Issue 50

Keeping the Lights On: As metal prices – and demand – rise, the focus turns to mine activity. That takes power. And that’s South Africa’s problem.

‘We are…in a position contractually of an emergency or force majeure. All pre-arranged emergency options have been used and exhausted. The system is extremely vulnerable and any unforeseen events could have consequences on a national level.’ Eskom, 25 January 2008

Excerpted from a letter sent to the company’s 138 largest industrial customers, that statement by Eskom, South Africa’s monopoly utility company, abruptly announced the country’s power crisis. And without a reliable source of power, the country’s major mines soon announced that they would be forced to temporarily shut down.

The combination of the sudden reality of force majeure, the fallout from suspended mine production and the likelihood of a multiyear power crisis swiftly led to precious metals prices heading steeply northward. While South Africa’s share of newly mined gold supply is a sizeable 10%, with close to 80% of platinum production emanating from the region, it was unsurprising that the platinum market experienced a much more intensive reaction.

Eskom had been forced to load shed – a term meaning blackout or power cut – as a result of a shortage of supply capacity. As the last in a series of measures that had been taken by Eskom to reduce demand on the electricity system and prevent a total collapse of the national supply system, the company’s letter to its customers synthesised the emergency situation facing the South African economy.

The Developing Power Vacuum

When and how did the power generation situation come to fall apart? Although the crisis seemed to come almost without warning, in reality, as early as 1997 the government had recognised that major investment in the electricity network would be required for the country not to suffer a power crisis by 2007. Unfortunately, neither the utility company nor the government invested in the network infrastructure or planned for the future. Here we are in 2008, and the scenario predicted more than 10 years ago has become a firm reality.

In examining the reasons for the crisis, cost was, as ever, one factor. South African electricity historically has been extraordinarily cheap – the gap between the electricity prices of South Africa and those in the rest of the world grew significantly over the years, and the country is now 74% cheaper than the next low-cost nation, Canada. As long as electricity was so economical, there was no incentive for either industrial or residential consumers to alter their consumption patterns, and the continuance of this situation was taken for granted. Furthermore, the inexpensive electricity ensured a lack of competition: private companies simply could not compete with Eskom prices, and so the company’s state monopoly continued.

Increasing demand was the second factor. According to Eskom’s official figures, electricity consumption grew 4.3% in 2007 compared to 2006 – not an exceptionally steep rate of increase, but it does signify how pressured the electricity network was just one year ago, and how a relatively small increase in consumption was enough to temporarily cripple the South African precious metals mining community. Moreover, peak demand consumption was greater for each week in 2007 than it was in 2006.

To a certain extent, the country has been a victim of its own success: the South African economy has grown by leaps and bounds, with GDP close to 5% since 2004. Fuelled by investment from both home and abroad, the expansion of the economy has placed additional pressure on an already stretched electricity network. The reserve capacity of the national grid, which represents the spare power available to meet all electricity needs at any point in the day, was pushed to unprecedented levels. The reserve margin – the surplus electricity that exists when demand is at peak levels – fell from a historically high level of 25% in 2002 to almost nil in 2008.

Eskom report 15% as their minimum preferred reserve margin, a level that gives them the flexibility to carry out maintenance regularly without overly stressing equipment. However, with the reserve margin now almost gone, there are fewer opportunities for essential maintenance, and power stations are being effectively overworked – a state of affairs that does not bode well for the future.

Thirdly, the present situation has also been aggravated by serious issues with both coal supply and quality (wet coal after heavy rain), which has culminated in the significant hike in unplanned outages and generator trips. Poor weather conditions have increased the demand for electricity, and this has also led to very difficult coal handling situations at power stations. Furthermore, coal stockpiles were allowed to fall below a 10-day supply in January, with some power stations dangerously close to full coal depletion. Eskom are striving to rebuild their inventory to 20 days – however, as of 2 April, stocks remained precariously low (at an average level of 12 days) with some stations close to only five- days worth of stockpiles.

Eskom's 24 power stations can be found in almost every province of South Africa. The map shows the type and location of these power stations. Source

Watts and Wherefores: The Problems and Solutions

A little technical background will help in understanding why the recent outages occurred. South Africa has a generating capacity of just under 37,761 megawatts (one megawatt, or MW, is one million watts). At the end of January, the system lost over 5,000 MW due to boiler leaks and failures, equipment failure, poor coal quality and issues with coal supply. In addition to this, close to 3,700 MW was lost to planned essential maintenance. Therefore, supply fell below 80% capacity – insufficient to meet consumption needs – which forced Eskom to load shed. This situation continued until 90% power was fully restored on 4 February.

In order to address the problem in the very short term, either the demand or the supply side of the equation had to give; Eskom demanded a 10% fall in electricity consumption from its users. While the company did begin the process of re-opening power stations that had been mothballed over 10 years ago, along with re-hiring retired skilled workers to correct a chronic shortage of competent staff, the rationing formula was the sole option that could produce immediate results. Therefore the only viable short-term option to restore a sufficient reserve margin lay firmly in the hands of the consumers.

Eskom implemented a three-stage National Emergency Response Plan, going out to 2012, to establish a ‘secure supply of power.’ Phase 1– the Stabilisation Programme – began immediately. The company sought a 4000- MW reduction in electricity consumption, comprising 1000 MW through appeasement of coal-related issues, an 1800-MW load reduction from municipality customers and a further 1200 MW (10%) from industrial consumers.

In an ideal world, this conservation of power would have negated the need for further load shedding. Indeed, mining houses were 100% behind this move and Eskom praised their efforts to reach their targets. However, other business sectors and residential consumers were slow to change their ways, and there were signs of a lack of commitment from the entire community. The Minister of Public Enterprises stated that ‘large industrial customers have delivered demand reduction since February. However, we have not been able to achieve significant savings from the commercial and residential sectors. This means that we are unfortunately forced to move to scheduled load shedding from March 31, 2008, to ensure that there is greater equity in dealing with the capacity constraints.’

On 13 March, Eskom announced the beginning of Phase 2: Power Rationing, to last from March until July 2008. As part of this stage, Eskom is seeking the full support of all users and is asking that the commercial sector, residential and other smaller customers cut their power demand by 10%. Unfortunately, due to adverse weather conditions and unplanned generator failures, the pressure on the electricity network persisted, and the move to Phase 2 also corresponded with the return of emergency load shedding.

Eskom publicly stated that the burden of reducing pressure on the electricity grid should not rest with key industrial users, and the utility company moved to supplement power to certain consumers. However, the move to augment power consumption to the mining community was not applicable to the full industry – rather allocations will be decided on a case-by-case basis.

The Chamber of Mines stated that Eskom, along with the government, ‘will take into account the circumstances of a company, in particular the number of jobs threatened as a result of a power rationing. ‘This pointed towards an obvious increase for the gold industry. Goldfields, which have publicly stated the real risk of 6,900 job losses, have received 95% power capacity at certain mines. While welcoming this move, Terence Goodlace, Head of Gold Fields South African Operations, also acknowledged that, ‘the additional power allocation will not prevent the forecast production losses of more than 20% in the current quarter [Q3F08].’

But power concerns remain a long-term issue for the South African nation, with an Eskom target of five to eight years. Phase 3: Power Conservation, to be enforced from August 2008 until 2012, will focus on the sustained reduction of 3000 MW. Over the next five years, the company plans to invest ZAR300 billion in new generation capacity, with a capital expenditure plan of ZAR1.3 trillion to 2025. Programmes such as the implementation of efficient compact fluorescent lights (CFLs), the restriction on the sale of traditional incandescent light bulbs, solar water-heating programmes, more efficient building standards and the substitution of electricity for liquefied petroleum gas are being examined by both the government and Eskom. This crisis presents huge opportunities for private enterprises to provide viable alternative sources.

Increasing Cooperation, Conservation – and Costs

The reality facing the mining industry is that a 10% reduction in power supply will likely translate into lost output in the short run as miners adapt to a more ‘mine smart’ approach. Based on this rationale, it is not impossible that the South African platinum output could decline by in excess of 500,000 oz in 2008. In such a situation, forward rates will intensify, and the market would likely return to backwardation.

For gold – already in a challenged supply environment – the slowdown in South African production will only continue, and a 10-to- 15% decline in metal output is not an improbability. However, given the threat of sufficient job losses in the gold industry, this sector should benefit from any increase in electricity capacity awarded by Eskom, and supply pressures should be alleviated to a certain extent.

The January statistics for South African gold and PGM output, which fell 16.5% and 15.9% respectively year-on-year, are a very real indication of the immediate ramifications of the electricity crisis on mining production. Indeed, the figures are unlikely to improve in the months ahead, as the lack of full power requirements continues to hit final production directly.

Capturing the nervousness of participants within such an illiquid market, platinum has been characterised by severe intra-day price swings – a market volatility that is not welcome by end users of the metal. Will auto manufactures concentrate on thrifting their platinum requirements and intensify their focus towards palladium substitution? In many cases, auto companies alter their PGM loadings on the occasion of new product launches. Therefore, there is likely to be a considerable lag before any decline in platinum autocatalysis demand becomes apparent.

However, this is not a one-way street, and such a scenario needs to be factored against a world moving towards tighter emission legislations. This will lead to continuing high requirements for platinum from the auto industry. Jewellery demand, with more immediately price-elastic consumers, would typically react negatively to such intense price movements. However, recent platinum turnover on the Shanghai Gold Exchange is surprisingly healthy. Indeed, Q1 2007 volume was 29% greater than the same period in 2007, therefore the initial appetite for platinum in the current price environment is not so negative when put into context of 2007 figures. Of course, it is still early days, and consumers will display their true colours as time progresses.

There is one factor in this mess that almost everyone seems to agree on – the current situation must be seen as an opportunity to fix a decades-old problem. Out of a once mighty and envied power generation and distribution system, a new, improved – and perhaps more economically sensitive – power network will be built. Power costs will increase: there is no choice. Indeed, the national energy regulator granted a 14.2% increase in March (however, Eskom are currently seeking a revision of this hike to a massive 53% from April this year).

If such an increase were granted, the knock-on effects to production costs across the mining sector would be significant. With the South African winter in force from May to August, Eskom’s ability to provide adequate power to the mining industry will be severely tested as pressure on the electricity grid escalates. How capacity issues are addressed is in the hands of the South African government and its people.

It cannot be stressed enough that this is not a short-term problem – power usage must be increased along with the needs of the country’s economic growth. In tandem with increased capacity, energy conservation must be a fundamental part of the way forward.

Dr Edel Tully joined Mitsui Global Precious Metal in July 2006. As Head of Precious Metals Research, she has global responsibility for market analysis and forecasting across gold, silver and the platinum group metals. Prior to joining Mitsui, Edel was a researcher and lecturer from 2002 to 2006 whilst earning her doctorate in gold calendar seasonality dynamics at Trinity College, Dublin.