Wednesday, May 7, 2008

Electricity Shortage in South Africa To Keep Precious Metal Prices Aloft

South Africa (SA) accounts for majority of the world’s precious metal with almost 90% of platinum, 80% of manganese, 73% of chrome, 45% of vanadium and 41% of gold (source: Department of Minerals and Energy). Until 2007, SA was the world leader in gold production. Since 2007, China, with approximately 270 million ounces produced, has taken the lead. SA, with 254 million ounces, remains firmly in second place.[i]

The problem is that mining for these precious metals, as well as diamonds, requires lots of electricity. In 2007, the 1,127 mining companies used 32,421 gigawatt-hours (billion watt-hours) of electricity, or nearly 15% of all electricity produced by Eskom (see chart, below). However, the issue of insufficient supply of electricity is something that South Africa has been dealing with for sometime now.

“The government has blamed the power shortages on increased demand caused by years of economic growth and the provision of electricity to black townships that were not connected in the apartheid era. But it has also admitted it failed to heed a warning from Eskom 10 years ago that without new power stations it might not be able to meet demand by 2007.”[ii]

In January 2008, South African state-owned utility company, Eskom began systemic rolling blackouts and requesting 10% reduction in electrical consumption (or they call it, power load-shedding) to prevent a complete blackout. This had affected the mines, some of which had to shut down operations for several days, thereby putting upward pressure on the spot price of precious metals.[iii]

Potential Risk Events
1. Eskom supplies 95% of all South Africa’s electricity under a government mandated price-cap. As of 2007, the average price for kilowatt-hours was 18.06 SA cents, or $0.024 (2.4 U.S. cents). (By comparison, the average price in 2007 for kilowatt-hours in the US was 9.14 U.S. cents, or 70.5 SA cents.)

The low electric rate discourages new private investments in power generation. Therefore, the potential is high that the rolling blackouts (power load-shedding) will continue, until Eskom is able to bring additional power generations online. This will result in periodic stoppage of mine operations and intermittent spike up in the spot price of precious metals.

2. Eskom’s current reserve capacity is 8%, a decrease from 15%, previously. The combined effect of growing demand for electricity and lack of excess capacity is another factor that raises the potential for a rolling blackout. While Eskom has received the approval to build a new power generation plant in 2004, the likelihood that a new power plant will be built anytime soon is low due to the artificially low electric rates.

The SA government is in a difficult situation. The inflation rate for basic services and staples have been increasing at a high rate; at 5.2% as at 2007:
Even with the continual rate hikes, the electric rates are still too low for a private utility firm to profitably build a power plant. Conversely, the continual increases in the electric rate have put public opinion against Eskom, making it difficult for the utility to raise rates. In fact, Eskom’s latest request for a 53% rate increase was rejected. This will lead to further rolling blackouts until either demand is reduced or supply is increased.

3. Eskom had requested that industries and municipalities reduce their electricity consumption by 10%.[iv] However, this will be too little too late. As there is no reliable way to measure compliance with reducing demand, it is anyone’s guess as to whether this reduction drive is actually working.[v] The danger is that the utility is counting on the 10% savings in their supply projection. If the demand reduction targets are not met, this will lead to continuous rolling blackouts.

4. Effect of the rolling blackouts is playing havoc with the substations, causing one to explode and another to catch on fire. Given the continued stress on the supply of electricity, it is highly likely that the rolling blackouts will continue to tax the electric grid system, leading to more substations to be damaged, and further reduction in the supply of electricity.

5. Even with the continuing concerns about the reliability and sufficiency of electricity in South Africa, there is news of more energy hungry factories slated to come online, including:

  • Rio Tinto's $2.7-billion aluminum smelter, capable of producing around 720,000 tons of aluminum annually, near Port Elizabeth in the Eastern Cape.
  • In September 2006, Russian billionaire Viktor Vekselberg announced plan to invest $1 billion to build a manganese and ferroalloys plant at Coega.
  • In early in 2008, United Manganese of Kalahari announced plans to spend $200 million to develop an untapped deposit.
  • De Beers is building a new diamond mine at Voorspoed in the Free State, which is expected to start production towards the end of 2008, producing about 700,000 carats a year.
  • Tata Steel is constructing a R650 million high-carbon ferrochrome plant in Richards Bay on the KwaZulu-Natal coast.

It bears watching but the chronic electricity shortage in South Africa is highly likely to cause series of blackouts lasting several days. Since the mines require reliable supply of electricity to ensure miner’s safety and smooth operation, any prolonged disruption in the supply of electricity will adversely affect production.

For mining companies, this will result in negative impact on earning, and to their stock prices.[vi] For precious metals, this will result in periodic price spikes.

This problem will not be resolved in a year or two as the problem is endemic in the functioning of the South African government. Therefore, until South Africa has more reliable and sufficient source of electricity, do expect to hear news of rolling blackouts and disruption to mining production.

May your trades be profitable!

Ed Kim
Practical Risk Manager

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