The outlook for the mining industry
Comment of the Day

March 24 2011

Commentary by Eoin Treacy

The outlook for the mining industry

An Australian subscriber, with vast first hand experience of the mining industry, contributed two detailed emails last year which appeared in Comment of the Day on April 27th and May 5th respectively.

Eoin Treacy's view His commentary focused on the reliability of reserve estimates. He made the point that these calculations do not reflect economic considerations. New technology can increase reserve life and higher commodity prices can make previously uneconomic reserves viable once more. Therefore it is misleading to talk about mine reserves without taking these additional factors into consideration.

He also pointed out that most mining booms end because supply begins to exceed demand rather than demand dwindling. In the last 10 years miners have been cautious about bringing new supply online and have managed to attain progressively higher prices for their respective commodities. However, a number of the larger miners have plans to open significant new operations over the medium-term which will result in a substantial boost to aggregate supply. Rio Tinto's plan for a massive iron-ore mine in Guinea is an example. (Also see Comment of the Day on March 22nd). In light of this development I asked the subscriber concerned for his opinion which he kindly submitted. Here it is in full:

"As for the iron ore are a few thoughts.

"In my experience, the biggest thing that turns mining booms into busts is over-supply, even while (usually) demand continues to grow. Up until now, many commentators have focussed on Chinese growth, and how long will it last, and how fragile it is or isn't. Clearly if Chinese growth falters than there is an issue for commodity suppliers. But this is not a great concern of mine.

"But if demand grows at 10% and supply grows at more than 10%, at some point the relative bargaining positions will change, and (if past experience is a guide) the price impact could be very substantial. This is a concern of mine. There is a lot of mooted supply coming on to the market. $120/tonne can quickly turn to $50/tonne, and this would certainly take the gloss off a lot of mining stocks. The issue is one faced by any capital intensive industry, but mining is particularly sensitive because of the idiosyncratic nature of mining investments. Let me explain:

"1) If your industry cost structure is nearly all operating costs, when you have over-supply (and the price drops) then supply is readily taken out of the market. Supply imbalance and price dislocation resolves fairly quickly

"2) If your industry cost structure has a high element of capital costs (cash costs much lower than average selling price) then this resolution of supply/demand imbalance takes longer and varies greatly across industries. For example: faced with over-supply, airlines will discount (the costs of a marginal, otherwise empty seat is very low) but this is a survival tactic good for only a short time. The limit in time and sustainability of the over-supply situation meets economic reality because a big chunk of the capital deployed (the aircraft) can be redeployed elsewhere. The airline industry might have high capital costs, but not too much is sunk costs because if things turn pear-shaped a relatively high proportion of the capital value can be recovered by turning it so some other use. Also booms in this and many other industries tend to be sectoral, so the non-over-supplied parts of the world can happily absorb the redeployed capital.

"3) In the mining industry, commodities are traded across the globe, almost all of the capital cost is a sunk cost, and prices can fall to at or below cash costs and supply won't necessarily be taken off the market. Indeed, in the past, price falls have often been accompanied by increases in production as under-capitalised producers try to squeeze as much cash out of their operations as possible, exacerbating the supply/demand imbalance. And even for the well-capitalised producers, high closure costs and high care-and-maintenance costs mean that mines might keep operating at below cash costs. Is this what we are facing?

"It's a big topic, but very relevant. I have done a number of presentations recently on this and similar issues, urging caution in bringing on too much supply, and also suggesting that the way we go about making these investments is flawed in that it promotes too high planned and initial production rates from new mines. But in hot sectors (e.g. Iron ore mining, right now) this isn't information that too many people want to hear!

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