Can investors handle polarised metal prices?

By George Cheveley | Published: 31 March, 2010

Metal prices may be notoriously volatile in the short term, driven by a combination of price inelasticity and the violent stock changes commonly seen at the front end of long supply chains. Whilst this volatility may offer arbitrage opportunities for metals traders, it may be viewed as ‘noise’ for analysts trying to determine the long-term value of a company.

For them, it is the long-term price of a metal which determines a company’s valuation, typically around two-thirds of which relates to cash flows further forward than four years. The long-term price is not a function of short-term stock cycles; rather, it is dependent upon the marginal cost of production (the price at which supply will begin to be shut down) and the price at which new projects can make sufficient returns (the incentive price).

Ten years ago, before the current boom in commodity prices, the range of forecasts for most long-term metal prices tended to be narrow, with most analysts reaching a consensus view due to the fact that prices had moved relatively little for a number of years and growth rates were low. As demand growth was low, few new projects were required and thus only the best prospects with the lowest incentive price were developed.

However, with the acceleration of Chinese demand growth utilising much of the available supply capacity for many metals, views on long-term prices have changed markedly in ten years and the range of views has expanded considerably. For example, in 2000, analysts’ view of long-term copper prices was around 90¢/lb ($1985/tonne) on average in real terms and the range was 80¢/lb-$1.05/lb. Today the consensus on long-term prices is close to $2/lb and the range is around $1.60-2.50/lb. Even allowing for inflation, this change in forecasts has been dramatic and the widening in range of views has made it increasingly difficult for mining companies and analysts to agree on valuations.

In addition, higher demand growth rates coming off a higher base level have led to an increased number of mines needing to be developed each year in order to match supply to demand. This in turn has led to the current increased activity in exploration and project development – including that taking place in many African countries which had previously been underexplored.

However, as mining companies discover deposits in more remote or “politically riskier” countries, the problem of evaluating projects and forecasting long-term prices becomes even more complicated. It is difficult enough to evaluate the current risk level of a country; predicting how it will develop in the future is even more complex. Added to this is the increasing unpredictability of historically lower risk developed countries as increasing sovereign debt burdens put pressure on governments to raise taxes and royalties to increase revenues.

For investors looking to forecast how long-term prices will develop, it would seem the obvious answer is that if growth is higher and more projects are required, riskier projects will need to be developed. It follows that price expectations will then have to be higher. This has been borne out by developments over the last ten years. But history tells us that over the very long run (30 years or more) metals prices have fallen – or at best remained the same – in real terms. Either new mineral regions have been discovered or developed, or new technologies have lowered the costs of mining or processing.

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