London, 18 March 2010

Resource firms are poised to be hit by a fresh bout of cost pressures just as recession lifts and demand shows signs of recovery. The downturn gave respite to mining and oil firms from costs that had skyrocketed during the last boom and partly offset the hit to profits from weak commodity prices last year, but 2010 earnings are likely to reflect creeping cost pressures. Growing mining and energy industry inflation is expected to only trim margin growth for now, not outpace buoyant oil and metals prices, but any correction in prices will result in the pinch being felt more, analysts said.

"We have seen short-term rebounding on cost pressures," Chief Executive Mark Cutifani of South Africa's AngloGold Ashanti told the Reuters Global Mining and Steel Summit last week. "My forecast is it will get tougher again."

Renewed confidence in economic recovery has spurred companies to restart mines and drill new oil wells, once again creating shortages of equipment and skilled workers.

In the oil sector, the main industry capital cost index doubled from 2004 to 2008, then fell by about 15 percent from its peak, but is now bottoming out. The IHS Cambridge Energy Research Associates, which developed the index, has said costs are poised to bounce back.

Time Bomb?

Rising costs could be a ticking time-bomb that goes unnoticed in the near-term as profits benefit from a strong rebound in resource prices since last year's downturn. Benchmark copper prices have more than doubled since their lows last year while crude oil has gained 125 percent.

"I think metals prices will rise at a greater rate than underlying cost inflation," said analyst Nick Hatch at ING. "But if we get a correction or set-back, if you argue things are running somewhat ahead of themselves, then clearly you might see some sort of impact."

Some investors are concerned that the metals market is vulnerable to a pull-back as underlying demand remains weak in the West and inventories are stubbornly high. Looking to the future, analyst Paul Galloway at Bernstein Research fears high prices may lull companies into brushing aside discipline on costs in their pursuit to expand.

"We... believe that costs will start to rise in line with commodity prices and that once again, costs will eventually be forgotten in the chase for revenues," he said in a note.

Overheating Risk

A rebound in the oil price has already led to a scramble to launch new projects, Chief Executive Christophe de Margerie of French oil major Total told a briefing recently.

"At $80/barrel, projects are really becoming attractive and there is a strong demand, especially for high tech projects... unfortunately there are not enough contractors, he said.

"There is a risk of an additional overheating." Some firms are already being forced to boost cost estimates for building new projects.

Anglo American disappointed investors several weeks ago when it increased the price of building its flagship Minas Rio iron ore project in Brazil by 40 percent to $3.8 billion. Last month, Chevron said the cost of the 100,000-barrel-per-day expansion Athabasca Oil Sands Project (AOSP), a joint venture with Royal Dutch Shell Plc, had climbed to $14.3 billion from $13.7 billion a year ago.

Oil companies had previously postponed new projects in Canada's oil sands after sharp inflation made new projects uneconomical to develop. "If you look at the overall capex profile in mining, I would think you're probably talking about a 15-20 percent increase across the industry in 2010," said Hatch at ING.

"That means there's more people chasing after the same number of contractors, workers, trucks, truck tyres and other inputs." Rates for oil rigs were hammered as demand slumped during the downturn, but Morgan Stanley said in a recent note that the slack in the market was expected to disappear by summer, which should lead to jump in rates.

Warning signals are also coming from the labour market after widespread lay-offs during the downturn lifted pressure on galloping labour costs.

"In certain parts of the world -- it's most obvious in Western Australia -- we have tight labour markets. It's increasingly difficult to get the skills that we need and we're going to see then cost pressure," Chief Executive Tom Albanese of Rio Tinto told a briefing last month. A second major headwind mining groups face is the rising cost of inputs, such as explosives used to blast away rock to access rich ore, he added.

"We're not going to stand still while these headwinds are here, we're going to continue to work on increased productivity," Albanese said. But moves by resource firms to boost efficiency may increasingly be submerged by structural cost increases.

Mining group Xstrata boasted $500 million of real cost savings in 2009, but that was fully offset by rises in general inflation and mine inflation, Bernstein's Galloway said.

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