Higher input costs will start to squeeze margins, Citigroup says

Despite rising costs, mining companies will still be able to deliver “sustainably higher” earnings before tax and depreciation (EBITDA) margins over the next five years than they have over the past 20 years, a new research report from Citigroup Global Markets says.

But the equities research arm of the global investment bank cautioned that its analysis of costs and incentive prices also indicated that while there will be higher long-term margins than there have been over the last two decades, margins will be “at lower levels than the companies are currently enjoying.”

Take copper as an example. In the last five years, copper prices have risen by 357%, and the average cost of the industry has gone up by 74%. (Between 2002 and 2007 in the copper industry, annual labor costs rose by 12%; energy by 24%; service by 11%; and freight by20%.)

According to Citigroup’s calculations, if the price of oil strikes US$150 per barrel, cash operating costs for copper would increase by around 36% and if the price of oil hits US$200 per barrel, operating costs would rise by 58%.

If that were the case, “margins for the copper industry would fall from around 78% to 68% and 61% respectively, using our copper price of US 355 cents per lb,” Citigroup wrote in its May 16 report entitled “The Alchemy of Mining.”

If margins in the copper industry are to maintain the levels reached last year, then at an oil price of about US$100 per barrel the copper price would have to average US 424 cents per lb, the report noted.

“Going forward, the mining sector will likely be more susceptible to rising input costs, which would erode margins,” the report said. “Under this scenario, the mining sector could de-rate, similar to that of the large oil sector, where margins have remained constant despite a large increase in the oil price.”

In terms of supply, that will depend on whether prices rise to the point where returns beat the cost of capital of investing.

Citigroup believes that supply is likely to continue to disappoint the market. (In the last four years, the supply of copper, nickel, zinc and aluminium has grown by less than 5% a year.)

It forecasts that the majority of Greenfield projects principally in the base metals commodities “are below the companies’ returns at consensus long-term pricesa sharp increase in capital capex cost could kill the project economics.”

For copper alone, operating costs in the last two years have gone up an average 51%, while capex costs have increased by about 45%.

As for consumption, Citigroup pointed out that it will “remain above trend levels” for the next four to five years, but that the “killer of this cycle” will come when nominal GDP growth in emerging economies falls below the cost of capital, which is currently running at about 5%.

Currently Citigroup’s top stock picks are: Anglo American (AAUK-Q, AAL-L), First Quantum (FM-T, FQM-L), Peter Hambro Mining (POG-L), Vedanta Resources (VED-L), Ferrexpo (FXPO-L), and Xstrata (XSRAF-O, XTA-L).