You are here

Commodity boom has a dark side as cost creep erodes windfall

[NEW YORK] Mining and metal companies are rediscovering the downside of rallying prices: higher costs.

A sharp rebound in commodity markets in the past two years put producers in a profitability sweet spot after years of cost-cutting to cope with low prices. Now, as the upturn matures and the higher cost of energy and other materials starts to bite, some companies are beginning to struggle to maintain margins.

As the quarterly earnings season unfolds, companies from Alcoa Corp to AK Steel Holding Corp have seen their shares slump amid signs that cost creep is eating into profit. Machinery giant Caterpillar Inc said it expects higher material costs to mostly offset price increases for its products. Freeport-McMoRan Inc also flagged the effect of oil's surge in its earnings call.

Unit costs for miners probably will rise 5 per cent to 10 per cent this year, with energy and currency looming as the biggest immediate pressures and wage inflation more likely toward year-end, according to Roger Bell, director of mining research at Hannam & Partners LLP. Costs may also rise as producers go after more "marginal tons" by mining trickier areas, he said.

sentifi.com

Market voices on:

"It's going to be a theme that reemerges in 2018," Mr Bell said by telephone. "It always does when the commodity prices improve." Not all producers are exposed in the same way, with metal processors that buy most of their ingredients facing the larger brunt of higher raw-material costs.

Members of the Bloomberg World Mining Index have seen a sharp recovery in profitability as metal prices rebounded. The average gross margin has recovered to 27 per cent from 16 per cent two years ago, and is expected to reach 34 per cent in 12 months' time, according to analysts tracked by Bloomberg. Margins at steelmakers and iron-ore miners have also expanded but probably will plateau over the next year, the estimates show.

Alcoa mines the bauxite that it uses to make alumina and in turn aluminum, shielding it somewhat from cost creep. Still, as chief executive officer Roy Harvey noted in an interview last month: "There's not a lot of backwards integration opportunities when you produce your own raw materials." There's also a delayed effect of higher input costs. Caustic soda, for example, takes six months to flow through to the balance sheet, Mr Harvey said.

Fuel costs can account for 25 per cent to 30 per cent of costs for some miners and are largely beyond their control, Bell said. In the case of Cleveland-Cliffs Inc., energy was cited as one of the key culprits for an 11 per cent jump in the cash cost of goods sold and operating expense rate in US iron ore.

For US Steel Corp, the higher cost of coal, iron ore, scrap, gas, electricity, other metals and electrodes are offsetting some of the steel price gains.

"Not one of those in itself is significant, but we add them up, it makes an impact on the numbers," Dan Lesnak, head of investor relations, said on Thursday's earnings call.

It's not all doom and gloom, with producers arguably better placed to mitigate inflation than in past cycles after cutting costs and debt in the downturn.

Digital efforts, smaller headquarters, productivity improvements and more women in the workplace (which compensates for labor tightness at mines where fewer people want to live) all help to offset higher costs, according to Phil Hopwood, the global mining leader for Deloitte. In addition, energy price increases may have a lesser impact than before because miners are switching to cheaper alternatives.

"What is different this time around is that the mining companies are actually looking at different ways to challenge their input cost models," Mr Hopwood said.

Similarly, capital-equipment costs may be contained by the fact that miners have become much more efficient in the wake of the downturn and may be reluctant to reinvest even as prices recover.

The last time Freeport purchased a new haul truck was in 2008, CEO Richard Adkerson told analysts last week. The company has managed to contain capital costs by rebuilding and maintaining some equipment in-house, and by timing new purchases carefully, a contrast with "lots of years" in which "we've been Caterpillar's biggest customer," Mr Adkerson said.

Currency appreciation is also a factor, with Petra Diamonds Ltd. saying on Monday that earnings will be hit hard by a stronger South African rand.

The US dollar is coming off its worst year since at least 2004 and is already off to a slow start in 2018. Metals are priced in US dollars, but mined mainly in other countries. So as the currencies of producing countries appreciate against the US dollar, costs there rise in dollar terms.

Labour costs are another concern for producers as markets tighten. The industry is paying close attention to copper giant Chile, which is preparing for its busiest year ever for wage talks as unions are emboldened by higher prices.

BLOOMBERG

Powered by GET.comGetCom