Mining giant Anglo-American recently offered an update on the preparation of its Minas-Rio iron ore mine in Brazil for production. This is one of the group's larger, more long-term projects and, as with most mines, it is not simply a matter of turning up and starting to dig. Infrastructure has had to be put in place at the mine itself, a port built on the coast and a 300-mile pipeline constructed to link the two.
When Anglo-American originally bought the rights to the mine, it expected the cost of putting the appropriate infrastructure in place to be $3.5bn (£2.2bn) and that production would start in 2011. The company later upped this guidance to $5.8bn and is now suggesting the cost of completing the mine is unlikely to be less than $8bn – a figure above the upper end of most analysts' expectations.
Over the space of half a dozen years, in other words, the projected cost of preparing the mine for production has more than doubled while actual production has yet to begin. Cost inflation has been rampant through the whole supply chain and that is before the rising costs of mining labour and other operating costs, which we have considered in articles such as Emerging risk, are factored into the equation.
Following this latest cost guidance, there is a suspicion among a number of sector analysts and other experts that, at current iron ore prices, the overall value of the Minas-Rio project – that is, the total money expended by Anglo-American upfront set against the cash flows expected to be generated during the life of the mine – is likely to be a negative number. To state the obvious, that is a far from ideal situation.
Upfront development costs, long life times and fluctuating commodity prices mean any mining project will inevitably involve a great deal of uncertainty. However, if a business ends up building a mine with a negative lifetime value based on the current price of whatever it is mining, it must then rely on that price rising in the future to bail it out.
That people and companies are terrible at predicting the future is a point we've made a number of times before, for example in trying to forecast. However Anglo-American’s experience with Minas-Rio serves to make a broader point about the economics of the mining sector. On the face of it, an increase in the price of a commodity naturally looks to be very good news for the companies that mine it out of the ground - and on a short term view it is.
But as soon as new capacity has to be built, to replace those mines on which the bumper profits are being made, higher commodity price can act to drag up costs – whether for land development, labour, production equipment, taxes etc. All of these other parties see the rising profits being earned by the mining company and try to grab a share of them for themselves.
Even though there are plenty of examples of this happening throughout history, planners still consistently fail to take forces such as these into account, meaning projects can quickly end up costing significantly more and running substantially late – Minas-Rio will not now be producing before the second half of 2014.