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Inflation, oil threaten mining profits Add to ...

Surging commodity prices are starting to send shivers through the wildly profitable mining sector as concerns mount that rising oil prices and creeping inflation will eventually lead to another correction.

As miners boast record revenues from the latest run-up in metal and material prices and use excess cash to make rich-premium acquisitions to expand operations, many are also signalling a shrinking of profit margins in the months to come.

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The caution is coming through warnings of higher operating and capital expenses due to rising costs for energy, materials and labour as well as general inflation.

A growing chorus of industry experts are suggesting a pullback in the current cycle as central banks around the world, including in resource-hungry China, are expected to continue raising interest rates to control inflation.

"There will be a moderate tightening of monetary policy … which will be sufficient to take some of the steam out of economic growth," Philip Klapwijk of commodities consulting group GFMS said Sunday at the annual Prospectors & Developers Association of Canada (PDAC) conference in Toronto.

Higher interest rates slow spending on everything from cars to construction, which in turn curb demand for industrial commodities such as copper and coal. That, coupled with last month's record-high global food prices and oil trading above $100 (U.S.) per barrel, its highest level in two years, has even the most bullish commodity experts changing their tune.

"I am taking away some of my affection for base metals," said Don Coxe, head of Chicago-based money management firm Coxe Advisors LLC and BMO Nesbitt Burns Strategy Adviser, citing in particular rocketing food and fuel prices.

"This is not the stuff of a roaring bull market, except for gold and silver," he said, which are considered more like currency and a hedge against higher inflation. The rebellions in northern Africa, which are driving up the price of oil on concern of supply interruptions, are "the biggest threat to the global economy since the subprime crisis in the U.S., and nobody knows how it's going to play out," Mr. Coxe said.

While slightly higher oil prices aren't expected to derail global growth, "all bets are off if oil prices are sent sharply higher as a result of potential supply disruptions to the major oil-producing countries," Scotiabank economist Aron Gampel wrote in a research note.

Still, the mining business today is booming with industrial commodities such as copper, coal and iron ore reaching record prices in the past few weeks. Some believe any correction will be short-lived given the steady demand for resources from industrializing nations such as China, India and Brazil. China, the world's largest consumer of metals such as copper, continued on its rapid growth trajectory even during the 2008-09 global economic meltdown, which helped pull the mining industry from one of its worst routs in decades.

The China growth story will be the mantra repeated by miners at this week's PDAC conference, the industry's largest global gathering known for its hype and backroom deal-making. However, a healthy does of skepticism is dampening some of that enthusiasm with some experts believing the current record-breaking cycle is unsustainable.

HudBay Minerals Inc. chief executive officer David Garofalo warned last week that the industry may be headed for a downturn. "We are not in a super cycle, this is a cycle and when the central banks find religion on inflation again, the cycle will be over," he said.

PDAC executive director Tony Andrews noted that mining is a cyclical business. "Some people will be pretty exuberant, others will say, 'Remember this is a cyclical industry.' If you are in this business you have to plan for those cycles," he said.

While a correction is "unlikely" this year, according to GFMS's Mr. Klapwijk, he warns inflation will puncture profits in the mining industry.

Miners around the world are already guiding investors about rising costs due to inflation. Toronto-based Barrick Gold Corp., the world's largest gold producer, said capital expenditures on three of its development projects will rise between 10 to 25 per cent, or by a total of about $2-billion, due to higher labour, energy and raw material costs. BHP Billiton Ltd., the world's largest diversified miner, said higher fuel and energy prices and increased labour costs reduced its profit by about $500-million for the last half of 2010.

Osisko Mining Corp. chief executive officer Sean Roosen said construction costs have gone up by 10 to 15 per cent at his gold projects in recent months, and the company is budgeting for oil prices of $120 to $140 per barrel in the near term.

Inflation is a "tide that will rise all ships" in the mining sector, Mr. Roosen said. However, he noted that gold companies also benefit because investors tend to buy more of it in uncertain economic times.

Gold hit a record $1,440.10 per ounce last week, driven by investors nervous over unrest in Libya and the Middle East.

"We are enjoying the best margins that ever existed," said Mr. Roosen, who is set to capitalize directly with his flagship Canadian Malartic gold project in Quebec expected to begin commercial production this spring.

Follow on Twitter: @BrendaBouw

 

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