By Henry Bonner (firstname.lastname@example.org)
As we recently explained, the practice of “high-grading” where a miner extracts only the high-grade ore from a deposit has been widely adopted in the mining industry over the past 10 years. The method increases short-term cash flows, but can harm the profitability of a mine over its lifetime.
As an investor, you want the miners in your portfolio to deliver the highest overall return possible.
On this subject, we received a helpful response from reader Mark Jones, a Partner at mining consulting firm Whittle Consulting. He says many mining companies fail to optimize operations for the highest return on investment.
The damage can be caused by well-intentioned, highly proficient technical experts who are applying a narrow-focused approach to the overall mining operation.
They may focus on the individual technical challenges, sometimes destroying part of the shareholders’ value in the process.
In a paper titled Misguided Objectives that Destroy Value, Gerald Whittle, the Managing Director of Whittle Consulting, explains how this happens. He makes some useful points for investors in mining companies. Designing a mine involves a lot of ‘moving parts,’ he explains:
“The fact is that most planning decisions are linked in terms of the consequences they have on the overall outcome, so many complex trade-offs must be considered.” These include the time value of money, the opportunity cost of a decision and planning for a depleting resource.
So what should you look out for? To paraphrase Mr. Whittle:
The mine plan generally attempts to extract as much economic ore as possible; reduce the total expenditures of building the mine; maximize the lifetime of the mine; and minimize the amount of metal lost during the recovery process (where the metal is separated from the host rock).
The problem is that a mine engineer might take on these technical challenges as ends in themselves, instead of maximizing cash returns. As shareholders, our ultimate concern is our return on investment.
· Size of the deposit: The size of an ore deposit generally means the amount of tons that contain a certain percentage of base or precious metals. The problem is that the total number of tons that are worth mining is not necessarily the same as the optimal number for the best economics. Sometimes the overall return will be higher without retrieving certain portions of the mine. But the idea of 60% or 80% retrieval of economic tons can be disconcerting to management.
· Mining costs: Lowering operating costs can damage the overall economics of a mine. For instance, larger equipment can make mining cheaper per ton, but won’t be as discerning of what portions of the ore is worthwhile to extract. Simple pit shapes can make operations run more smoothly and cheaply, but also can result in mining useless portions of the mine. In addition, mining operations account for only 15% of the total cost of the value chain, so mining companies should take into account the effects on the costs of the downstream activities.
· Maximizing the life of the mine: Extending an operation means the engineers and workers will be employed longer, and governments will enjoy royalties over a longer period. But, especially taking into account the time value of money, extracting the ore quickly can be preferable in order to maximize shareholder returns.
· Maximizing recovery: Getting the maximum metal from the ore seems to make sense, but there are issues to consider. Increasing recovery for certain types of host rock can increase costs faster than the increase in revenues from the higher recovery. Increasing recovery usually involves leaving the ore at the processing plant longer. This ‘residence time’ can worsen what is often already the main bottleneck in the operation.
The key take-away from these points is that maximizing metal or profit per ton is not the objective – maximizing the cash margin produced per day is.
Another point is that operations engineers prefer to keep everything steady over the life of the mine. It’s easier to run if the same amount of ore comes out each day, and the same amount is processed. But these are not ends in themselves. As Mr. Whittle explains: “Any mining/processing plan that has constant stripping ratio, mining rate, cut-off grade, or plant configuration cannot be optimal, and is therefore subject to improvement.”
“Using simplified, seemingly well-meaning local objectives is not satisfactory, as these can be counterproductive to the overall outcome.”
If you invest in companies who are building or designing a mine, beware if management decides to structure the operation to attempt to address one particular technical consideration.
Shareholders should make sure that technical challenges and operational ease alone aren’t driving management’s decisions. Returns can suffer substantially if management forgets the end goal is to make money for shareholders. You want to see big cash flows early in these capital-intensive projects.
Disclaimer: The referencing of material from Gerald Whittle is not an endorsement of Whittle Consulting,and is cited for informational purposes only. No compensation was made or received in consideration of the publishing of this piece.