Costs and currency crucial for commodities

The fun started early at the annual Diggers & Dealers forum in Kalgoorlie yesterday with delegates bravely predicting a higher gold price, to which the market responded by driving the gold price below US$1300 an ounce.

For anyone in Kalgoorlie attending the conference and watching the gold price at the same time, it was like living in disconnected worlds.

There was the boyish, irrational optimism of goldminers keen to talk up their commodity just as investors around the globe demonstrated their different view, selling gold to end a five-week recovery.

Picking a winner from those divergent positions is not hard. The market is both bigger and more powerful than the relatively small Australian goldmining industry, which is struggling to deal with the twin forces of high domestic costs and a resurgent US economy and its control of the world’s only true reserve currency, the greenback.

Even the miners would smile grimly at the dark suggestion that they are between a rock and a hard place.

Costs, which have blown out across the mining sector during the 10-year resources boom, are starting to correct as workers recognise the choice of taking a pay cut or losing their job. Contractors are at the sharp end of that process.

Trimming staff, however, is a small gesture because the big costs in mining are in the consumables such as diesel fuel and electricity. And you only have to stand on the viewing platform at the southern end of the Superpit on the outskirts of Kalgoorlie to see where the diesel goes, as a fleet of heavy-haul trucks grind their way out of a 400-metre deep hole.

Because so few costs can be cut substantially, goldminers are at the mercy of the gold market; and right now that is not a merciful place thanks to signs that the global economy is becoming a more predictable and optimistic place.

Big issues remain to be resolved, such as the uncertainty over China’s rate of growth and ongoing weakness in Europe. But as the US, which retains the title of biggest economy in the world, gathers strength, warning bells ring loudly in the gold market.

If there is a positive factor at work it is the falling Australian dollar, which has helped boost the domestic gold price to around $1,460/oz, a level that ought to be enough for most mines to operate profitably – not that the local price has stopped speculation of more mine closures.

International miners in particular are beating a retreat from the Australian gold industry because they do not take the Australian dollar into consideration when preparing their accounts.

That’s why companies such as Canadian-based Barrick and US-based Newmont are trying to sell some (or all) of their Australian assets, creating the potential for locals to ‘buy back the farm’ – if they’re brave enough.

Worryingly, gold could be a trendsetter for the rest of the mining sector, which has been become over-reliant on the fading China growth story.

The big issue for industry in Western Australia, and the government that relies heavily on mineral royalties, is the fate of the iron ore sector, which also got an airing at Diggers & Dealers courtesy of an upbeat address by Fortescue Metals Group chief executive Nev Power.

In a classic demonstration of the old adage ‘he would say that, wouldn’t he’, Mr Power said there would not be a repeat of last year’s iron ore price crash.

Others, mainly market observers not pushing a barrow on behalf of the iron ore company they work for, are not so confident; and while the Australian dollar should ease some of the pain, there is a growing view that China’s growth slowdown will flow through to iron ore prices.

One of the more interesting pieces of recent iron ore research looked at the long-term cash profit margin of the big WA miners in three different currency environments.

According to Goldman Sachs, Rio Tinto was operating last year on a margin of $A74 per tonne of ore produced. BHP Billiton was on a margin of $A40/t, FMG was on $A34/t, as was Atlas, while Mt Gibson operated on a margin of $A28/t.

But, in the pessimistic world of Goldman Sachs, iron ore is heading for a long-term price of $US88/t, a level that would severely test mining company profitability if not for another long-term view, and that is the Australian dollar at US74 cents.

The combination of a lower iron ore price and lower dollar should assist Australian iron ore miners to retain profitable operating margins, but if the dollar sticks in the mid-US90c range the smaller producers will be in trouble.

For WA, the key message from this year’s Diggers & Dealers forum is that the combination of costs and currency values, not commodity prices, will be the critical measure of success, or failure.