a recent star, has been stumbling. And the duller products—coal and iron ore—have been, well, pretty dull.
But don’t cry for the miners. They are making heaps of money.
The latest to report is Xstrata, the highly ambitious London-listed company run by Mick Davis. Almost half of the company’s $43 billion market capitalization was built up through acquisitions in 2006, most notably of the Canadian Falconbridge. The rapid growth flattered the reported 112% increase in operating profits, to $8.3 billion, but there is no question that the company is doing well.
Xstrata is busy squeezing out operating efficiencies from its newly-acquired assets, but high prices provided most of the 2006 growth. The cost of new copper mines comes to something like $3,300 a tonne, according to Goldman Sachs. The cost of producing copper from existing mines is a lot lower. No wonder that Xstrata’s operating margin was 31%.
Compare that to 2004, Xstrata was unrecognizably different then, but Rio Tinto, another large miner, has not changed much. Its 2006 operating margin was 41%. In 2004 it was 21%. And at the time, 2004 was the best year in the company’s history.
Xstrata depends more than its big peers on the industry’s generous cash flow. It paid for most of its 2006 acquisitions in cash, adding $11 billion in debt to the balance sheet. The $1 billion of interest expense hardly made a dent in operating profits, but at 2004 prices, it would have eaten up roughly 40%.
All things being equal, the company would then have had to borrow more in order to pay its dividend and invest in increased production.
Looking forward, at the 2006 rate of cash generation Xstrata will be able to pay down all its debts in less than three years. As long as metal prices do not tumble much before then, Davis’s decision to gear up for growth will be proved absolutely correct.