How to trace mineral projects from valuation to production

Finland (image courtesy of Pyry Tanskanen on Flickr)

Following a recent Edumine four-day short course, "Valuation of Mineral Projects Based on Technical and Financial Modelling" in POHTO's Oulu facility in Finland, one of the delegates raised an interesting point that has wide relevance to active operations.

The Valuation course covers project appraisal as a forward-lookingperspective at the pre-production stage. As a manager on an active operation the delegate, in his daily work, hasto deal with multiple development scenarios which are an inherent part of mineplanning.

The delegate asked about the utility of applying theprinciples of discount cash flow modelling at the pre-funding stage, whichallows comparison between development scenarios in an active operation based onthe performance indicators of NVP, IRR and pay-back.

Where the development of a new mine is going to cost over $2B, this is the domain of the large international mining companies that will use their corporate cost of capital for evaluation studies and act essentially as their own investment bank

These would provide a snapshot of the value derivedfrom a given period of production where there is a simple relationship betweenthe amount of ore produced and the capital cost. In an active operation though, an investmentin a particular element, for example footwall pre-production development and drillhole sampling, might be part of the normal cycle of mining as productionproceeds. There is no fixed end pointwhich can be incorporated into a DCF model. Other performance indicators, suchas cash costs and tonnage of ore delineated, then become more relevant inranking development decisions. He pointed out that the scenarios are seldom so marginalthat DCF modelling is likely to expose a feature that would not already beapparent from normal mine planning.

The Valuation course may add more content around theboundary condition that applies to the normal allocation of sustaining capitalin pre-production development on an active mining operation with a defined minelife, compared to the creation of what is essentially a new mine, albeitexploiting the same deposit.

In the former case this is part of routine mineplanning with costs met from cash flow. There is no merit in setting up a DCFmodel if for no other reason than that the time span is seldom more than fiveyears whereas the optimum period for applying the technique at a 10% discountrate is about 15 years. The main flexibility is around allocation of costbetween capital expenditure and operating costs. In accounting terms, it isbest if this can be allocated to operating costs to allow immediate taxrelief. Tax relief on capital cost isobtained through depreciation where benefit is deferred.

With the development of a new mine in the Valuation course I use a hypothetical case study, the objective of which is to evaluate the di??EURerent alternatives available to a mining company operating in the Peruvian Andes following the discovery of an undeveloped deposit close to its operating mine.

This grants them options such as the opportunity to extend mine life, increase annual production and to introduce a drastic change in the mineral processing method. I then go on to point out that using debt also means that the full Capex of $460M does not have to be met from the cash ??,ows of the parent company generated from their existing operations. These can then be distributed as dividends.

This in turn enhances share price and allows theequity portion of the capital requirements to be raised through a rights issue.Equity investors also have the comfort that in order to secure this level ofdebt the bankers would have undertaken a rigorous technical review of theproject. The role of independentengineers instructed by the banks ensures better planning and better managementat the EPC stage.

The case studies in the Valuation course also covered the transition from surface to underground which often involves significant capital investment ($2.6B in the case of Venetia). These are manifestly new mines that will exploit deep extensions of the same deposit.

In summary, a medium sized company considering developing essentially a new mine (albeit on the same deposit) at a cost of around $500M should consider the use of project finance.

The banks will be very comfortable as operating cost estimates will be well constrained and production will be undertaken by experienced operators. Where the development of the new mine is going to cost over $2B then, this is the domain of the large international mining companies that will use their corporate cost of capital for evaluation studies and act essentially as their own investment bank. Lending to subsidiaries on a rolling basis ensures they manage the corporate gearing that supports their share price and sets the corporate cost of capital. This does impact on mine planning where a major pit push back is proposed.

Pit optimisation algorithms have to assume a discount rate ???xed by the parent company. The operation cannot therefore use a gearing optimisation approach where the subsidiary cannot act as an independent company and raise fresh equity and secure debt from an independent investment bank. They must use the parent's corporate cost of capital.

This must impact on stripping ratios and may even sterilize some ore - a source of some frustration to planning departments on mines. In some cases, the discount rate they are required to use in mine planning is well above the corporate cost of capital which means a much more conservative stripping ratio is generated.

The next delivery of the Valuation course will be in Vancouver from March 31 - April 3, 2020 inclusive.

Learn more here.

(By Dennis Buchanan, Director of the MSc in Metals and Energy Finance, Department of Earth Science and Engineering, Imperial College, London.)