Global industrial production and what it means for mining, Part 2

The shift in the location of industrial production has significant implications for mineral transportation. Mineral production historically developed in response to, and in the vicinity of, industrial production, whether in Europe, the U.S. or Russia. Logically, however, there is no particular reason for comparative advantage in industrial production and in mineral extraction to be found in the same country.

Japan started to break down the historical association of mineral production and industrial production with its rapid industrialization in the 1960s and 1970s, and was followed in this by Korea and Taiwan. China is in the process of taking this one step further, and dry bulk freight markets are beginning to feel the pressure. Despite the weak condition of the world economy, the freight market is extremely tight, and spot shipping rates at very high levels; this notwithstanding a record build-up of over 20 million dead weight tonnes in 2001 and another 15 million in 2002. The underlying trends supporting these market conditions have, however, been in train for some time. Since 1980, the trade in seaborne iron ore has grown at 3.5% a year, which is more than twice the rate of global demand for iron ore over this period.

Trade in seaborne coal has grown faster still, at an average of 6.8% a year.

One of the natural consequences of this development is that mining companies are taking a closer interest in the value chain, which extends beyond their gates to the consumer. In the case of iron ore, between being mined and charged to the blast furnace, only one-third of the chain typically is managed by the iron ore producer. The question inevitably arises as to whether greater involvement in the remaining two-thirds might unlock additional business value.

What these various factors appear to mean for miners is that the prospects for future market growth are robust, at least for the next couple of decades. Growing populations and rising income per head in developing countries will translate into metal and mineral demand growth in line with, and possibly in excess of, rates of growth experienced over the past two decades. Although this growth has hitherto been focused on industrial metals such as steel, aluminum and copper, it is likely that, with time, there will be a shift in the product mix to more consumer-oriented products, such as white minerals, along with precious metals and diamonds.

A second thing that appears to be happening is that smelting and refining activities are migrating to newly industrializing countries as these countries seek to secure the metal for their manufacturing machines. In terms of their process characteristics and the reproducibility of their underlying technologies, metallurgical plants have more in common with manufacturing plants than with resource developments. China’s growth of metallurgical production is thus far out-pacing its mine development.

Finally it is apparent that the ongoing shift in the location of industrial production means that miners will need to adjust their market focus geographically and, because of the growing distances between mine and market, may need to think more about the value chain beyond the mine gate.

Such a development anyway fits neatly with mining companies’ growing commitment to product stewardship in the context of their ongoing transition to sustainable development. What these developments do not mean, however, is either that the location of mine investment will necessarily follow that of manufacturing and smelting or that the growth in demand from developing countries will necessarily have any major implications for the behaviour of long-run prices in the industry.

The drivers of comparative advantage for mining and manufacturing remain fundamentally very different. Quality mineral resources are non-reproducible and have to be mined where they are found.

In addition, labour costs represent a smaller part of the cost base for mining than for manufacturing. This is not to suggest that there are no ongoing shifts in the location of mineral production, as there have been in industrial production, only that they tend to be slow-moving and respond to different stimuli. There is no disguising the fact that U.S. mine production of copper has declined significantly in recent years under the combined impact of a strong U.S. dollar, resource depletion and regulatory pressures. Equally, the opening up of many developing countries to inward investment in mining during the 1990s has helped boost their role in world mining, most notably in Latin America.

However, this is not so evidently a developed/developing country issue as is the case with manufacturing. Thus, since 1990, a period during which Chile has dramatically grown its copper industry and China, its industrial production, Australia has managed to increase its share of world iron ore production to 20% from 13%, its share of nickel mine production to 17% from 8%, its share of copper mine production to 7% from 4%, and its share of zinc mine production from to 17% from 13%.

In part, this reflects the simple fact that mining investment often follows earlier established mining successes. However, it also reflects the fact that, as a capital-intensive industry, the question of being able to mount large-scale projects in conditions of acceptable legal and political risk continues to weigh heavily on mining companies and on those that finance to them. Here, things have not changed as clearly, or as sustainably, as many in the industry might have wished. Indeed, the past few years have produced several instances of the re-emergence of resource nationalism.

Developing countries may well have the lion’s share of the world’s best undeveloped resources, but investment attractiveness in the industry comes as a package, and the greater security of investment conditions in many developed countries acts as a significant counterweight to considerations of resource availability. Moreover, developments in bulk transportation have made the geographic proximity of mineral and industrial production less important than it was historically.

What may happen, indeed what already is happening, is that some of the rapidly industrializing countries will want to become more involved in mining activities overseas as a means of securing raw materials for their industrial machines, much as Japan did in an earlier era. China has been quite assertive in this capacity with respect to its iron ore supplies and has investments or joint ventures in Peru, Australia and Brazil.

Looking at the supply cycle, investment in the mining industry peaked in 1997. In retrospect, it is easy to observe that the industry overdid it at this time, whether because of unrealistic growth expectations, strategic imperatives of individual companies to diversify away from their home bases, or because buyers had paid top-dollar for projects which they were then obliged to develop rapidly in order to start to earn returns.

Following the negative demand impact of the Asian financial crisis and then the bursting of the U.S. technology bubble, the industry has experienced a prolonged period of attrition of surplus capacity through closure and rationalization.

This process is nearing its end, and raw materials markets — for example, those for copper and zinc concentrates, alumina, and iron ore — have tightened appreciably. For similar reasons, the scrap markets for many metals are also displaying tightness. In short, supply-side fundamentals are turning constructive and, when demand-side conditions allow, will underpin a resurgence in prices and, doubtless, a new wave of investment.

It is altogether more difficult to predict when the demand cycle will deliver the conditions for recovery. Most forecasters see some improvement in economic activity rates in Organization for Economic Co-operation and Development (OECD) countries in coming months, helped by a rebound from the depressive effects of the Iraq war and by lower oil prices. However, there remain significant doubts about the strength of the follow-through, and the consensus
view appears to suggest a recovery in which growth gradually reverts to trend rather than materially outperforms it.

The range of uncertainties bearing on the economic outlook certainly remains impressive, covering as it does Middle East geopolitics, the twin deficits of the U.S., the volatility of currencies, the problems of Japan’s banking system, Germany’s industrial sclerosis, and now SARS.

One indicator of where we are in the demand cycle for metals and minerals is provided by the relationship between industrial production and retail sales in OECD countries. This indicates whether inventories through the system are being built up or run down. Although the ratio is on a declining trend, reflecting the ability of companies to operate with progressively lower levels of stocks (and may in the last couple of years also reflect something of the structural shift in industrial production out of the OECD), the index is currently well below trend. This suggests that the phase of destocking has been largely completed but that the phase of restocking has yet to begin. With the exception of the early 1980s, previous periods of stock-rebuilding when the index has moved back towards trend have seen strongly recovering metal prices.

A similar pattern is evident in the U.S. stocks’ data for fabricated metal products. These stocks have been substantially reduced since 2000, falling back in real terms to where they were during the recession of the early 1990s.

Although year-on-year changes indicate that the period of stocks’ decline may be coming to end, there is no evidence yet of renewed stock building. Like the recovery of investment, the building of stocks is waiting on a clear signal from demand. This is not currently forthcoming.

Nor is it clear yet what might serve as the driver for a resurgence of demand in the OECD countries. In the meantime, growth in emerging Asia should continue to help provide underlying support for the metals and minerals industries. The greater excitement, however, lies in the role that the further growth of its industrial production and consumer markets will play in driving the sustained recovery that must eventually follow.

— The preceding is an edited version of a report published by London-based Rio Tinto. The author is the company’s chief economist.