Diamond Buyers Club

Mining and metal companies are rediscovering the downside of rallying prices: higher costs.

A sharp rebound in commodity markets in the past two years put producers in a profitability sweet spot after years of cost-cutting to cope with low prices. Now, as the upturn matures and the higher cost of energy and other materials starts to bite, some companies are beginning to struggle to maintain margins.

As the quarterly earnings season unfolds, companies from Alcoa Corp. to AK Steel Holding Corp. have seen their shares slump amid signs that cost creep is eating into profit. Machinery giant Caterpillar Inc. said it expects higher material costs to mostly offset price increases for its products. Freeport-McMoRan Inc. also flagged the effect of oil’s surge in its earnings call.

Unit costs for miners probably will rise 5 percent to 10 percent this year, with energy and currency looming as the biggest immediate pressures and wage inflation more likely toward year-end, according to Roger Bell, director of mining research at Hannam & Partners LLP. Costs may also rise as producers go after more “marginal tons” by mining trickier areas, he said.

“It’s going to be a theme that reemerges in 2018,” Bell said by telephone. “It always does when the commodity prices improve.”

Not all producers are exposed in the same way, with metal processors that buy most of their ingredients facing the larger brunt of higher raw-material costs.

Members of the Bloomberg World Mining Index have seen a sharp recovery in profitability as metal prices rebounded. The average gross margin has recovered to 27 percent from 16 percent two years ago, and is expected to reach 34 percent in 12 months’ time, according to analysts tracked by Bloomberg. Margins at steelmakers and iron-ore miners have also expanded but probably will plateau over the next year, the estimates show.

Delayed Effect

Alcoa mines the bauxite that it uses to make alumina and in turn aluminum, shielding it somewhat from cost creep. Still, as Chief Executive Officer Roy Harvey noted in an interview last month: “There’s not a lot of backwards integration opportunities when you produce your own raw materials.”

There’s also a delayed effect of higher input costs. Caustic soda, for example, takes six months to flow through to the balance sheet, Harvey said.

Fuel costs can account for 25 percent to 30 percent of costs for some miners and are largely beyond their control, Bell said. In the case of Cleveland-Cliffs Inc., energy was cited as one of the key culprits for an 11 percent jump in the cash cost of goods sold and operating expense rate in U.S. iron ore.

Better Placed

For U.S. Steel Corp., the higher cost of coal, iron ore, scrap, gas, electricity, other metals and electrodes are offsetting some of the steel price gains.

“Not one of those in itself is significant, but we add them up, it makes an impact on the...

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