Friday, January 17, 2014 10:49 AM ET

Comparing mining costs with Fredy Ponce, Part II

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By Tiffany Grabski Neighboring Latin American mining countries Peru and Chile share many common traits when it comes to geology, but a series of other factors have led these two countries to develop two very distinct mining districts. Sharing the Andean copper belt, home to many of the countries' biggest mines and supplying a significant portion of world copper production, together these two countries attracted 11% of the worldwide exploration budget for miners in 2013, according to SNL Metals & Mining research. However, a steady drop in metal prices combined with a steep spike in costs is making miners much more selective, inflating the competition for mining sector income between these two countries. At the same time, miners already operating within these regions and sectorwide will be forced to apply new strategies to reduce costs, or risk falling profit and a depletion of their margins which also means a drop in income for the countries where they are located. In a continuation of SNL Financial's interview with Fredy Ponce on mining cost strategy, what follows is an edited version of the second part of an interview in which mining cost expert Ponce expands the Peru vs. Chile debate by comparing costs in the two regions.
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In-depth, insightful interviews with movers and shakers in SNL's sectors, including executives, analysts, investors, academics and authors.

SNL Financial: We hear a lot about increased costs in Chile due to recent spikes in energy and labor costs, but what about Peru? What costs associated with the mining sector have seen the greatest increase in recent years in Peru? Fredy Ponce: In the past five years, the greatest cost of mining operations has been linked to labor costs, an increased supply costs and the appreciation of the Peruvian sol compared to the [U.S.] dollar. Labor costs have increased due to a greater demand from the operators, as a result of the development of new mining projects on a national level, causing the salaries of mining personal working in Peru to register an increase of more than 15% per year. This is then further complicated by the lack of qualified technicians, generating a rapid movement from one company to another in a "war for talent" that mining companies and construction firms are currently facing. The lack of sufficient talent in the sector has obliged mining companies to invest more in operation costs.

Secondly, mine supplies such as copper sulfate, lime, fuel, tires and ammonium nitrate used for the fabrication of explosives have also seen significant price increases. And finally, the variations in the exchange rate have also become an element of profit reduction for mining companies in Peru. The fall of the American dollar affects miners due to 40% of the operational costs being expressed in local currency. In the last two years, this has produced a negative effect in the total cost for mining companies because of a nearly 3.5% drop in the dollar compared to the Peruvian sol. What costs associated with mining operations in Peru continue to be particularly competitive in comparison to Chile or other countries in the region? In the context of lower commodity prices and an increase in production costs, such as we are experiencing at present, mining projects in Peru are at an advantage due to the fact that the energy costs and labor costs in Peru continue to be very competitive, unlike many other countries. With a worldwide average of US$121 per megawatt hour for electricity, Chile has the second-highest electricity costs of the mining countries worldwide, only surpassed by Congo at US$141 per megawatt hour, and 83% higher than the average in Peru of US$66 per megawatt hour. For BHP Billiton, energy represents approximately 20% of its costs in Chile, for example 3x [the amount] it costs the company at its mines in Peru and the United States. Equally so, the workforce in Peru is multi-functional and has qualified miners. In Chile, a mine will pay 188% more than the average cost for mine workers worldwide. Are there any other countries in Latin America that may be more competitive when it comes to mining costs than Peru? The business of mining is that of costs rather than prices. In other words, competition in mining is based on costs. Cash costs used to compare the cost of production for copper have increased from 2006 at an average of 10 U.S. cents per pound each year [through to 2012]. It has been this way in almost all of the copper producing countries except for Indonesia. For example, Kazakhstan has had the greatest increase in costs, of around 73% [from 2006 to 2012], followed by Peru at 72%, the U.S. at 58%, and Chile [at] 56%. Despite the increased cost to produce copper, however, Peru continues to be the most competitive country in the region in terms of cost, seeing as the cash cost for one pound of copper produced in Peru has climbed to 87 U.S. cents, which is nearly 42% lower than the world average of US$1.49 per pound. In other words, Peru maintains a relative advantage of lower production costs, which allows it to confront in a better way the current drop in metal prices. Currently, about 90% of Peru's copper projects are in the first or second quartile in terms of costs, making them very attractive investments. The world's top copper producers at the moment Chile and China both have higher costs than Peru. China had an average cash cost in 2012 of US$1.18 per pound and, according to Codelco data, Chilean mines have fallen 17 places in the world ranking of copper cash costs. In 2000, Chile held fifth place in the ranking, with a cash cost of 46 U.S. cents per pound, and in 2012 it was down to 22nd place with a cash cost of US$1.59 per pound. How would you break down the main differences between mining costs in Peru and those in Chile? There are two main factors used to analyze cost competition in the mining industry between Chile and Peru: energy and labor. Chile has been hit hard due to the rise in energy costs it has been experiencing, which have reached record levels. Energy costs represent 22% of mining costs in Chile, where miners are paying on average US$121 per megawatt hour. If you compare this to Peru, the energy here is 83% less costly than in Chile, and represents only 5%

of the total operational cost, which has attracted the interest of various mining companies now analyzing projects here. On the other hand is the productivity and the cost of labor. They both were factors that used to be key advantages in Chile. A lack of workers has increased the cost of salaries, as well as bonuses and new benefits obtained through collective negotiations, and caused miners in Chile to fork out more cash in order to retain their workers. From 2001 to 2009 there was an 82% increase in the cost of human capital in Chile, but only a 36% increase in productivity, according to the national mining society SONAMI. This situation has obliged Chile to invest more in professional training on a large scale, technology, resource management, all aiming to increase efficiency. Are there any disadvantages linked to costs in Peru when compared to Chile? Peru advertises all the time that its greatest strength is energy, Chile's greatest weakness. But there are also factors that add to costs in Peru such as the social conflict that can add to costs via time and resources spent on attending to political, community and NGO complaints. Another aspect that is disadvantageous to Peru is the mine logistics chain, where the main issue is transportation because moving goods in Peru is much more costly than in Chile. This becomes more complicated due to a lack of infrastructure, just as much for moving equipment from the port as it is for removing minerals from the site. In comparison, Chile's mines have a spectacular system of infrastructure for both land and sea transport. That all said, it will not be easy for Chile to remain competitive in a scenario where copper grades fall below the current average of 0.85% to 0.67% copper. You mentioned social conflict as a concern for costs in Peru. Is the main cost associated with that the delays that result or the social funds that are being created to prevent conflict? Without a doubt social conflict in Peru is the main cause for delays in the execution of mining projects. According to a study by McKinsey & Co., 42% of the mining project portfolio, which is currently more than US$53 billion, has some type of delay greater than one year due to social problems. In Peru, there are US$18 billion in paralyzed projects, waiting to be executed, with their environmental impact studies approved, and two-thirds have suffered delays due to social conflict. If they do not execute these projects, the country is going to have negative effects, which will play a role in its ability to grow and would fail to see between 300,000 direct and 700,000 indirect jobs created. Adding to that, a risk analysis completed by Gold Fields Ltd. determined that an increase in social tensions and the potential for social movements together with a greater scrutiny from regulators and greater environmental requirements are the main risk factors in Peru the same factors that saw the delay of 20 projects worth US$25 billion between 2012 and 2015. In order to avoid these delays, miner contributions to communities have definitely been increasing. The miner Southern Copper Corp. offered in 2013 100 million [Peruvian] soles as a voluntary contribution to the Arequipa district Cocachacra, Islay province, for the approval of the Tia Maria project social license. With this contribution, they could complete different projects in the district such as water and drainage projects and others that the population has considered. The Canadian company Bear Creek Mining Corp. obtained in 2013 the social license for its Corani project in Puno, having come to an agreement with five communities close to the mine that together come to 800 people. Within the agreements, Bear Creek agreed to a total of US$36.8 million, US$1.6 million annually for 23 years, to finance projects of social character to benefit the local population.

According to the Peruvian ombudsman, at the end of the year there were 223 social conflicts, representing the delay of projects in the order of US$25 billion. About 70% of the conflicts are found in areas of precarious infrastructure, electricity and telecommunication.
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