Mining Companies Take the Long View – by Robb M. Stewart and John W. Miller (The Wall Street Journal – December 14, 2011)

The near-term outlook isn’t great. So why are miners expanding their capacity?

There seems to be plenty for the mining industry to worry about. Prices of many commodities have tumbled in recent months. Production costs have risen sharply. The economies of two of the industry’s most important customers, China and the U.S., look like they may be heading for slower growth, maybe even recession in the U.S.

But the biggest mining companies in the world aren’t fretting. They continue to sink billions of dollars into projects to expand their output capacity.

That’s because they expect demand in the long run to be far beyond what it is now or whatever level it might reach in the next couple of years. And unlike some of their small competitors, which might have to scale back operations or even shut down if the pressures on the industry don’t ease soon, the big miners appear to have wide enough profit margins and big enough cash reserves to weather a rough stretch.

Some investors are focused on the short term, worrying that if mining companies continue to pump up supply in the face of uncertain demand, commodities prices will drop even further and company profits will collapse. Those concerns are reflected in sharply lower share prices in the sector. But others are buying selectively, in the belief that the big miners have got it right with their longer-term approach.

Cost Challenges
High costs “make bringing on new supply very challenging,” says Ian Ashby, president for iron ore at Australian mining giant BHP Billiton Ltd. “There’s a tight labor market, and bottlenecks for tires, trucks and consumables.”

The average rate of inflation for iron-ore mining equipment and machinery has been 11% per year since 2002, according to consultants McKinsey & Co. As one example of what that means, the cost of the massive tires used on some vehicles at mining sites has climbed above $70,000 per tire, mining executives say, and the tires last only about four months.

Meanwhile, the labor squeeze has driven salaries well into the six figures for workers like 26-year-old Wayne Rider. Three months ago Mr. Rider was stacking boxes in a warehouse in Perth, Australia, making 40,000 Australian dollars a year, or about US$41,000. Now he drives trucks for NRW Holdings Ltd., a mining-services company, for A$120,000 a year. Still, it isn’t work that many people want to do—at least not enough to keep wages down. And as miners continue to expand their operations, the upward pressure on salaries grows.

Some miners are experimenting with automated trucks, trains and drill rigs, or plan to do so, to help control labor costs. But those efforts are too new and small-scale at this point to have much impact or to be judged practical or not.

Energy costs, including electricity and fuel, are another major drain on miners. Higher energy prices compared with a year earlier knocked $95 million off earnings for the six months ended June 30 at U.K.-based Rio Tinto PLC, one of the world’s biggest mining companies.

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