Only sober realism can save platinum industry

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The recent announcement that Anglo American Platinum (Amplats) is to close and mothball shafts seems to have caught some role-players unawares. But it has been obvious for some time that the platinum industry is in serious financial trouble.

The high profits of yesteryear have vanished and large parts of the industry are operating at unsustainable losses.

When a company makes continual losses, it must fund these by borrowing or by persuading its shareholders to put up new capital. If lenders or shareholders are not convinced that a return to profitability can be achieved, funding will not be forthcoming and the company will be forced to close. Companies in the loss-posting platinum sector have been wrestling with these challenges for some time. To continue production, Lonmin was forced to ask its shareholders last year to double the capital they had invested in the company. Amplats warned it was reviewing its operations.

The immediate cause of their financial woes was the dramatic fall of the platinum price in the middle of last year. The economic recession in Europe saw car sales collapse, which meant weaker demand for the platinum used in autocatalysts. The price strengthened to $1,600/oz since then but remains far below the $2,000/oz reached in the first half of 2008.

However, even at its recent lows, the platinum price was much higher than a decade ago, when the norm was about $500/oz. Thus, an industry that was previously profitable at $500/oz is now not profitable at $1,500/oz. This reflects deep structural problems. Widespread strikes last year simply added to existing pressures. What has gone wrong?

The problem lies with production costs, which rose much faster over the past decade than the platinum price. This rise in costs is the accumulation of several factors. Possibly the most important is geological. Ageing mines and higher production requirements meant mining the UG2 ore body instead of the more accessible Merensky reef. This had cost implications that were underestimated.

At the same time, the industry embarked on aggressive expansion to meet anticipated rising global demand for platinum group metals. The need to preserve mineral rights under the new "use it or lose it" principle in SA’s mining legislation was an additional factor. So higher-cost mines were brought into production. This reduced profitability and required producers to fund large additional capital investment.

Mining is a highly energy-intensive industry and rapidly rising electricity costs also cut into profit margins. South African electricity consumers are being forced to fund from revenue the capital costs of Eskom’s capacity expansion. The damaging effect of this punitive tariff structure is now becoming apparent right across the economy.

Growth targets doubled employment in the platinum industry from 90,000 to 195,000 workers between 1998 and 2011. As a result, total mining employment in South Africa rose to more than 500,000 people, despite the loss of 118,000 jobs in gold mining in this period. But higher employment numbers were not matched by equivalent increases in production. Production rose just 46%, so platinum output per employee fell by one-third.

Higher employment was accompanied by wage settlements higher than inflation. Thus, the total wage bill rose fourfold in real terms from 1998 to 2011.

Finally, production has been severely disrupted by temporary shaft closures by government regulators in response to mine deaths, as well as by illegal strike action. Nor is there any way to catch up lost production by working extra shifts — mines already operate around the clock. And, as a large proportion of costs are fixed, the effect of lost production on cost per ounce produced has been considerable.

The cumulative result of this means the industry is no longer profitable at current prices. Ironically, strike-related production losses in SA have kept the platinum price buoyant. This short-term relief will disappear when production returns to normal and there is a risk that investors in physical platinum may sell their stocks, adding to excess supply. About 40% of global platinum demand is from autocatalysts and 30% from jewellery. Sluggish global economic growth will restrain demand for some time yet. Thus, it is unlikely that prices will rise sufficiently to rescue the industry in the immediate future.

To restore profitability at current prices, costs must be reduced. Platinum is South Africa’s largest export earner, so it is vital that robust business models are put in place to ensure production is sustained at profitable levels. Some high-cost production and jobs will have to be shed to protect overall output and employment. It is a time for sober realism on all sides. The costs of getting things wrong will be enormous.

• Gavin Keeton is with the economics department at Rhodes University. This article was published Business Day Live.