Recession economics returns to metals

Northumberland, a county in northern England, does not usually feature on the radar screen for metals investors.

Yet Lynemouth, the site of an aluminium smelter owned by Rio Tinto, is the latest flashpoint for a debate that was last heard in the depths of the 2008 financial crisis. The miner recently announced it would close the plant explaining that it was “no longer a sustainable business” due to rising production costs.

As the prices of metals such as aluminium, nickel and platinum slump, recession economics is making a comeback in the metals markets. Investors are no longer just asking which metal is in more demand in China, but which metal’s price is so far below the cost of production that miners will have to shut down output.

A tumble of as much as 25 per cent since the start of the year in the prices of metals and minerals such as aluminium, iron ore and platinum have sent analysts scurrying to their spreadsheets and estimates of production costs.

If prices fall below the cost of production for higher-cost producers – known as the top of the industry’s “cost curve” – for a sustained period, then miners and smelters should stop producing and so bring supply and demand back into balance, according to the orthodoxy among analysts and investors.

“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,” says Catherine Raw, natural resources portfolio manager at BlackRock, one of the largest investors in the sector. “You have a cost push rather than a demand pull.”

The price falls are causing widespread pain in the metals and mining sector. But while their focus may have shifted from demand to supply, investors are still looking to China – despite scattered instances of production cuts in the west.

The country is not just the largest consumer of most metals. It is also one of the largest and highest cost producers of many of them – including about 40 per cent of the world’s aluminium, iron ore and refined zinc output.

Already there are signs that high-cost aluminium smelters in China are beginning to shut down, helping to erode a supply surplus. The country’s aluminium production has fallen 12.5 per cent from September to November, according to Max Layton of Goldman Sachs – equivalent to nearly 6 per cent of global output. And Xstrata, the world’s top zinc producer, told investors this month that “up to one-third of Chinese zinc mine production is high cost and at risk if prices remain at these levels”.

The situation for other metals is less clear cut. The prices of platinum and rhodium, two precious metals used primarily for catalytic converters in the car industry, have both fallen to the lowest since 2009, but miners in South Africa which account for more than three-quarters of global platinum supply, are slow to cut output in response to falling prices. In nickel, many analysts believe current prices below $19,000 a tonne are putting pressure on Chinese producers of nickel pig iron, a low-grade ferronickel that has rapidly become a key swing factor in the global market.

For copper, on the other hand, prices are still trading far above the cost of production for any miner in the world, despite recent falls.

But for all the hype and early signs of cuts, many investors remain sceptical about the ability of production costs to act as a floor for the markets if demand continues to wither. In the 2008-2009 crisis, for example, aluminium fell to a low of $1,279 a tonne – a price at which almost every smelter was losing money.

“The experience of late 2008 showed that cost support is pretty much an economic concept,” says Duncan Hobbs of Macquarie, the Australian bank that specialises in the natural resources industry.

One of the problems is that shutting down production is often a costly process, so miners and smelters sometimes operate at a loss in the hope that prices will recover. “Markets aren’t perfectly efficient. It takes a couple of months for someone to realise prices won’t rise and to shut production down,” says Ms Raw of BlackRock. “In the short term, prices could go in any direction.”

And economics is not always the most pressing factor. In Bogoslovsk, for example, an aluminium smelter in the northern Urals mountains, Rusal recently announced it would close down an ageing smelter complex – only to reverse the decision after an intervention by the Russian government, which was concerned about the 2,000 jobs that would have been lost. The political dynamics of the South African platinum industry are similar.

Even so, as Rio’s employees in Northumberland have discovered, there is often a limit to the losses that miners and smelters are willing to accept.