Ed Lotterman: Will global prices undermine metal-mining projects?

Copper-nickel mining remains in the news in my home state of Minnesota as one firm’s environmental impact statement was approved last week. But another project was set back by state and federal decisions on land access. It is impossible to say how these or initiatives in other states will turn out.

It is ironic that approval came as metals prices continue to fall sharply. The project was announced as the global commodity boom emerged a decade ago. But since 2011, the trend in prices has been downward.

The price of nickel dropped 60 percent over the past five years and that of copper by nearly half. A return to even the average price of the last decade may not come for many years. Of course, the projects, if they fly, can be expected to be around for many years.

So what does this mean for new mining projects in general?

The key, as in all business decisions, is balancing of revenues and costs. That is easier with a short-term business. It is hard when planning a venture such as mining that will operate for decades.

Thinking first about costs. Intro econ students learn the important distinction between fixed, variable, sunk and marginal costs. The first do not vary with the level of output and must be paid even when output is zero, unless business goes bankrupt. Variable costs do go up and down as output changes, and when output is zero, so are these costs.

Modern metal mining is an industry in which fixed costs are huge — both in absolute terms and as a portion of the total production costs over the life of a project. Getting to the point where ore can be extracted can take years and hundreds of millions of dollars. For open-pit operations much of this is to remove the overburden, the valueless soil and rock that lie atop the actual ore. This can amount to millions of tons that must be excavated and moved.

For an underground operation, shafts must be sunk, lifting, ventilating, dewatering and compressed air machinery installed. For both types, some ore-processing plant must be built.

Once all this is in place, mining can begin and variable costs incurred. These include the fuel, electricity, labor, repairs and supplies like explosives. Revenue from sales of metals must not only pay these operating expenses, but there must be enough additional to amortize the upfront investment over the life of the mine.

Once developed, the costs to that point are largely “sunk” from the point of view of society as a whole. That is, the labor, fuel, machinery use, explosives and so forth are gone forever. Moreover, the mine will exist whether worked or not. So from then on, the question of whether to work the mine depends on the added or “marginal” revenue from selling output versus the added, or marginal, costs of operation.

As long as the extra revenue from operating exceeds the extra cost, whoever owns the mine will run it. They also would like sufficient surplus to pay off the fixed investment, but that doesn’t factor into the decision of operating.

The fixed costs of developing a mine can be estimated accurately. Revenues and operating costs over the life of the mine are more difficult.

Revenue depends on price of output. Prices of natural resource commodities tend to fluctuate sharply over time. Adjusted for inflation, the long-term trend is down.

One could look at trends and assume they will continue. However, the fluctuations are large enough that any mine in operation for a specific stretch may face average revenues well above or well below longer-term trends. Someone looking at the preceding 40 years when contemplating opening a mine in 1995 would have missed the greatest boom in generations.

Gencore, the multinational that owns the proposed project here, knew back in 2006 that the developing boom would not last forever. And it knows the current bust won’t, either. But exactly what the average will turn out to be is not only unknown but unknowable.

That is because events like dramatic growth of the Chinese represent what economists term “uncertainty,” when there is no one which to compute specific expectations. One can examine a range of alternate scenarios, but the final decision is subjective.

Future commodity prices are not the only uncertainty. Future operating costs may vary, too. Hardly anyone anticipated the jump in diesel fuel costs that took place after 1973 or the current low natural gas prices. The Bureau of Labor Statistics computes a specific producer price index for “Copper, Nickel, Lead and Zinc Mining.” That shows considerable variation over the past 30 years. In the last five, it has fallen by the same degree as prices of copper and nickel. But these costs are not likely to fall further, while metals prices well may.

Mining firms make sophisticated analyses, but irrationality enters in. Over the decade starting in 1998, during which Chinese demand drove commodity prices upward, many existing mines increased output capacity and new ones were opened. Everyone knew the boom was unsustainable, but there was the temptation that one’s own particular project would pay off before the bust came.

That capacity increase is now a sunk cost. Global output won’t quickly revert to what it was 20 years ago. Even if firms that increased capacity go belly-up as a result, someone will buy the mines at a reduced price and continue operating.

Will any new project reach production? Perhaps. But prospects for metals are much less positive than when the process started, and the outcome is not certain.

This story was originally published March 19, 2016 at 12:24 AM with the headline "Ed Lotterman: Will global prices undermine metal-mining projects?."