Commodities boom comes with a cost

By Bina Brown
For CNN

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(CNN) -- Financial markets provide a perfect example of where people think commodity prices are going in the future.

But for an investor interested in resources stocks, it also pays to consider where a company's costs are headed.

The current commodity price boom looks like it could continue for a while yet. Even so, some resource sector enthusiasts are questioning the rationale behind the forward calculations applied to resource companies globally.

The massive $10 billion full year profit result delivered this month by Anglo-Australian resources giant BHP Billiton highlights the possible mismatch between record commodity prices and future costs.

The company's record profit represents the reward for historic investment and acquisition of world class projects capable of passing return thresholds in less buoyant times.

The outlook provided by BHP Billiton is that "commodity markets remain strong, underpinned by supply restrictions and a generally constructive global economy ... there are no signs of an imminent retreat in bulk commodity prices ... we are likely to see an extended period of high cyclical prices."

Given these circumstances, is it difficult to forecast anything but good times ahead for global resource companies?

While sustained demand from countries including China, India and Japan is underpinning commodity prices, there is the question of costs to consider.

How can the market be expected to provide a long term valuation of a company based on today's profit and tomorrow's prices without an accurate measure of tomorrow's costs?

Even the most basic business accounting calculates "profit" as the excess of revenue over costs.

Cost estimates

Could it be that the market is simply unable to estimate the cost side of the equation, so it is applying long term pricing rather than spot prices to the sales/revenue side?

In the new world of global financial markets, anyone can reference the price of copper, nickel, and crude oil by surfing the web and viewing the live 3-month forward price -- and in some cases 10-year forward prices -- on world exchanges such as the London Metal Exchange, the New York and Chicago Mercantile Exchanges and futures exchanges in Japan, Hong Kong, Sydney, Sydney and Shanghai.

But with the possible exception of some tradable freight futures, no meaningful markets exist for the estimation of costs.

Consultants and analysts can attempt to estimate the impact of rises in wages, steel, and diesel fuel to the construction and subsequent operation of a new mine. But really, an estimate is the best they can do.

The myriad commodities produced by BHP and it global resource peers are consumed in the production and delivery of its products. So cost pressures are present and the market is well aware that costs are rising -- but by how much?

The costing process is similar to a home renovation. The long awaited new kitchen can be meticulously planned, materials and construction method selected and a final quotation delivered in writing from the builder.

But the final product may be delivered late and over budget due to a change in the price or timing of the very small quantities of materials and labor required to complete the project.

It is not uncommon for a world class resource asset to be 10 years in planning and commissioning before the first cashflows are realized.

It comes as no surprise, then, that given the current demand for materials, skilled labor, and expertise, accurately estimating both the capital costs and operating costs of a mining project a decade in advance is pushing the limits of even the wiliest share market investor.

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