How North American resources firms can overcome their capital cost disadvantage

Capital efficiency is rising fast as a major imperative in the resources[1] industries due to regional company disparities in cost of capital as well as energy transition investment ambitions.

Companies have recently been struggling to allocate precious capital funds to meet ESG objectives, while maintaining or increasing market share.?As outlined in a past post, the share of investment going to conventional capacity, like traditional polymer and refining processes has dropped in favor of “the new” – energy transition assets, including those in the circular economy.

In addition, there is a tremendous amount of investment opportunity in North America due to reshoring, the Inflation Reduction Act (IRA) and Chips Act as mentioned in my previous post.

However, North American[2] (NA) companies have the burden of higher capital costs relative to overseas peers, which threatens their ability to compete.

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Advantage gap

The cost of capital, as measured by weighted average cost of capital (WACC)[3], for the top 334 global public companies in the resource industries shows regional gaps. NA companies have higher capital costs than their European, Asian and MEAFR[4] competitors.

As of July 2023, NA chemical companies had an average cost of capital of 6.3%, while European companies averaged 5.3% and Asian companies, 4.2%.?This gap has been going on for many years, affecting the ability of NA producers to build projects in their own backyard. ?In fact, according to the American Chemistry Council, 65% of US chemical industry investment since 2010 has been foreign direct investment.

For most resources industries, the WACC gap has worsened over the past few years, by 2.6 percentage points for the energy sector for instance[5].?

Let’s look at the reasons for the gap. Cost of capital is related to debt and stock prices.

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Debt and interest

Starting with debt, NA and European firms generally have lower debt levels than their Asian counterparts. For instance, in chemicals, average debt-to-capitalization is about 32% and 14% for NA and European companies, respectively.?This contrasts with 36% for Asian companies. There are similar differences in energy, refining and metals/mining.??

However, NA companies have a higher cost of borrowing (interest expense), by 1.5 to 5.5 points, depending on the resources industry segment, versus Asia. Perhaps this explains the difference in their debt-to-capitalization ratios.

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Stock volatility – the real disparity

NA companies’ higher cost of capital seems to be related mostly to the “beta[6]” in the WACC calculation.??

Beta is a measure of the relative volatility of a stock versus the rest of the market.?This beta is not related to companies’ managements, but the systematic risk in their listing’s geography.?

Exchange rate volatility may be a large component of the volatility risk. The US has experienced the highest volatility in real effective exchange rates[7] versus other countries reviewed except for Brazil (see chart). Since early 2020, US dollar exchange rate changes recorded a standard deviation[8] of 5.4, versus 2.4 for the euro and 3.1 for the Chinese yuan.?

Other risks likely impacting the beta (and exchange rates) are:

·???????Interest rate movements

·???????Government policies

·???????Increased passive investing

·???????Other factors, like storms/droughts

How to win

During the earlier days of the NA shale gas boom, many new gas-based chemicals projects occurred in the region.?Companies did not feel a need to spend more on efficiency measures at the time, as margin expectations were so high and would significantly exceed the benefits provided by efficiency add-ons or anything that could slow down a project.?The focus was on getting capacity started up as soon as possible to take advantage of low-cost feedstocks.

This time, the advantage will be more with companies able to build with the best positioned technologies at the lowest cost.??It’s not a “gold rush” on feedstock.

Obviously, there continues to be a great opportunity for Asian and MEAFR companies to invest in NA markets due to their WACC advantage.

For NA companies, to beat the capital cost disadvantage, companies should focus on the total cost of capital projects, which encompasses cost, timing and quality, for example:

·???????Developing new/leading edge manufacturing technologies

·???????Deploying digital construction management platforms

·???????Improving equipment supply chains

·???????Using modularization

·???????Employing standardization

·???????Retaining talent and teams

·???????Implementing other steps directly related to an efficient construction

Now is a critical time for producers to make investment decisions and be disciplined in their capital programs.?

To keep ahead of the latest industry trends, ask me about getting the monthly Advisian Market Perspectives Report or see Advisian’s additional perspectives here: https://www.advisian.com/

Also, see Worley’s latest thinking here: https://www.worley.com/our-thinking

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[1] Resources industries here include energy, refining, chemicals, crop chemicals, mining, and metals

[2] North American companies for this analysis include the United States and Canada

[3] This analysis uses S&P Capital IQ’s WACC screen calculations, which use levered Beta and assume equal effective tax rate for all companies.?WACC represents the cost of capital from shares (equity) and debt.

[4] Middle East/Africa

[5] The problem is not exclusive to resources industries, it is apparent in other industry sectors as well, such as automobile manufacture

[6] Beta represents the volatility or riskiness of a stock relative to the market and is used in determining the cost of equity in the WACC calculation

[7] Real effective exchange rates are adjusted for inflation and trade weighted

[8] Using standard deviation here as a measure of volatilityng