Metals analysts are under fire for failing to predict the bull market. But are producers’ decisions on new mine capacity supported by better bets on long-term prices? Understandably, producers tend to keep their price assumptions to themselves, but they have almost certainly risen sharply in recent times.

Analysts’ five-year forecasts use the supply/demand balance and expected inventories from new mines. Beyond that, they use incentive prices for capital expenditure, plus a margin of return. By this measure, prices are still high.

“We believe prices will be based on cost at the margin, plus an allowance for uplift, though it is possible prices can go below marginal cost. You can argue that prices are above long-term costs now, so could revert to a long-term equilibrium, though this may take a long time. Margins on copper have never been higher,” says Vivek Tulpule, Chief Economist for Rio Tinto.

Tulpule also notes surging iron ore prices, which “exceed anything we have seen in the past”. For all metals he has “adjusted our long-term prices upwards – significantly in some cases – on the back of higher demand”.

Analysts sense similar increases by many copper producers, not only from belief in sustainable high prices, but also intense cost pressure.

“When you look at producer price assumptions you have to say the industry got it wrong,” says UBS analyst Robin Bhar. “Metals prices are the biggest assumption for a project in the ground. For decades copper was seen at around $2,300/tonne. Today, incentive prices have risen, so producers assume almost $4,400/tonne as the long-term price for capital expenditure on copper projects. Costs have risen so much that these price assumptions had to rise.”

“In terms of prices falling to the marginal cost of production, that would mean long-term prices being a lot lower than at present. All of the base metals would fall, except for aluminium, which is not far above production costs. That kind of adjustment, however, would happen over a long period,” says John Kemp of Sempra Metals.

Rising costs, notably labour and energy, have put the brakes on new investment. In some models, inflation accounts for up to 50 per cent of new capital expenditure. As miners rush to increase capacity, inflationary pressure grows.

This pressure has already put some projects in jeopardy. Massive capital cost inflation at Teck Cominco’s Petaquilla copper mine in Panama – doubling from last year’s $1.7 billion estimate to $3.5 billion – threatens its viability, and further inflation could push the final bill higher still.

Skyrocketing construction costs saw Teck shelve Galore Creek in British Columbia. It now admits Petaquilla’s numbers are challenging and the mine is in limbo.

From the mine’s assumed lifespan tonnage, analysts derive $5,000/tonne as the mine’s assumed long-term incentive copper price. One problem, they say, is producers’ use of cash cost and not full operating cost as the basis for investment. Bhar notes that for aluminium this could be nearer $3,300/tonne than $2,500/tonne, while from data in Rio’s bid for Alcan, analysts derive a presumed long-term aluminium price of $2,400-2,500/tonne.

Aluminium, now at around $2,600/tonne, is rare in trading near its cost of production. Copper appears to have a huge margin, trading at around $7,800/tonne with cash costs estimated at $3,000-4,000/tonne. However, full operating cost analysis shows the margin is, in fact, lower.

If metals settled around the marginal cost of production, they would – apart from aluminium – trade considerably lower. So, is this what producers expect?

“You never know if you’ve reached the top of a cycle until you come off it, so you have to look at the fundamentals,” says Tulpule. “For aluminium, for instance, we see relatively tight stocks and we see the underlying cost structure at the margin much higher than previously.”

A long-term price fall could spell problems for some projects. Teck Cominco’s Petaquilla mine would certainly cease to be viable. Aluminium projects, too, could be under pressure and perhaps many others, depending on presumed margins and the severity of price falls.

Jim Banks
LME Ringsider enewsletter
Spring 2008