Metal producers should steer clear of using forward prices to assess potential profitability of new projects or for budgeting purposes as this could lead to misleading conclusions.
Instead they could look at long-term price forecasts or use consultants. However, there are times when a producer without in-house research or unable to pay consultants, has little choice. In this case results should carry a health warning.
The debate has heated up again because industrial metal prices in recent weeks have rallied.
For example aluminum for delivery in December 2019 on the London Metal Exchange has jumped about 15 percent to around $2,700 a tonne since early June when markets feared the debt crisis in the euro zone could trigger sovereign default.
The main problem is that forward prices are usually a function of interest rate expectations and time to maturity.
I've seen mining companies use the forward price in presentations as a representation of future prices. The forward curve historically is a mispredictor of industrial metal prices, said Robin Bhar, analyst at Credit Agricole.
(The result) could be an unrealistic budget. Project viability could therefore be a risk ... giving the go ahead to a new project on the basis of higher forward/forecast prices.
Producers and consumers sometimes use forwards to hedge their output or consumption needs. Often they are used by funds to make directional bets on metals such as copper, used in power and construction, or aluminum used in transport.
But prices to deliver or take delivery of materials two, five or 10 years down the road are only a snapshot. Liquidity is scarce and one order -- a day, a week or a month later -- could change the price significantly.
I've seen mining companies use forward prices to argue for projects that eventually turn out not to be feasible, a UK-based fund manager said. He declined to name the companies.
If they have no alternative then people should be upfront about what they are using to assess profitability.
Some recommend miners use long-term price forecasts -- also used by analysts to evaluate share price prospects and potential revenues of mining giants such as BHP Billiton and Rio Tinto.
Producers have to deal with price exposures for a long time, sometimes 10 years and for this they normally use long-term price forecasts, which are based on costs, said Justin Lennon, analyst at Mitsui Bussan Commodities.
But as can be seen in the Reuters survey of long-term metal prices, normally published in October during LME week, few analysts are prepared to make these forecasts -- only 16 last year.
That compares with more than 50 contributions for the latest Reuters poll of analysts price forecasts for 2010 and 2011.
Rio Tinto told Reuters that its long-run price assumptions are calculated in-house by the company's economics team based on its view of long-run marginal cash costs in each industry. BHP Billiton declined to comment.
Marginal cost producers are the highest cost producers.
Norwegian aluminum producer Norsk Hydro said: We normally look at different scenarios, of which LME forward prices can be one of several, but it will not be the only factor that forms the basis of our analysis, Hydro said.
However, one reason given for including forward prices in the equation is the perception that they are impartial.
The forward price is the only unbiased forecaster. The good thing is that you can realize (buy or sell) prices on the forward curve, said Eugen Weinberg, analyst at Commerzbank.
Analysts price forecasts are often inconsistent.
(Editing by Sue Thomas)