How stock to price relationships affect metal prices and mining company profitability.
Author: Christopher Welch, Bloomsbury Mineral Economics*
Posted: Monday , 07 Jan 2008

The last few years' increases in base metal prices have mainly been explained by other analysts in three ways: that a significant increase in Chinese consumption has brought stocks of metals down to critically low levels; that speculation in metals has affected prices; or that the markets have been artificially manipulated.
Bloomsbury Minerals Economics (BME) has another explanation.
In 2005, BME concluded that it was in fact long only investment (not to be confused with short-term speculative positions), and a resulting new dual purpose of metals (to fulfil industrial raw material needs and provide potential convertibility to cash for investors' rights to future metal) that changed the stock to price relationships and led to higher prices today. Now, metals stocks are starting to increase, leaving miners and analysts with a dilemma: Where will metals prices go with a stock build? And, how do you value a mine or mining project with no consensus on medium term prices only on very long-term averages?
If one were to assume that any of the first three explanations were correct, and the fundamental stock to price relationships remain unaltered, then you might envisage that prices would retreat down the path upon which they appeared to climb. Figure 1 shows copper stocks to price relationships assumed to be a single population. Figure 2 is a graph of the same data split into year groups and it gives a different picture. A shift from the main population is clear from 2005 onwards, and the latest data show low but non-critical stock levels that would previously have corresponded to much lower prices, but which are now accompanied by high prices.

The second figure illustrates the movement in the stock to price relationship curve. In 2005 the curve moved up and right, followed by two years of more vertical shift which has left the current group of points high up on the y-axis. Recent increases in stock levels would have brought the prices right back down to more historical levels had one of the first three explanations been correct.
Because there has been no return to historical price levels, and stocks are building, there is uncertainty as to how long it will take for price to return to the consensus long-term level, and what stock build would be needed to achieve this. The consensus long-term average prices are sufficient to encourage future players to enter the market and to bring future mines into production.
Using copper as an example, the long-term average price is widely believed to be between US$1.35-1.50/lb ($2,980-3,310/t), far below the current spot price of just under US$3.17/lb (US$7,000/t). There is no consensus timeframe for a return to the long-term average prices but at BME we expect that we may not be back down at these levels for another 5 to 15 years.

How does an upwards shift of the stock to price relationship curve affect the valuation of mining projects? Essentially, an upwards shift means that the sharp downwards correction in metals prices may not happen. Instead, a steadier reduction in prices is likely to occur, down to the consensus average long term prices.
The slower than expected return to long-term prices will obviously lead to increased profits for miners, however, it will also have some negative effects on the mining industry. As the prices stay high, more mines will be built which will firstly lead to increased demand for mine personnel that are currently in short supply. Increased demand for mining equipment and vehicles will further increase lead times for key items which has already doubled over the last three years. Most noticeably, a slower return to long-term average prices will increase the number of mine strikes as miners seek their share of profits. This will lead increased mine disruption and then support high prices, which will lead to yet more mine strikes in a vicious cycle.
The negative effects have already hit the industry as many independent feasibility studies on mine projects have used historical average metals prices upon which to base a project's economics, but have also used conservative labour and plant component estimated prices and construction timeframes. This has combined with recent US dollar weakness to lead to underestimation of mine development costs. It has already caused some delays but is likely to have a greater effect in the near future.

Most recently, Nova Gold and Teck Cominco's Galore Creek mine's development has been suspended due to estimated development costs increasing by 126% in less than an 18 month period because of increased labour costs and construction costs and the effects of currency fluctuations. The companies used future metals price estimates of US$1.50/lb copper and US$500-600/oz gold and reasoned that the mine would not return sufficient profit to warrant its development. US$1.50 may be reasonable for the very long term, but is it reasonable for the medium term and the early years of a new project's life?
Junior-mid tier mining companies are now scrutinising the assumed metals prices in feasibility and economic studies of mining projects. For copper, assumed prices of US$1.90 have been used to justify bringing a mine into production. There is a requirement for a good gauge for mid-term metals prices.
BME's Interactive Price Models are an invaluable tool for economic evaluation of mining projects, based on near and mid-term price estimates.
Unlike other price models, BME's models incorporate five main drivers: a "base" driver which can be production cost related, the US$ Index, industrial production (IP) growth, metal exchange stocks, and also money invested in commodity index funds. Going back to BME's initial explanation for the rapid increases in base metals prices (long-only investment into commodities and the dual purpose of metals), there is currently over US$160 billion invested in commodity indices. Taking the weightings of base metals in all of the major indices, and attributing physical holdings of metal for the cash invested, it is possible to calculate the virtual holdings of metals. For copper, the virtual holding of metal is estimated to be 795 kt from a total investment of US$6.32 billion. Given that the current LME stock level is less than 200 kt, the virtual holding of metal will naturally affect the market. Hence, the inclusion of commodity index investments into our model. The other main advantage of our models is that we give the user the opportunity to change the driver data to include their own forecasts and opinions. Once included, the charts are updated to graphically illustrate how the user defined driver data will change the metal's price.

Figure 3 shows the latest output from our Interactive Copper Price model as a cash chart. It is clear the amount of price movement that has been attributed to investment in commodity index funds. What is also noticeable is that the "base" value, which incorporates production costs, has a steep incline. This will also support prices. At BME, we see that further investments into commodity indices will continue, not at such a rapid pace as was seen during 2005, but still a noticeable increase. Combined with low levels of exchange stocks and working stocks, the outlook for the price of copper remains robust.

BME produces Interactive Price models for all of the base metals and has recently produced a model for gold (figure 4), which uses exchange traded fund holding as well as commodity index fund holdings as a driver of price. If you are interested in further information about our models, please visit our website (