Silver mine production costs fall and producer hedging turns negative

A view from London on the latest GFMS annual survey of the world silver market undertaken for The Silver Institute in the US.

LONDON - 

In its latest annual survey of the silver market for the Silver Institute, independent analysts GFMS Ltd report that the weighted average production costs in 2006 at primary silver mines dropped to $2.74/ounce, down a hefty 51 cents or 16% from the average of $3.25/ounce in 2005. 

The decline (compare with a 17% increase in gold mining costs) is attributable to the commodities boom as the value of secondary lead, gold, copper and zinc production has risen by 32%, 36%, 83% and 137% respectively.  As a result of these high prices, costs of silver production at, for example, Greens Creek (Rio Tinto and Hecla), worked out at a negative $3.47/ounce; Morococha, however, takes the major plaudits with full year cash costs recorded at negative $3.71/ounce, a "greater than six dollar reduction year-on-year".  

Primary silver mine supply contracted by 10% in 2006 against 2005,and accounted for 25% of gross silver mine supply. In other words, the other 75% comes out of the ground as a by-product credit to copper, lead-zinc and/or gold, i.e. for nothing or at negative costs, as illustrated above.  

Furthermore the contribution to supply from industrial scrap return can arguably be regarded as price-inelastic and GFMS notes that with the exception of India last year, where there was some price-induced return during 2006, the market was far less sensitive to the price rally than it was in the gold market.  Scrap return in 2006 was essentially the same level as in 2005 (a marked increase in India, offset by declines elsewhere, notably in Europe and North America).  Similarly, net government sales are effectively price-inelastic.

What all this is leading to is the implication that, of some 912 million ounces of silver supply in 2006, just 18% is price-elastic.

Production from primary lead/zinc mines was once again the largest contributor to mine supply, accounting for 33% of total, while copper supplied 26%, primary silver, as noted above, 25% and gold, 13%.  Other mines accounted for the 3% balance.

Meanwhile the delta-adjusted global producer hedge book contracted last year, falling by 7% or 6.8 million ounces, reducing the level to 82.0 million ounces.  This is equivalent to five weeks' demand, while the reduction in the hedge book was the equivalent of less than half of one week's demand.

Output in Australia "plummeted" although this was offset by strong growth in the world's top three producers, Peru, Mexico and China, leaving global mine production at a record high of 646.1 million ounces.  Australia's problems revolved around ground stability and metallurgical problems at the country's two largest mines.  Output at BHP's Cannington mine in Queensland, which had been the world's largest producing mine in 2005, dropped by 16.2 million ounces because operations were idled at the property's southern zone during a period of rehabilitation that occupied much of the second half of the year.  Australian output overall dropped by 28% to 55.6 million ounces, meaning that Australian production last year accounted for 9% of total, against 12% in 2005. 

Peru was the world's largest producer, accounting for 17% of total, followed by Mexico (15%) and China (12%).  These three countries, plus Australia, thus accounted for 53% of global mine production last year.

The change in the hedge book comes as something of a surprise given the high price of the metal last year and the high proportion of metal that is produced as a by-product.  This is partly explained by the fact that a number of producers have been locking in prices through silver purchase agreements, rather than using the forward market, which is relatively illiquid.  High price volatility was also something of a deterrent.  Project financing was also less of a factor last year than previously.

The report describes the activity in the hedge market last year in some detail, including project financing from Bema at Kupol and Barrick's closure of the legacy hedge book from Placer, as well as defining the composition of the hedge book and outlining a number of silver purchase agreements from a group of leading silver producers.  The composition of the hedge book was little changed year-on-year, with forwards accounting for 31%, net calls and net puts respectively accounting for 35% and 34% of the total.  There is also an analysis of the price sensitivity of the delta-adjusted hedge book, outlining how the net call and net put positions change.

The study expects "robust" growth of approximately 3% in 2005 as fresh mine supply, particularly in South America and Mexico, more than offsets declining production at maturing mines, for example Eskay Creek, which is expected to close in 2008.

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