(The opinions expressed here are those of the author, a columnist for Reuters.)
By Andy Home
LONDON, July 3 When Indonesia banned the export of unprocessed minerals in January of this year, the consensus view was that the most significant impact would be on the nickel and aluminium raw material markets in that order.
Copper barely warranted a mention.
Analysts at Macquarie Bank, for example, issued a research note on January 14, two days after the ban came into effect, examining the implications in a question-and-answer format. The only reference to copper came in the 19th bullet point under the telling heading: "Have copper producers been let entirely off the hook?"
Six months on, though, and one of the country's two giant copper mines is on care and maintenance and the other has cut production by half. There have been no concentrate exports since January.
Not only is this the single biggest hit to copper mine supply this year but it is acting to accelerate a fracturing of the copper concentrates pricing model.
Both Freeport McMoRan, which owns and operates the Grasberg mine, and Newmont Mining, major stakeholder in and operator of the Batu Hijau mine, appear to have been blind-sided by the January rule changes.
After all, not only are both major employers and tax-payers in Indonesia, but both also thought themselves protected by what they believed to be legally-binding contracts of work (COW) covering their operations in the country.
In theory, such COWs set in stone the level of taxes and royalties payable over the contracts' life-time.
And anyway, copper concentrates are not unprocessed minerals. As Newmont has repeatedly pointed out, around 95 percent of the value chain is captured in this form of copper. Why would anyone build a new smelter in Indonesia just to get the last five percent?
Indonesian policy-makers, though, beg to differ. There will be a steep and escalating tax on exports of copper concentrates until 2017, when they will also be banned completely.
Those legally-binding COWs, it seems, will simply have to be changed to accommodate the new regulations.
After weeks of negotiations, Newmont this week announced it would seek international arbitration.
Freeport is still talking. But then it has an even bigger problem. Its COW expires in 2021, unlike Newmont's, which runs to 2030.
That places a major question-mark over the future of the Grasberg mine, not least because Freeport has to spend heavily on switching to underground mining when the open pit is exhausted in 2017.
In the interim, neither has been exporting since the start of the year, depriving the global market of a major source of raw materials.
Freeport has reduced the milling rate at Grasberg by around half to align mine output with the intake capacity of the country's sole existing copper smelter, which Freeport partly owns.
Newmont also has an off-take agreement with the Gresik smelter but not big enough to support continued operations at Batu Hijau. Rather, it will deliver 81,000 tonnes of concentrates from stocks over the remainder of this year. The mine itself was shuttered and placed on care and maintenance in June.
Batu Hijau was scheduled to produce 110,000-125,000 tonnes of contained copper this year, meaning it will lose around 10,000 tonnes for each month of closure.
Grasberg was originally expected to produce 1.1 billion lb (just under 500,000 tonnes) of contained copper in 2014, guidance that was trimmed to 900 million pounds (just under 410,000 tonnes) at the time of Freeport's Q1 report.
Even that, though, assumed a resumption of exports in May, the company warning that any delay beyond then would mean "a deferral" of 50 million lb (22,700 tonnes) per month.
Right now, therefore, the absence of a deal on the resumption of exports is costing around 34,000 tonnes per month of lost, or "deferred" as Freeport would call it, copper production.
In times gone by this would have been a major bull driver in the copper market. But those were the days of chronic mine shortfall. Today, the supply picture looks very different as a wave of expansions and new mines comes on line to the point that just about every analyst out there thinks 2014 will be a year of substantial market surplus.
Albeit a little less substantial, given the combined hit from both Indonesian producers.
But the real significance of the loss of export flows from Indonesia goes beyond just the affected tonnage.
Both Batu Hijau and Grasberg produce "clean" copper concentrates containing a lot of gold and very little bad stuff like arsenic.
This is an increasingly important differentiator in the copper raw materials markets because a lot of the new mines coming on stream produce "dirty" concentrates.
The prime example is the Toromocho mine in Peru, owned and operated by China's Chinalco, which warned in June that not only was it downgrading its production guidance this year due to commissioning issues but that the arsenic content of some of the concentrates being produced exceeded five percent.
That's a critical threshold, since Chinese smelters can't treat such material on environmental grounds. In fact, they can't even legally import it.
This means it must be blended with cleaner concentrates, such as those from Grasberg and Batu Hijau.
The copper concentrates pricing model was already starting to fragment along these lines even before the Indonesian export halt.
The treatment charge on Toromocho material, for example, is quoted at close to $200 per tonne, compared with the $95.50 negotiated by BHP Billiton with Chinese smelters for second-half 2014 deliveries. And that's not factoring in the excess penalties smelters can charge for all the bad stuff in the concentrates.
That evolution of concentrates pricing into a two-tier model, one for "clean" and another for "dirty" concentrates, is only going to accelerate with the loss of a sizeable amount of "clean" Indonesian material.
LOSSES TODAY, LOSSES TOMORROW
Some sort of deal between Freeport and the Indonesian government, allowing for the resumption of exports from Grasberg, does look on the cards. Newmont may find it tougher, judging by some pretty pointed comments from Indonesia's new chief economics minister about its decision to go for arbitration.
But the longer-term impact is unchanged, since Indonesian policy-makers show no signs of bending on the key provision that from January 2017 what is mined must also be refined in the country.
The inference is that Asian copper smelters are going to lose permanently two major sources of concentrates supply, and "clean" supply at that, in a couple of years time.
By then, the current mine supply growth dynamic will have waned. Indeed, analysts are already pencilling in a return to copper deficit, a lagging effect of the current shareholder-led austerity in the natural resources sector.
The copper market appears to have been just as blind-sided by events in Indonesia as the two producers operating in the country.
But this is still a preview. The real impact will come in January 2017, when the total ban on copper concentrate exports kicks in. (Editing by William Hardy)