Must-know: Why capital intensity makes a difference

Why capital intensity makes a difference

Iron ore companies’ major capital expenditure items are equipment, labor, infrastructure, consultancy, and other services and studies. Capital cost incurred to set up an iron ore unit and operating costs per ton are the two main considerations before setting up a plant.

Capital intensity

Capital intensity is a measure used to determine the efficiency of production. It’s calculated by dividing the total capital expenditure (or capex) incurred by the ton capacity of the plant. There are many factors that determine the capital intensity of a project:

• Development time – Cost escalates with the delay in setting up of a plant.
• Geographic location – This is what determines the topology of the place and infrastructure requirements.
• Quality of deposit – This includes the type of deposit, grade, and percentage of impurities present. Low grade with high impurities would require large investments for beneficiation.

Rising capex requirements

Capital expenditure requirements for the iron ore industry have been rising for the past few years, mainly because of:

• Rising labor and equipment costs – Skilled labor is in short supply. An average employee at BHP Billiton (BHP) and Rio Tinto (RIO), received an additional 211% of their salary. Equipment prices have also risen considerably for miners especially in the wake of rising commodity prices.
• Declining ore grades – Iron ore grades are falling world-over, even Vale (VALE) is mining lower-grade ore types because the grades have deteriorated significantly. Cliffs Natural Resources (CLF) is already mining magnetite deposits with low grades and incurring higher cost per ton. The previous chart also shows that normally magnetite projects have higher capital intensity. Companies have to use expensive deeper extraction technology and also ore beneficiation when ore isn’t high quality—this leads to escalation of costs. These companies form 18% of the iShares S&P Global Materials Sector Index Fund (MXI).
• Stricter environmental regulations – Obtaining licences and clearances has become quite complicated and time consuming.

In conclusion, rising capital expenditures will lead producers to pass on the cost in terms of higher prices over the long-run, while excess supply will keep the prices low. This means only players with scale and financial might are able to do capital investments to add supply to the market at reasonable capital intensity levels. As a result of the current level of prices, all the other capacity additions should cease for the time being.