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Evaluation and acquisition of deposits

by
F.-W. Wellmer and W. Neumann
Abstract
The evaluation and acquisition of deposits is
affected by numerous influencing parameters whose
precise determination and weighting is a critical
factor in the success or failure of an acquisition
decision or the implementation of a mining project,
particularly in times of falling metal prices. The fact
that the quality and quantity of deposits cannot be
changed only serves to underline the high level of
due diligence involved in decision making. This
paper analyses the most important standard
evaluation and calculation methods as well as the
influencing factors on deposit acquisition. This paper
also highlights and discusses the most important
relationships between deposit characteristics,
purchase and market price, profit forecasts and
country risks.
The first aspects to be discussed are the evaluation
methods. All economic evaluation methods involve
comparing the project cash inflows and outflows with
one another, i.e. the exploration expenditure and
investments as negative cashflows compared to the
positive cashflows including the difference between
the income from ore and concentrate sales and total
operating costs, interest on foreign capital, taxes
and production royalties. Depreciation is not
included here. Depreciation is not a cashflow but
rather a financial instrument to determine the
taxation base.
In the previously commonplace statistical evaluation
methods, uncorrected cashflows were compared
with one another or booked against one another. In
an ancillary method - calculating the payback period
- this calculation method still plays a role. The
payback period calculation determines how long it
takes to recoup the invested capital. This ancillary
method plays a role in particular in evaluating the
country risk which is discussed in detail below.
Nowadays, it is more usual to use dynamic methods
which take into consideration the current market
value of money. Cashflows consist of cash, and
cash has a current market value. It has a current
market value because people prefer to be paid
earlier rather than later because one can then use
the money itself to earn more money. This means
that later cashflows are penalised in comparison to
earlier cashflows, i.e. they are discounted. In order
to give all cashflows a base value, one has to agree
a fixed point in time. This is normally taken as the
start of production. Discount factors are derived from
compound interest tables: they are the reciprocal
values of accumulation factors. Whilst cashflows
after the cutoff date are discounted, cashflows
before the cutoff date are accumulated.
The sum of the discounted positive cashflows during
the production period are now compared with the
sum of the accumulated negative cashflows during
the investment period (and possibly also during the
exploration period) i.e. to give the difference
between the two. This difference is Net Present
Value (NPV).
(1)
where I equals investments, CF the annual
cashflows, q=I+i, where i is the assumed interest
factor, which is discussed below in more detail. n is
the year in question.
The net present value itself needs standardising if
several projects are to be compared with one
another. This is done by dividing by the investment.
(2)
Once one has determined interest rate i at which the
net present value becomes zero, this interest rate
becomes the rate for internal rate of interest, or the
Internal Rate of Return (IRR).
In expression (1) q are the discount factors derived
from the compound interest calculation incorporating
the simplification that the cashflows all occur at the
end of the year. In reality, they take place throughout
the year. Some evaluators therefore work with
discount factors (DF) based on continuous rates of
interest, where i is again the interest rate and t is
time:
(3)
These discount factors are lower than the
discontinuous rates of interest in expression (1) and
thus highlight even more the effect that cash inflows
later on in the year have on lowering net present
values. An example is shown in figure 1.
Fig. 1 : Compound factors
0
0,1
0,2
0,3
0,4
0,5
0,6
0,7
5 10 15 20 25 30
compound rate i
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A
F
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0,3
0,4
0,5
0,6
0,7
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q
-
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t -i
( )
n -
n
q =
i + 1
1
These are the most important evaluation methods
used by all major mining companies. BHAPPU and
GUZMAN surveyed 20 North American mining
companies in 1995 and reached the following
conclusion (table 1):
Tab. 1: Priorities of 20 selected mining companies ( Bhappu, 1995 )
IRR Payback-Period NPV Other Methods
Primary 11 3 8 3
Secondary 3 6 5 0
Tertiary 1 2 0 0
A weakness in the evaluation methods described
above is that they completely ignore the
management flexibility, e.g. in the case of price
changes - in other words, the ability to react to price
volatility. For this reason, up-to-date mining project
evaluations also apply a further development of the
method used to evaluate financial derivatives
(options) called the Modern Asset Pricing method
(MAP). This is also a dynamic method which takes
into consideration the current market value of
money. The management flexibility is taken into
consideration via decision trees. Figure 2 shows an
example of this for a copper project where
management had the option of stopping the project
at any time, and the option after 7 years of
developing a less concentrated deposit which would
increase the productive lifetime by 11 years
following production of the more highly concentrated
deposit in the first 9 years.
Fig. 2 : Copperproject with the option of 2 different terms
Since, as table 1 shows, virtually all major mining
companies use the same methods, this raises the
question as to how one can establish a critical
advantage in the international competition amongst
companies in the acquisition of deposits. "Where
can improvements be made?"
The first step is a sensitivity analysis. Figure 3
shows the graphic results of an analysis of this type.
Each project naturally has its own specific
characteristics, but in principle, most sensitivity
analyses reveal the same trends:
the most sensitive parameter is always the
commodity price. This is followed by ore grade and
concentration as a result of processing - which
influences net grade. This is followed by the much
less significant size of the reserves and operating
and capital costs, and then the even less significant
exploration costs.
Fig. 3 : Sensitivity diagram for an intended mining operation
Extrapolating the future trends of strongly fluctuating
commodity prices - particularly of commodities not
governed by any dominant producer prices - is
extremely difficult. The companies therefore usually
incorporate a range of prices in their sensitivity
studies and apply the "lower third rule". The lower
third rule involves carrying out a worldwide
comparison of costs amongst all of the competing
companies. The deposit being evaluated must
therefore lie within the lower third of costs amongst
all competitors - this is based on the assumption that
a slump in prices will first lead to the closure of the
highest cost producers, and that the associated
reduction of capacity, and therefore supply, will
trigger a rise in prices. Application of the lower third
rule is therefore a strategy for maximising the mines
chances of surviving cyclic price fluctuations.
Deposit evaluations require very accurate
calculations of the ore grade. This generally starts
with investigating the analysis provided by the
vendor. This is done on the basis of verification
analyses by reliable laboratories. It is quite common
for significant corrections to be made to the stated
analysis of a deposit on the market. These new
analyses then form the basis for reserves
calculations. Today, this more and more often
involves geostatistical methods to determine the
most reliable possible block grades from the -
unavoidable point restricted - drilling data. These
reserves blocks then form the basis for extraction
planning.
Because the NPV in the first years makes a much
larger impact than the NPV from later years -
because of discounting factors incorporated in
dynamic economic evaluation methods (see figure
1) - it always make sense to extract the highest
grade areas in the first years of operation. This is
helped in some deposits by favourable geology:
copper and gold deposits often contain shallow
zones of enrichment - in fact, many porphyritic
deposits are only economically mineable because of
these enrichment zones. Empirical values can be
used for deposits on the market where inadequate
data is available to carry out differentiated block
estimation - although this means that only global
overall estimates are feasible. As a general rule, it is
frequently possible to mine grades within the first
years that are approximately 10 % richer than the
average value overall (fig.4).
Fig. 4 : Relative grade development of the production of Endako,
British Columbia, Canada, in the years 1965 - 1993 ( Wagner, 1999 )
If a deposit in the early stages of exploration is on
the market, the first thing to check is whether it is
possible to discover new high grade zones which
have been missed. A case in point is the Nanisivik
Zn-Pb deposit on Baffin Island in the far north of
Canada. After the US American company Texasgulf
discovered the deposit in 1961, exploration drilling
initially concentrated on the eastern part of the S-
shaped deposit. When the Canadian company
Mineral Resources International took over the
deposit in 1972, further exploration focused on the
western part which proved to have considerably
higher grade. When production started in 1976 it
was this part of the deposit that was initially
extracted.
Another example is the porphyritic deposit at Ok
Tedi in Papua New Guinea. This deposit was
discovered in 1968 by the American company
Kennecott. The deposit had a leached gold capping
zone above the copper ore body. This zone was
virtually ignored during the Kennecott exploration
period because of the low gold price. However,
when the consortium formed by the Australian
company BHP, the US company Amoco and the
German consortium Kupferexploration continued
exploration in 1976, there had been a considerable
increase in the price of gold (1968: 40.06 US$/oz;
1976: 125.32 US$/oz). They carried out additional
exploration, and the gold capping zone became the
key reserve during the first operating phase.
The main processing parameters can be determined
by experienced mineralogists, even during the early
stages of exploration, on the basis of microscopic
analysis e.g. the milling grade required and the size
of the yield. Processing experiments on a laboratory
scale are carried out immediately, if sufficient
sample material is available, to determine the yield
and the bond index for the energy consumption
during milling. In simple deposits, e.g. coarsely
intergrown Pb-Zn deposits in carbonates, it is even
possible to incorporate laboratory values as final
values in subsequent feasibility studies. In the case
of complex deposits, it is often only possible to work
at a tonne scale up to the pilot phase. If the deposit
is being evaluated with a view to possible
acquisition, standard practice includes new
microscopic examination and laboratory tests to
check the yield figures.
Because the major mining companies and
international consulting companies which are usually
involved in feasibility studies today are basically all
at the same technical level, the capital and operating
costs calculated in all evaluations will be roughly
comparable. One of the possible influencing factors
is a reduction in the lifetime of the mine, i.e.
maximising the capacity. This can result in a cost
degression of the specific costs on the back of
economies of scale. The Taylor formula is used to
determine the optimum lifetime of a mine:
lifetime n (in years)= 0,2
4
tonnage total (4)
Various investigations have shown that real average
capacities comply with this formula but that there is
a relatively wide range whereby the mines with
higher capacities are often found in developing
countries. The objective here is not only to maximise
net present value but also to minimise payback
periods - particularly because of political risk.
This preliminary work to calculate reserves,
determine the processing and mining parameters,
as well as to estimate costs and incorporate price
assumptions for the commodity involved, generates
all of the parameters required to calculate the net
present value from expression (1). The only question
to be answered now is what interest rate i does a
company use. In addition to price assumptions,
fixing an interest rate i probably allows the greatest
amount of flexibility available to a company when
evaluating a deposit with acquisition in mind.
When assessing the interest rate i, companies
generally orientate themselves to government
bonds, long term capital investments with the lowest
risk, and specifically the so called bond rate. This is
supplemented with a risk factor because every
industrial activity involves the risk of failure. This is
particularly true for mining activities because mining
risks are generally higher than normal industrial
risks. During periods when long term capital
investments with minimum risks of approx. 10
percent were possible in classic industrialised mining
countries such as Canada and Australia, the risk
premium was at least 50 percent. Similar absolute
values are applicable today given the low interest
rates on government bonds, so that some
companies nowadays calculate with i = 10 %. In the
above mentioned survey of mining companies
BHAPPU and GUTMAN found in 1995 that interest
rates aquiered (IRR) varied between 11 and 16 %
with an average of 12,5 % (Tab. 2).
Tab. 2: Minimum Required Rate of Return ( Bhappu, 1995 )
Primary Commodity Minimum Real
Required Rate
Standard Deviation
( % ) ( % )
Gold 11,1 3,6
Copper 11,8 2,6
Iron Ore 16,0 1,4
Others 13,0 2,8
Total Group 12,5 3,5
Added to this is another risk premium reflecting the
specific country risk. This is dealt with below in
detail. Some countries have limiting values for
additional taxes (additional profit tax or resource rent
tax) when the internal rate of interest exceeds a
certain limiting value. This reveals what a given
country considers to be the upper limit of normal rate
of interest. In Papua New Guinea, this limit is, e.g.
20 percent, or 12 percent above the US discount
rate. Reliable statistical averages can be calculated
in countries which have a large functioning market
for the sale of deposits, so that one can then derive
the interest rate which is considered standard from
the transactions. These conditions are more
frequently fulfilled in the case of the pit-and-quarry
industry.
This involves two types of sales: either the deposit
itself is sold once and for all at a fixed price or the
pit-and-quarry company acquires the extraction
rights and pays the owner a production royalty. The
one-off payment can be compared with the annual
production royalty payment with the help of a
formula derived from expression (1), which allows
the interest rate i to be calculated (Wellmer, 1992).
Fig. 5 is an example of this for German brick clay
deposits.
Fig. 5 : Compound rates for the net present value calculation based on the
comparison of the purchase price and the royalties on the purchase
of brick clay deposits in the old states of Germany (by STEIN, 1991)
This clearly shows that the interest rate decreases
as lifetime increases. Although the strong drop in
interest rates for reserves between 5 and 15 years,
as well as the absolute values, cannot be used as
global generalisations, the trend is obvious. If the
deposit only has a short lifetime, the operator carries
a high risk. For instance, there could be start up
difficulties with the plant, with associated financial
shortages, for which it may not be able to
compensate because of the short lifetime. Deposits
with short lifetimes may also be more strongly
affected by any price fluctuations than would be the
case with long lifetimes. Experience shows that price
slumps and price rises can affect metal deposits
every 4 to 5 years.
The country risk was already mentioned above. The
higher the country risk, the shorter the payback
period demanded by the investor (as discussed
above) and the lower the price that the investor will
be prepared to pay for comparable deposits with
comparable levels of exploration. Country ranking
tables are regularly published in trade magazines on
the basis of surveys of mine managers. Table 3
shows a typical example:
Tab. 3: Estimation of the country risk by the mining industry* (MJ, 1996)
positive nominations
1 Argentina 95% Countries with the potential to develop
2 Chile 95% profitable mines within the next 10 years
3 Peru 86%
4 Brazil 77%
5 Indonesia 73%
6 Mexico 55% geological Potential
7 Ghana 50% price of the deposit
8 Bolivia 45% business surroundings
9 Philippines 32% political stability
10 Venezuela 23%
11 Zimbabwe** 27%
12 Namibia** 27%
13 Kasachstan** 32%
14 P.N.G.** 27%
15 South-Africa** 27%
* Consulation of 100 managers of mines
** With inclusion of negativ rating
Figure 6 shows the relationship between specific purchase prices for gold deposits and the relevant country risk.
Fig.6 : Gold deposits - purchase price / Country Ranking
0
50
100
150
200
250
300
350
400
0 20 40 60 80 100 120 140
Country Ranking ( AusIMM - Bulletin, 1994 )
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This country ranking according to the Australian
Mining Monthly (Feb. 1993) incorporates various
aspects such as political stability, social risks,
legislation and currency risk. The three deposits with
low scores, i.e. with low country risk, are in the USA,
Canada and Australia. The two deposits with high
scores, i.e. a high country risk, are in Russia and
PNG.
Another clear example of the dependence of price
on country risk:
The large Ghanaian gold company, Ashanti
Goldfields, with the British company Lonrho as major
shareholder, published a comparison in 1994 of how
stock market investors rate the reserves in the
ground of companies in North America, Australia,
South Africa and Ghana (Financial Times 29.4.94).
Evaluation of unmined reserves with respect to 1 ounce of gold (31.103 g)
Tab. 4:
North America 160 US-$/oz
Australia 140 US-$/oz
Ghana (Ashanti) 92 US-$/oz
South Africa 50 US-$/oz
This clearly shows the influence of country-specific
political environments. This not only includes the
political risk but also other factors, e.g. different tax
systems or environmental policy legislation. Figure 7
shows a wide variation in taxes and royalties, in
other words, production royalties.
Fig. 7 : Fluctuation of taxes and royalties .
Specifications for 64 mining countries.
( SEG Newsletter, 1998 )
If one ignores for the time being the stock market
ratings of mining companies, but concentrates
instead on deposit acquisitions, and relates the
purchase prices to the contents of the deposit, one
ends up with a picture as shown in figure 8 where
the acquisition prices are shown as a function of the
relevant commodity prices. Naturally, the values
have a wide range because they involve three
superimposed parameters:
- The status of the deposits. Investors will be
prepared to pay more for a fully explored deposit
than for a deposit in the early stages of exploration,
which in practice only highlights the potential but
provides no high levels of security for the ultimate
grades and reserves.
- Investors are prepared to pay more for potentially
more economic deposits than for less attractive
deposits.
- For comparable deposits, investors are more likely
to pay a premium for a deposit in an attractive
country than they are for deposits in countries with
difficult background conditions.
Tables 5a and 5b give the figures for acquisitions of
copper and gold deposits in Chile to highlight the
range for deposits with similar levels of development
under constant country risk (after GORMANN,
19994).
0,0001
0,0010
0,0100
0,1000
1,0000
10,0000
100,0000
1.000,0000
0,10 1,00 10,00 100,00 1000,00
Market price per lb metal or ounce precious metal in US$
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Zn/Pb
Cu
Ni
Au
Fig.8 : Comparison of purchase price with market price
Tab 5a: Specific prices in US-$/oz gold content
(Whateley & Harvey, 1994)
Project Acquisition cost
La Coipa 27
El Hueso 63
San Cristobal 16
Choquelimpie 11
Can Can 21
Fachinal 6
Andacollo 5
weighted average 24

Tab. 5b: Specific prices in US-cents/lb. copper content
(Whateley & Harvey, 1994):
Project Acquisition cost
Zaldivar 0,4
Quebrada Blanca 0,5
Leonor 1,0
Pelambres 0,8
Lince 1,6
Candelaria 0,3
Cerro Colorado 1,0
weighted average 0,5
If one is considering the impact of economics, one
must first know the economic factors such as net
present value, internal rate of return, or the payback
period as discussed above. These factors are rarely
available. A general evaluation is therefore carried
out incorporating average cost curves interpolated
from known cost information with the help of
exponential curves. These exponential curves have
the following form
b
x a y

= . where y equals
specific costs (specific investments or operating
costs), x equals the capacity, and a and b are data
set constants (cf. e.g. WELLMER 1992). The net
present value was calculated using a constant rate
of interest.
If one now compares purchase price as a function of
net present value one should arrive at an
approximately straight line positive correlation
between purchase price and net present value when
comparing deposits in one country (i.e. constant
country risk) and at similar levels of development.
Figure 9 clearly shows the strong influence of
country risk when comparing deposits at similar
stages of development in different countries. This
model shows that prices resulting in a negative NPV
are still being paid in attractive countries such as
Canada or Sweden. In effect, these are premiums
for future potential or new reserves.
If one actually has access to individual economic
data on deposits sold in attractive countries such as
Canada and Australia, as well as attractive
developing countries such as Chile, Argentina or
Brazil, one repeatedly finds that purchasers are
willing to pay substantial premiums to succeed in
what is a generally tough competitive environment.
This raises the question of whether the investor can
recoup these premiums and make an operating
profit. At the start of this paper we discussed the
major effects of commodities prices. One obvious
possibility is to speculate on higher commodity
prices. The most important factor though is usually
the evaluation of the future reserves upside.
Deposits are rarely 100 percent explored.
Experienced economic geologists will be able to
analyse in great detail the geological situation, and
any geochemical and geophysical data available, to
interpret the presence of additional ore bodies.
Evaluating the upside is therefore a very important
and possibly the most difficult overall aspect when
evaluating and acquiring deposits. This is also
described in the form of empirical curves. Figure 10
shows, for instance, curves of this type on reserve
growth during operating periods where 100 percent
represents the reserves determined by the feasibility
study and which formed the basis for mine
development.
Fig.9 : Relation Purchase Price - NPV - Country Risk
for 4 comparable projects
0
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30
40
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60
70
80
-200 -100 0 100 200 300 400 500
NPV in Mio US$
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increasing country risk
Canada
Sweden
Canada
Russia
Fig.10 : Growth curve models in the exploration of different deposit types ( Wagner, 1999 )
The 3 curves shown differentiate between:
Volcanogenic massive sulphide mineralisation
(VMS) which forms very heterogeneous non-ferrous
metal deposits (Cu, Zn, Pb, Au, Ag) which are
usually stratiform or massive.
Areally extensive sedimentary deposits (Pb, Tn) of
Mississippi Valley type (MVT) which are usually
shallow and predominantly have thicknesses below
100 m.
Porphyritic deposits which are usually of low grade
but of very large extent (Cu, Mo, often with Au) and
are typically shallow. Because of the low grade and
the average deposit size of 140 MT, open cast
mining capacities are usually high.
Comparing the exploration growth curves of the
three deposit types clearly shows type-specific
patterns. These range from the erratic curve
associated with porphyritic deposits; the exploration
success S-curve in MVT deposits; and the almost
linear-proportional growth in the exploration of
massive sulphide bodies. The curve for the MVT and
porphyritic types changes dramatically after
extracting around 60 percent or up to two-thirds of
the ore bodies. This inflection also occurs in some
VMS deposits, although without having an effect on
the average trend. This common characteristic is
probably attributable to the fact that after repeated
exploration successes and the establishment of
adequate reserves, an increase in operating
capacity is sometimes recommended. This can
increase the level of exploration as a result of
intensive development in previously unworked parts
of the deposit which often leads to the discovery of
additional reserves.
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