Metals: Cost is main influence on miners’ profit

Earlier this year the talk among industry executives and investors was whether miners would be able to keep up with booming demand for industrial metals.

Fast forward just six months, and question on many lips is how many of them will be forced to close down production because they are losing money.

The shift in sentiment has been dramatic. The mood among European traders and consumers of metals is particularly glum: some are seeing a drop of more than 30 per cent in metal demand from the region.

The change in mood has reopened a debate last heard in the midst of the 2008-2009 financial crisis: at what point will producers respond to falling prices by cutting production?

The critical equation, many investors believe, involves the cost of production of the metal. If prices fall to a level where a significant proportion of miners or smelters are losing money by producing a metal, the argument goes, then they should shut down production, and so support the markets.

“If you’re bearish, and you think we’re going to move out of a demand-led environment, then you ask which metals are best supported by the cost curve. You have a cost push rather than a demand pull,” says Catherine Raw, natural resources portfolio manager at BlackRock, one of the largest investors in the sector.

A plunge of 15-35 per cent in metals prices in September and October alone was dramatic enough to bring prices to a level where analysts believe at least some Chinese producers are losing money.

The highest-cost aluminium smelters require a price of roughly $2,200 to break even – whereas the metal recently fell below $2,000 for the first time in more than a year.

“Prices are trading furthest into the aluminium cost curve which should mean they have less room to fall compared with other metals, such as copper, if the macro environment gets worse,” says Gayle Berry, metals analyst at Barclays Capital.

Indeed, there are already signs that the fall in prices is beginning to impact production – though so far the impact is largely contained in China, the highest-cost producer of most metals.

Data released by China’s National Bureau of Statistics show that production of almost every major metal, ore and semi-finished product dropped in October.

Aluminium output was 8.7 per cent lower than the previous month, iron ore was down 13.1 per cent, and nickel fell 14.7 per cent.

The level of Chinese production is increasingly important to metals markets. While the rapid rise in the country’s demand for commodities in the past decade is well-documented, there has been almost as dramatic an increase in its share of global supply.

Chinese companies now account for 40 per cent of global aluminium production, 26 per cent of nickel, and 37 per cent of iron ore, according to Deutsche Bank.

Colin Hamilton, commodities analyst at Macquarie in London, says that the falls in Chinese production since October demonstrate that “high-cost Chinese supply, particularly from small private sector enterprises, is both extremely flexible and price-sensitive and enters and exits the market very quickly as fundamentals change.”

The flexibility of Chinese production bodes well for non-Chinese producers. So far, only a few marginal projects, such as Rio Tinto’s aluminium smelter at Lynemouth in the UK, have been shuttered on the back of the fall in prices.

For the rest, the cuts in Chinese output could help them stay in the black by supporting prices.

Crucially, however, that depends on the ‘cost of production’ argument holding true. Unfortunately for the global mining industry, many investors are sceptical – noting that in 2008-2009, prices for most metals fell well below the cost of production for many miners and smelters.

“In the short term, prices could go in any direction,” says Ms Raw of BlackRock. “Markets aren’t perfectly efficient. It takes a couple of months for someone to realise prices won’t rise and to shut production down.”

In the longer-term, she says, metals prices should remain above the highest-cost suppliers’ cost of production.

Nonetheless, it takes a particularly gloomy approach to invest solely on the basis of which producers are least likely to lose money. Ms Raw prefers iron ore – a combination of a demand and a supply story.

The largest companies – BHP Billiton, Rio Tinto and Vale – have very low cost operations in Australia and Brazil, but booming demand from emerging economies means the high-cost supply from China and India is necessary, effectively preserving the margins of the big miners. Prices, she notes, have rapidly rebounded after falling below the break-even point for high-cost Chinese miners.

“Iron ore is the market we find is the most interesting. It is the one that has just been tested – and the theory seemed to work.”