METALS COST INFLATION
Despite these ‘barriers to exit’ however, we would
Figure 1: Cost Curve Dynamic – Slope Comparison 250
Nickel 150 50 -50 Lead -150 -250
Aluminium Gold
-50 -40 -30 -20 -10 Source: Deutsche Bank
of marginal capacity augments this inflationary trend. Cost control represents the single
most important value-added strategy for managers. Improved anticipation of geographic risks and opportunities, the use of hedging tools, backward integration, and a focus on quality assets represent the most effective ways to meet this challenge. Accordingly, we believe that the metals with the greatest future cost pressure include nickel, copper and iron ore.
Costs & Price Determination Commodity analysis is based on
the notion that supply response is, in large part, price sensitive. As prices decline sufficiently to push the profit margins of higher-cost supply into negative territory it would be expected that this supply adjust by minimising losses and shutting down. Certainly there are various considerations for a shut-down decision: 1) The cost to idle/suspend operations,
2) The volatility of the commodity – it would be embarrassing for the manager to idle production only to see prices rebound,
3) Contractual obligations (input & output) and,
4) Political interference. 66 June 2012 0 10 20 30 40 50
IronOre Copper Zinc
expect that under normal circumstances markets will adjust to deteriorating economics; whereby supply contracts to meet or exceed the implied contraction in demand (implied by the falling price). On this basis an analysis of the industry cost curve can be helpful in determining value for a specific commodity; particularly when the price reflects a demand contraction which may be excessive when compared to the likely actual demand situation. The slope of the cost curve can be of considerable
significance in helping to determine the probable response of supply in a weakening price environment. We would assert that the greater the slope the greater the likely supply response. Our reasoning is the following: as prices decline high cost producer margins move quickly negative, but more importantly margin erosion occurs rapidly vs. other peer producers. If high cost production resists closure, margin pressure remains relentless and prices continue to fall eventually forcing a capitulation. Critical to this is the relative isolation
of high cost capacity, as differentiated from peer producers. This contrasts with industry curves which are relatively flat. As prices fall there is little response until prices fall sufficiently to capture a considerable swathe of capacity. At this point there is, in our view, a kind of brinksmanship, whereby producers try to outlast each other as margin pressure grows. Moreover, the delayed response by supply in a flat cost environment means prices can stay low for longer than would be expected.
... we expect that political interference could be an increasingly important variable in preventing the normal supply response
Figure 1 compares the slopes of various selected metals/
materials markets together. In this exercise we compared the relationship between the 20th
percentile and the 80th percentile
on the cost curve and then compared across metals markets. On this basis (all else being equal) we believe that the nickel market followed by iron ore should be the most responsive to falling prices. At the other end, aluminium and gold could be expected to be rather unresponsive or exhibit a more sluggish producer response as conditions deteriorate.
Geography The New Tax: ‘Keep Operating’ Operating conditions are often considerably more complicated
than our analysis above suggests. In fact in the current stressed economic environment we expect that political interference could be an increasingly important variable in preventing the normal supply response that one would expect if price conditions were to deteriorate. We see the resulting non-responsive nature of supply to lower prices as a kind of tax that government applies to industry (although one could argue that this loss in value is simply transferred to the consumer – zero sum).
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