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Interpreting a Mining Cost Curve 101: the Basics
The cost curve is a widely used analytical framework in mining. What does it mean? Why does it matter? How can it help you make better mining corporate finance and strategy decisions?
The full name for the cost curve used in mining is the industry cost curve (“Cost Curve”). It can be used to analyse …
- Market structure
- Market dynamics and
- Market risk.
A thorough analysis of the Cost Curve should be completed to determine ...
- Relative cost
- Competitiveness and
- Expansion incentives.
This hub is the first in a series to help you become an expert user of the Cost Curve. This hub looks at the Cost Curve basics - so that you can start to use the Cost Curve to make better mining corporate finance and strategy decisions.
FIRSTLY, THE COST CURVE IS NOT ...
There are a number of different types of (small c) cost curves in economic theory. Generally, they are used to show the cost of production at varying production levels for a company and can help management determine the production level that maximises profits. The:
- Cost of production (p) is shown on the y-axis and
- Quantity of production (q) is shown on the x-axis
The four primary types of cost curve are the:
- Short run average cost curve
- Short run marginal cost curve
- Long run average cost curve and
- Long run marginal cost curve
These cost curves can all be used for mines and or mining companies - read more about them on wikipedia. However, the cost curve referred to in mining is generally the (industry) Cost Curve, which is a little different.
COST CURVE FUNDAMENTALS
The estimated production capacity for the product, or its substitute along the x-axis on a mine or company basis. The width of the bars indicates the quantity each mine/(company) produces per annum.
The estimated cost of production per unit is shown in the height of each bar. Mines/(companies) are arranged in order from lowest cost producer on the left to highest cost producer on the right.
THE ALL IMPORTANT DEMAND LINE
Typically, Cost Curves will not show the demand line, it changes frequently along with the price. You don't need to be given it because you can plot where it should be. The demand line's horizontal extent indicates the quantity of market demand and its vertical position is equal to the price sufficient to make the next producer marginally profitable. Using these rules you can estimate the position of the demand line.
In the Cost Curve above, if we knew that the price was currently $32.50 we could estimate that demand was between 54 and 57mtpa and place the demand line on the Cost Curve as per the Cost Curve below.
In the example below the demand line indicates that:
- Current demand is equal 57Mtpa
- Current market price is $32.50t
- Four mines are producing at full capacity
- Mine five is producing at approximately half capacity and
- The three highest cost mines are dormant.
Using the two rules for estimating the position of the demand line gives you a number of analytical tools. You can estimate the:
- Price if demand changes. What happens if demand is halved?
- Profitability of each miner at different levels of demand/ pricing
- Supply and demand assumptions of any price forecasts
- Pricing risk and competitiveness of any miner on the Cost Curve
The Cost Curve can lead you to make significant errors if you don't understand the details. In the next post we will look at the assumptions behind the Cost Curve.
- INTERPRETING A MINING COST CURVE 102: ASSUMPTIONS
In 102 we are going to look at the three main assumptions behind the Cost Curve – so that you can apply it correctly and in the correct situations.
- COSTCURVE.COM.AU - MINING CORPORATE FINANCE & STRATEGY
High barriers to entry, high barriers to exit and long lead times can fix mineral supply in the short term and lead to cyclical prices. This requires that miners analyse market structure to develop capacity plans and understand ...
- AN INTERACTIVE COST CURVE DEMO
For more information on the mechanics of the cost curve, look at this interactive demo from McKinsey and Company. It provides a good demonstration of price setting and demand.