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DecisionNext Blog

To cut or not to cut?

Published by Bill Hart November 11, 2015

For some time, a debate has been raging in the mining industry about a fundamental question of business strategy. Some players, such as Ivan Glasenberg of Glencore and Andrew Forrest of Fortescue, advocate cutbacks in oversupplied markets to attempt restore prices.  These players see that a balanced (or short) market is a goal.  Others, such as BHP Billiton and Rio Tinto managers, argue that if the low cost players do not supply additional tonnes, others will and the price will be unchanged.

So which side is right?   The question at the heart of the debate is whether mining companies can influence prices for their products. One side sees price as an externality in which their actions have little influence and the other side believes production decisions can actively shape price.

For those that see price is an externality, there is only one strategy for falling prices: to cut costs, often by increasing volume. Attaining  cost leadership is the only way to realise competitive advantage and holding ‘low cost ‘Tier 1’ assets is the only acceptable portfolio choice.   By extension, these players are unconcerned with the actions of other players in the market.   For example, when a senior BHP Billiton executive played down the impact of production cuts by miners, arguing that commodity prices will not be affected because most of the mines being shutdown are unprofitable (Australian Financial Review 15 October 2015). His argument was that shutting high-cost marginal operations has no impact on underlying prices for these minerals.

The other camp in this debate maintain that oversupplied markets result in lower prices.  Further if there is sufficient expansion of supply by the lower cost players, the overall industry structure can be affected.  If high-cost producers are eliminated, the cost curve will flatten and prices will inevitably fall to structurally lower levels.  The goal of these players is carefully to match expansions to demand, aiming to keep markets close to balance.  For these players, a mining company’s strategy has to focus on market outcomes and encompass much more than cost cutting and productivity initiatives.

What does economics tell us?  The academic literature is unequivocal that it is the high-cost producers that determine the price, for example:  “The marginal producer is the one who is just barely induced to remain in operation by the existing state of affairs and who is so situated with respect to volume of output that his dropping out will exert sufficient pressure on the array of price influencing forces, through the supply side of the market, as to bring about a recognizable change in product price.” (Dr. W. A. Paton at the University of Michigan).

What do commodity markets themselves indicate?  It is undeniable that miners are more than price takers. A good example was the switch in 2010 from annual benchmark pricing for iron ore to a relatively transparent spot price market.  Ironically, it was BHP Billiton that orchestrated this controversial change in the pricing basis. In the preceding years an enormous gap had arisen between benchmark prices and the spot market. Many exploited the arbitrage between the two prices while miners looked on helplessly. BHP Billiton’s push for change allowed the miners to secure the producer surplus during the period of tight demand in 2010-2014, which in turn assisted in generating rivers of cashflow for established iron ore producers.  It is extremely unlikely that the traditional annual pricing system would ever have resulted in prices this high.

Many mining executives argue that if they don’t expand and produce the additional tonnes, somebody else will. But if the additional production drives out a higher cost supplier, the net result will be lower prices on every tonnne sold that will offset any revenue increase at the expense of the displaced producer. A relentless focus on increasing tonnes in oversupplied minerals markets is like the proverbial rat race – an endless pointless pursuit which is ultimately futile.

The mining industry’s current focus is purely cost driven, using capital, expansion and innovation to further reduce costs.  But without an understanding of markets, shareholder returns will suffer. A more lucrative innovation would be to explore markets to better understand what drives prices.

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