Henk Groenewald, Coronation Asset Managers
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The (rising) cost of success
David McKay
Posted: Fri, 24 Aug 2007

[miningmx.com] -- HAS THE WORLD’S mining industry changed forever? Most analysts are prepared to say it has, though with some guarded qualifications.

Certainly there’s been a fundamental shift in metals demand that, some say, will sustain much higher resources production for generations. Mining companies should be deliriously happy. The fact they’re not is a matter worth prosecuting.

“The cost of mining has increased a lot over the past three years,” says Henk Groenewald, portfolio manager and commodities analyst at South Africa’s Coronation Fund Managers. “Although that will limit the downside potential of commodity prices it will also squeeze margins.”
entire resources cost base trending higher
Energy prices have increased with other commodity prices, which means that miners are facing increased costs that are trimming margins. Says Groenewald: “The upshot is that the profits mining companies have been enjoying over the past few years simply can’t continue indefinitely.”

A recent UBS report expressed similar concerns. It said rising labour costs add to the equation. “Quarterly results suggest costs are rising, associated with higher materials, labour costs and unfavourable exchange rates that continue to question margins.”

South Africa’s major gold mining companies prove the point. In first quarter 2007, Harmony’s total cost of production was US$516/oz. Gold Fields and Anglogold Ashanti’s production costs were around $450/oz. “That’s very high,” says Groenewald.

It’s also higher than the average cost of mining an ounce of gold in South Africa, which according to JPMorgan research is $389/oz. It’s also worth noting that labour costs comprise up to 60% of total on-mine costs, so it’s not just the price of fuel that will keep the world’s largest gold producer in a cost crunch. In the US, gold mining costs have increased by 44% since 2004, largely due to more expensive energy.

Razia Khan, Standard Chartered Bank’s London-based regional head of economics for Africa, says the irony of a rising commodity complex is that it can hurt commodity exporters as well as importers. “As prices rise commodity exporters such as South Africa will face increasing competition for the commodities it needs to ensure its economy keeps going – oil being the most obvious example.”

The booming resources trade is also putting strain on the global supply chain, with obvious cost implications. “The global logistics structure is running at full capacity and that will also keep the entire resources cost base trending higher,” says Groenewald.

Of course, with everyone scrambling to ply resources hungry emerging economies with the commodities they need downward price pressure could still occur. Even in the face of rising demand for commodities it’s certain that supply will catch up with demand. The environment for resources has changed, but you can’t tear up the rulebook in economics.

Marginal miners stand to get hurt in particular. “If they’re marginal at a time when profits have been phenomenal there’s no way they’re going to survive once cost pressures and supply increases start crimping their margins further,” says Groenewald.

Absa economist Chris Hart says increases in supply will come in incremental steps. “Even if you do ramp up supply you’re still faced with depletion, as expanded mining operation can easily turn a 50-year resource into a 30-year resource. That’s because exploration is lagging extraction.”

Combining that depletion factor with the structural outward shift of the demand curve is a recipe for further price increases, or at least sustained high prices. “The world is experiencing a structural change that’s resulting in structurally higher levels of demand,” says Hart. “That’s coming from several merging markets – not just China – that are adding around 3bn people to the global economy who now have the potential to enjoy higher levels of prosperity than ever before.

“In many ways, the effect of that is very similar to the Industrial Revolution of the 1800s. Once the tiger is out of the cage it will continue for at least a generation or two.”

Still, there’s scepticism concerning notions of a super-cycle, with some analysts preferring to think of metals markets in a lighter, less dramatic concept of a super trend: a broad agreement that metals demand will continue to grow and simultaneously become vulnerable to corrections.

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One possible harbinger of that cyclical downturn could be the current weakness in the US economy, where first quarter GDP growth slowed to an annualised 1,3%. The slowdown in the US housing market may also contribute to weaker consumer demand. That’s ominous for China, which exports most of its wares to the US.

In that scenario there’s potential for damage to commodity exporting countries that rely on Chinese demand to keep the prices of their exports high. Yet there’s a theory that a slowdown in the US economy could, perversely, be good for commodity exporters – provided a slowdown doesn’t result in recession.

First National Bank chief economist Cees Bruggemans says a weaker US economy could prompt the US Federal Reserve to cut interest rates. That would narrow the spread between US and global interest rates and keep the flood of yield-seeking liquidity pouring into emerging market equities. There’s another effect as well: an interest rate-led revival of US consumerism would keep China hungry for commodities.

Fortunately, economists still expect the US to expand by 2% in 2007 while the economy is still adding jobs, perhaps the surest sign that the US economy is far from shrinking.

What’s more, a US slowdown would impact negatively on the US dollar, which would most likely result in stronger commodity prices. Since most commodities are priced in US dollars a weaker greenback implies a pricier resources bill. China’s recent growth performance of more than 11% is also a sure sign that the Asian behemoth will be hungry for commodities for some time to come.

That’s probably why there’s no shortage of South Africans who believe firmly that the commodities super cycle is still well intact. South African sentiment towards commodities can be a useful indicator of their future direction. South Africa’s entire economy has been built on its rich resources. It’s still the world’s biggest exporter of gold and platinum and accounts for more than 80% of known platinum reserves.

Paul Theron, MD of South African stockbroker Vestact, says commodity prices are intact for at least a generation. “I’d say commodity prices are likely to stay high for another 20 to 30 years.”

Khan is also a supporter of the super-cycle theory. “I recently returned from a two-week stint in China for the African Development Bank. China’s GDP growth rate is definitely sustainable well into the future. There’s just no getting away from the fact that we’re in a long-term super-cycle, whatever the short-term fluctuations in the market.”

Liston Meintjes, chief investment officer at Metropolitan Asset Management, is another believer. Things are different this time. “The global demand equation is a lot more forecastable today than it was 30 years’ ago, when China and Russia were still command economies. That means people can bring mines on stream and count on the demand staying put.”

However, like Hart, Meintjes says greater cyclical volatility within the broader upward cycle is likely. “Hedge funds are undoubtedly playing in commodity territory. That means it’s not just a supply and demand picture you have to look at. There’s a strong investment focus, particularly for precious metals like platinum and gold, which implies greater volatility.”

Khan also warns that investors who ignore the possibility of short-term instability in the markets could be in for a few nasty surprises. “With the benign global growth scenario that’s fostering easy liquidity we could see higher volatility and more short-term corrections, as risk is usually not sufficiently priced when investors get caught up in the big picture.”

For every 10 bulls there’s always a bear lurking in the shadows and Groenewald is convinced a cyclical downturn is just around the corner. “At the moment equities are pricing in the fact that prices will come down over the medium term.”

By “medium term” Groenewald says he means five years, which could be a money-making opportunity for long-term investors who want to take a 10-year bet on commodity prices running upwards for longer. “It all depends on how long you think the run will last,” he says.

In many ways it’s a two-view story. After all, things don’t last forever and this is still a cyclical sector.