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Implosion of negative factors set to drive metals prices even higher

by Dan Coatsworth

The rise in coal, gold and iron ore prices suggests that the commodities boom still has legs to run. Supply disruptions are pushing up short-term selling prices and gold is shining as a haven investment, giving life to the resources sector which many industry commentators had presumed to be at the peak of its cycle. Cracks in the global economy, rising costs and production problems, however, may imply that the mining sector’s crown of glory could be living on borrowed time.

Rio Tinto’s latest quarterly performance figures, published last week, gave a typical illustration of how large-cap mining companies are still succeeding despite operating pressures. Copper was down 12% on the previous quarter and 23% on the year as grades fell, a similar story to the 5% quarterly drop in uranium production. Coking coal slipped 32% because of the floods in Australia. Against these negatives, two commodities which accounted for nearly half of Rio’s 2007 earnings saw significant growth.

Aluminium on the up

Iron ore production decreased by 4.1% on the previous quarter due to weather issues but actually increased by 16% year-on-year. Rio’s aluminium output increased by 23% on the previous quarter and 386% on the year, helped by the acquisition of Alcan. These commodities will overtake copper in 2009 as the main contributors to Rio’s earnings, according to Liberum Capital, an investment bank set up last year.

The drop in several areas of production means that analysts are liable to downgrade the company’s earnings forecasts. UBS did just that last week, knocking 3% of 2008 EPS and 6% off 2009, primarily on reduced coal and copper growth forecasts.

Copper prices rising would mean producers could sustain earnings on lower output. China is investing billions in an infrastructure-for-copper deal in the Congo, making it easier to bring on new copper mines, but this won’t dilute the copper price, says Julian Emery, a mining analyst at Ambrian. ‘New projects are planned in the Congo and Chile, but these won’t be enough to replace the diminishing big mines. Producers are having to go deeper underground for copper, which is when you have to look closely at the economics of mining.’

There could come a point where strong selling prices will no longer offset higher costs and falling production. Rio needs to make existing operations more efficient, let alone invest in new projects. This is why market leaders BHP Billiton and Vale are seeking major acquisitions, combating cost pressures through economies of scale.

‘Higher operating costs are a problem, driven by such factors as a shortage of labour and rising tyre prices. However, the real crunch is power,’ says Emery. ‘This is affecting so many companies, particularly exploration businesses who are having to use diesel generators at great cost.’

China has been key to the commodities boom, now accounting for up to a third of world industrial metal demand, according to ABN Amro. Chinese inflation is running out of control, forcing monetary policy to be tightened. An economic slowdown suggests a drag on commodity demand but this level of reduction won’t be too damaging, says ABM Amro analyst Nick Moore: ‘Growth is being cut (in China) from such an elevated level that it still implies overall world growth for commodities.’

ABN Amro has downgraded forecasts for Chinese copper demand growth from 17% in 2007 to 14% in 2008. It says aluminium offtake growth will ease from 38% in 2007 to 24% this year. Construction around Beijing will stand still for three months around the Olympics, to ease pollution. This may briefly but severely disrupt commodity imports for the building industry.

China’s steel industry has indirectly caused a global rise in iron ore prices. For example, Ferrexpo only sells 20% of its iron pellets to China, but rising Chinese demand for the commodity has enabled the Ukraine-based miner to command a sharp rise in selling prices to Europe. It has secured a 90% price rise for over half its production this year, with a similar rise expected soon on the remainder of output.

Disruption rules

Supply constraints will be key to another commodity rally, though beware of longer-term surplus diluting prices. John Meyer, head of resources at Fairfax, said last week that metals should hit new price highs within days or weeks. ‘Consumers are holding off but the market has patience and a stack of supply disruptions are about to force consumers into the public market place. A general strike is called in Peru, probable strikes in Chile and Mexico, environmental issues in Indonesia, heavy rains in Australia and Zambia plus droughts in other areas are causing supply issues.’

Liberum Capital analyst Michael Rawlinson says a doubling in copper and other commodity prices could force ‘draconian actions’ upon China. ‘The potential social implications of rampant inflation would be much worse than the downside of rising employment,’ he warns. ‘Under the scenario of a “melt-up”, investors should hold on to the miners for one spectacular run before what will be a very hard fall.’