Higher commodity prices are masking a mining cost crisis – creating a warning for investors

What high commodity prices are giving to mining stocks, rising costs are starting to take away, a trend which comes with an investor wealth warning.

Geopacific Resources (ASX: GPR) is a perfect example of what can happen at the small end of the mining market when costs overpower what looks to be a promising gold project.

For much of last year, Geopacific appeared to be making solid progress building its Woodlark gold mine in Papua New Guinea, until rising costs associated with bad weather, COVID-19, and a poor design of several aspects of the mine, first forced a slowdown and then a complete halt.

The company’s shares dropped by 40% from $0.32 to $0.19 in mid-November, before creeping back to $0.21 in mid-December when management requested a trading halt to provide breathing space while a detailed examination was made of costs, construction issues and funding.

Last week, with trading in Geopacific still suspended, the situation took a turn for the worse with all work stopped, staff made redundant, and talks initiated with financiers as part of a major review.

Clues to the crisis at Geopacific can be found by re-examining reports leading up to last week’s formal freeze, including a warning in the September quarter report (filed on 29 October) that early site work was being delayed by wet weather on Woodlark Island located off the east coast of the PNG mainland.

But that hint was buried in a generally upbeat announcement and was superseded just two weeks later with a development update which triggered the share price fall.

Cost blow outs could take centre stage in coming weeks

Geopacific is not alone in feeling the effects of cost increases in most aspects of the mining industry with COVID-caused labour shortages, delays in the delivery of essential supplies and capital equipment and a sharp increase in fuel prices thanks to a 50% rise in the price of oil over the last 12-months.

The next few weeks could see the cost question take centre stage for all mining companies as reporting season rolls around with a flood of half year and full year results certain to contain management comments on cost inflation.

Every company will try to manage the cost challenge in its own way with an increase in merger and acquisition activity a likely development.

An early example of WA cost crisis

Bardoc Gold (ASX: BDC) was an early example of the cost crisis in WA, one of Australia’s premier mining regions, where closed borders and an acute shortage of skilled labour has created a hothouse economic environment which is bruising all industries.

Like Geopacific, Bardoc was confident of being able to develop its namesake mine near Kalgoorlie, until late September when costs killed that plan.

In March last year, the pre-production capital cost of the Bardoc mine was estimated, in a definitive feasibility study, to be $177 million.

Six months later, after a strategic review, the pre-production capital cost had blown out by 31% to $232 million.

Bardoc said the review had been undertaken: “in light of the rapidly escalating cost environment due to rising materials and input costs, the tightening WA labour market and other COVID-19 related supply challenges”.

Rather than try to push ahead on its own with an increasingly costly mine, Bardoc welcomed a share-swap takeover offer from rival goldminer St Barbara (ASX: SBM), which will develop the mine but haul the ore to its Leonora processing plant – posing a major cost saving.

Situation to worsen

What hit Bardoc’s costs last year will be worse in WA this year following the flood-forced closure of the Trans Australia rail line, which has limited the flow of goods and services (even Perth supermarkets are running close to empty) and the first signs of significant COVID infection in the WA community.

Before Geopacific and Bardoc, the mining industry was served a timely warning by iron ore miner Fortescue Metals Group (ASX: FMG), which was forced to make major changes to its Iron Bridge project after a 30% cost blow out and construction delay. This has added the best part of $1 billion to the final cost of the development.

The next few months could see WA’s cost problems come to a head because, until now, Covid has not been a major issue with mining companies managing the occasional interruption and slow changeover of shifts.

But with the WA border being prised open the number of COVID cases is rising rapidly and even with the isolation requirement reduced to one week (and perhaps less for essential workers) it is likely the mine efficiency will take a hit, and costs will rise further.

Labour shortages

Another look at the challenge of cost increase in the mining industry should come next week when BHP (ASX: BHP) releases its half year profit statement (15 February), followed by Rio Tinto (ASX: RIO) with its full year report on 23 February.

Both mining giants have previously warned that labour shortages are affecting the operations of their big WA iron ore business units and even when border restrictions ease, they are planning for continued problems with workforce absenteeism caused by COVID isolation requirements.

Mineral Resources (ASX: MIN), a second-tier iron ore producer, this week provided a fresh look at the challenge of labour shortages in WA and the discounting of low-grade iron ore by Chinese steel mills.

It was that combination which played a leading role in the company dropping its dividend for the half-year to 31 December after a $500 million profit plunge from $520 million in the opening half of last financial year to a lowly $20 million in the latest half.

There is now abundant evidence that Australian mining is facing a cost crisis which is being masked by high commodity prices.

If the high prices remain, which is highly unlikely over the long run, the problem might be manageable.

But when commodity prices retreat from near record levels, today’s higher costs will almost certainly remain and might continue to rise in tune with higher rates of inflation, leading to an unpleasant pincer squeeze on profits as sliding revenues bump into rising costs.

Investing in mining today ought to come with a wealth warning as costs bite.