Separate controllable from uncontrollable producer cost pressures during price upswings in mineral commodities

Implications: Rio Tinto recently announced that its net profit fell 14% for the first half of 2007 compared to a year earlier despite an increase of 15% in gross revenue.  This announcement demonstates the challenges mining producers face during sustained mineral commodity market price upswings to contain their production costs.  The key for analysist of mining companies is to understand the difference between controllable and uncontrollable cost pressures. 

Analysis: During sustained upswings in mineral commodity markets such as those experienced in the gold, copper and other mineral markets during the last several years, higher prices create an environment in which mineral reserves and production of those reserves increase due to additional material becoming economic to produce.  This phenomenon happens on two levels.  First, entire projects may initiate production or recommence production that previously were in shutdown mode.  Secondly, at projects that were already producing under lower price scenarios, certain portions of the ore bodies that previously were unsuitable for production due to lower ore grades or other production constraints are brought into production.  These production increases are in response to the higher global demand that is fueling the price upswing.

On the one hand, mining companies can experience higher margins due to higher mineral commodity prices.  On the other hand, however, the worldwide production increases create cost pressures that are largely out of the control of producers.  As producers increase production, they create higher demand for the cost elements that represent procuction inputs.  For example, increased production must be accompanied by a larger workforce.  As most mining jobs require skilled workers, mining companies must begin to compete more vigorously for the pool of available workers.  Similar pressure pushes up the cost of the many contracted services that support the mining industry.  Demand for mining equipment, such as haul trucks, drilling equipment, shovels, etc. increases, as well as demand for the spare parts to support efficient operation of that equipment.  Capital projects become more expensive as demand for construction contractors, processing plant construction materials, etc. goes up.  Demand for shipping and other forms of transportation rises to accomodate higher sales volume, and demand for downstream processing services such as smelters, etc. builds.  These trends can be seen in the results of operations of virtually all the major producers over the last several years.

Analysts attempting to understand the performance of one producer compared to its peers are challenged to separate these largely uncrontrollable cost pressures from those that mining companies can control.  Mining companies often do not provide sufficient disclosures to help analysts understand the difference.   Mining companies typically have cultures highly focused on cost control since they have little control over the market price of their products.  During sustained price upswings, there is always a risk that this cost containment culture will break down or weaken resulting in poor day-to-day decision making that incorporates a tolerance for waste and inefficiency.  For example, a spare parts inventory manager at a mine site may decide to airlift in certain spare parts at the last minute rather than plan well in advance and take advantage of cheaper freight options.  Such inefficiency would never be tolerated during a price downswing, but may go unnoticed during a price upswing.  This is the Mining Industry's version of "creep."

Another partially controllable cost pressure relates changes in the mine plans.  Every mining operation has a detailed production plan that attempts to maximize profitability through a strategic approach to extracting ore, moving waste material, etc based on the characteristics of the ore body and other factors.  During sustained price upswings, mining companies often bring lower-grade ore into production.  The lower-grade ore results in higher-per-ton production costs - a certain amount of production cost increase is inevitable under such a scenario.  However, such production cost increases can be exacerbated by poor planning and execution (i.e. sloppiness).  Sometimes in an effort to sustain higher production, maintenance on mining equipment and plant facilities can be sacrificed, creating a situation in which the overall operation experiences more costly downtime, etc.

Rio Tinto's press release doesn't provide enough information to determine how much of its cost increases are controllable vs. uncontrollable.  It will be interesting to see if its more detailed half year report will shed further light on this.