Mining: A Golden Light in the M&A Gloom

2023 was another strong year for M&A in the mining sector. While global M&A activity generally continued the downward trend seen since the peak of 2021, the value of mining M&A activity continued to grow. Although the number of deals in the sector fell over that period, average deal sizes grew, with 2023 likely to end with the highest aggregate transaction value for ten years.

In this article we will look at some of the particular challenges to mining M&A and consider why, despite those challenges, the sector is performing strongly.

Mining M&A Boom

M&A in the mining sector is not immune to the same challenges as the wider M&A market, particularly the availability and affordability of finance in a high interest rate environment. Yet despite these challenges, mining M&A is hitting highs not seen for a decade. Why has mining avoided the global downturn that has impacted many other segments of the M&A market? It seems there is no single or overarching reason, but the result of a combination of factors.

Energy transition

Since the First Industrial Revolution coal, later together with oil and gas, has powered the world’s industries and homes and has been a key raw material in the production of steel. Coal demand is at an all-time high, despite being estimated to have been the biggest single contributor to global warming. While coal remains a major source of revenue for a number of multinational mining companies (and is likely to remain so for some time), the mining industry will be an increasingly important player in the world’s transition to cleaner energy. Electric vehicle batteries rely on vital minerals and metals (such as lithium, cobalt, nickel and graphite), the magnets in wind turbines contain various rare earth elements, and copper is a key raw material for solar panels and electrical systems. Unless obtained from recycling, all of these substances need to be extracted from the ground, purified and processed.

To meet the ever-growing demand for these newer materials and to improve their own green credentials, many large miners are transitioning away from coal and into decarbonisation materials and this, in part, is driving M&A activity in mining. A recent example is the announcement by BHP and Mitsubishi in October 2023 that they had agreed to sell their joint venture interests in Queensland’s Blackwater and Daunia coal mines to Whitehaven Coal for at least USD3.3 billion. On the buy side, BHP completed its USD6.9 billion acquisition of copper and gold exploration and mining company, OZ Minerals, in April 2023.

Strong commodity prices

In 2021–22, many mining companies enjoyed bumper profits due to strong commodity prices driven by increased post-COVID-19 demand and the impact of Russia’s invasion of Ukraine. While significant portions of those additional profits were returned to shareholders, there remained healthy surpluses available for growth, both organic and by acquisition.

Risks of greenfield projects

The earlier stages of the mining cycle – exploration, discovery, development and construction – are fraught with risk: only a tiny proportion of exploration projects become working mines and, for those that do, delays and costs overruns are common. In a higher interest rate environment, the financial impact of such risks becomes even more significant. By acquiring a mining project in which at least some stages of the mining cycle have been completed, rather than starting entirely from scratch, the buyer will reduce its financial risks.

Fragmentation

Parts of the mining industry – particularly gold (and, to a lesser extent, aluminium, copper and nickel) – continue to be fragmented, and so there is considerable scope for consolidation. 2023 saw completion of two large gold mining acquisitions: in addition to BHP’s acquisition of OZ Minerals, Newmont Corporation (already the world’s leading gold producer) acquired Australia’s leading gold miner, Newcrest Mining Limited, for USD17.0 billion.

Challenges in Mining M&A

All M&A carries an element of risk: however much due diligence a buyer undertakes and however carefully its lawyers draft the transaction documents, a buyer may never fully understand what it is buying, and its value, until it actually owns the asset. Changes in the political or economic climate, technological advances, integration challenges and failure to capture expected synergies are just some of the many hazards that can befall even the most careful of purchasers.

Mining is, inherently, a risky business, and accordingly a mining M&A deal carries higher degrees of uncertainty than transactions in many other sectors. Below we briefly discuss some of the particular pitfalls in mining M&A and how some of them can be mitigated.

Regulatory and environmental/health & safety risks

Mining involves the extraction and processing of large amounts of minerals, often consuming significant amounts of water and energy. Many of the by-products of mining and the chemicals used in processing are harmful to health and the environment. Hazardous waste products are retained on site and, if not carefully managed and maintained, may present ongoing dangers for decades, even after a mine has ceased production. Heavy industrial equipment, restricted and remote working environments, the use of explosives and the presence of toxic or explosive gases and dust are just some of the many risks to mine workers. Thankfully, the mining industry has come a long way since fatal mining accidents were a regular occurrence, but the dangers remain. In addition to these ongoing hazards, mining companies and their buyers are subject to potential legacy issues relating to, for example, workplace exposure to harmful substances or to historical pollution. Unsurprisingly, therefore, regulatory and environmental matters are key risks in mining M&A, which are complicated by different regulatory and environmental standards across jurisdictions.

Political and country risks

Mining projects are often situated in emerging markets with weak or inadequate legal and regulatory systems. Corruption levels in such countries are often high, not only presenting challenges to the ongoing operation of businesses within the law, but also exposing companies and their owners to potentially very significant penalties in relation to inherited, historical breaches of anti-corruption laws. In politically volatile countries, there is a greater risk of the imposition of punitive taxation or royalty payments. And even in more politically stable countries, miners are at risk of the expropriation of mining assets by the state, as demonstrated by the announcement in April 2023 by the government of Chile, which has the world’s largest lithium reserves, of its intention to nationalise the country’s lithium industry.

Commodity price volatility

Changes in commodity prices can significantly affect the feasibility and profitability of mining projects. Mining companies therefore, to a greater or lesser extent, hedge this exposure using various hedging techniques, such as off-take agreements, forward purchase agreements and commodity derivatives.

Financing

Securing debt financing for mining operations or M&A transactions can be challenging, particularly for early stage projects where the risk of ultimate failure is particularly high. Even for projects at a more advanced stage, the pool of banks prepared to lend has diminished since 2015 when some banks had their fingers burnt as a result of defaults flowing from the 2014–15 global commodity price crash. Banks are also increasingly aware of their own green credentials, which may lead to an increasing reluctance on the part of banks to finance fossil fuels and their producers. Coupled with this diminishing pool of major lenders, since the beginning of 2022, interest rates in most major economies have risen sharply, greatly increasing borrowing costs. Traditional equity capital markets continue to be available to finance mining operations, but typically they favour later-stage operations. Miners are therefore increasingly looking to alternative sources of finance to fund their organic growth and M&A.

Mitigating the Risks

Some of the challenges inherent in mining M&A cannot easily be mitigated beyond ensuring thorough due diligence in potential areas of concern. Warranty insurance coverage, indemnity escrows and other contractual protection measures from the seller may also be available but are unlikely to provide complete coverage. However, some risks can be reduced by structuring (in particular, by investing through joint ventures) and, in the case of financing, by utilising financing techniques beyond traditional bank lending and project financing.

Joint ventures

Joint ventures are common in mining, and there are a number of reasons for that. Sometimes a local property owner may not be willing to relinquish its property rights entirely, and sometimes it may be a legal/governmental requirement that an international party teams up with a local partner. Joint venture arrangements can also be particularly beneficial to international mining companies seeking to operate in an unfamiliar country. As well as an element of risk-sharing, teaming up with a local partner can mitigate certain other challenges. For example, entering into a joint venture with an entity connected with the state or local authority is likely to reduce the risk of that state or authority imposing punitive taxation or royalty payments on a mining project. Local partners and their connections will also likely be more familiar with the applicable regulatory regimes, including planning and environmental laws.

Alternative financing structures

Traditional financing methods, such as project finance, remain available to the right project run by an experienced operator. However, as already noted, such financing is less widely available than it has been historically, and generally does little to mitigate the risks associated with a mining project. Mining companies are therefore increasingly looking to alternative sources of finance for projects.

• An offtake agreement is an agreement with a commercial buyer (such as an end user or commodity trader) to sell an agreed volume of production for a future period of time, and such arrangements have been widely employed in the industry for many years as a means of guaranteeing a minimum level of demand for a mine’s output. For commodities that are in growing demand (such as the key components of electric vehicle batteries), such agreements are attractive to an end-user buyer keen to ensure a dependable supply. Depending on the agreed pricing model, such arrangements may also hedge the miner’s (and the buyer’s) exposure to commodity price fluctuations. However, a traditional offtake agreement does not typically assist a mining company with its up-front investment costs.
• Royalty agreements are a way in which investors may share in the returns of a mining project in exchange for an upfront capital payment. From the mining company’s perspective, these arrangements are attractive for a number of reasons, including because there are typically no fixed payment obligations and the agreements are typically limited recourse to the relevant assets. On the downside, the miner is effectively providing the investor with upside sharing in the project either for a period of time or for the life of the mine. Investors in royalty agreements include specialist financial companies, institutional investors and private equity investors.
• Streaming agreements are another way in which investors may share in a mine’s output, and the pool of typical investors is similar to that of royalty agreements. The streaming company will make an upfront payment (akin to a deposit) in exchange for the right to receive a proportion of a mine’s production, usually at a predetermined price. Over time, the deposit will reduce as the relevant commodity is delivered to the investor.
• Prepayment agreements both assist in the upfront financing of a mine’s development or its working capital requirements and provide the benefits of a traditional offtake agreement. The finance provider (typically a bank or syndicate of banks, but may be an international mining company) will agree to make an upfront payment in return for regular physical deliveries of an agreed amount of commodity; in effect, it is a loan where the principal and interest is repaid in kind.

Outlook

Commodity prices have now largely weakened from the highs of 2021–22 so, absent an unexpected supply side squeeze or a sudden increase in demand, the extraordinary profits seen by the major mining companies over recent years are unlikely to return in the near future. However, prices remain above long-term average levels and so should provide miners with ongoing flexibility to finance strategic M&A operations, at least in the short term. Commentators expect consolidation in the mining industry to continue, in particular in the gold sector, driven by (amongst other things) desires to achieve scale, to diversify geographically and to replenish depleting project pipelines. The other recent key drivers of the increase in mining M&A activity – energy transition and greenfield risks – are also likely to remain relevant for the foreseeable future. As a result, the strong performance of the mining M&A sector is expected to continue into 2024 and perhaps beyond.