The vulnerability of the mining industry and private companies to economic and market volatility, both locally and globally, has become a central concern for decision makers and contributors to the South African economy. The exposure to price and market volatility based on global instability is a reality that all buyers and sellers in the mining industry must consider.
The volatility of world commodity prices is transferred to local commodity prices; this makes planning and decision making difficult. Global commodity prices rebounded from their depressed levels during the second half of 2009 following improved liquidity and confidence in financial markets.
SEIFSA's index of Cold Rolled steel showed an increase of 80.62% in September 2008 (year-on-year) for local merchants, while the decrease in early 2009 were reaching 36.77% (year-on-year) . Brent Crude prices boomed to an 80.49% increase in June 2008 (year-on year), followed by a decrease of 50.84% in December 2008 (year-on-year). These extreme volatilities imply that all steel companies, like their
customers, must now focus on reducing working capital, cost and input cost savings (containment), and efficiency improvements.
With Labour, Steel, Electricity, Transport, oils and fuels as some of the largest components driving input costs in the mining industry, it is important to keep these costs in check. Although there is very little scope for commercial savings relevant to the input costs such as electricity, which is a regulated price, technical savings still poses some opportunity. At the same time commercial savings on the other large input costs, such as steel, labour and transport are open for opportunity, if the necessary tools, processes and escalation processes are in place.
It is important for any decision maker to make use of an index process or methodology, which gives an independent price and cost benchmark and accurately reflect price changes; also to justify contract price changes. The use of price and cost indices will assist any organisation in tracking changes in inflation and assist in containing costs.
The use of cost and price indices, simplifies the price adjustment processes which benefit both a supplier and purchaser of a good or service. At the same time it provides an independent (because these indices are published by independent institutions such as Stats SA, SEIFSA or ETSA) benchmark to adjust prices, up or down. The purpose of these price adjustments at the hand of an index (or indices) is to compensate a supplier or provider for market changes or movements beyond his or her control. Poor decision making and planning on the side of the supplier, e.g., adverse exchange rate hedging or the lack thereof, should not be used to amplify a price increase, and at the same time is also not reflected by the indices.
Because business is conducted in a high economic and market volatility environment, the distinction between volatile and non-volatile cost components are important. Highly volatile cost components such as steel, oil, fuel and copper pose huge challenges to any commodity manager. The frequency of price adjustments may need to be adjusted, as a supplier of these highly volatile components may need to be compensated more regularly as some of these prices (see graph above) may escalate (or drop) very rapidly. The opposite is true for non-volatile cost components, such as labour and overheads.
At the time of the decision of the volatile and non-volatile cost items as well as the applicable indices, the argument often arises about a fixed portion in the negotiations or contract, should it be included or not? A fixed portion (as oppose to fixed costs) normally refers to the portion or percentage of total costs which are not adjusted over the life span of the contract. This has specific benefits for the buyer of a good or service, should the execution of the contract happen in an inflationary environment. The opposite is true when deflation is present. At the same time the disadvantage for the seller in an inflationary environment is that the escalation which he or she is entitled to is smaller, with the percentage (%) of the fixed portion.
Some suggestions to commodity managers, buyers and suppliers of goods and services need to be noted. One of these suggestions is to determine the volatility of the good or service and the frequency of price adjustment before a contract is concluded. Make sure that the escalation clause in the contract contains detail of either a cost adjustment formula, or detailed indices which will guide the price adjustment process during the duration of the contract. Consult an index expert to select the best index for each of the cost components, both volatile and non-volatile. In this way the interests of both the buyer and supplier are protected.
Louis Otto,
Chief Economist, Economic Trend South Africa,
+27 82 327 4300
Louis.otto@economictrendsa.co.za
China remains hungry for commodities and export growth
Resources and commodities ride a dollar price carousel
Inflation in the mining industry and the use of price and cost indices