Platinum producers are generating juicy profit margins and returns on investment, but they should enjoy it while they can - it may not last for long unless they can rein in surging costs.

Conditions in markets for platinum group metals (PGMs) look attractive. An unusually large deficit in the platinum market last year is expected to be even larger in 2008.

A slower growth rate in some regions of the international economy has yet to work through to physical demand for platinum or the associated metals, palladium and rhodium.

Spot prices for these metals have been strong. Platinum has risen this year to record levels of more than US$2 000/oz, up more than 70% since the beginning of September.

This was partly a result of a decline in production in SA, which supplies 78% of total new mine production of platinum, 34% of world palladium output and 86% of rhodium production.

Production fell elsewhere as well. UK-based platinum metals research house Johnson Matthey says global platinum supplies fell in 2007 by 4,1% to 6,55m oz, with sales from SA, Russia and North America all decreasing.

However, the fall was most marked in SA, where output dropped despite a ramp-up of production at a number of smaller operations. The growth occurred at several mines such as Crocodile River, Mototolo and Two Rivers.

Two Rivers, near Steelpoort in Mpumalanga, is 55%-owned by African Rainbow Minerals, which also manages the mine. It entered production and delivered a R945m cash operating profit in the nine months to June 2007.

Eland Platinum, founded and developed by the Pouroulis family, also started production last year, just after being acquired by international mining group Xstrata for almost R8bn. Several other platinum mines are being developed elsewhere.

But overall, says Johnson Matthey, the SA PGM mining industry had a "very turbulent year" in 2007.

The year started with the temporary closure of one of Lonmin's smelters for a rebuild after a matte leak, cutting output. The two-yearly wage negotiations between the mining houses and the unions later in the year led to a difficult working environment in which strike action was common, if relatively short.

A new safety regime meant extended closures of individual shafts each time a fatal accident occurred, further cutting production. With the usual range of geological challenges present too, says Matthey, supplies fell from 5,3m oz in 2006 to 5,04m oz in 2007.

This, of course, was before the Eskom electricity crisis started in January. Most of the local producers have since forecast lower output for 2008.

A global slowdown, depending on its severity, could soften demand this year for industrial metals, including the PGMs. However, Matthey says it is still likely that demand for platinum and palladium will grow in 2008.

This would be underpinned, in part, by increased investment demand. The appearance of new exchange traded funds specialising in platinum was a feature of the market last year. Some investors have moved into gold and other precious metals as "safe havens" during a period of currency volatility, economic slowdown, rising inflation and financial worries.

Investment demand has helped make up for a substantial surplus in the palladium market. Prices have risen to a record in the rhodium market, where demand from industrial consumers increased in each of the past six years.

Conditions in these markets are important, as most of the SA producers of PGMs derive only half of their sales revenues from platinum. Other contributors include rhodium (about 25%), nickel (12%) and palladium (12%).

Nickel, used in steel-making, has fallen sharply from its high reached in May last year, and is looking weak, but remains well above its longer-term trading range. Between October 2001 and May 2007 this price spiked upwards by more than 1 000%.

For local PGM producers, one of the biggest operational issues, and a key concern for investors, given the signs of resurgent inflation in the world economy, is the cost trend in the industry.

SA platinum mining companies have had varying success in managing costs in the past year. This is influenced partly by the depth of operations and mining methods - surface or shallower operations usually cope better, though these are also being hurt by high prices of diesel.

Among the larger producers, Impala Platinum's (Implat) performance with cost management (and production) has been among the best.

In the six months to December, its unit costs per ounce of platinum produced increased by 12,7%, on the back of 5% volume growth. The biggest causes of the increase, Implat said, were inflation and measures taken by management to retain skills.

SA's skills shortage, says Implat CE David Brown, is one of the biggest problems facing local producers. The company is trying to address this through steps such as retention bonuses, but those increase costs.

When Lonmin - the third-largest producer of PGMs - reported results for the six months to March 2008, it showed earnings before interest and tax up by 60%, but this was mainly because of higher product prices.

Its mine production for the half-year was 13% lower than in the previous comparable period.

Output at its two main mines, Marikana and Limpopo, says CE Brad Mills, was hit by the four-day Eskom power outage at the end of January; an increased number of safety-related shutdowns; and high levels of absenteeism around Christmas and Easter, particularly among key skill groups. The group's unit costs for the period rose by 18%.

The cost performance at Anglo American Platinum (AngloPlat) was even more worrying. In terms of PGM production, this group is the industry leader, accounting for about half the SA output of platinum.

Its operations are not only larger than its rivals' but also the most complex, as it produces PGMs from 10 mines - the largest being Rustenburg and Amandelbult - and runs substantial refining units. Adding to the management complexity, it is involved in a large and costly expansion programme aimed at extending its leading market share.

In the year to December, its headline earnings were a record R12,3bn, up 2,8%. However, its cost of sales increased by R5bn, or 22%, compared with 2006.

The group's poor safety record led its controlling shareholder, Anglo American, to suspend mining operations at the Rustenburg mine for seven days last year.

Ralph Havenstein resigned as CE over this issue, and Norman Mbazima and Duncan Wanblad were appointed joint acting CEs with mandates to apply much higher safety standards.

Operational performance - and safety - are now the key challenges facing this group, whose share price has significantly underperformed Implat's for some time.

It will also be the critical challenge for Neville Nicolau, who was appointed group CE in May. Previously chief operating officer of AngloGold Ashanti, Nicolau brings a strong background in running deep-level mines.

Mbazima and Wanblad say in their review that the inflationary pressures experienced on the group's operating costs have started to affect its projects and will continue to be felt in 2008.

AngloPlat's expansion programme aims to increase the group's PGM production at a compound rate of 5% annually. Its capital expenditure was R10,7bn last year, up from R7,5bn in 2006, and it expects to spend about R10bn in 2008.

Volume growth and a more consistent production pattern - if that can be achieved - will help to ease the pressures on costs.

For now, the returns in this industry are highly attractive. Despite its operational difficulties, AngloPlat last year reported a return on equity of 44%, up from 16,4% in 2004. Its gross profit margin was 40,7%, compared with 23,4% three years ago.

The established producers have also paid out large dividends in recent years, and should continue to do so.

However, unless the industry's cost performance is significantly improved, profit margins and returns on equity in the sector could soon be shrinking again.