Price and currency volatility - Mining and metals - EY

1 Price and currency volatility Mining and metals Across the Mining and metals sector, there Diversified miners Is hedging a sanctuary from volatility ? is renewed emphasis on performance, December 2012 Fall in earnings The drastic fall in gold prices during meeting targets and responding to April 2013 increased pressure to hedge shareholder needs, with the sentiment new production forwards. In The lost art being one of long-term positive outlook. of hedging3, EY found that a hedge program Producers are focusing on protecting is most valuable when cash flow is at its margins and containing soaring operating worst when prices are low as long as it costs rather than boosting output.

2 Cost was entered into when prices were higher. cutting and profit pressure are pushed Companies should be cautious about the in large part by market risks, including herd mentality to hedge with falling prices commodity Price volatility , interest and and close out hedge books during times of exchange rates, and equity risk1. rising prices. Ideally, In the December 2012 reported results of the time to hedge is when metal prices are the large diversified Mining companies, near their peak. A good indicator is to mineral Price movements of US$ determine when prices are trading above comprised 79% of the fall in period-on- their historic trend average where period earnings.

3 Producer currency hedging is more likely to produce gains movements generally provide a natural rather than losses. The recent drop in the Price FX Other hedge against these movements, as they gold Price demonstrated how the speed often depreciate with falling prices. Source: Ernst & Young research, company reports of Price changes challenges in-house risk However, large-scale quantitative easing management systems to respond in more economic to mine as gold prices in the US, Europe and Japan has prevented a timely fashion. soared above US$1,800 an ounce. this depreciation from occurring in most Producers have deliberately lowered their While the majors may have the financial producer nations.

4 As such, the currency gold ore grades as the gold Price has risen strength to absorb the downward Price risk, impact on earnings was also adverse but but, if gold prices remain low, the process mid-tiers and juniors entering production only by 2%. This loss of a natural hedge has can be reversed. The result will be less might not. This means smaller producers made it even more critical for Mining and low-grade ore processed, with gold grades may have to bow to pressure from potential metals companies to quickly respond increasing and cash costs being reduced. lenders to enter new hedge contracts4. to volatility . An unexpected but positive side-effect With rising costs being a sector-wide Lower commodity prices and the higher of this scenario is that gold mines with the problem, we expect to see more companies cost of Mining mean producers have sought flexibility to increase their head grade may using short-term hedging to lock in costs, to curb costs to maintain margins.

5 In the actually produce more gold when prices and potentially profits, through short-term case of gold, producers have, where are lower 2. commodity Price hedging. practical, targeted higher-grade ore instead of lower-grade material, which became 1. Business Pulse Exploring dual perspectives on the top 10 2. Australian gold miners give hedging the cold shoulder, 3. The lost art of hedging, EY, April 2011. risks and opportunities in 2013 and beyond: global report, Reuters, 24 April 2013. 4. Let's hedge gold again like we did last whenever, Mineweb, EY, 2013. 24 January 2013. 2 Price and currency volatility : Mining and metals As supply begins to catch demand, we expect a period of even greater volatility in mineral prices and producer currencies.

6 The knee-jerk reaction is to start hedging again. However, for most, the opportunity to establish an effective hedge is past new solutions are necessary to deal with volatility . Managing revenue and cost volatility in the short term will be a focus for the miners.. Jay Patel Mining & metals Transactions Partner, EY, Canada volatility and risk the appropriate interactions between risks. this perceived risk. Alternatively, the risk Many Mining and metals companies do this of volatile prices can be somewhat offset by The Mining super-cycle has amplified the but stop there. They don't go on to assign management taking advantage of Price Price signals for increasing supply.

7 Probabilities to these risks. Much of the spikes and limiting the exposure to Price But it has also created the conditions for Price and currency uncertainty can be seen slumps. Such choices could include: increased volatility as producers chasing empirically with how the market is pricing massive returns may collectively overshoot Undertaking no new action uncertainty. Modern computing power and supply, causing prices to crash and thereby Suspending Mining and process stockpiles models enable not just the one scenario to reducing future supply via the industry be prepared, but multiple scenarios using Reducing shifts and hence production capital strike.

8 This will be accentuated as numerical methods, such as Monte Carlo Deferring new development many high cost, low-grade mines, whose simulation. The risk or the uncertainty lives were extended by the past decade's Moving to highest grade reserves profile helps focus management's attention higher prices, will close over the next couple Abandoning production and selling either on what can be done to maximize the of years in the face of low prices. Until the the project or hybrids thereof outcomes. It also focuses attention on how supply-demand equilibrium is restored, much the Mining and metals companies Such flexibility can alter a project's risk and we expect to see Price volatility as the may be willing to pay, by way of cost of value profile and static DCF analysis does new normal.

9 Action, to drive preferred outcomes. not account for how these actions affect Mining and metals companies must consider project value and risks. In a period of falling prices it is important to the potential Price and currency outcomes remember that there are other options to Best practice responses to Price and well beyond both current forward curves avoid the risk or suffering the fate; the currency volatility include using probable and current mine plans. Given what we have challenge for managers is to identify these measures of uncertainty and flexibility experienced in recent years, many potential options and evaluate them in the face of analysis.

10 This approach will not only value scenarios could exist. Examining those as potential Price and currency uncertainties. a project in an environment of uncertainty, static scenarios provides little insight as to but also provide Mining and metals the likelihood of each. The modern mine Using the right tools to tame volatility companies with a guide for the possible manager must consider these scenarios in a The humble discounted cash flow (DCF) courses of action to optimize their returns. dynamic environment that considers the model is as ubiquitous to Mining as hard Unfamiliarity with these tools and the probabilities of each in a deterministic hats and high-visibility shirts.