Evaluating a Mining Deposit: Economic Study Key Numbers

The first tutorial looking at an overview of the mining deposit, we can now look at the key numbers shown within economic studies, assuming that the companies have released these studies. These reports tend to have a number of key numbers that all have the same meaning, but that are imperative if you want to analyse a deposit either on an absolute or comparative basis. Whilst is it fully important to appreciate various facts from within the first tutorial (such as the country of operation), economic studies provide a much better method of valuation compared to an in-the-ground resource method, so economic studies override previous valuations derived.

Whilst there are a significant amount of important qualitative (non-numerical) facts, this tutorial will provide an example and brief overview of the headline quantitative (numerical) points that are easy to compare. For example, economic studies also look at infrastructure availability.

Just before covering an example, it is important to understand that different types of economic studies exist, that are for projects at differing levels of development. Levels of confidence and required detail increase with each bullet point:

- Scoping Study/Preliminary Economic Assessment -> Can include inferred resources
- Pre-Feasibility Study -> E.g. Includes more precise ranges for CAPEX and OPEX 
- Feasibility Study (Bankable Feasibility Study = BFS, Definitive Feasibility Study = DFS)

An Example

Let's take a look at an example I have derived and walk through seven core comparable metrics. These are shown in the table below. The example given looks at two imaginary gold projects: Project Snake and Project Tiger. Remember that you need to be comparing projects that contain the same resource. Gold is measured in ounces (oz), so that abbreviation will be used throughout the example. The seven metrics are shown down the left hand side of the table.


This may look particularly difficult to interpret and without understanding the concepts it can be a difficult task in comparing the headline financials of the two projects. To break it down and make it easier, let's look at each metric in turn, and I will cover which project has the advantage, and why.

Output per year
Just before we start, it is highly important to stress that several point cannot be looked at in isolation, and I will help explain why at after we look at every metric. In this case, output per year tells us how much gold resource the project will produce per year in a particular economic case - it is a figure that will be used to find several other metrics. In isolation however, the higher the output, the better as it tells us that revenues and cashflows will be higher each year. Project Tiger has the advantage.

Capital Expenditure
Initial or upfront capital expenditure is the amount of cash that needs to be spent to get the project started, before production starts. Sustaining capital expenditure is the amount of cash that needs to be spent each year when the project is in production, in order to sustain output. However, for this we will look at the initial CAPEX.

Since companies tend to draw upon debt facilities to pay the CAPEX to get a project into production, low CAPEX operations are preferable assuming the other metrics are favourable. A low CAPEX enhances the chances of being able to fund the project. However, I'll stress that it needs to be looked at in relation to other metrics. An additional $125m in this case secures an extra 35,000ozs per year in the case of Project Tiger. However, on an absolute basis, Project Snake has the lower CAPEX figure. Project Snake has the advantage.

Net Present Value
The net present value of a project is one of the key metrics in determining the worth of a project. It is a complex mathematical method of forecasting the current value of an asset based on a number of parameters. Of course, by itself, it is relatively useless - it is not uncommon to see a sub-$100m company possessing a project with a net present value multiples of the market cap - some of the other metrics help. You should look at the post-tax net present value, rather than the pre-tax net present value. The example shown is for post-tax. Project Tiger has the advantage.

Therefore, put simply, the higher the net present value, the better. There is a catch though. Net Present Values use something called a discount rate. A discount rate is a discount that you take according to peers across the industry, or at least it should be. Ensure that the discount rates used in the comparison match up. Here are example numbers:

12% discount rate -> NPV of $374m
10% discount rate -> NPV of $528m
8% discount rate -> NPV of $740m
6% discount rate -> NPV of $880m

Notice that the NPV increases when the discount rate falls - you are discounting the rate of the project less so it is perceived to be worth more. Some companies may be tempted to use a lower discount rate to boost their NPV figures. Use the same discount rate as other peers. Generally speaking, 8% is a commonly used discount and 12% is rarely used.

Internal Rate of Return
This is a metric measured as a percentage and is effectively a way of quantifying the profitability of an investment with regards to return over time. Once again, this is based on discount rates so use one that is appropriate. The higher the IRR, the more attractive a project is to a potential funder. Without looking at specifics, if a post-tax IRR is below 20%, then the project is unlikely to be able to access funding. 20% is considered a 'hurdle rate'. Any project with a post-tax IRR significantly below 20% is highly likely to be unattractive, no matter what the NPV or CAPEXs are.

IRRs can be increased over time according to a number of points that I will point out after covering each metric. In this example, Project Tiger has a much better IRR. Project Tiger has the advantage.

Operating Expenditure
OPEX is highly important. Take the gold price to be $1,300/oz. Without taking into account general and administrative costs, Project Snake makes a margin of $500/oz whilst Project Tiger makes a margin of $650/oz. What does that suggest? That means that Project Tiger can withstand a lower gold price. Since a mining project can run for decades, the ability to withstand price fluctuations is critical.

After all, the gold price might be $750/oz in 3 years time. If that were to happen, Project Snake would not be viable, whereas Project Tiger would be viable (albeit the NPV and IRR would fall sharply). The lower the OPEX and the greater the margin, the better. Project Tiger has the advantage.

Life Of Mine
This metric incorporates the size of the resource in relation to the output. A mine with a small resource and a high rate of output would use up that resource quickly, so would have a short life of mine. Therefore, the LOM must not be viewed in isolation. It might simply indicate that a project is not capable of a high rate of output.

Nonetheless, 22 years at 40,000ozs compares favourably with 12 years at 75,000ozs. Project Snake has the advantage.

Payback Time
This is linked to the initial CAPEX, output, OPEX and IRR numbers. A low initial and sustaining CAPEX combined with high output and low OPEX would suggest that the payback time is low. A payback time less than 2 years is exceptional for mining companies, with less than 5 years usually the target. If the payback is significantly over 5 years, then the project can be deemed to be risky and the project again is thought to be unattractive. The shorter the payback time, the better. Project Snake has the advantage.

Conclusion - Which deposit is better in this example on these seven metrics alone?
Project Tiger. It has a higher output per year and despite having a shorter LOM, we can infer that the resource size is not much smaller. The payback time is still very good at 3 years 4 months and the IRR is much higher at 36%. OPEX is also lower than Project Snake's and the NPV is considerably larger. For these reasons, the higher CAPEX figure is not a significant deterrent, and Project Tiger appears to be a more favourable project than Project Snake.

But...

There are two further points to examine for, that are equally and potentially more important.

1. The Price of the Substance
Economic studies use a substance price to find NPVs and other metrics - it is at the heart of the economic study. Ensure that the price used is both reasonable and provided by an independent source, rather than management estimates. It is often the case that companies persuade the report writers to either use prices that are too generous, or to use trailing prices if the substance price has dropped sharply, recently. 

Ensure that the price used is reasonable - for example, gold prices are currently around $1,300/oz. Using a gold price of $1,700/oz would be inappropriate. If the price estimate is provided by an independent third party, and demand/supply for the substance has strong fundamentals, then using a price higher than the current price is justifiable. If there is a sound fundamental reasoning why, iron, for example will reach $150/tonne by the end of 2016, then that figure could be acceptable - remember that mines are long-term projects, so look at the OPEX along with the price of the substance used. If the price is higher but the OPEX margin is higher, then it is easier to accept.

2. Is there Room for Improvement?
This can take a variety of forms. How much of the resource has been used in the economic study? Is there scope for tax credits or subsidies to be granted - this could boost the CAPEX, OPEX, NPV and IRR significantly. Is there scope for byproduct credits to be added to the study to realise further value?

Essentially, are there notes in the economic study that suggest that these key metrics can be upgraded. This can be an important consideration as all of the seven metrics can change considerably if new aspects of a project are included. That can even mean that a previously weak project becomes viable and attractive. 

3. Is the CAPEX prohibitive?
One reason why projects do not get off the ground is because the amount of upfront CAPEX makes it prohibitive to undertake (relative to the size of the company). A project can have the lowest OPEX in the world, but if the CAPEX is the highest in the world by a big margin, then the project is not necessarily economical or attractive from a project funding perspective.

As pointed out - keep an eye out for traps such as unreasonable price traps, room for improvement traps and discount rate traps. These traps are not necessarily negative (they can be positive), but may lead you to develop a skewed opinion of a particular project. As stated at the start, the resource in question and other qualitative points are key too - a monopoly may exist in a resource that means an average project might be bought by the monopoly at a favourable price - there are many different considerations. A separate tutorial will look at common qualitative measures.