Financial risks can take many forms: liquidity risk, financing risk, currency risk and pricing risk.
The prospect of a company not having enough cash to meet its day to day expenditure or being unable to obtain financing to fund a project is probably the most serious financial risk that a company will encounter.
In a worst-case scenario, the adverse impact of any one of these financial risks could result in the closure of a company as it is unable to meet it financial liabilities.
This article examines three key financial risks that mining companies are exposed to.
1. Financing risks
The ability to raise finance and decisions around how that new or additional finance should be structured is critical to the success of any mining project.
Funding is needed not only to construct the mine and build up the associated infrastructure; but also to undertake the agreed exploration and development work programmes.
Depending on the risk profile of the mining company and prevailing economic or market conditions the financing needed may not be available to the company on sensible commercial terms.
For example, in order to bring in new investors, additional equity financing may only be available at a lower price than the current share price. This means that the ownership stake of existing shareholders in the company will be diluted and reduce the overall value of their investment.
Debt financing brings its own risks: these include restrictive covenants being imposed on the company by the lender which could impact operating activities. Or the funds may only be released once certain (possibly onerous), conditions are satisfied.
In the event that the company is unable to raise additional finance, the scope of its operational activity may be reduced and production could slow or stop. This could potentially result in its interest in the licence or project being diluted and even terminated.
Consequently, the company may be unable to deliver the exploration and development programme within the timescale set out in the business case. Ultimately, the lack of suitable financing options will drive down the share price of the company.
2. Commodity price risk
Significant changes in the market prices for commodities will have an impact on the cash flows generated by a mine. This is arguably the single biggest factor affecting the profitability of mining companies.
Market prices for commodities are sensitive to changes in a range of political, environmental and macro-economic factors. Any of these can impact the supply and demand of the resource and as a consequence can lead to substantial price fluctuations.
For example, changes in demand caused by changes in fashion can impact the use of gold, silver or platinum in jewellery. Strategic decisions by central banks to increase or decrease their holdings in gold reserves can also impact the price of gold and other precious metals.
War or adverse weather can cause disruption to supply chains; technological innovation in the motor industry, particularly demand for electric cars, means an increase in the need for lithium used in the batteries that power those cars. All of these factors can lead to unexpected movements in commodity prices.
Where the market price of a commodity falls below the expected cost of production over an extended period of time, then the production company will need to consider suspending (or abandoning) its mining operations.
Alternatively, it will be required to issue further cash calls on investors to sustain ongoing losses. Either way, the effect on the company’s share price could be quite detrimental.
3. Currency risk
Currency fluctuations can affect the financial performance of any company but particularly mining companies where revenue is derived from commodity sales; as many commodities are denominated or priced in US dollars (gold in particular) and an increase in the value of the US dollar can lead to a fall in demand of the associated commodity.
The strength of the US dollar vis-a-vis other currencies can therefore result in mining companies no longer generating the revenues expected from the project.
Another currency risk factor which affects UK based companies who raise the finance they need in sterling but incur a substantial portion of their capital and operating expenses in the currencies of the overseas countries in which they operate. Any fall in the value of the pound will make the funding of those costs more expensive in sterling terms. This will adversely impact the mining company’s cashflow and operating profits.
Investing in commodities
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