Tuesday, September 23, 2008

Commodity Pricing

In 2002, the average price for nickel was around $3 a pound. Shortly thereafter, the market took off. The price for nickel reached a peak of over $23 a pound in 2007, and has since fallen off. Today, its price is something short of $10 a pound. Still, the $10 a pound today is far above the $3 a pound of six years ago.

Despite prices that look very high in the light of history, nickel production facilities are closing in several parts of the world. What explains a market that could sustain a production facility at $3 a pound but cannot sustain that same facility at $10 a pound?

The answer lies in the way prices work. The price of any product is the cash cost of the next unit of production. This is true in any market but is most easy to observe in a commodity market. In a falling price environment, the cash cost of the next unit of production is approximated by the cash cost of the last production that closed. In a rising price market, the commodity price is the cash cost of the next unit brought into production. Now let’s see how this rule works.

After 2002, as demand for and the price of nickel began to accelerate, new production came on line. Some of these new mines can produce cash at prices as low as $5 in today’s market. The high prices discouraged some demand. Customers, where possible, turned to substitute products, which dampened the growth in demand somewhat. The result is that there may be as much as 90,000 metric tons of excess capacity in the marketplace, about 5% of current demand. Hence, the drastic fall of prices since 2007.

But, even at today’s $10 a pound, nickel operations are closing, which tells us that the cash costs of those operations must be above $10. How could that be when they could produce cash in 2002 with a $3 price?

The culprit here is costs. The mining industry is energy-intensive in a market where energy prices have soared dramatically. The industry uses a great deal of steel and sulfur in its production. The rising costs of these commodities have increased the cash costs of nickel production. Very few operations could continue operating at 2002’s price of $3. Most throw off cash at a price of $10 or more per pound. If the commodity costs of sulfur, steel and energy decline, so too will the price of nickel.

In summary, over the last six years, demand increased and prices rose to meet that demand. This caused customers to reduce their demands somewhat and competitors to bring on new capacity, some with relatively low cash operating costs compared to older operations. At the same time, the cash costs of operating a production facility increased dramatically because of the rising costs of other commodities used in the production of nickel. (See the Perspectives, “Must the Cycle Start Again?” and “Who Has Pricing Power?” on StrategyStreet.com.) The net result is a 2008 nickel industry that is more efficient than that of 2002 but with higher costs of the commodities required for production. So 2002’s $3 per pound price has risen to $10 per pound. However, if the prices of the commodities the industry uses were to fall to 2002’s levels, the price of nickel would likely fall below $3 per pound.

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