Rising metals price=rising mining profits? Think again!

November 1st, 2007

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Currently, the resource story goes like this: China’s relentless economic growth (see our views on the China growth story: Contradictions in the red hot Chinese economy) is going to result in relentless rise in metal prices, which means that mining companies which produce these metals are going to earn more, which results in rising profit. Rising profit will then result in rising share prices.

Well, is this story always true?

Indiscriminate buying of this resource story can result in losses for the investor. We will use Oxiana as an example here. In this news report, Oxiana to outlay $1bn on copper and gold, it reported:

The cost increase at Prominent Hill makes Oxiana the latest resource developer to feel the impact of tight construction market conditions and cost increases in materials and equipment ? the so-called downside to the commodities boom.

The key point to note is that higher metal prices do not always translate to higher profit. Higher prices merely translate to higher revenue. Profit is the excess of revenue against costs. So, despite rising revenue, profit can actually fall if costs rise faster. For Australian resource companies, here are some of the potential pitfalls:

  1. Rising Australian dollar- Metals prices are quoted in US dollars. If the Australian dollar is appreciating faster than the rise in metal prices, then the price of metals in Australian dollar may not rise that much. In fact, it may even fall. Worse still, if the cost is in Australian dollars, then profit margins will be squeezed.
  2. Peak of business cycle- As we all know, Australia’s economy is at productive capacity constraint. What this means is that the Australian economy is running out of resources to continue every project and production growth in the economy. Without sufficient resources in the economy, we will see manifestation of price inflation as the economy is banging its head against the brick wall in an attempt to continue the past growth trend. As we said in The first step in an economic slowdown?mal-investment in capital,

    As the economy booms, entrepreneurs make plans and invest in the belief that the economy?s capital structure will provide the necessary higher-order and complementary capitals in the future. What happens when capital are mal-invested, leading to an unbalanced structure of capital in the economy? The entrepreneurs? plans will fail, which mean they will have to liquidate their investments. When that happens en masse, it will result in what we see as layoffs, cancelled projects and so on.

    In Oxiana’s case, as managing director Owen Hegarty says (quoted from the above-mentioned news article),

    Just about every second you turn around, the price of something else has gone up.

    Please note that we are not predicting that Oxiana will suffer the fate of bankruptcy. We are merely using Oxiana as an example to explain this concept.

So, in the days to come, we expect to see more of these cost blowouts for mining companies. Some may survive and some may die as the cleansing process runs its course.