Posted by Alana Wilson on 5/28/2013 2:01:53 PM
By John L. Dobra i
We all know about defensive driving. But, there is also defensive mining and
I’m not talking about avoiding workplace accidents, environmental damage, public
relations problems, etc., although those are all important issues to be defensive
about. All over the world, mining is done by a social contract between miners,
workers, and communities. But it is also done in the face of an inevitable and
reoccurring market cycle that creates risk and a need to mine defensively.
The conventional wisdom holds that mining, and particularly precious metals
mining, is an enormously profitable business, and it is true that some mines are
profitable and some are even very profitable. However, what about in general and
in the long run?
For the most part, mining is a highly competitive and risky industry with market
structures characterized by having many sellers of most commodities, many buyers,
no significant entry barriers, and miners sell homogenous products. The first two
characteristics – many buyers and sellers – imply that buyers and sellers have little
pricing power, that is, they are price takers. While entry barriers are greater today
than they have been in the past because of regulatory factors like permitting
processes, bonding for reclamation, etc., it is still possible to open mines in most
political jurisdictions. And finally, product homogeneity means that no copper, gold,
silver, iron, etc., miner can claim that their copper, gold, etc. is better than anyone
else’s so that they can raise their price.
The implications of this kind of market structure for industry profitability is that
in the short run miners can make profits or suffer losses, and in the long run their
profits will be approximately zero. To understand, consider the reoccurring market
cycle illustrated by the graph below.
The typical pattern is that some outside factor like an increase in demand for
some commodity will drive up its price. For example, in the late 1970’s inflation
drove up the price of precious metals. This led to an increase in investment in gold
mines in the early 1980’s, and then an increase in production in the late 1980’s.
This increase in production coupled with European central bank selling in the 1990’s
sent prices downward. Mines were closed, merger and acquisition activity in the
industry increased and production leveled off and investment declined. Then, in the
early 2000’s, with low prices, central banks halted their sales programs reducing
supply, and the cycle started again. Since about 2002, gold prices have risen
dramatically, investment in exploration and mine development have increased, and
prices have started falling.
From 1989 to 2006 the correlation between gold prices and the profitability of
major North American gold miners has been 0.05 which means that there is
essentially no correlation in the long run. In other words, gold miners at least, have
been chasing the cycle like a dog chasing its tail. When prices go up, they invest
their increased revenues in expansion and lower their cut – off grades (i.e., process
lower grade ores) which raises their costs. When prices fall, they cut back on
investment and process higher grade ores to lower their costs. The result is that in
the long run the spread between prices and costs stays about the same.
There is a story familiar to most economists (which, sadly, passes for
economist humor) that a student once asked Milton Friedman if he would pick up a
$20 bill if it were lying on the sidewalk? He is reported to have answered “No,
because in long run equilibrium it wouldn’t be there” – just like miners’ long run
iDirector, Natural Resouce Industry Institute and
Associate Professor of Economics
University of Nevada
Senior Fellow, Fraser Institute
Reno, NV 89557