Higher Oil Prices Will Cost Miners

Gold Miners

Miners are cashed up and ready to splurge.

To meet the demand forecasts of major consumers like China and India, the world’s biggest mining companies are using their capital to increase their supply potential – and they’re moving quickly.  

Just last Friday, Australia’s mining giant, BHP Billiton, announced $12.8 billion in an expansion campaign devoted to increased coal and iron ore operations. 

In the next financial year, they plan to spend an additional $20.8 billion in capital investment. But exactly how much more will their growth projects cost them with oil prices going up?

Well, it could be a lot.

Miners look at oil prices as a key metric in determining their production costs.  For example, changes in oil price affect open cast mines where inland transportation costs are higher.  Miners that transfer coal by rail, truck, or river barge use fuel as a key input in their production cost models.  Oil prices can also affect the freight market.  If a miner plays a role in the transportation of goods, say in the case of a Colombian mine selling to Chinese buyers, he might face premiums from shipping companies, even if they’re selling at FOB basis- this increases the per ton threshold to break even.

Miners know two things: First, just about 40% of the world’s electricity is generated using coal.  Second, infrastructure development projects are abundant and widespread.  This cooperative demand is on course to outpace production.  Though cash cows like BHP Billiton, VALE, and Rio Tinto are just coming of record profits in 2010, they are still exposed to risk from oil volatility.

So where is oil going?  Analysts are looking everywhere: potential supply disruptions from further crises in the Mid-east, whether or not Japan can get their refineries in order, or even how US regulators will address drilling permits here at home. 

If we look at our bulls, they seem to be betting on energy commodities to fuel the appetites of the BRICs.  Some might even be callous enough to argue they’re hedging against scanty currencies.  Buffet’s purchase of Lubrizol Corp. should be enough for all of us to know that, long term, oil is going nowhere but up. 

While little is certain, we can be sure that speculation is rampant, inconsistent, and rather unchecked.  In the short term, banks like JPMorgan put Brent at $118, even flirting with $130, in the next quarter.  The reality is, if we see a long term increase in oil prices from political turmoil, Black Swans, or just bad policy- we can expect greater costs for miners.  If you link that with divested interest from actual production of goods to capital investment, we may see less stellar earnings on the horizon.

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