Understanding Mining Sector Costs

Understanding the various costs within the mining industry is integral to recognising why there is such a high project failure rate. In fact, the majority of pre-financial crisis IPOs - between 2005 and 2007 - on AIM were junior mining and oil companies who were taking advantage of the commodity price booms in gold, oil and a range of other minerals and the increased investor appetite they brought. However, the financial crisis and the excess supply that the pre-crisis investment boom has led to collapses in commodity prices across the board, with a mass exodus of these same companies delisting from AIM as they struggled to access financing. This tutorial will look at the costs involved in the mining industry and the various figures that companies will report.

Types of Mining Sector Costs

Costs in the mining industry and broadly similar to every other industry, but they are substantially higher, and the first revenues to offset these costs only comes either when a project enters production (which is rare), or if there is an asset sale. Consequently, there is normally a substantial period of time (at least 3 years and usually over 5 years) whereby the entire costs incurred have to be funded through debt or equity. In addition, debt is usually off limits due to the high-risk nature of the sector, if the project is not near to production.

So what are these main mining sector-specific costs?

1. Exploration costs
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These costs are self-explanatory. They are the costs incurred in exploring an area so will include costs associated with scientific studies such as geophysical studies and magnetic surveys. These scientific studies are intended to identify regions where mineralisation is likely to exist, which can then be tested through drilling; the bulk of exploration costs are borne out of these drilling programmes.

These drilling programmes typically last multiple months at a time, consist of the drilling of vertical or slanted holes at intervals across kilometres, usually testing some sort of geological anomaly which could point towards mineralisation. Consider the example of a drilling programme to the right.

Further test work on the results of the drilling will be undertaken afterwards and costs involved with economic studies can be bundled in with this sector. Economic studies are an in-depth evaluation of a mineral resource to assess its economic viability by looking at things like access to ports, and the quality of mineral that can be produced with respect to the price the mineral sells for.

2. Initial Capital Expenditure (CAPEX)
If a project has been deemed to be economically viable, and financing has been sourced, then construction of the project can begin. The initial CAPEX is the cost of constructing the various buildings and machinery required for production. It involves things such as purchasing processing equipment, metal smelters and developing any required road and communications infrastructure.

This last point is particularly important for mining projects since the projects are usually located far away from populous areas. These initial CAPEX costs are typically extremely high and run into the hundreds of millions of dollars. It's the magnitude of costs required to get a project into production that is the core reason why many projects don't reach production. Many financiers see superior returns on their invested cash elsewhere if the initial CAPEX is extremely large.

Hence, you could have the best quality iron deposit in the world, but if the initial CAPEX is so large that no financier can get a timely return on that invested cash, then it won't go ahead as the risks are too great.

3. Sustaining Capital Expenditure (CAPEX)
As the name suggests, sustaining CAPEX is the expenditure required to sustain a certain level of production. For example, this might include replacing processing equipment after a certain period of time since it depreciates over time. On a smaller scale, it might involve replacing the tyres of the dump trucks required to move material around a worksite.

4. Ongoing Operating Costs
These are the costs incurred in the operations itself. Think of it as the cost of sales that we typically think about when looking at a non-mining sector company. This is often set out as the cost per unit of mineral produced. This is found by first finding a total $ cost figure that is then divided by the units of mineral produced. These operating costs include wages of workers, electricity and energy costs; essentially any costs that are direct mining costs. So if you had an iron ore production company, you would probably state your operating costs as $ per tonne of iron ore.

There is a modification that can be made for gold production companies. Following a change in disclosure agreements at the World Gold Council, gold companies started releasing something called the All-In Sustaining Cost (AISC). This is a more enlightening operating cost figure as it takes all the sustaining costs that the company incurs and translates it into a $/oz figure. These sustaining costs originate from adding administrative costs, sustaining exploration and CAPEX costs to the base operating costs.

Since the AISC includes costs which are indirect, it will always be higher than the standard operating cost figure. A quick comparison table for a few companies in terms of their operating costs and AISCs is shown. Assuming there was no difference between the companies in terms of debt, production rates, mining jurisdiction and other factors, then a lower AISC is strongly preferable as they can better withstand a lower gold price environment.

Obviously, the factors are not all the same, and Serabi Gold actually has much lower production rates than some of the other companies so it's not useful on its own, but it is still an important figure to understand. In fact, if you look at the cash cost figures for Petropavlovsk and Acacia Mining, you can see that it's not always the case that a lower cash cost equals a lower AISC.

5. Mine Closure and Rehabilitation Costs
These are the costs incurred at the end of a project's production life. Companies incur closure costs when ceasing production at a project such as the cost of removing equipment from the project site. Rehabilitation costs are costs incurred when a company tries to return the project area back to an environmentally friendly state. This is usually a governmental requirement and may involve the planting of trees and removal of any toxic materials.

A Typical Exploration Project Cost Cycle

Exploration Project Mining Cost Cycle
The above graph shows a typical exploration project cost cycle. The key point to take away is that the entire mining industry is based on a 'cost-before-cash flow' model. Significant cash outflows have to take place before an undeveloped project can reach production and start paying back its costs already incurred.
Assuming that a company purchases a completely untested project area, the lowest absolute cost will likely be the purchase of the rights to explore that area itself. From that point onwards, investors are tapped for equity many times over, which makes the industry very high-risk. The vertical axis looks at the rate at which costs are incurred. The highest CIR is during the initial CAPEX phase when significant costs are incurred over the course of typically 1-5 years. These costs tend to stretch up to $1 billion, and in some cases can amount to billions of dollars. The closure costs have a particularly high CIR given that they are incurred over a short-period of time (typically 1-2 years) and are not immaterial. The sustaining CAPEX has a low CIR since the very high absolute cost levels are offset by the long period of time that they are incurred over.
A set of example figures are given below the graph for gold explorer Amara Mining's Yaoure project in the Ivory Coast. Some areas of Yaoure were previously developed when Amara purchased it so the graph for Amara does not exactly fit at the start as it wasn't an unproven project. However, the subsequent costs incurred give you a sense of the scale that each of these costs can stretch to.