Why The Mining Companies of the Future Will Value Economic, Political, and Social Science Competencies Over Geology and Engineering
30 June, 2019
The Mining Industry has a Unique Set of Economic and Political Characteristics
Ore is the raw material of the mining industry. Unlike manufacturing, which can be moved across borders to respond to political, social and economic flux, sites of extraction are geographically fixed. The unrefined mineral is typically owned by the current and future citizens of the country in which it is located and managed by the government of that country. Therefore, extracting ore requires engagement with governments, as the guardians of their citizens’ mineral assets, civil society and consumers. Finite resources must be continuously replaced by companies to replenish the extracted ore and maintain reserve levels. This replacement requires exploration, acquisition or shifts in the mineral price above the costs of extraction and processing, making more of the body of ore economical to mine.
The industry’s product, concentrated or processed ore, is linked to a cyclical and volatile global marketplace, where prices are decided on international terminal markets such as the London and Shanghai Metal Exchanges. These terminal markets and the similar, or fungible nature, of the industry’s product, results in mining companies being price takers and bound to the prices on the exchanges. In contrast, other price-setting industries, with differentiated products, can charge more or less than the peers in their category due to differences in product specifications. As price takers operating in a highly competitive marketplace, long term survival and profit for mining companies is dependent on achieving a lower cost of production per unit, on average, than others producing similar ore concentrate.
There Has Been Strategic Convergence Around Operational Efficiency
Since the slowdown in the commodity super-cycle, the strategy has converged around cost-cutting and operational efficiency. Uniform technology, historically slow growth due to sector maturity, limited product differentiation and the attachment to price setting terminal markets has intensified this confluence. Industry leaders have focused on cost reduction, capital efficiency, productivity, exploitation of big data and divestment of non-core assets as their strategy to gain competitive advantage. At the same time, the search to acquire and prove new assets through new green field exploration has constricted, placing more weight on operational efficiency and exploration of existing brownfield sites than the development of unique portfolios of green field, high-grade assets. This focus is evidenced in the shrinking pipeline of quality development projects and limited discoveries.
Sustainable Competitive Advantage is a Result of Differentiation, not Operational Efficiency
Reducing costs through the implementation of new technologies across the value chain, and the creation of efficiencies of scale and scope through merger and acquisition activity has resulted in higher margins and improved cash generation in the short term. However, as prices gravitate towards the industry’s average marginal cost of production asset sweating alone will push the productivity frontier outwards and lower prices for all in the long run. The value gains will be captured by customers and suppliers, not by the companies themselves. As Michael Porter argues, operational efficiency may return higher profits in the short term. However, it will not facilitate a competitive advantage over the long term.
Differentiation, in combination with optimised operational efficiency, is argued by Porter to be the only way to achieve sustainable competitive advantage. Holding unique access to ore bodies is one of the few ways that a mining company can differentiate themselves from their competitors, due to one company or a consortium of companies being the unique owners of a specific ore body. Owning a high-grade asset is an inimitable advantage. A high-grade ore body can produce the same quantity of ore concentrate for a lower relative cost than lower grade deposits, due to the mineral concentrations requiring less ore for the equal mineral quantities. Having access to high grade deposits is therefore a long-term sustainable advantage.
Emerging and Frontier Markets Present the Greatest Opportunity to Own Unique Assets
Mines which are currently productive in OECD countries will over time experience reduced grades and become sub-economic. Exploration or acquisition will be required to replace these reserves. Emerging and frontier markets present the most significant potential for high-grade deposits, with the USGS estimating that 85% of the world’s known reserves reside in emerging and frontier markets.
However, in the face of this substantial opportunity, there has been declining interest in exploring and acquiring assets in developing countries. Over the past decade, there has been a shift to exploration in OECD countries over emerging and frontier markets. This shift in geographic focus increases the opportunity to derive competitive advantage for those successful at operating in emerging and frontier markets.
However, These Jurisdictions Present Substantial Challenges
Legacy stakeholder expectation due to high revenues generated during the commodities supercycle and the widespread discourse of the resource curse, combined with a lack of understanding of risk and reward between government and investor has led to increased politicisation of mining in emerging and frontier markets. Misalignment between the four to five-year political cycles and twenty to fifty-year mine life exacerbate these challenges.
The ‘obsolescing bargaining model’ was developed by Raymond Vernon, in the 1970s to describe the shifts in power between multinational companies and host governments during a project’s lifecycle. This model has subsequently been updated to the 'political bargaining model' and is especially evident in the mining industry in emerging and frontier markets. Host countries requiring technology, capital and skills offer incentives to mining companies to enter the country. At inception, the mining company has the power, holding the decision as to whether to invest in that country. However, once mining companies have invested in the construction of infrastructure, they are unable to move this investment out of the country and the power shifts to the host government. Immovable assets have been used to hold the company’s hostage to extract further taxation demands, as evidenced in Tanzania with the plight of Acacia and to dangle the potential of expropriation.
Local companies also have an advantage over multinational mining companies. Studies, such as Shapiro's examination of Strategic Heterogeneity in the Global Mining Industry, have illustrated that local companies experience higher returns on assets generated in their country of origin over global firms. This advantage may be conferred through the precedence of on the ground relationships and decades of favour trading over the rule of law. Transparency requirements may also work against multi-national mining companies, whereby local companies can gain an inside track of any upcoming tender.
The Above Ground Risks of Operating in Emerging and Frontier Markets are Greater Than Technical Below Ground Competencies
Emerging and frontier markets, have highly complex political economies and large numbers of stakeholders affected by the industry. Mining operates in an ecosystem which is far more extensive than a mine’s physical footprint, including community, government, employees, investors, academia and civil society. Except for a few countries (such as America) the current and future citizens of a host country own their finite natural resources wealth and have a vested interested in their responsible extraction.
These interests are informed by a perceived asymmetry of information and power between mining companies and state governments. This can often create the context for mistrust, as illustrated in extractive industries having some of the lowest trust scores of any industry. These factors have contributed towards more significant project risks being driven by factors above the ground due to challenges to the social licence to operate and shifting political conditions. An article by Heinz in the Strategic Management Journal estimates that two-thirds of the market capitalisation of publicly traded junior mining companies are a function of above ground, stakeholder engagement practices and only a third a function of the value of the asset in the ground. Managing risks and fostering trust requires a detailed understanding of complex political and social situations and active stakeholder engagement and management as well as stakeholder value creation.
Jobs for stakeholders in emerging markets have represented a significant driver for the social licence to operate for mining projects. Automation and remote operations, potentially from outside the host country, present a substantial challenge to shared value across stakeholders. Companies developing projects in emerging markets will have to demonstrate value to their communities in other ways. The risk of not fostering a social licence to operate is evident in Davis and Franks’s article “Community Conflict in the Extractives Sector” published by the Harvard Kennedy School of Government. They argue that extractives companies with a capital expenditure between USD 3-5 billion will suffer on average USD 20 million in net present value in lost sales per week due to business interruption from communities. Others estimate that 73% of project delays are a result of non-technical, above ground risks.
As highlighted in PWC’s 2019 Mine report, the investor perception of the mining as an industry focused on extracting minerals from the ground as cheaply as possible through geological and engineering expertise has limited investments and the attraction of talent to the sector. As global priorities shift to climate change, provenance and sustainability, the mining industry must focus on how the industry can sustainably generate the economic and social capital required for sustainable shared value for all stakeholders. Rising stakeholder demands characterise the market. There is a need to shift investor perception of miners from a focus on extraction to one of builders of shared advantage through economic and social capital.
The Competencies Which Will Address These Above Ground Risks Are Economic, Political and Social Sciences
Differentiation, in combination with operational efficiency, is the driver of sustainable competitive advantage. It is a function of owning unique, high-grade assets, the most significant potential for which is in emerging markets. The skills required to operate in emerging markets differ from OECD countries in terms of stakeholder engagement and the generation of shared economic and social value for communities, citizens and consumers.
Efficiency through geological and engineering expertise to convert rock to ore concentrate is no longer enough for sustainable advantage in the mining sector. As the industry increasingly focuses on the generation of shared economic and social outcomes to manage stakeholders and works to generate shared advantage, the economic, political and social science expertise which are required to achieve these objectives and manage above-ground risks will be more and more critical. These competencies will be a driver of differentiation and therefore, sustainable competitive advantage. The mining companies of the future will value economic, social and political science competencies over engineering and geology.
Tom Mills, Director and Head of Research at Two Oceans Strategy