A white paper released by the company, titled Price and Currency Volatility: Mining & Metals, predicts that unprecedented price volatility will be a huge test for mining and metals companies as they seek to manage the instability.
Up until now, demand for most commodities has outstripped supply for part of the decade, leading to buy-out prices and encouraging new supply.
With supply and demand now approaching equilibrium, Ernst & Young said longer lead times in changing supply were leading to over and under corrections in supply, causing increased price volatility.
Highlighting the recent price instability, Ernst & Young cited a December 2012 report on the results of large diversified mining companies in which mineral price movements accounted for 79% of the $US25.6 billion ($A26.3 billion) fall in the period-on-period earnings.
Ernst & Young global mining and metals leader Mike Elliot said companies would now be focused on reacting to the downside risk of price and currency volatility through to 2014.
“The knee-jerk reaction is to begin hedging again,” Elliot said. “However, for most, the opportunity to establish an effective hedge has passed and those that are enticed to enter into significant hedging may create problems for themselves during the next upswing during this period of volatility.”
Ideally, the time to hedge is when metal prices are near their peak and companies must tread with caution to hedge with falling prices, Ernst & Young warned.
While the majors have the financial means to absorb downside risk, mid-tiers and juniors entering into production might not, with Ernst & Young predicting smaller producers may have to bow to pressure from potential lenders to enter new hedge contracts.
“With rising costs being a sector-wide problem we expect to see more companies using short-term hedging to lock in costs, and potentially profits, through short-term commodity price hedging,” Ernst & Young said.
Furthermore, volatile conditions would also see many miners use put options to manage short-term price risk.
Ernst & Young urged companies to look at ongoing solutions and ways to manage the risk that would deliver benefits.
“Mining companies that can build flexibility into their business to respond to short-term volatility can create a competitive advantage,” Elliot said.
Steps companies can make to respond to risk include increasing the flexibility of costs to become less fixed, being nimble with changes to cut-off grades, improve integration of mining and financial planning; increase the speed of mine planning to match volatility and prepare for a future hedging program for when prices increase.
Importantly, Ernst & Young said, communication was key.
“Companies also need to do a better job of communicating to their shareholders the changes they are making to increase flexibility and what impact that may have on future margins,” Elliot said.
“Without this, shareholders will expect the worst; that a company is unable to capture the price rises but is fully exposed to price falls.”