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Freeport-McMoRan (NYSE:FCX) has managed to steer itself through a difficult period with operational prowess. In the face of rising production costs and lower global material demand, however, mounting political obstacles are creating new pressure on profit margins for the world's largest publicly traded copper producer.

Rising copper prices are helping to offset rising production costs. But politics, the perennial wild card, is going to make it harder to maintain margins. Higher production costs led to declining operating margins for Freeport-McMoRan in 2011. Operating margins have held up better in 2012 and increased slightly in the third quarter, admirable performance given a 15% decline in revenues in the quarter. Overall, Freeport-McMoRan margins have been much healthier than those of its industry peers. With governments in its key markets making demands for higher royalties on mining projects, the economics of some of some of Freeport-McMoRan's key projects are changing.

In light of higher costs in the way of taxation in the foreseeable future, Freeport-McMoRan needs to ramp up production on current and new assets, a step its executives say it is taking. China, Indonesia and the Congo are all political hot spots where mining economics are changing. For a number of countries, the answer to falling government revenues in a slower global economy is to raise mining royalties. In Indonesia where its Grasberg mine makes up 19% of its revenues the government is seeking to raise its gold royalties from 1 to 10%, and impose a 3.5% royalty on copper.

In the Democratic Republic of Congo, Freeport-McMoRan can expect higher taxes on its copper and cobalt production at its Tenke Fungurume projects. The Congolese government seeks to raise revenues from mining projects from 10 to 25% by 2016. It is reviewing a number of measures to reach this goal, including raising its stake in mining projects from 5 to 35%. Additionally, it is seeking a royalty increase for non-ferrous metals such as copper and cobalt from 2 to 4%, from 2.5 to 6% for 'strategic' and precious metals, and from 4 to 6% for precious stones. Also being considered is a windfall profit tax when metal prices rise 25% above those cited in a miner's feasibility study, and the end of preferential custom rates on imports once mines are in production.

Freeport-McMoRan is likely to continue to bring on new production in these countries and elsewhere to make up for the lost revenues and added expenses. To maintain its industry beating margins, however, it needs to manage the environmental and labor strife in Indonesia where its Grasberg mine brings in healthy revenue streams. With the largest recoverable gold and copper reserves, the Grasberg mine on the island of New Guinea in Papua province is a high profile target for environmental and labor discontents. Freeport-McMoRan has been slow to recover from the three-month labor strike over wages at the mine. Moreover, ore quality is lower than anticipated due to delays in accessing higher grade ores. The mine was clearly hobbled in the third quarter, earning a net cash cost of $1.65 per pound versus a credit of $0.48 in the year-ago period.

Freeport-McMoRan's plans to increase production output by 25% over the next three years at its mining properties throughout Africa, Indonesia and the Americas will help to offset the increases in royalties. Its more immediate concern may be its stock price as analysts talk down the demand for metal to build China's booming economy. In mid-October, Goldman Sachs cuts its 12 month estimate for metal consumption in China by 11%, citing a forecasted reduction in demand from the construction, consumer appliance and auto sectors. Freeport-McMoRan, unlike some of its competitors, is experiencing an increase in copper demand from China. Ahead of its third quarter earnings announcement the company endeavored to communicate its rosier copper outlook in China through Bloomberg and other media. Meanwhile, Goldman Sachs has lowered its 12-month forecast for copper from $9,000 to $8,000 a ton.

Freeport-McMoRan's operating margins edged up in the third quarter despite the slowdown in production of its most productive mining assets. This performance bodes well for the company going forward. If Chinese copper demand holds up and Indonesian labor strife is reduced, profit margins can be expected to expand. It will be a tighter squeeze if either one of these revenue streams fail, especially if royalty demands are raised in Indonesia and the Congo. As Freeport-McMoRan ramps up production, it is probable that margins and cash flows will feel the squeeze until more production comes online. The company's cash flow from operations are declining after steadily increasing for several years. For the first nine months of 2012, operating cash flows were $2.5 billion versus $5.9 billion in the year-ago period. As the company invests more heavily to produce and buy more productive assets, capital expenditures are also increasing. Capital expenditures for the year so far are $2.5 billion versus $1.7 billion for the first nine months of 2011.

Key to Freeport-McMoRan's success is its investment in productive assets, assisted by its operational strength. It expects brownfield expansion in Africa and the Americas to contribute one billion pounds of copper annually over the next three years. In Indonesia, higher ore grades should increase revenues. The company is restarting several copper plants in the Americas.

BHP Billiton (NYSE:BHP), on the other hand, is shutting down and selling off unproductive assets around the globe, including its Pinto Valley Copper mine in Arizona. Other asset sales include diamond, aluminum and iron mines. Significantly, BHP, in contrast to Freeport-McMoRan, is experiencing a decrease in copper demand from China. Without China to offset the global decline in material demand and unproductive assets in its portfolio, BHP is looking more like a future turnaround story.

In a lower gold price environment, Freeport-McMoRan has focused on copper. Its diversified portfolio and adept switching between productive assets at opportune times will continue to be one of this company's strengths. Gold production and sales are down as gold has become a smaller production component in its South American operations. Pure plays such as AngloGold Ashanti (NYSE:AU), Goldcorp (NYSE:GG) and Gold Fields Limited (GFL) have shown less resilience. With the expectation that gold will go up, the gold majors have been investing heavily in exploration. While Freeport-McMoRan could lose some upside as a result of its slowdown in gold production, it still offers a more diversified and stable investment picture long-term.

Source: Freeport-McMoRan: Don't Sell This Stock