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Lack of capital will jeopardise carbon goals, create next super cycle

Signatory states to the Paris Agreement have pledged carbon neutrality by 2050 and many other countries and regions have ambitious objectives to reduce their CO2 footprint. California, the UK and the European Union, for example, will ban the sale of internal combustion engine vehicles after 2035. This demands a greater, more reliable and cost effective supply of electric vehicles, which in turn requires mining industry investors to challenge their assumptions. Let us consider a number of issues to help make this electrification revolution happen.

Bert Koth

In the transition to a zero-carbon economy, wind and solar are expected to generate 62% of all electricity by 2050. The EV sector alone is expected to consume about 5.7 million tonnes of copper annually, which equals another five Escondida mines-worth of annual production.

This incremental metal requirement, which does not even take into account increasing metals demand from continued global infrastructure spending, comes against a backdrop of declining mined copper grades worldwide (1.2% in year 2006 to 0.9% now) and inadequate new mine production.

The last major new copper discovery, Kamoa, was made in 2008. Chile's state-owned copper mining company, Codelco, expects to invest US$31 billion by year 2030 solely to maintain its copper production at current levels in the face of declining grades.

And it is not just about copper. The material make-up of a wind turbine (chart below) will surprise many.

Material Make Up of a Wind Turbine - t/GW

Raw materials demand for wind and solar PV technologies in the transition towards a decarbonized energy system, 2020. Source: Wood Mackenzie, European Commission

Demand for rare earths as a result of wind energy, EVs and electronics requirements is expected to increase fourfold at a time when there is almost no downstream processing capacity and upstream rare earths production outside China.

The audience at a recent AGM where this chart was shown was surprised to learn that metallurgical coal and iron ore dominate the material requirements for large capacity wind energy installations. As an aside, the "metallurgical coal intensity" of solar energy is about 10-times higher than wind energy, with between 700-900 tonnes of metallurgical coal required per MW of installed solar capacity.

Despite decarbonisation efforts in the steel industry, met coal will stay a key raw material for steel production for decades. Unloved does not mean unneeded!

Tin is, according to the Massachusetts Institute of Technology, the metal most positively impacted by current technological and environmental trends.

Six iPads require as much tin as one automotive vehicle. Despite this obvious need for clean and ethically mined tin, about 40% of tin is mined in an opaque artisanal manner under often appalling working conditions. A similar demand surge is expected for battery metals where lithium demand, is expected to increase seven times by 2030.

Despite such a highly constructive long term demand outlook, capital spend on new mining projects has declined by $11 billion annually on average since the 2012 peak of $181 billion. Exploration spending outside gold declined by 49% during the same period. The stage is therefore set for another metal price upcycle, potentially in proportion similar to the super cycle experienced in the 2000s.

Surely, in the face of such a tight supply-demand outlook with the expectation of high long-term prices, it should be possible to mobilise material amounts of risk capital for mining?

Far from it.

Outside the gold sector, which is experiencing its strongest bull market in decades, there is very little capital available for exploration, project de-risking and mine development.

While the share prices for mining juniors outside the precious metals sector have risen by 33% in the equity market recovery since April 2020, higher share prices do not mean that more capital is available for mine development. Many listed junior miners are illiquid, and as a result it only takes a limited number of trades to materially move the share price but the secondary capital driving the stock market does not necessarily make itself available to provide primary risk capital for mine development.

Over the past 12 months the mining industry raised about $6.8 billion in equity, only a surprising 25% of which was spent on project development. If we unpack this number further, we find that of the $1.7 billion development equity capital, about 60% was raised and spent by the gold industry and only 40% ($690 million) was spent on mine development outside gold. This is an almost negligible number in the $1.6 trillion market cap metals and mining industry.

Mining Equity Raises Last Twelve Months By Purpose/Application(1) 

 

Source: Capital IQ, Company Filings 

  1. Shows equity capital raises >=$10 million by companies listed on the ASX, TSX, TSXV, NYSE, LSE and AIM. Use of proceeds as per company disclosure.
  2. Project development is inclusive of funding of feasibility studies, exploration and development capex.

The capital raising hurdle that mining juniors and mid tiers need to overcome is best illustrated by the ratio of development capital required over the market capitalisation of the company owning the development asset.

Project Capex as a Proportion of Market Capitalisation (3,4)

 

Source: Capital IQ, Company Filings 

  1. Reflects sum of initial capital cost for the aggregate set of development projects owned by a given listed mining company, as outlined in the latest published technical report from that company, divided by that company's market capitalization. Junior Miners are defined as companies with less than $100M market cap, Mid Cap Miners are defined as companies with between $100M and $1.5B market Green metals defined as nickel, tin, copper, lithium, cobalt & rare earths

As you can see from the chart, in the gold sector that multiple is acceptable - meaning gold juniors can raise the development capital relatively easily - but the financing hurdle outside the precious metals sector remains high, despite recent share price improvements.

Even junior developers of "green metals" projects require on average 6.8-times more capital to develop their projects than the present market capitalisation of the underlying companies. As a result, most of these projects may end up financially stranded and if the capital can be raised, it will likely be massively dilutive for existing shareholders.

Why is there not more equity in the room?

1. Investors have been burned in the past. A lot of capital providers and investors have essentially retreated from the mining sector. Regular capex overruns, permitting and other delays and some technical project failures have cost investors dearly. I estimate that, while no official statistics exist, among large investors - sovereign wealth funds, trading houses, generalist and mining specialised private equity firms etc - the pool of accessible equity for mine development has shrunk by between 60-70%, if not more.

2. ESG. While obviously and incontrovertibly a driving force for good, ESG is often misunderstood or misconstrued as being a reason for not investing in mining at all. Again, it is hard to quantify the full extent of this ideological capital withdrawal, and clearly some commodities (eg metallurgical coal) are more affected than others. I have encountered large investors who withdrew from mining investment for ESG reasons. Unfortunately, the public relations efforts of the mining industry are not adequately effective. Newspaper headlines in mainstream media are dominated by the bad news and accidents in the mining industry, ranging from tailings dam failures to blowing up historically valuable and culturally sensitive heritage sites. What the wider public in most cases does not appreciate, due to the absence of information provided in mainstream media, are the range of positive benefits generated by mining investment.

Good examples of ESG initiatives can be found across listed and privately owned mining companies. They are the norm, not the exception. Doing the right thing for the environment and the community constitutes the social operating licence for a mining project, without which a project simply cannot succeed.

Unfortunately, the rewards from virtuous acts by mining companies are rarely saluted in mainstream media, whereas the risks of mining, although infrequent, usually make the front page news.

3. Continued misallocation of capital in the junior mining markets also contributes to the investor retreat. According to Capital IQ numbers, about 22% of all equity raised by the mining industry over the past 12 months was spent on corporate, G&A and overhead cost, meaning almost as much capital was spent on corporate overheads as on project development. This is a shockingly high ratio when considering that corporate G&A is ultimately dead capital, as it does not create intrinsic value in the ground.

Can alternative finance providers, like structured mining debt, royalties and streams fill that equity funding gap?

In short, the answer is, no. The gap is currently too wide. While alternative finance has emerged as a powerful force in the market and often as an alternative to the traditional project finance route, in almost all cases, the development of a mine will still require a significant equity contribution.

For the first time in the career of this author, it is easier to obtain the debt than to secure the equity, and if the equity is not available, the project becomes financially stranded.

At the current rate of underinvestment, it is hard to see how the material and mineral demands of an energy transition to zero carbon can be met, which puts the achievability of our targeted zero CO2 future at risk

At Denham Capital, we are regularly approached with projects where the debt has been secured but a significant equity gap remains. The most pressing shortage in the market is equity and it also sometimes becomes a challenge to reconcile economic expectations if senior secured debt expects similar returns to the equity, because equity investors may not invest for fear of being crushed by the debt.

So how will we obtain all the metals and minerals required for the energy transition to a zero carbon economy?

At the current rate of underinvestment, it is hard to see how the material and mineral demands of an energy transition to zero carbon can be met, which puts the achievability of our targeted zero CO2 future at risk. At the same time, long-term supply shortages are likely to create significant uplifts in commodity prices, which in turn will generate significant returns for producing companies and entrepreneurial risk capital providers. The financial case will be improved but consumers will have to bear the cost.

The mining industry must do a much better job communicating to mainstream and social audiences why it is an essential industry which aims to benefit all stakeholders. Mainstream media publications, in turn, must accept the responsibility of reporting in a balanced manner on this critical industry so investors can make informed decisions on a more level playing field. Mining companies, large and small, also need to conscientiously address their fiduciary responsibilities and reduce the number of failures, capital overruns, and overpriced acquisitions to regain the trust of often disillusioned investors.

While all this will take time to achieve, it is critical that it happens. Attention must be paid so that we together can mobilise the longer term capital required to supply the metals necessary to sustain the electrification revolution.

 

Bert Koth is a Perth-based partner in the mining fund at private equity firm Denham Capital. Prior to joining Denham, He worked at BHP Billiton, ING Barings, and Deutsche Bank. He currently serves on the board of directors of Tremont Master Holdings, Pembroke Resources and Auctus Minerals.