METALS COST INFLATION
years. At the same time however, the implied average grade of exploited iron ore within China has fallen almost in half. We would also point out that this is the average grade, this would further imply that the grade of new incremental iron ore mined is much lower, and in fact,
100 150 200 250 300
50 25th Percentile 0 1980 1985 1990 Sources: Brook Hunt, Deutsche Bank
we understand from various sources that grades of around 15% are not uncommon. Therefore, while the grades of the
highest quality iron ores (from Brazil and Australia) have been falling over the same period, from around 62/63% to 58/59% or so, the average industry grade has witnessed a much steeper decline because of the addition of vastly inferior ores.
Energy We expect oil prices to remain
high over the next several years, averaging US$ 117/bbl (Brent) this year and US$ 120/bbl in 2013. Our long-term price assumption for oil (both WTI and Brent) is US$ 130/ bbl. Oil, like the metals/materials space is subject to some of the same inflationary conditions that we have discussed previously. In addition to geography and
geology however, oil (and energy in general) is often subsidised by local governments. With economic growth increasingly problematic, many governments are less willing or able to keep prices artificially low. This is
70 June 2012 1995 2000 2005 2010
Energy Intensity Figure 6 shows the energy intensity for
selected mined commodities, however instead of just using the industry average
we have also highlighted the marginal producers. In this way we see that in many instances, particularly for
iron ore and nickel, the marginal high-cost producer becomes more sensitive to changing energy values. Again, in many cases this is a function of a deterioration in the quality of the resource being exploited.
Cost of Capital In theory we would argue that capital is one of the most
important and valuable principles of the modern economy. Capital, representative of excess value created within an economy, can in turn be used with care to extract greater amounts of capital (or return). This ultimately creates wealth (which we would characterise as capital which may be used for less productive purposes). We stress that this is at least the theory; in practice capital’s
value characteristics may be considerably different. With the US Fed’s target interest rate hovering close to zero for the past two years; and likely to remain there for the next two years, this indicates how cheap low-risk debt capital is: for the lowest risk instruments capital is effectively free. However, while the risk-free rate has become return free, the
equity risk premium (ERP) has moved higher. The rise in equity capital is reflective of the poor performance of equity markets in an environment of improving earnings/cash flow. This represents a de-rating of the market as investors factor in greater macro- economic risk. This is of course fundamentally linked with why the risk-free
rate is as low as it is. For example, the ERP for the European market at the current level of nearly 11% remains elevated, particularly
resulting in an added lift in cost pressure for many consumers of energy. Examples of this theme include:
India: the energy subsidy burden is around 2.5% of GDP vs. the government target of 2%. The government will look to reduce the burden in a staggered manner.
China: the NDRC recently raised gasoline/diesel prices for a second time this year, by 6-7% (more than the usual 3- 4%).
Figure 5: Copper Costs – Quality Differentiates Copper Cost Evolution: 25th to 90th Percentile (USc/lb) However, there are bright spots in the 90th Percentile
energy story; this is particularly obvious in the US. The exploitation of shale oil and gas is transforming the energy balance in North America. In fact it could be argued that the gas market is structurally over- supplied in the US. Despite this advantage, we expect that energy prices in the US will remain highly influenced by world energy prices. US metals/mining companies will nevertheless, likely have the advantage of more attractive relative prices for energy on a long-term basis.
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