Profitability of commodities producers can be a costly business

27th September 2012

One tool for assessing this, used by the industry itself, are ‘cost curves', which map out the lowest prices at which different  mines producing, say, iron ore globally are able to make money digging the commodity out of the ground. Differences in inputs like wage rates, the efficiency of the machinery in use and the quantities of saleable by-products mean that some mines need higher commodity prices to ‘break-even' than others.

If demand for a commodity falls and its price falls too then, in theory, those producers who are no longer profitable should stop producing – this is called ‘moving down the cost curve'. As a result, some unprofitable supply is taken out of the market, helping restore balance to the supply and demand equation, which in turn helps stabilise pricing. The reverse is true if prices rise, higher prices mean previously marginal mines can make money which brings new supply to the market over time and limits price increases. As a result, commentators often cite the structure of the cost curve for a particular commodity when trying to justify why prices are unlikely to fall very far from their current level.

So at least runs the theory but, as ever, what happens in theory very rarely happens in the real world – and one of the reasons for this has been graphically illustrated by the unfortunate events surrounding the Marikana mine in South Africa.

Wherever they are located in the world, mines tend to be significant economic assets that employ huge numbers of people and therefore sit at the heart of their communities. They tend to be politically very important too as they generate a lot of wealth for governments through employment, taxes and so, while closing down a mine may be economically advisable, it is much less likely to be seen as politically desirable. Even ‘mothballing' a mine rather than permanently closing it can be a very expensive process so neither decision is taken lightly – and that is doubly the case once politicians become involved.

When prices fall, mining businesses want to reduce not only capacity but also costs by cutting wages but both are politically very difficult and so they do not readily happen. All of which means the cost curve theory is much less likely to be followed in practice and, while a commodity price fall will see some of the higher-cost capacity taken out of the system, this may not be sufficient to restore balance and stabilise pricing. The resulting combination of excess supply and insufficient demand is only a recipe for suppressing prices further, dragging even more mines into the red.

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