Published in the October 2009 Australia’s Mining Monthly

Ernst & Young global mining and metals sector leader Mike Elliott believes a “slash-and-burn” approach to cost cutting in mining could erode future cash flow as the sector recovers.

He said the operating costs explosion during the boom had left a costly legacy that needed to be addressed.

“Boom-time ‘production at any cost’ attitudes have left an unsustainable level of costs for mining and metals companies, and with the fall in commodity prices, cost containment is now the biggest strategic challenge for the sector,” Elliott said.

“In the downturn, the temptation has been to take quick-fix cost-reduction options, rather than looking at strategic and sustainable reductions in cost structures.”

Reducing workforce numbers, maintenance and exploration spend, and mining high-grade areas might initially improve bottom lines, but could also have negative long-term impacts on project value and profit if not managed properly.

“There is a fine balance between cost-reduction activity and maintaining enterprise value,” Elliott said. “With an underlying skills shortage and an ageing workforce, the loss of organisational knowledge and skills and the potential for diminished staff loyalty are not insignificant risks.

“Similarly, equipment reliability, growth in mineral resources available for future production, and retaining mine viability are all important aspects of protecting mine value.”

Many margin improvement programs are failing, according to research by Ernst & Young. A survey of 115 multinationals in the FTSE 350 found up to 70% of companies that had implemented cost-reduction measures had not seen a year-on-year improvement in cost-to-revenue ratio after three years.

Elliott suggested using “innovative” and “sustainable” cost-reduction measures to help free up much-needed cash.

Some miners are addressing the problem by cancelling or reducing supply contracts, which Ernst & Young said presented a time delay between restarting production and cash injection.

In the report “Margin Protection in the Mining and Metals Sector, Cutting Costs not Corners”, Ernst & Young recommended production cuts instead. This can be done by reducing working capital in slow-selling stockpiles, restricting investment in mine development and undertaking campaign-style activities.

Ernst & Young suggested paid leave, reducing shifts or implementing salary freezes or reductions could also cut costs. This would be more favourable and less risky than cutting staff altogether.

Joint ventures also minimise expenditure on particular operations. Juniors partnering with larger players leverage knowledge and expertise, and increase investment.

These strategic cost reductions could save 5-10% of operating costs, 10-20% of mining support costs, and more than 20% of back office costs.

Mining consultancy Coffey Mining argues contract renegotiation could save companies millions. Chief mining engineer Linton Kirk said the economic downturn offered opportunities to re-examine existing contracts.

“Contracts that were written in the boom times may no longer be suitable for the current economic conditions,” he said.

“Smarter businesses who review contracts and create fairer and easier to administrate contracts will go a long way towards ensuring their long-term survival.”

Faults arise when contracts are not considered from both viewpoints and when foreseeable changes that can affect deals are not defined.

Kirk said incorporating simple project details into contracts could save millions.

“Simple details are frequently not included within the original contract and can result in lengthy renegotiations,” he said.

Conflicts between mining companies and contractors frequently result from common legal loopholes.

“Every contract is different, but terms and conditions that unreasonably bias one side or the other are the cause of most disputes,”

Kirk said. “Terms such as the ‘right to terminate the contract for convenience’ or to ‘change the schedule frequently without adequate notice’ often cause problems.

“These conditions should always be qualified with reasonable compensation for the contractor. This not only protects the contractor for any expenses incurred, but from a mining company’s point of view, fixes an upper limit to which it may be liable.”

KPMG Middle Market Advisory practice partner Don Abell told AMM the downturn was time for companies to “get their house back in order”.

“If you’ve come through buoyant times, there are some inefficiencies that naturally creep into businesses. So this really becomes an opportunity for people to get their house in order, and if they do that well they come out of downturns very strongly,” he said.

KPMG’s annual Private Companies Survey showed private companies were weathering the global financial crisis but approaching the coming year with caution. Many Australian businesses surveyed with turnovers between $20 million and

$400 million felt they had not overstretched and had adequate access to credit.

“The results suggest that many private companies entered the downturn with lower-geared balance sheets compared to public companies,” Abell said.

Some 42% of respondents cancelled major projects or expansion plans compared to 15% in 2008. The majority of remaining businesses (57%) had put plans on hold.

Preferred alternatives to redundancy were long-service leave (27%), annual leave (50%), or reduced working hours (20%). Forty-three per cent of all respondents had frozen salary increases.

Abell said unnecessary expenditure not core to the business had slowed.

“However, private companies seem to be prepared to act, with 90 per cent of respondents claiming to be very well or moderately well prepared to take advantage of any opportunities during the downturn,” he said.

Abell said reckless cost cutting could risk a company’s ability to come out of a downturn strongly, and fewer companies favoured this approach. “Slash and burn is not a good approach and we have found, certainly in our survey, that people are taking that approach much less than we might have seen in other significant recessions,” he said.

PricewaterhouseCoopers resources industry leader Mike Happell sees the majority of mining companies approaching the downturn with a different perspective.

“A lot of them are looking at smarter ways to manage their maintenance spend and manage their assets,” he said. “So doing more sophisticated work around managing their supply chains so that they can make savings that don’t have negative implications in terms of long-term maintenance requirements on assets or cutting production significantly.”

Happell believes there is less concern top-tier miners will take a slash-and-burn approach than lower-tier companies.

“When the financial crisis really hit the commodity markets late last year, there probably was a little bit of a knee-jerk reaction, but I think at that top tier it has definitely corrected itself and it’s much more back to business as usual,” he said.