1. Introduction
Mineral economics involves the following four principal areas of concern.
• Accounting practices
• Commodity markets
• Financing
• Economic Evaluation
Accounting Practice
Accounting practice for mining companies follows accepted standards for resource industries with the only significant modification being the treatment of depletion and royalties. The treatment depends mainly on the applicable laws at the mine location. Accounting practice for mining contractors is different from mine owners and follows accepted standards for the construction industry. Accounting practices are not pursued in this chapter except where they relate directly to financial evaluation.
Commodity Market
Commodity market volatility is of great concern to a mineral producer. In the past, some metal mining alliances have attempted at various times to control the price of zinc, tin, and silver with no permanent success. Anti-monopoly legislation strongly condemns manipulating commodity markets in the United States, as it does to a lesser degree in other industrialized nations.
Selling prices of metals may be legally secured in the short term by forward selling; however, there is normally no assurance in the longer term. Normally it is the longer term that applies to the period of time that it takes to bring an ore body into production and thereafter. Since it is now generally accepted that future metal prices are unpredictable, the commodity market is given little consideration in this chapter.
Financing
Financing required for the construction and operation of mining projects may be provided internally, but most mining companies resort (at least in part) to joint venture partners, independent financial institutions, international development agencies, local governments, and/or the equity market to provide the capital they require. This chapter does not deal with financial instruments or the mechanics of borrowing money. The only relation to financing is the reference to “due diligence,” which is a requirement of vigilant financial sponsors.
Economic Evaluation
Economic evaluation (investment analysis) is at the heart of feasibility studies and due diligence. These are of immediate and significant concern to the mining community. For this reason, financial evaluation is the primary focus of this chapter.
“It looks just a little more mathematical and logical than it is; its exactitude is obvious, but its inexactitude is hidden…” G. K. Chesterton
“The process of finding and developing mines, including the financing of these activities, involves a chain of activities and people. Such a chain is only as strong as its weakest link.” Kenneth Grace
Economic studies for proposed new mines and expansions of existing mines that demonstrate a rate of return less than 15%, rarely proceed to fruition; yet, the actual return on investment is less than 10% (on average). The list of 30 companies that make up the well-known Dow Jones Industrial Index no longer includes any mining corporations. Perhaps there is something wrong with the manner in which financial evaluation has been conducted by the mining industry.
In these days of specialization, the mining engineer no longer performs detailed economic calculations, such as those required of a definitive feasibility study. Instead, the calculations are typically performed by the mine’s financial department or an independent institution (employing financial analysts armed with specialized computer programs). The calculations themselves can be done in a split second. Unfortunately, this facility with numbers can provide opportunity to maneuver or misinterpret key data and produce an erroneous conclusion. One result is that investors have become more suspicious of glowing financial projections and miners (who live with the consequences) are required to become adept at auditing reports prepared by others. Such an audit is the most significant part of the due diligence procedure. Due diligence has become regular practice whenever mineral properties are about to change hands or independent financing is proposed.
The information in this chapter is selected to help direct the reader to identify potential flaws in traditional methods of financial evaluation, assist with due diligence, and suggest means to ensure the viability of a proposed mining venture.
2. Rules of Thumb
Metal Price
• The long-term average price of a common mineral commodity (the price best used for economic evaluation in a feasibility study) is 1.5 times the average cost of production, worldwide. Source: Sir Ronald Prain
Pre-production Capital Cost
• The pre-production capital cost estimate (Capex) should include all construction and operating expenses until the mine has reached full production capacity or three months after reaching 50% of full capacity, whichever occurs first. This is the basic transition point between capital and operating costs. Source: John Halls
• The pre-production capital cost expenditure includes all costs of construction and mine development until three months after the mine has reached 25% of its rated production capacity. Source: Jon Gill
Cash Flow
• The total cash flow must be sufficient to repay the capital cost at least twice. Source: L. D. Smith
• Project loans should be repaid before half the known reserves are consumed. Source: G.R Castle
• Incremented cash flow projections should each be at least 150% of the loan repayment scheduled for the same period. Source: G.R. Castle
• The operating cost should not exceed half the market value of minerals recovered. Source: Alan Provost
Net Present Value
• The discount factor employed to determine the NPV is often 10%; however, it should be Prime + 5%. Source: G.R. Castle
• In numerous conversations with managers of mining firms, I have found that 15% in real terms is the common discount rate used for decision purposes. Source: Herbert Drecshler (1980)
• The true present value (market value) of a project determined for purposes of joint venture or outright purchase is equal to half the NPV typically calculated. Source: J. B. Redpath
Rate of Return
• The feasibility study for a hard rock mine should demonstrate an internal rate of return (IRR) of at least 20% – more during periods of high inflation. Source: J. B. Redpath
Working Capital
• Working capital equals ten weeks operating cost plus cost of capital spares and parts. Source: Alan O’Hara
Closure Costs
• The salvage value of plant and equipment should pay for the mine closure costs. Source: Ron Haflidson
3. Tricks of the Trade
• The optimum production capacity is not sensitive to the taxation rate. This means that it may be accurately calculated before a comprehensive determination of the applicable tax rates is completed. Source: L. D. Smith
• The capital cost estimate should be calculated in both constant (current) and escalated dollars, but the operating cost estimate and revenues should not be escalated, except in corollary sensitivity analyses. Source: John Halls
• In theory, sunk cost should not be included in the capital cost estimate. In fact, the sunk costs may be written off only if the project fails the evaluation. If the project proceeds, the sunk costs survive and by standard accounting practice, they later appear in the operating cash flow. This is one reason why sunk costs are often found included in the financial evaluation. Source: Douglas Stirling
• The working capital requirement is often estimated as being equal to three months operating cost. This may not be enough; the working capital requirement is closer to three months revenue if the revenue in cash flow is valued when produced rather than when received. By deferring the revenue stream three months or more as appropriate, the operating costs are left in the cash flow as expended. Source: Douglas Stirling
• Operating costs include maintenance, repair, and minor equipment replacement. Source: R.J. Vance
• Equipment replacement more than $US 5,000 should be capitalized. Source: Arthur Park
• Cash flows are typically spread in intervals of one month for the pre-production phase and by quarters or annually thereafter. Source: Douglas Stirling
4. Economic Evaluation
The standard principles of economics used generally in the broad scale are also applied to the mining industry. Four standard measurements that are well understood by economists are typically applied to mine evaluation.
• NPV
• Rate of Return on Investment (IRR)
• Payback
• Competitive Cost
The first three of these are interrelated to the extent that they consider a mine as a wasting asset and each of them utilizes cash flow in their analysis. Each is often assumed to be a separate test of validity; however, as will be seen, they are all merely variations of the same mathematical routine when analyzed from an engineer’s viewpoint.
Cash Flow
Cash flow may be described in general terms as the cash generated from operations in a specified period of time (month, quarter, or year). For evaluation purposes, it is the net of estimated cash inflows and outflows for operations. The cash flow determination for an evaluation can be simpler than for actual on-going operations. In the context of a financial evaluation for a mine, cash flow may be generally defined by the following computation.
Gross Revenue
Less Selling and transportation costs
= Net revenue
Less Mine operating cost
= Gross profit
Less Capital cost allowance (depreciation)
= Income before exploration deductions
Less Exploration and development deductions
= Depletable income
Less Depletion allowance
= Taxable income
Less Mining taxes
Less Corporate income taxes
= Net profit
Plus Capital cost allowance (depreciation)
Plus Depletion allowance
Plus Exploration and development deductions
= Cash Flow
Cash flow is further defined and discussed in the appendix to this chapter.
Net Present Value
NPV may be described as a rational attempt to put a dollar value on the mineral property. A more accurate definition is that NPV is the difference between the present value of the positive and negative cash flows, discounted to the present time at a predetermined interest rate. Financial analysts define it simply as the sum of discounted cash flows. The NPV calculation considers that the calculated profits from a proposed mining venture are an annuity for the estimated life of the mine. In simple terms, the NPV is the present value of the annuity less the initial investment and is usually expressed in millions of dollars. The NPV procedure may be used also to help assess the value of an operating mine that is for sale.
NPV Calculations
Calculations require projected cash flows at regularly spaced intervals (months, quarters or years). They may be completed using the formula given below, or by using a table of present value dollars. Most computer spreadsheet programs also provide a built-in function for calculating NPV given a series of cash flows.
Discount Factor
A discount factor is first determined to perform the NPV calculation. A figure of 10-15% is common in the hard rock mining industry. The discount typically consists of the sum of two components: the safe return rate plus a risk rate. The safe return figure is a tangible real market rate while the risk figure is often an arbitrary or notional rate.
Safe Return Rate
The rate of safe return is that provided from a safe alternate investment, such as federal government bills or bonds. It is a simple matter to decide an accurate value for this figure.
Risk Rate
A good number for the risk rate is not so easily determined and has been dealt with in the previous chapter of this handbook. The risk rate is a weak link in the financial evaluation.
Example
Determine the NPV for the following mining project.
Facts:
1. Assume a discount rate of 15%
2. $100 million initial investment
3. The project will return $35 million in each future year
4. The calculated mine life is five years.
Solution:
NPV/$1 million = -100 + 35/1.15 + 35/1.152 + 35/1.153 +35/1.154 +35/1.155 = 17.3
NPV = $17.3 million
Rate of Return on Investment
Rate of return on investment is the return on pre-production capital investment expressed as a percent in which both the capital investment period (negative cash flow) and the subsequent revenue stream (positive cash flow) are discounted to the date of initiation of major capital investment. More simply, it may be described as the maximum rate of interest that could be paid for the capital employed over the life of the mining investment without the venture incurring a loss.
The rate of return on investment is currently defined by financial analysts as “discounted cash flow rate of return on investment” (DCF-ROI). It is identified as “IRR” in typical computer spreadsheet programs. The standard formula given below defines rate of return on investment as that discount rate at which the present value of positive cash flows equals the present value of negative cash flows. It is the value of the “discount factor” in the previous formula when equated to zero.
Most computer spreadsheet programs also provide a built-in function for calculating the IRR; however, IRR can also be calculated manually by trial-and-error and interpolation between results.
Example
Determine the rate of return on investment for the same mining project.
Facts:
1. The mining project has a $100 million initial investment
2. The mining project will return $35 million in each future year
3. The calculated mine life is five years.
Solution:
NPV/$1 million = -100 + 35/1.221 + 35/1.2212 + 35/1.2213 + 35/1.2214 +
35/1.2215 ≈ 0
DCF-ROI = 22.1%
The value obtained from this economic computation is traditionally the most significant measure of project feasibility. It is also commonly employed to rank alternative scenarios for an individual project or several proposed projects competing for limited resources.
Threshold Rate of Return
Consideration of risk enters the evaluation procedure when a threshold (hurdle) rate of return is established to confirm or deny the viability of a project. Like the discount rate developed for the NPV calculation, the threshold rate of return may be said to comprise the sum of a safe rate and an arbitrary risk rate. Presumably, the threshold value determined for the rate of return takes a more conservative view of risk into account than does the discount rate determined for the NPV, since it is typically found to be at least 5% higher.
Opportunity
The amount by which the rate of return calculated for a project exceeds the hurdle rate may be referred to as the “opportunity.”
Payback
Payback is the period of time (measured in years) that the accumulated cash flow could retire the pre-production capital invested without considering the time value of money. More simply, payback is the number of years needed for the cash inflows to equal the cash outflows. This measure is not considered as significant as the other two (NPV and IRR). One reason it is calculated is to determine whether the project meets the empirical requirement – that pay back occurs not later than the date that half the ore reserves are exhausted. Payback may be obtained by solving for the maximum value of ‘n’ in the previous formula (at a “discount factor” of zero) or by inspection of the cash flow spreadsheet.
Example
Determine the payback for the same mining project.
Facts:
1. The project has a $100 million initial investment
2. The project will return $35 million in each future year
3. The calculated mine life is five years.
Solution:
-100 + 35/(1+0) + 35/(1+0)2 + 30/(1+0)3 = 0,
Payback = 35/35 +35/35 +30/35 =2.9 years
(In this example, payback occurs after half the ore reserves are exhausted, and, therefore, does not meet the empirical requirement.)
Sensitivity Analysis
A sensitivity analysis (variance analysis) is normally performed once these first three procedures are developed. It is the process of determining the sensitivity of the present value, rate of return, and payback of the project for any one input variable.
Once a series of variables has been examined, two of the input variables may be combined together for consideration (this is uncommon). An example of a variable would be a 10% fall in metal price. If the fall results in more than a 20% decrease in the rate of return, the project is deemed to be sensitive to metal prices. Sensitivity results are frequently plotted in simple graphical form to illustrate the risk applicable to each variable. The identification of such sensitive relationships indicates areas where extra study may be warranted to confirm or improve estimate accuracy. In some cases, a statistical probability evaluation is applied to the results of sensitivity analyses.
Competitive Cost
Competitive cost analysis is considered by many mining companies and financial lending institutions to be the most reliable tool for economic appraisal in today’s depressed market for mineral commodities. The analysis consists of comparing the estimated cost of producing the mineral commodity with the range of actual costs incurred at other mines around the world that produce the same product. The cost data may be obtained from an investment service.
The data is arranged on a spreadsheet that provides cost and annual production for each significant producer in separate columns. A third column contains the total cost of production that is obtained by multiplying the figures for each entry in the first two columns. The columns for production and total cost of production are added to obtain totals that are then divided to obtain an estimate of the average cost of production on a worldwide basis*. Further analysis produces a figure for the lower quartile cost of production.
If by competitive cost analysis, the estimated operating costs are lower than the average cost of production, it is a favorable indication. If the estimated operating cost lies within the lower quartile, its viability is considered proven by this analysis. The theory and advantages of the competitive cost analysis method are dealt with in the previous chapter. The weakness of this procedure is that is takes no account of capital costs and does not consider the time value of money. No project should be evaluated solely on this basis.
Case History
Early in this century, the Anaconda Company performed a financial analysis on its Portrerillos property in Chile that indicated a financial return lower than hoped for due mainly to the long preproduction development schedule. The company proceeded with the project anyway; secure in the knowledge that it would be a very low cost producer. The mine weathered the great depression and later provided funds for other ventures in Chile that eventually (towards the middle of the century) provided for regular repatriation of $300 million a year from profits.
* The average cost may also be used to determine a fixed metal price for the previous three evaluation procedures (refer to Sir Ronald Prain’s rule of thumb).
5. Appendix
Notes on Cash Flow (courtesy of Douglas Stirling) In the project evaluation process or ongoing operating analysis, cash flows may be calculated slightly differently by different companies and for different purposes. In terms of evaluation, operating cash flow could be defined generally as the cash generated from operations. It might typically be the net of the cash inflows and outflows for operations determined as follows.
1. Net revenues from products (net of any selling and transportation).
Less
2. Production costs (labor, materials, services, etc. on the accrual basis).
3. Non-cash production costs (depreciation, development write off, exploration write off, reclamation accruals, etc.).
4. Pre-tax earnings/profits.
5. Income taxes (federal, state/provincial – cash and non-cash).
6. After-tax earnings / profits (on accrual basis).
To find “operating cash flow” from operations, one must add back the non-cash operating items.
Plus
(Some or all of the following, depending on purpose or company preference, would be shown separately so the reader can understand and adjust the information as they wish).
7. Non-cash costs (depreciation, depletion or other write-offs for exploration, development, property acquisition, deferred income taxes, reclamation, etc.).
8. Interest (that relating to property acquisition).
9. Royalties paid to a property owner for their ownership interest (may be a profit sharing rather than a production cost).
10. Plus or minus working capital changes during the period depending on the change + or -.
11. Cash flow from operations (before ongoing capital requirements).
Less
12. Ongoing capital, exploration, and development expenditures considered non-period operating costs would be capitalized so would not be included in the operating financials income statement.
13. Working capital changes (+ or -).
14. Net Cash Flow (after ongoing capital requirements).
The preceding calculation may be done on a stand-alone mine or mine property basis to the headworks / loadout facilities, or may include processing facilities if stand alone or on a shared basis. Down the line costs from loadout would typically be segregated so that the individual values are known. Other costs that may be used in the evaluation are shared corporate cost allocations, sunk costs (costs incurred prior to the evaluation date), interest for financing, royalties etc. (some of which have been discussed above).
As there is no standard classifications or formats, individual properties and ownerships often have unique items with which to deal; therefore, if the unique items are set out separately, they may be considered by any reader, as desired.