As supply and demand approaches equilibrium in many commodities, longer lead times in changing supply are leading to over and under corrections, causing more price volatility, says Ernst & Young
Unprecedented price and currency volatility will continue to test mining and metals companies for the next few years as the sector approaches supply/demand equilibrium in many commodities, says a new Ernest & Young white paper.
Mike Elliot, Ernst & Young’s global mining and metals leader, advised that mining and metals companies will be preoccupied with reading to the downside risk and price and currency volatility in 2013 and 2014.
Price volatility is underscored by the December 2012 reported results of the large diversified mining companies, in which mineral price movements account for 79% if the US$25.6 billion plunge in the period-on-period earnings.
“As supply begins to catch demand, we expect a period of even greater volatility in mineral prices and producer currencies,” observed Jay Patel, mining and metals transactions partner, Ernst & Young, Canada.
“The knee-jerk reaction is to start hedging again,” said Patel. “However, for most, the opportunity to establish an effective hedge is past—new solutions are necessary to deal with volatility. Managing revenue and cost volatility in the short term will be a focus for the miners.”
Elliot suggests that many miners may use put options to manage short-term price risk but that these are increasingly expensive, and advised that companies need to look at ongoing solutions to managing the risk through the shorter price cycles.
“The sophisticated model tools available now mean that miners can consider multiple scenarios to identify how and where volatility impacts the business, and identify in advance possible actions to optimize their returns,” he said.
Mining management can take advantage of price spikes and limit the exposure to price slumps through several different choices including: undertaking no new action; suspending mining and process stockpiles; reducing shifts and hence production; deferring new development; moving to highest grade reserves; or abandoning production and selling either the project or hybrids thereof.”
Being nimble with cut-off grades and mine sequencing “is imperative to reacting to price and currency volatility,” the white paper suggests. “Having pre-planned scenarios for mine and mill grade cut-off in a variety of price scenarios is essential for a flexible response in a volatile price environment.”
“Like cut-off grades, the extraction sequence can influence the optimization of cash flows from a mine during a period of price volatility,” E&Y advises. “The ability to quickly access new price data and amend mine sequencing is imperative to reacting to price and currency volatility.”
Increasing the flexibility of mine costs is another valuable tool, the white paper suggests. Some common options include: creating flexibility in maintenance to flex the timing of preventative maintenance; introducing mining contractors to provide labor flexibility; using equipment hire to support peak production; outsourcing energy supply to “power by the hour” model; varying stockpile management; and undertaking campaign rehabilitation using contractors.
Challenging notions of scale is another tool suggested by E&Y. “Questions that should be posed include:
--Is the dilution created by large-scale mining equipment tolerable in a lower price environment?
--Does a smaller-scale truck and shovel fleet re-optimize capital for the reduced scale of production and does it provide the added benefit of decreased dilution?
--During lower prices, is the mine better off under-trucked rather than over-trucked even though this costs shovel utilization?”
“These may all result in lower production, potentially higher recovery and lower,” the white paper advises. “The real advantage is planning in advance to enable fast action before the majority follow suit.”
In their white paper, Price and currency volatility—mining and metals, E&Y also urged metals and mining companies to improve the integration of mine and financial planning; improve the speed of mine planning to match volatility; develop a communication plan that quickly communicates changes to mine planning both internally and externally; and prepare for a future hedging program when prices once again increase, while managing short-term price risk.”
Elliot stresses that companies need to do a better job of communicating to their shareholders “the changes they are making to increase flexibility and what impact that may have on future margins. Without this, shareholders will expect the worst—that a company is unable to capture the price rises but is fully exposed to price falls.”
Investors in turn should be seeking to understand where value is being created through the introduction of greater flexibility in the companies they are investing in because it will be a differentiator in bottom line results,” he concluded.