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How long can the recovery in these mining shares last?

Mining shares have had a great run so far this year. Glencore’s (LSE: GLEN) shares have gained a staggering 190% year-to-date, while those in Anglo American (LSE: AAL) have done even better – up 266% this year. But as of recently, it appears their luck may be about to run out – both stocks are among the worst 10 performers in the FTSE 100 this week.

Recovery in commodity prices

Much of the reinvigorated investor interest in mining shares has been attributed to the rise in global commodity prices this year. Global supply disruptions, China’s restocking and, more recently, Trump’s election victory have all been bullish factors for the three minerals and metals that account for most of the sector’s profits – coal, iron ore and copper. However, because these tailwinds are — by their nature — short term, there remains huge uncertainty with the longer term price outlook.

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With the market still oversupplied and demand from emerging markets slowing, the likelihood of a sustained recovery in commodity prices seems remote. What’s more, higher cost producers which have been forced out by the commodity price rout last year could re-enter the market if the outlook improves. Unless we see more supply disruptions, market fundamentals may only keep prices lower in the longer run.

Debt reduction and lower production costs

But it’s not just the rebound in commodity prices that’s been behind recent gains in these mining shares. Glencore and Anglo American, which were some of the worst performers in 2015, have taken big steps to cut debt and lower unit production costs.

Glencore expects to sell between $4-5bn worth of underperforming assets this year, and has a goal of cutting net debt to between $17-18bn by the end of 2016. That’s around $5bn less than at the end of June this year, and significantly below the peak debt figure of nearly $30bn in 2015.

Anglo American has a net debt target of less than $10bn by the end of the year, which is down from its peak of $13.5bn in mid-2015. It is also on track to deliver production efficiency savings worth $1.6bn this year, which should have a massive impact in boosting its lagging profitability and allow the company to return to positive free cash flow this year.

Bottom line

Although both miners have strengthened their balance sheets and improved their profitability, I’m avoiding their shares. There is just too much uncertainty with commodity prices in the longer run and valuations are unattractive right now, with shares in Anglo American and Glencore currently priced at 14.6 and 36.1 times their respective forward earnings.

Moreover, following their dividend cuts in 2015, neither company is in a strong position to resume dividend payments. Net profits and free cash flows remain well below their pre-2014 levels, and both companies have prioritised debt reduction over returning cash to shareholders.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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