Marginal Cost: Less Support Than Many Think

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1 4 June 213 Fixed Income Research Marginal Cost: Less Support Than Many Think Commodities Research Research Analysts Ric Deverell ric.deverell@credit-suisse.com Tom Kendall tom.kendall@credit-suisse.com Marcus Garvey marcus.garvey@credit-suisse.com Andrew Shaw andrew.shaw@credit-suisse.com Hard to define, even harder to find With many commodity prices in retreat over the past four to six months, market discussion has once again turned to the topic of cost support, with many suggesting that the newly elevated production cost base will prevent further substantial falls in prices for most commodities. While conceptually the cost of supply should provide a longer-term floor to prices, history indicates that in the shorter term prices can penetrate the cost curve deeply for periods of time. Supply, it seems, is often more sticky than the cost curve would suggest this has already been the case for thermal coal and nickel. Consequently, cost support is really more about longer-term price influences than it is about pricing in the near term. Historically cost factors appear to have been highly dynamic, with the marginal cost of production (and consensus long-term forecasts) tending to move up with spot prices and then falling as the cycle turns down. Costs (like all market prices) are endogenous to the broader economic environment. Perhaps the largest driver of costs remains the value of exchange rates in the big producing countries; this impacts embedded cost factors relative to international commodity prices. The run-up in the Australian dollar since 21-2 (when it was a shade above 5 US cents) is a good example of how, in a floating exchange regime, higher commodity prices tend to be reflected rapidly in the exchange rate. As the cycle now turns again, the Australian dollar has also begun to correct; the AUD is currently 13% below its 211 peak but remains around 25% above its long-run average in real effective terms. Our FX strategists expect the AUD to fall to.85 against the USD over the coming year, with reputable economists such as Ross Garnaut suggesting that it will need to move back towards longer-run averages in coming years as the economy shifts away from resources-intensive investment. The Australian example highlights how labor costs can also retreat, with the major miners already beginning to reap substantial cost reductions as the tension comes out of the market for contractors and productivity drives bite. These dynamics are well reflected in previous cycles. For example, the cost of extracting copper more than halved as prices (in real terms) plunged to their troughs in the late 199s/early 2s. Costs more than doubled again within seven to eight years as prices ran up sharply from In conclusion, while costs remain a critical variable in forecasting commodity prices, they are more relevant for gauging long-term pricing; in the shorter term, there is much less rigid support in bear markets than many expect. ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER IMPORTANT DISCLOSURES, PLEASE REFER TO CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION Client-Driven Solutions, Insights, and Access

2 4 June 213 What have costs got to do with the price of metals? Short-run prices can invade deeply into supply cost curves Using copper as an example, spot prices peaked above US$1,/t (US$4.5/lb) in 211, well above longer-run historical prices since the early 19s. Today, these prices stand almost 3% below their super-cycle pinnacle and appear set to edge closer to their 1- year real average. Since the Great Recession it has become increasingly clear that China, as the principal engine of the surge in prices since 25, has entered a period of reduced rates of economic growth, the effects of which were obscured for a time by the massive stimulus of 29. The heat has also dissipated from other emerging markets previously touted as the likely source of a prolonged boom in commodities demand, unmatched by ready supply. What looked likely to be an extended super-cycle of high emerging market growth, and a long-duration price boom, now looks increasingly likely to give way to a more rapid return to equilibrium prices for most industrial commodities than most commentators had expected. These levels we believe will remain above what appear to be anomalously low pricing in the 199s, but shorter-term movements below longer term are also highly likely, as has happened in the past; this volatility is often forgotten and cost structures do not seem to protect from an undershooting of prices in oversupplied markets. Many of the factors that drove the prices of industrial commodities to extraordinary levels have dissipated. Demand is no longer running so far ahead of supply, and in some cases far from it. At the same time supply constraints on many of the factors that resulted in rampant cost inflation for most producers have also started to ease, albeit in lagged response to receding physical market tightness. Exchange rate influences paramount and rapid This is reflected in those sources of production where exchange rates are typically heavily tied to exports of natural resources. The run-up in the Australian dollar in the past decade is a prime example of how, in a floating exchange regime, higher commodity prices quickly translate into rising exchange rates and hence a squeeze on margins as the gap between international prices and domestic costs narrows. With the cycle now turning, it is notable that the Australian dollar has also begun to correct, with the AUDUSD currently 13% below its 211 peak but remaining around 25% above its long-run average in real effective terms. Our FX strategists expect the AUD to fall to.85 against the USD over the coming year, with reputable economists such as Ross Garnaut suggesting that it will need to move back towards longer-run averages in the years ahead as the economy shifts away from a hefty input from investment in building natural resources production capacity. The Australian example also highlights how labor costs can also retreat, with the major miners already beginning to reap substantial cost reductions as the tension comes out of the market for contractors. The drive on achieving higher productivity is also likely to translate into waning operating costs per unit of output. Marginal Cost: Less Support Than Many Think 2

3 4 June 213 A similar example is afforded by Chile, where the peso has plunged 7% from its recent May highs and now lies 14% below its early 28 peak. This will go a long way towards staving off cost escalation. The fall-off in the subsequent period of 28-9 to levels 36% below today s CLPUSD rate illustrate the potential for simple cost savings associated with currency depreciation. It is worth remembering that copper spent nearly nine months below US$5, through this period. Exhibit 1: Australian dollar exchange rates reflecting shifts in terms of trade based on commodities exports AUD real trade-weighted index Source: Credit Suisse Long-run vs. short-run prices One problem is that it is easy to fail to distinguish between long-run and short-run prices and the differences in how markets juggle with supply-demand imbalances over shorter periods of time. Costs for many, if not most, inputs for producers are prices in their own right, determined effectively in contestable markets on the basis of supply and demand. If demand for labor falls, so too, within certain limits, do costs. Moreover, there is a difference between unit labor costs and the way these translate into costs per unit of production as suppliers learn to do more with less. In the long run, most costs are variable (or avoidable all together), including capital. In the shorter run, this is not true many costs are fixed, at least for a certain period of time. The response of suppliers collectively to streamline over-zealous supply can take time and requires a price signal, sometimes a severe one. A marginal cost operator, for example, may weigh the cost of paying for unwanted labor (even at a loss) against the possibility that a return to better times, which may be just ahead, merits maintaining higher production rates in anticipation of higher profits. These influences, as well as subtleties in industry structure that affect decisions to cut back supply, mean that in the shorter, or even medium term, prices can swing sharply as supply surpluses build up or take time to remove. For copper, the metal has gained a long-lasting scarcity premium where prices have been bid up (by consumers) well beyond the marginal cost of supply (helped by speculators). Marginal Cost: Less Support Than Many Think 3

4 4 June 213 We postulate that this premium is a residual effect of sentiment that anchors price targets on long-run incentives to add new mine capacity, with too little acknowledgment that costs of production also tend to fall with headline prices. Many of these costs are set in markets too, and levels are negotiable, albeit claims on economic rent have grown. These claims will also likely recede if supply surpluses mount through both expanding supply and moderation of demand growth. Exhibit 2: Real long-term copper prices Deflated by US CPI, Real 21 US$, average 16, Exhibit 3: Real long-term aluminium prices Deflated by US CPI, Real 21 US$, average 3, 14, 12, 1, 8, 25, 2, 15, 6, 4, 2, Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service, IMF 1, 5, Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service, IMF Long-run price assumptions are a hypothetical construct used to support investment decisions. For producers with disciplined valuation and investment decision-making practices this entails determining a market-expected price over the life of an asset as a reference point. This approach acknowledges that market-expected prices (which are different from the consensus of commodity analysts) also change through time. In other words, these assumptions are not strictly forecasts of future prices at any single point in time. Beyond the vagaries of forecasting future demand and supply, there are two major flaws in the way many observers assess future prices, in our view: First, as we stated before, we believe it is a mistake to accept that production costs are rigidly fixed. As demand surged, largely due to China s appetite for commodities, costs of many inputs have escalated sharply in recent years as scarcity impacted the supply of everything from energy to labor. However, we argue that this scarcity will prove relatively short-lived and that many costs, even over the medium term, are variable, across a broad spectrum. Second, the assumption that all developers will receive an adequate return on investment in future supply is an erroneous one. In theory, in the very long run, prices should trend towards the incentive of the marginal source of supply. Here, we believe this is the price at which NPV for the indifferent project is zero. In reality, determining the marginal project is extremely difficult, depending on many factors, not least of which is the required level of supply to meet future demand in a world where demand is changing, sometimes dramatically. In short, supply growth is lumpy, with long lead times from the decision to invest to the achievement of production (when the costs are then sunk). Marginal Cost: Less Support Than Many Think 4

5 4 June 213 Copper The cost-price relationship Using copper as a main example, Exhibit 4 illustrates the sharp escalation in costs in copper mine supply since 25. In money-of-the-day terms, mine-site cash costs have doubled, largely due to steep increases in the unit costs of labor (direct wages), service provision (essentially a form of labor) and consumables. Energy costs have also risen, but for copper mines these are a smaller proportion of costs than, for say, aluminium production. Exhibit 5: Copper mine costs of production sharp rises in consumable and labor costs Direct cash costs, US$/t (money of the day) Exhibit 6: Many of these costs are also priced in contestable markets Direct cash costs, % of total Services & Other Stores Fuel Electricity Labour Services & Other Stores Fuel Electricity Labour Source: Credit Suisse, Wood Mackenzie Source: Credit Suisse, Wood Mackenzie Exhibit 7: Mine-site costs at copper mines in Real cash costs and % of copper price (for concentrate-producing mines), US$/t Conc. Mines SXEW % of Copper Price Source: Credit Suisse, Wood Mackenzie In Exhibit 8, we can see that the costs of copper mine production on average in real terms have also surged since the early 2s. This trend applies to both mines producing copper concentrate and mines recovering cathode in SXEW plants. However, in the 198s and 199s real costs fell sharply from an average of more than US$3,/t to less than half that level at about US$1,3/t in 2. This trend reflected a shift from a period of relatively strong demand prior to the deep inflationary recession of when cyclical demand collapsed. Marginal Cost: Less Support Than Many Think 5

6 4 June 213 Further, the 199s saw the emergence of large-scale new copper mines, especially in Chile, as well as the rapid evolution of SXEW technology to recover previously uneconomic oxide ores in the US and Latin America. Coming at a time of moderating demand, prior to the China and emerging market growth surge from the early 2s, these factors drove production costs down sharply in the 199s. Interestingly, in real terms, mine costs of copper production are little higher today than they were in the late 197s. As prices surged from 25, costs also rose, but costs as a proportion of prices declined to around 35%. In 212, costs represented a higher proportion of the price as costs continued to escalate and prices started to decline. To determine if this is simply a lagged effect of costs rising to meet prices on their way back down requires a closer look at the marginal costs of copper production. Mapping short-run prices (annual and price ranges) to different positions in the pecking order of costs of production (25 th, 5 th, 75 th and 1 th percentiles), illustrates that prices have remained well above short-run marginal costs of production since 25. Indeed, such premiums of prices over cash costs were much more modest and shorter lived in the price peaks of the late 197s and late 198s. In general, average prices for the year have sat above the highest cost of production but for periods of the year prices have fallen to levels commensurate with the cash cost of production at the 75 th percentile in theory, in 28, for instance, 25% of copper supply was produced at a cash loss for a spell. It is important to remember here that, in the case of copper, the market has seen an extended period of supply deficiency but, with demand growth fading, we believe this shortfall will disappear, at least over the course of the next two to three years. As supply continues to expand beyond needs, the premium in prices seen since 25 should fade. Moreover, if surpluses continue in 214, as we expect, consumers will drive prices down to levels that encourage curtailments in planned supply. Even if this means a return to prices close to the marginal cost tonnage, this implies periodic falls in prices to US5,5/t (roughly the 1-year average), even assuming cost levels remained at inflated 212 levels in real terms. With input prices declining, as well as efforts to increase productivity now paramount in the eyes of many producers, short-lived falls in prices could go much deeper. Prices falling this sharply will do little to assist host governments in their efforts to claim more benefits from copper s boom, nor will it bolster the plans of producers wrestling with large-scale, expensive expansion programs. The point is, in the short run, that does not matter and cyclical prices will further trim the expectations of stakeholders seeking a claim to a greater share of the windfall profits that flowed in the not-so-distant past. At least for copper, there appears to be sufficiently responsive an industry structure to make price movements deep into the supply cost curve relatively mild and short lived. However, if costs are pared back more sharply as headline prices slip, a virtuous circle of price drops could occur. Marginal Cost: Less Support Than Many Think 6

7 June 213 Exhibit 9: If surpluses build significantly, the case for rigid short-term cost support is hard to argue Direct cash costs of copper mine supply, US$/t Exhibit 1: Copper prices are far higher than underlying costs of production both will likely fall Direct cash operating costs of copper mine supply. Real (212) USc/lb Current price = US$7,37/t 9 th percentile = US$5,335/t 5, 1, 15, th 75th 25th Annual range of LME prices - monthly averages Tick denotes annual 9th Source: Credit Suisse, Wood Mackenzie Source: Credit Suisse, Wood Mackenzie The importance of industry structure Metals like nickel and aluminium behave differently to copper when supply runs well ahead of demand. This is because industry structure has a pronounced influence, either the levels of vertical integration in the case of aluminium, or a weak avoidable cost structure in the case of nickel. Both are processing-intensive industries and this also seems to play a hand. In fact, nickel seems to be an extreme example, with prices dipping to the 5 th percentile on the cash cost curve on a frequent basis in the 198s and 199s and again since 28. In the past, in our opinion, this reflects that many suppliers operating a single asset have a lack of flexibility to cut back rapidly. To some extent the market cleared only when larger producers, such as Inco in Canada, curtailed production at higher-cost units in their minethrough-refining complexes in order to reduce costs and preserve profitability. More recently, the emergence of nickel pig iron production in China against a background of weaker demand growth has dented industry profitability, with significant numbers of producers outside China failing to cover cash costs for significant periods of time in the past five to six years. China s purchasing power for nickel ore in RMB terms has meanwhile risen as its currency has steadily appreciated. In US dollar terms, average cash costs of nickel supply have risen by 6.4% in 2-12, according to Wood Mackenzie, although these may have peaked, with laterite ore purchasing prices and energy costs falling back. With the nickel market in oversupply, prices today at less than US$15,/t (US$6.74/lb) have fallen below the 75 th percentile on the cash cost curve and could have further to go, especially if costs continue to get trimmed. Median costs are estimated by Wood Mackenzie to lie at US$13,8 (US$6.26/lb) for 212. Marginal Cost: Less Support Than Many Think 7

8 e Cost ($/lb Ni) 4 June 213 Exhibit 11: Nickel prices are now biting deep into the cost curve, but costs are also almost certainly coming down Cash cost of nickel production and LME prices, US$/lb Ninth decile Upper quartile Median Lower quartile LME Price Source: Wood Mackenzie, Credit Suisse Iron ore s concentrated supply will impact the cost-price relationship For iron ore, a concentrated industry structure may induce a different cost-price response as supply surpluses grow in 2H 213 and 214. This is especially so as Australia is supplying a growing share of seaborne iron ore the depreciation of the local currency is likely to trim back production costs rapidly. Unlike for the base metals, there is no real market of last resort for the bulk commodity, with inventory largely maintained for working purposes, albeit inventory cycles do impact prices sharply. As supply overwhelms demand, prices will fall as prompt cargoes become more readily available and consumers bid down prices for what they need. The key to where short-run prices settle is therefore the extent to which more costly tonnage is removed from the market (i.e., left in the ground). However, every mine has its marginal tonne and, while the major producers boast the lowest average costs of production, not all of their production is low cost. Under a fierce fall in prices, larger operators could also be prompted to reduce shipments in order to enhance profitability. The iron ore cost curve has a long tail of relatively high cost suppliers to North Asia s markets, including, but not limited, to higher-cost Chinese domestic supply. Here again, we see the ingredients for a much deeper invasion of the supply curve than many commentators expect, not just because of currency factors, but also by the likely reining back of short-term production costs along the entire curve. Further, the current predominant focus of major producers on productivity and operational improvement, as well as greater economies of scale, may mean that the curve steepens in shape. It is interesting to remember that spot prices dipped well below US$7/t CFR China in 28-9, demonstrating that short-run price support can be slow in arriving. Remember, iron ore prices have ranged almost 2% in the past four years alone, from US$65/t to more than US$19/t. Marginal Cost: Less Support Than Many Think 8

9 tonnes 4 June 213 Gold Mine supply swamped by stocks There are a number of problems with trying to assess cost support for gold using marginal cost of production metrics. The primary one of these is that above-ground refined inventories of gold are massive relative to mine supply. That is not new; Newmont Gold s 1993 annual financial report summed the situation up rather well: Market gold prices can fluctuate widely and are affected by numerous factors beyond the Company's control, including industrial and jewelry demand, expectations with respect to the rate of inflation, the strength of the dollar (the currency in which the price of gold is generally quoted) and of other currencies, interest rates, central bank sales, forward sales by producers, global or regional political or economic events and production costs in major gold-producing regions such as South Africa and the former Soviet Union The demand for and supply of gold affect gold prices, but not necessarily in the same manner as supply and demand, may affect the prices of other commodities. The supply of gold consists of a combination of new mine production and existing stocks of bullion and fabricated gold held by governments, public and private financial institutions, industrial organizations and private individuals. As the amounts produced in any single year constitute a very small portion of the total potential supply of gold, normal variations in current production do not necessarily have a significant impact on the supply of gold or on its price. Exhibit 12: Above ground reserves of gold are huge: growth in cumulative gold supply since 2 versus annual mine production Tonnes 6, 5, 4, Cumulative supply used as investment Cumulative supply used in jewelry Cumulative supply used in industry/dental Annual mine supply near to market 3, 2, 1, Source: Credit Suisse, Thomson Reuters GFMS, World Gold Council, the BLOOMBERG PROFESSIONAL service far from market In a typical year, only around 15% of mine supply is consumed in industrial and dental applications, in which the metal is removed far from the market. That leaves ~2,5 tonnes per year of gold flowing into jewelry and investment products. That is 2,5 tonnes per year of gold that is relatively near to the market. Indeed, scrap flows have been close to, or exceeded, 1, tonnes a year for the past six years. As Exhibit 12 shows, in the 12 years of the bull market alone, around 14, tonnes of gold accumulated in one form of investment product or another. Marginal Cost: Less Support Than Many Think 9

10 $/oz Au 4 June 213 In total, a conservative estimate would put above-ground inventories of gold in the region of 2 to 25 years worth of mine supply. One can argue about what proportion of that is available to be readily liquidated (we would suggest at least half), but the point remains that mine supply and costs cannot act on the price of gold in the same way that they can influence commodities. Setting aside that point, there are other barriers to establishing what the effective marginal cost of production for gold might be. In particular: There is no definitive metric for measuring all-in costs for the sector. Cash costs per ounce and gross margins are now widely viewed as very poor guides to true stay-inbusiness costs, but there are a number of alternatives. The World Gold Council is currently involved in an initiative to get to an agreed standard, but reporting the treatment of variables such as by-product revenues, interest expenses, profits on energy hedging, etc. is yet to be finalized. The upper end of the cost curve is quite steep, meaning that sizeable falls in price only affect a relatively small proportion of production. That is, in part, a consequence of the fact that the industry is highly diverse, both in terms of geography and ownership. We do think gold production costs are relevant to the price of the metal but over a much longer time frame, measured in years, than for a commodity such as iron ore, where above-ground stocks are measured in weeks, not decades. Note also that in the 198s the last gold bust cost of production proved less of a barrier than most had anticipated, with costs falling steadily right through to 2 (in both nominal and real terms). It is also notable that the industry spent several years from the mid-199s onwards with the price of gold in real terms very close to, or below, the average C3 cash cost in real terms (see Exhibit 13). Exhibit 13: Historical average gold mining industry cash costs versus gold prices Deflated to 212 US dollars. Shaded section highlights price close to or below cash costs C3 costs (real) Average gold price (real) Source: Wood Mackenzie, Credit Suisse Marginal Cost: Less Support Than Many Think 1

11 GLOBAL COMMODITIES RESEARCH Ric Deverell, Managing Director Global Head of Commodities, GFX and Asia Strategy ric.deverell@credit-suisse.com Eric Miller, Managing Director Global Head of Fixed Income and Economic Research eric.miller.3@credit-suisse.com LONDON One Cabot Square, London E14 4QJ, United Kingdom Tom Kendall, Director Head of Precious Metals Research tom.kendall@credit-suisse.com Marcus Garvey, Analyst marcus.garvey@credit-suisse.com NEW YORK 11 Madison Avenue, New York, NY 11 Jan Stuart, Managing Director Head of Energy Research jan.stuart@credit-suisse.com Stefan Revielle, Associate stefan.revielle@credit-suisse.com Johannes Van Der Tuin johannes.vandertuin@credit-suisse.com SINGAPORE One Raffles Link, Singapore Andrew Shaw, Director Head of Base Metals & Bulks Research andrew.shaw@credit-suisse.com

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