LONDON, UK, Nov. 26 /CNW Telbec/ - The following paper from Rio Tinto
chief economist Vivek Tulpulé has been issued today to coincide with the Rio
Tinto Investor seminar.
- Commodity markets are entering a fifth straight year of growth with
mineral and metal prices at levels well above their long term average
and in many cases above levels at the start of this year.
- Firm global economic activity led by China is expected to support
strong increases in demand for most metals and minerals over 2008 and
- With low stocks and a likely continuation of supply side difficulties,
most commodity prices are expected to remain well above their long run
trend over the short and medium term.
- It is too early to suggest that the current price cycle has peaked
across the range of commodities.
- While the central case is positive, we are mindful of the short term
risks associated with the predicted slowdown in the US economy.
- But, it is important to recognise that the United States is now
significantly less important in world commodity demand than it was
just five years ago.
- Additionally our analysis suggests that even a sharp slowing in the
US economy would have only a small impact on Chinese and Indian
economic growth and consequent demand for commodities.
- Viewed from a longer run perspective recent history and the IMF's
forecasts suggest that we are currently going through a period of
global growth not seen since the period of fast growth and
reconstruction in OECD economies following World War 2.
- Specifically, there has been a structural shift favouring rapid growth
in developing countries with large populations such as China and India.
Growth in these economies will be resource intensive as they
industrialise and urbanise.
- The implications for commodity markets are nothing short of profound.
Projections for iron ore, aluminium and copper suggest that demand
could double and even triple over the next 25 years.
- In time production can be expected to expand to meet faster growth in
demand at more sustainable prices. But that pricing environment is
expected to be significantly stronger than would be implied by
- It is expected that prices of many minerals and metals will remain
elevated above trend for longer than has been the case in the past
because of constraints on the speed with which production capacity
can be expanded over the next few years.
- Also most prices are expected to assume significantly higher
average levels over the very long run than has been the case
historically due to structural increases in industry costs.
- We present case studies relating to markets for aluminium, copper and
iron ore - three commodities that are expected to be drivers of the
industrialisation and urbanisation process in developing countries.
- Substantial growth is expected in the demand for iron ore reflecting
expected strong growth in steel demand related to the processes of
ongoing industrialisation and urbanisation in the developing world.
- Reflecting the current tight market spot prices have risen sharply over
the last few months with Indian ores currently selling in China at
around $190/tonne double their price at the beginning of 2007.
Australian and Brazilian ores are selling at a substantial discount to
this spot rate given current freight rates.
- A substantial amount of high cost production will be required to meet
growing demand over the long term. This strongly suggests the
possibility of higher long run prices & higher margins for traditional
lower cost producers.
- Prices are currently in the range of $2450-2550/t - levels supported by
industry cost structures.
- Aluminium consumption has grown the fastest of all non-ferrous metals
over the last 5 years and is forecast to grow rapidly over the next
- There has been enormous recent growth in Chinese consumption and
production but aluminium has benefited from increasing intensity in
many other regions including the OECD.
- Constraints on China's domestic bauxite production suggest that the
country's massive investment in aluminium capacity will remain reliant
on imported bauxite. This combined with China's high power cost
environment mean that Chinese aluminium capacity will continue to be
high cost on a global scale.
- Additionally, Chinese production will also be disadvantaged by a
stronger currency as the RMB edges toward fair value over time.
- The implied increase in the marginal cost of production for alumina and
aluminium means that their prices are unlikely to revert to the lower
levels implied by historical trends
- Reflecting the tight market situation, copper prices are currently in
the range of $6400/t-$7000/t - about three times higher than their
average level through the 1990s and well above levels achieved in the
early part of this decade.
- Prices could remain near current levels as long as production growth
continues to under-perform against the underlying demand trend creating
a need to ration supplies.
- Strong Chinese demand growth is expected next year and on the supply
side the likelihood of ongoing disruptions and possible constraints on
the availability of sulphuric acid affecting SxEw operations are
- The importance of investment funds in exchange traded commodity markets
means that large price movements could take place on the back of
commodity specific speculative shifts or broader shifts in investor
sentiment - well in advance of any fundamental change in physical
- Looking to the long run, strong demand growth prospects are based on
the expected resource intensive development of economies such as China
and associated investment in power distribution networks and other
- On balance, we believe that, as for many other commodities, there has
been a structural shift in copper costs supporting the expectation of
significantly higher long run prices than would be implied by
A fundamental shift toward fast and resource intensive growth
As 2007 draws to a close, resource markets are entering a fifth straight
year of cyclical strength with virtually all minerals and metals prices at
levels significantly above their long run historical trends and in many cases
above start of year levels.
Looking forward, global GDP growth is expected to be firm in 2008 and 2009
with rapid growth in China and other developing countries expected to reduce
any drag from slower growth in OECD countries. Such conditions should create a
basis for continued strong underlying commodity demand over the medium term.
At the same time, growth in production for a number of commodities is expected
to remain relatively constrained. In this context, it is entirely possible
that some commodity prices may not have reached their cyclical peaks as yet.
Indeed, illustrating the significance of current commodity market
developments in a historical context, if as expected, most prices remain well
above trend over 2008 and 2009 then prices will have been above trend for 6
years. This would be a 3-in-100 year event for many commodities.
Viewed in a broader setting, the current strength in most resource markets
can be seen as the result of a fundamental shift in economic forces that is
leading to rapid growth in developing economies with large populations. For
example, recent history and the International Monetary Fund's projections for
future growth would suggest that we are currently going through a period of
global growth not seen since the period of rapid economic development and
reconstruction that followed the Second World War.
China and India provide the most significant recent examples of the
current growth phenomenon but they are not alone. For instance, many countries
in the Middle East and ASEAN are also on fast growth paths. In such economies
growth tends to be resource intensive. In particular, the processes of
urbanization and infrastructure development that accompany early-mid stage
productivity growth and industrial development require increasing utilisation
of resources such as steel (and therefore raw materials such as iron ore),
aluminium, copper and energy. At a global level such a resource intensive
development pattern is expected to persist for at least another two decades
leading to sustained strong global demand growth for many commodities.
Prices are determined by both demand and supply and by its nature minerals
and metals production can be difficult to accelerate. But accelerating
production in cyclically high markets can also be very profitable causing a
'rush' to meet demand. The current 'rush' has manifested itself in a number of
forms including: increasing construction costs and project delays; higher
levels of disruption as existing production systems are stretched; higher
average production costs due to labour and other input cost increases; and
higher industry marginal costs as increasingly expensive production is drawn
in to meet demand.
In time, it is expected that sufficient commodity supply growth will be
induced to cause prices to revert down toward more sustainable long-run
levels. But the demand and supply phenomena just described suggest that it
will most likely take longer for commodity prices to return to long-run levels
than would have been the case if historical reversion rates had applied. At
the same time long-run prices and in some instances margins are expected to be
significantly higher than would be implied by historical trends.
Medium term expectations are for strong global GDP growth
Against a backdrop of record high oil prices, a rapidly slowing US housing
market and a credit crunch precipitated by the US sub-prime mortgage crisis,
the IMF is nevertheless projecting global GDP growth in 2008 of about 4.8 per
cent (in PPP terms)(1). This projection accounts for slowing growth in
advanced economies but relatively fast growth in the developing world. In 2009
a recovery in activity in advanced economies and continued strong growth in
developing economies are projected to generate global growth of around 5 per
cent(1). Viewed in a historical context such growth rates are high and
therefore provide a positive setting for underlying commodity demand in the
China's GDP has continued to surge, growing at 11.5 per cent (y-o-y) in
the first three quarters of 2007. In this period industrial production grew by
about 18 per cent, nominal fixed asset investment grew by about 26 per cent
and the trade surplus soared to about US$200bn. At the same time inflationary
pressures, mainly related to food and energy prices, have been increasing with
consumer and producer price inflation in October at 6.5 per cent and 3.2 per
cent respectively. In this setting the government has introduced measures to
restrain liquidity. But even with this tightening, GDP is expected to grow
rapidly at between 10 per cent and 11 per cent in 2008 and around 10 per cent
in 2009 based on strong domestic demand and a strong but moderating
contribution from net trade(2).
The US economy is expected to grow at around 2 per cent in 2008 as
residential construction continues to fall and private consumption growth
slows. On the other hand, a weaker dollar is expected to generate an improved
contribution to GDP from trade. In 2009 residential construction is expected
to start growing again and the positive effects of recently lowered interest
rates on investment and disposable incomes should lead to a recovery in
economic activity; GDP growth in the range of 2.5 per cent to 3 per cent is
expected in that year(3).
Japan's growth has been volatile during 2007. It grew strongly by 0.7 per
cent (q-o-q) during Q1, declined by 0.4 per cent in Q2 and then beat analysts'
expectations to grow by 0.6 per cent in Q3(4). The contraction in Q2 was
partly attributable to reduced residential construction resulting from the
implementation of a stricter building code. In 2008 and 2009 steady growth in
consumer demand and a rebound in residential construction are expected to
offset slower net exports to see overall GDP grow at around 2 per cent(5).
The Indian economy grew by more than 9 per cent in each of the first two
quarters of 2007 and growth of between 8 per cent and 9 per cent is expected
in 2008 and 2009(6). Capacity constraints in many parts of the economy are
creating inflationary pressures and in response the Central Bank has tightened
monetary policy. While this reduced inflation it probably also contributed to
reduced industrial production growth during the second half of this year.
Expected limited global economic risk from a further US slowdown
Markets have been nervous about the impact of slowing US growth on
commodity markets and speculation about this has had negative effects on
exchange traded prices. But in terms of commodity demand generally, the
importance of the United States has declined substantially relative to that of
China since 2000 and in the specific case of seaborne iron ore, the US is a
negligible market participant. In that context, the key issue for the health
of commodity markets over the medium term is the magnitude of any negative
spillover effect from a slowing US economy on economic activity in the rest of
the world and China in particular.
One macroeconomic linkage is clear. With slower US private consumption and
a weaker currency, US demand for exports from other regions can be expected to
decline and its own exports to increase. In terms of GDP accounting, this
would reduce the net contribution of the United States to aggregate demand in
the rest of the world. But it is easy to exaggerate the potential flow on
effects of this possibility on global economic activity including in Asia.
For example, modelling suggests that a sharp reduction in US consumption
and residential investment during 2008 to levels consistent with a US
recession and a weaker US exchange rate would be expected to reduce Chinese
growth by less than a percentage point. This would still leave scope for
Chinese growth at levels approaching 10 per cent. For India, the impact of any
further slowdown in the US would be expected to be smaller because of India's
more limited exposure to world trade.
The modelling captures the likelihood that, governments and central banks
in countries affected by any US slow down could boost economic activity
through monetary and fiscal responses. Some commentators have noted that such
economic pump priming would favour construction and infrastructure
development, which in turn is likely to be a positive for commodity demand.
Moreover shifts in trade flows and policy responses are only part of the
picture. A focus on these aspects alone ignores any shift in financial flows
favouring countries with better investment prospects. For example modeling
based on a framework that focuses on international financial dynamics suggests
that the flow on effects of any slowing in US growth could be reduced
substantially as financial resources shift away from the United States toward
other locations including developing Asia.
Some commodity specific examples further illustrate the point. Chinese
consumption of steel is believed to be affected only marginally by
fluctuations in external demand as China's steel industry is overwhelmingly
focused on meeting needs from the domestic construction sector.
Even in the case of copper, consumption is mostly driven by domestic
construction and infrastructure development which together account for the
majority of China's copper consumption. Exposure to external conditions arises
from China's position as a major global supplier of household appliances
containing copper components. China has also grown its exports of
semi-fabricated products and copper tubes in recent years, although it remains
a net importer of semis.
It is difficult to put a precise figure on the amount of copper embodied
in Chinese trade to the United States. But even if 20 per cent of total
Chinese copper consumption were related to exports and given that the United
States generally accounts for around 20 per cent of China's total merchandise
exports, the direct exposure of China's total copper demand growth to any
slowing in US economic activity would be very limited.
Since the start of this year the US dollar has weakened appreciably
against most other currencies. Recent falls in the greenback have been driven
by perceptions of increased riskiness in US asset returns in the wake of the
sub-prime mortgage crisis; and expectations that the US Federal Reserve may
cut interest rates to address growth concerns while other central banks may
raise rates to combat inflationary pressures.
The currencies of many commodity exporting countries have also been
affected by upgrades to market expectations about future commodity prices and
M&A activity. The Australian dollar has gained about 13 per cent against the
US dollar since the start of the year. The Chilean Peso has gained about 5 per
cent, the Brazilian Real has gained about 16 per cent and the Canadian dollar
has appreciated by about 19 per cent(7). Such exchange rate shifts have
increased average US dollar production costs for many commodities. But at the
same time, US dollar weakness provides support to prices of commodities that
are denominated in US dollars but with large non-US consumption and cost
Over time, market based exchange rates are likely to fluctuate on
ever-shifting speculation about relative interest rate policies and ongoing
concerns about risk and structural imbalances and commodity prices in the case
of large commodity exporters. In the case of managed currencies, policy and
economic pressures on governments or the emergence of unsustainable foreign
exchange flows will have the greatest influence on outcomes. Future rates of
appreciation in the Chinese RMB are of special importance for commodity
Chinese RMB expected to continue to strengthen providing a basis for
higher long run prices
A range of empirical analyses and the evidence of burgeoning trade
surpluses and foreign exchange reserves suggest that the RMB is significantly
undervalued. The extent of possible undervaluation is shown in the following
chart based on research commissioned by Rio Tinto. The straight line labeled
'Fair Value' shows a statistically determined relationship between real
exchange rates and per capita incomes. This empirical analysis backs the
theoretical argument (known as the Balassa Samuelson effect) that as
developing countries become richer their real exchange rates can be expected
to strengthen relative to those of the richest countries. The Chinese real
exchange rate has been and remains below the estimated fair value line
suggesting substantial scope for ongoing revaluation.
The Chinese authorities have progressively allowed the currency to
appreciate in nominal terms against the US dollar. Pressure on the RMB to
strengthen further is expected to continue, both to address political
frictions associated with the trade surplus and constraints on monetary policy
associated with a managed currency.
Importantly this process of revaluation has been increasing the US dollar
costs incurred by trade exposed industries including metals and minerals
producers. In aluminium and iron ore Chinese producers are already among the
highest cost producers in the industry and therefore any currency appreciation
would tend to increase marginal industry costs for those commodities over
time. In turn, this cost increase provides a basis for higher global prices.
Long run economic developments and implications for commodity markets
Long Run Growth and Development Entering a New Elevated Phase
It is important to reiterate that the IMF's growth projections for 2008
and 2009 are high when viewed in a historical context. This results from an
expected structural shift (rather than cyclical move) in global economic
activity based on the ongoing economic emergence of China and other developing
economies such as India. Indeed, the expected shift would take world growth to
levels not seen since the period of rapid growth and reconstruction in OECD
countries just after the Second World War. The longer term implications of
this shift for commodity markets are potentially profound.
Our revised analysis of longer run Chinese growth prospects suggests that
GDP growth can be expected to average levels approaching 9 per cent per annum
in the period to 2015 providing a sustained basis for strong commodity demand
growth. In a similar vein, a recent study carried out by the Development
Research Centre under China's State Council concluded that China's
industrialization stage will last into the 2020's with potential GDP growth
rate at around 10 per cent in the period to 2015 and 8 per cent from 2015 to
2020. A study by Australian National University academics, Garnaut and Song,
suggests that China is reaching a 'turning point' in its growth creating
potential for highly resource intensive growth in excess of 10 per cent over
the next two decades.
Indian growth has lagged behind China's despite both countries having had
similar per capita incomes in 1980. In more recent years Indian growth has
accelerated and importantly it has become less variable. Studies by Rio Tinto
suggest that India has the potential to grow at a sustained rate of around 10
per cent for at least a decade if key economic reforms are undertaken. Studies
by banking research groups produce similar results with long run growth
potential estimated to be in the 8 per cent-10 per cent range(8). Most of this
research points out that continued reforms that free up the ability of Indian
industry to respond to price signals remain crucial both to allow more rapid
allocation of resources to their most profitable uses and reduce inflationary
risks. In India's case it is arguable that the turning point favouring highly
resource intensive growth, identified for China by Garnaut and Song, is still
to be reached.
Commodity demand expected to grow strongly
The shift toward faster and more resource intensive global growth led by
developing countries has led to strong rises in commodity demand over recent
years. But per capita consumption remains relatively low in those countries
suggesting scope for strong growth well into the future. For example, while
China accounted for 60-90 per cent of the increase in global demand for steel,
aluminium and copper between 2000 and 2006 its per capita consumption of those
metals remains well below that of many OECD countries(9). For example in 2006
Chinese per capita steel consumption was about 60 per cent of that in the OECD
average while its per capita copper and aluminium consumption was at around
one-third of OECD levels. The implication is that Chinese demand for these
commodities - and associated raw material inputs - has substantial scope to
continue to grow rapidly for some time. Indian per capita consumption is a
fraction even of China's consumption, suggesting scope for rapid sustained
demand growth over the longer run.
Empirical analysis based on historical patterns of commodity consumption
and differences in commodity consumption between countries shows a
relationship between per capita incomes and commodity consumption - typically
known as 'commodity S-curves'. The S-curves suggest that as incomes grow per
capita consumption of commodities increases. At first growth is more rapid as
economies industrialise, build urban environments and commercial
infrastructure and then growth slows for rich countries as consumption per
head approaches saturation. Such S-curves are shown for a range of commodities
in the graph below.
The analysis shows that per capita consumption of aluminium, copper and
steel making raw materials tend to pick up at a relatively early stage of
industrial development. For aluminium the empirical analysis also suggests
that demand in developed countries has not yet achieved saturation implying
scope for more broadly based future per capita global consumption growth. For
commodities such as iron ore and coking coal it is important to recognise that
the S curves are for total consumption and not for consumption of seaborne
material. So, for countries in which domestic production of raw materials is
constrained, growth prospects for imports of seaborne materials may be greater
than for demand in aggregate.
The chart shows that the largest proportion of the world's population has
low average per capita rates of commodity consumption consistent with
relatively low incomes. As per capita incomes grow larger numbers of people
will consume increasing commodity volumes and aggregate global consumption of
commodities can be expected to rise at a fast rate. For example, based on the
S-curve analysis and assuming a plausible positive scenario for global growth
over the next 2 to 3 decades, the seaborne iron ore market could triple in
size relative to today's level.
Of course the analysis does not suggest that demand will increase at a
steady rate over time. Macroeconomic cyclicality along with stocking and
destocking patterns can be expected to play major roles in determining demand
outcomes for different commodities in any given year. For example, in China's
case with virtually all sectors of the economy growing rapidly, there is a
chance that developments in some parts of the economy could move out of phase
with developments in other parts. This suggests a possibility that at times
economic imbalances could emerge, generating cycles of strong growth and
capacity building followed by periods of slower growth, catch up and
consolidation. The implication is that Chinese growth and associated commodity
demand growth can be expected to have a cyclical pattern over time.
Supplies are stretched and capacity expansions have been delayed
The supply side of the mining industry continues to face challenges in its
response to fast demand growth. These challenges have been exacerbated by a
prolonged period of underinvestment throughout the sector due to slow demand
and low prices during the 1990's and into the early 2000's. As a result, the
industry entered the current cycle with reduced capabilities at all stages of
project development, from exploration through to construction and operations.
In this setting, the industry has become increasingly stretched in its attempt
to meet stronger demand and in many cases there is little slack in the system
to compensate for disruptions such as those related to events of nature and
downtime for maintenance.
There are few signs that constraints faced by the supply side are easing
in the short term - as indicated for example by shipping freight rates which
have reached new record levels in recent months. Operating and capital costs
have continued to rise in 2007 and supply has once again underperformed
significantly especially in the copper market.
Some of the supply challenges are medium term in nature. These are
typically related to: increased demand for materials and equipment, leading to
higher input costs and longer lead times; and bottlenecks in supporting
infrastructure (ports, rail and shipping).
Other constraints will take much longer to address. First, the industry is
moving increasingly toward the development of resources that in the past were
either considered to be too complex or low-grade or in regions with high
country risks and poor infrastructure. This is presenting challenges to mining
companies not only because new skills and technologies are required to develop
those resources, but also because of the increased capital intensity and
delivery risks associated with many such projects. Second, the industry and
its suppliers and contractors are facing acute shortages in the labour market
- especially in relation to skilled professionals such as experienced mining
engineers with project management experience - leading to increased project
costs and delays.
Importantly the mining industry is not alone in the struggle to access
material and human resources. The upstream and downstream oil sector as well
as the chemical industry have also stepped up their capital spending plans in
recent years and are competing for similar parts and equipment, construction
workers and the services of EPCM contractors. The competitive environment for
such inputs has led to capital cost escalation for mining projects and longer
lead times to deliver new capacity. As a result, the commodity prices required
to induce development of future resources are likely to face upward pressure.
Natural resources constraints facing the mining industry extend to its
access to supporting resources such as energy and water. In this context,
environmental considerations in the development of new projects present a key
set of long-term resource related challenges. Additionally, it is becoming
apparent that regulatory approvals are becoming an increasingly significant
barrier to rapid supply expansion. Such constraints are likely to persist and
perhaps become more significant over the longer term.
Commodity case studies
We present case studies relating to markets for aluminium, copper and iron
ore - three commodities that are expected to be drivers of the
industrialisation and urbanisation process in developing countries.
Current pressures in the iron ore market are intense as reflected by spot
prices, which have increased sharply over the last several months. Spot Indian
ores are currently selling in China at now at around $190/tonne, double their
price at the start of the year. After taking into account current freight
rates, Australian fine ores sold at benchmark prices (of around $50/tonne)
trade at a substantial discount to these spot prices. Brazilian ores, which
have significantly higher transportation costs to the growing Asian market,
sell at a lower but still significant discount(10).
On the demand side, steel production has grown rapidly leading to strong
growth in iron ore trade. Chinese crude steel production has continued to rise
by over 18 per cent y-o-y despite the levying of export taxes(11). While these
taxes and the weaker US economy have discouraged exports, this has been more
than offset by renewed strength in domestic demand. Evidence of this is
suggested by domestic Chinese steel prices which reached a new high in
Strong demand for iron ore is not limited to China, however. Annual
Japanese crude steel output this year is expected to hit a new record level
for the first time in 33 years and the German Steel Federation has recently
raised its forecast of domestic steel production for this year. While North
American steel producers have cut back output this has little impact on the
seaborne iron ore market as nearly all domestic production relies on either
domestic ores or scrap.
Increases in demand for iron ore have continued to outpace the ability of
low cost producers to add additional supply. Over the first three quarters of
the year Chinese iron ore imports rose by 15 per cent(12) - less than the rise
in steel production This means that in high-grade equivalent terms the amount
of Chinese iron ore production required to meet domestic demand is expected to
be around 350 million tonnes this year. Much of this is produced at a
relatively high cost. Chinese costs (in US dollar terms) have also been
affected by a strengthening RMB and this pressure is expected to persist while
the RMB remains undervalued. At the same time, as well as having to mine lower
grade ores, there is an increasing reliance on new more remote and therefore
more expensive supply from the far north eastern parts of China. Costs of
Indian ores have also increased due to new taxes and a progressively
strengthening rupee. There has only been limited progress on the major
infrastructure investments required in India to make its exports more
competitive and at the same time exports compete against strongly rising
domestic demand for ores. Most importantly the escalation in freight rates has
substantially increased the cost of landing ore in Asian markets from all
destinations. The overall implication is that current high prices have, in all
probability, been supported by a rising and steepening industry marginal cost
Over the longer run, continued strong growth in demand for steel in
developing countries and developed parts of the Middle East is expected to
result in substantial growth in seaborne iron ore trade over the next two
decades. Given the large volumes of high cost production currently in
operation and expectations for continued demand growth, any reversion of
prices to lower long run levels can be expected to take place over an extended
period. Additionally it is expected that a substantial amount of high cost
production from China and India will continue to be required to meet growing
demand over the long term. This strongly suggests the possibility of higher
long run prices and margins for the traditional lower cost producers.
Spot aluminium prices have moderated by about 10 per cent since the middle
of 2007 and are currently moving in the range of $2450/t-$2550/t(13). Prices
at around these levels are supported by production costs at the highest cost
smelters. Forward prices have increased in relation to spot prices reflecting
a market expectation that production with high marginal costs could be
required to meet demand for primary metal over the medium term.
Aluminium has experienced the fastest consumption growth of all
non-ferrous metals over the past five years and it is forecast to continue to
enjoy one of the most rapid growth profiles over the next two of decades. CRU
projects consumption to grow by more than 140 per cent over the period to
2030(14). One reason for the recent growth is that China's economic
development is highly aluminium intensive. But at the same time there have
been worldwide gains in intensity of use and favorable substitution across a
wide range of applications.
The strong and sustained growth in aluminium demand is starting to stretch
the resource base that has been the foundation of the development of the
aluminium industry - large-scale good-quality bauxite deposits and
competitively priced stranded energy.
In the case of bauxite the escalation in demand for aluminium is being met
increasingly from high cost and low-scale bauxite deposits in China and
opportunistic mining operations in Indonesia. Such sources of supply are
unlikely to provide a long term solution for the industry's rapidly growing
bauxite needs and have already led to stronger prices for traded ore. This
implies that significant investment in new large scale bauxite mines are
likely to be required if the industry is to meet demand projections.
Meanwhile, high energy prices combined with a greater integration between
regional energy markets through the development of LNG and gas-to-liquids
projects could increase the costs of power available to greenfield smelters
around the world. Together with a likely growing trend towards the
introduction of pricing mechanisms or tax regimes for carbon emissions,
sustainable stranded hydropower sources have become more valuable. This in
turn may increase the value of existing aluminium capacity linked to such
In the context of growing demand and constrained supply, the long run
pricing environment for the industry will be heavily influenced by the
evolution of costs. Turning first to alumina, refineries relying on imported
bauxite supplies, such as in Europe and the US Gulf coast, have traditionally
occupied the top-end of the alumina cost curve. High energy prices and rising
delivered bauxite costs have increased the competitive disadvantage of these
refineries over the past five years. The Chinese industry is currently adding
significant non-integrated alumina capacity drawing on its capital cost
advantage. These refineries are rapidly joining US and European alumina
refineries toward the top of the cost curve. The resulting increase in the
marginal cost of production means that alumina prices are unlikely to revert
to the lower levels implied by long run historical trends even if some higher
cost integrated capacity is eventually replaced by lower cost production.
As with alumina, in the case of aluminium new Chinese smelters are
fundamentally changing the shape of the industry cost curve. The rapid
increase in Chinese smelting capacity since the start of this decade reflects
the moderate barriers to entry in building smelters in China due to low
capital costs and short build times. However, this new capacity has come in at
the top-end of the operating cost curve mainly reflecting relatively high
power costs. Consequently, the industry aluminium cost curve has shifted up
since 2003 and become steeper. This has provided a new significantly higher
base for prices.
A key point to note is that the gradual appreciation of the Chinese
currency should also translate into higher US dollar production costs for
Chinese smelters - all other things being equal. To illustrate this point, the
effect of a further 10 per cent appreciation of the Chinese RMB on the
aluminium cost curve is shown on the chart above. With Chinese smelters
predominantly in the third and fourth quartiles, the top end of the curve
would shift up in such a scenario creating an even higher basis for aluminium
prices and higher margins for smelters in the lower cost quartiles.
Copper stocks have been at critically low levels since a surge in
consumption in 2004 depleted available inventories. From that point, stocks
have been constrained by supply's inability to match a stronger underlying
demand growth trend related mainly to Chinese growth. Reflecting the tight
market situation, copper prices are currently moving in the range of
$6400/t-$7000/t(15) or about three times higher than their average level
through the 1990s and well above levels achieved in the early part of this
Unlike for iron ore and aluminium, the scope for opportunistic and
high-cost sources of supplies to help bridge supply shortages has been limited
for copper. Current prices are therefore significantly above marginal costs of
supply. Short term copper prices are instead supported by the need to induce
those with the least 'willingness to pay' for copper to reduce their
consumption. In this context most of the switch away from copper has so far
occurred in the plumbing sector to the advantage of plastics. This means that
prices could remain near current levels as long as production growth continues
to under-perform against the underlying demand trend creating a need to ration
In terms of demand, most analysts are projecting flat copper consumption
outside of China in 2007. But within China copper consumption growth is
projected to grow by 15 per cent this year. Calculations of apparent demand
are pointing to growth well in excess of that number, although this is thought
to reflect the reversal of a destocking phase in China during 2006. Overall
global demand is expected to record its strongest growth since 2004, rising
this year by about 3.5-4.0 per cent(16). Looking forward, even with a
projection of high underlying average demand growth in China, demand for
material can be expected to fluctuate unpredictably over periods of months on
stocking and destocking cycles generating price volatility.
On the supply side copper miners have faced many of the challenges and
bottlenecks discussed earlier. Strikes and unforeseen disruptions from weather
related events and accidents have also affected the performance of existing
copper mines. It is estimated by Brook Hunt that actual global mine output
over the past three years has underperformed market expectations by a
cumulative 2.5 to 3 million tonnes of copper. This is equivalent to annual
losses of 4 per cent to 6 per cent which compare with losses in normal years
closer to 2 per cent.
The medium term outlook for copper will be highly dependent on whether
disruptions continue to run at high levels. Third quarter production reports
from copper mining companies suggest that this remains an ongoing issue. In
addition recent reports have pointed to potential shortages of sulphuric acid
which could constrain SxEw operations in the short term. This source of supply
has accounted for a high proportion of primary production growth over the past
The influence of investment funds activity could also be a factor
affecting medium term prices in the copper market. In particular, some
analysts are suggesting that additional demand associated with long only funds
means that stocks levels associated with a market in equilibrium will need to
be higher than in the past. In any case, the likely continued importance of
investment funds in exchange traded commodity markets means that large price
movements could take place on the back of commodity specific speculative
shifts or broader shifts in investor sentiment - well in advance of any
fundamental change in physical markets.
Looking to the long run, CRU projects that copper demand will more than
double over the next 25 years. Growth prospects are based on the expected
resource intensive development of economies such as China and the associated
investment in power distribution networks and other infrastructure.
Additionally, in a high-energy price and carbon conscious world copper can be
expected to benefit from any global drive for increased energy efficiencies
and any shift towards the development of local distribution networks around
sources of renewable energy.
Ultimately, the industry should be able to surmount bottlenecks in
equipment and supplies. However, some of the supply challenges are likely to
be of a longer-term nature. These include declining ore grades, an increasing
shift towards underground operations and the need for the industry to access
and develop deposits in countries with higher risk profiles such as the DRC.
Meanwhile upward pressure on capital costs for copper projects is likely to
remain. This suggests that future long run prices and margins may be
sustainable at levels well above long run historical averages without
encouraging excess capacity.
Historically copper prices have tended to trend towards the industry's
marginal cash cost of production. But reflecting the cointegrated nature of
costs and prices, cash costs have continued to move up driven by higher labour
rates and bonuses, increased royalty payments, and stronger prices for
supplies, services and energy. Exchange rate changes have also been
significant in key copper mining regions, exacerbating the upward pressure on
cost. Overall, cost increases have been felt more strongly at the margin and
we estimate 9th decile costs to be back near or even above levels last seen at
the start of the previous decade. While some of the recent cost pressures are
likely to subside in the longer term, we believe that, as for many other
commodities, a structural shift in the copper cost curve has occurred
supporting an expectation of significantly higher long run prices than would
be implied by historical trends.
Conclusion - faster long run average demand growth, extended medium term
price elevation and higher long run prices
Continued firm global economic activity led by rapid resource intensive
growth in China is expected to support strong increases in demand for most
metals and minerals over 2008 and 2009. At the same time with low stocks and a
likely continuation of supply side difficulties, most commodity prices can be
expected to average well above their long run trend over this period. It is
too early to suggest that the price cycle has peaked across the range of
While the central case is positive, it is important to remain mindful of
macro-economic risks especially relating to US housing and credit markets.
However it is also important not to exaggerate these risks as our modelling
suggests that they may not have a significant impact on the developing
economies that have been the growth engines of commodity demand. It is also
important to keep in mind that price movements from month to month will be
influenced by stocking and destocking and investment funds' activities that
may be only indirectly related to economic growth.
Over the longer run strong resource intensive growth from China, India and
other developing countries should continue to provide momentum to commodity
demand. Indeed, recent history and the IMF's projections for future growth
would suggest that we are currently going through a period of global growth
not seen since the period of fast growth and reconstruction in OECD economies
following the Second World War. The implications for commodity markets are
In time production can be expected to expand to meet faster growth in
demand at more sustainable prices. However, it is expected that prices of many
minerals and metals will remain elevated above trend for longer than has been
the case in the past because of constraints on the speed with which production
capacity can be expanded over the next few years. Also most prices are likely
to assume higher levels than has been the case historically due to structural
increases in industry marginal costs.
(1) IMF World Economic Outlook, October 2007
(2) Global Insight, Interim China forecasts, November 2007
(3) Global Insight, Interim USA forecasts, November 2007
(4) Cabinet Office, Government of Japan for historical quarterly GDP
growth estimates, Development of real GDP, November 2007
(5) Global Insight, Interim Japan forecasts, November 2007
(6) Global Insight, Interim India forecasts, November 2007
(7) Data downloaded from Ecowin database, November 2007
(8) Lehman Brothers, India: Everything to play for, October 2007;
Goldman Sachs, India's Rising Growth Potential, January 2007
(9) References to steel from IISI, World Steel in Figures,
September 2007; for references to aluminium CRU The Long Term
Outlook for Aluminium, 2007 Edition; for references to copper CRU
Copper Quarterly, October 2007
(10) CCCMC and Rio Tinto analysis (Indian exports), Mysteel, CUSTEEL and
Rio Tinto analysis (domestic concentrate), benchmark prices and
Clarksonspot freight rates (Australia and Brazil).
(11) IISI Media Release, November 2007
(12) CRU Steelmaking raw materials Monitor, November 2007
(13) LME data downloaded from Ecowin database, November 2007
(14) CRU The Long Term Outlook for Aluminium, 2007 Edition
(15) LME data downloaded from Ecowin database, November 2007
(16) CRU Copper Quarterly, October 2007
About Rio Tinto
Rio Tinto is a leading international mining group headquartered in the UK,
combining Rio Tinto plc, a London listed company, and Rio Tinto Limited, which
is listed on the Australian Securities Exchange.
Rio Tinto's business is finding, mining, and processing mineral resources.
Major products are aluminium, copper, diamonds, energy (coal and uranium),
gold, industrial minerals (borax, titanium dioxide, salt, talc) and iron ore.
Activities span the world but are strongly represented in Australia and North
America with significant businesses in South America, Asia, Europe and
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