Unlocking value in projects through Mining

Economics principles

1. INTRODUCTION
Mining is a business involving extraction of commodities of value to society from non-
renewable resources. Consequently there is only one opportunity to extract ore from
the ore body in order to unlock the value potential encompassed in the asset. It is
therefore imperative that the maximum value is unlocked during the extraction
programme, considering the relative wealth generated for shareholders and society,
the sustainability of society, the environment and the operation. The bulk of the value
that is unlocked is usually embedded in the initial design process.

How do you measure sucess

The most common measure of success is the return on investment, which is unlocked
during the extraction process. This is usually only determined and locked-in during the
study process.

Another measure of success is the profitability that is achieved on a monthly basis. A

further measure would be the enhancement the asset affords to the share price of the
operation. Increasing focus on sustainable development requires that the impact on
the society and environment received high priority as well.

All these measures are largely encompassed in the cash flow and the discounted cash
flows. This paper focuses on the dynamics of the cash flow and the most significant
elements influencing return in investment. These include the mine design, production
volume, sustainability, risk and valuation techniques.

When do you add the most value?

There are many different phases and definitions noted by different authors to
demonstrate and standardise the study process for new projects. This paper is based
on a process with 3 major components namely a conceptual study, a prefeasibility
study and a feasibility study.

The following diagram demonstrates this typical study process:

Figure 1

Concept Pre Feasibility Study Feasibility study

Should we Are we doing the Are we doing the thing right?

do the right thing?
thing?

Study diagram

Conceptual study

The purpose of a conceptual study is to determine whether there is "a” and not “the”
business case to justify expenditure to conduct a pre-feasibility study rather than an
exercise that hones in on the preferred option.

Prefeasibility study

The above sketch demonstrates the two-fold nature of the prefeasibility process
namely: A diverging process to ensure all options are considered, followed by a
converging process to select the option for the feasibility stage. To reiterate, the
concept study is not designed to facilitate the selection of the option due to the inherent
inaccuracy and limited scope of such a study. The pre-feasibility phase must be wide
enough to ensure that the whole universe of potential solutions has been considered
(low level of accuracy and limited detail in the diverging phase). During the converging
or selection process, it must be ensured that the accuracy is sufficient to ensure the
optimal solution has been chosen.

The Mining Economics optimisation as discussed in this paper is essentially captured

in this phase of the study. It requires a different mindset to the normal feasibility
process and this thinking process is the domain of Mining Economics.
The value that is unlocked in the process manifests in the degree of value-add to
shareholders, employees, suppliers, the community and the nation. The indirect
benefits derived from this unlocked value (which is seldom measured) is also
significant.
 Feasibility study

The feasibility study is merely colouring in of the optimal option selected during the
pre-feasibility study. Mining economics thinking is tested at this stage at greater levels
of accuracies and are honed in on the specifics of the orebody.

2. VALUATION METHODOLOGY

Most companies measure success of a project (or predict the success) by utilising
(DCF’s) Discounting Cash Flows. The use of DCF’s is a commonly accepted
international proven practice.

There have been significant improvements in valuation techniques over the last few
years, as new derivatives of the cash flow have been introduced. These include the
use of Monte Carlo simulations where the uncertainties of elements are included in the
cash flow. Furthermore, the introduction of option valuation includes the ability of
mines to adjust to changing circumstances.

It was evident from the reviews of numerous projects that project team participants do
not always concentrate on aspects which have greatest impact and significant effort
was often devoted to items that had limited impact on cash flow.. Furthermore,
significant risks or contributions were not afforded due attention. In order to facilitate a
proper understanding of the components that contribute to the cash flow, these were
formalised and are summarised in the next section of this paper.

This methodology of analysing a project is now commonly used by many project

leaders. It is often referred to as the "project DNA". This method of evaluating the
value of an operation has also been used in countless reviews to ensure that the focus
is on the items that add value. This process is also used as a tool in Anglo Technical
Division (ATD) in order to review new projects or, as a tool during consulting on
feasibility studies. The essence of Techno-economics is to understand the business
proposition of projects with regard to Risk and Return. Fundamental to assessing the
return is the principle of value maximization. When considering whether a project will
deliver maximum value a number of key macro and micro elements have to be
considered namely:
 o The determination, amount, timing and duration of capital investment
o The determination of costs
o The determination of the revenue line
o The feasible life of mine considering the ore resource, reserve and
mining plan, corresponding volume through put and product yields
o Cash flows profile and corresponding margins
o Risks associated with the cash flow profile
o Fiscal implications

Project DNA description

Figure 2

Cash Flow DNA Capital

FCF After Tax
FCF With Tax Shield
2,000,000
4
1,500,000
1,000,000
1
Curreny Value

500,000 5
0
0

10

12

14

16

18

20
-500,000
-1,000,000 3
NPV 10%: 12.7 million
-1,500,000
NPV 30%: (1.5) million
-2,000,000
IRR: 25.52%
-2,500,000 2
Years

The five genetic components of a cash flow

o Capital Expenditure (1)

o Time to Breakeven (2)
o Timing (3)
o Build-up (4)
o Steady State (5)
o Life of Mine/Investment (6)
 Figure 3
Capital
Cash Flow DNA FCF After Tax
Additional Measures FCF With Tax Shield
3,000,000 8,000,000
Cumulative FCF

2,000,000 Cum DCF

6,000,000
1,000,000
4,000,000
Curreny Value

0
2,000,000
0

10

12

14

16

18

20
-1,000,000
-
-2,000,000 DCF Break even NPV 10%: 12.7 million
Pay Back period
-3,000,000
NPV 30%: (1.5) million
-2,000,000
IRR: 25.52%
-4,000,000
-4,000,000
Peak Funding: 4,1 milliom
Peak Funding
-5,000,000 -6,000,000
DCF BE: 11 years
Years Payback: 6 years

Cash flow, cumulative cash flow and discounted cash flow

Additional DNA Elements that should also be considered during a valuation of as

follows.
o Real Discounted Cash Flow (DCF)
o Real Internal Rate of Return (IRR) versus Hurdle Rate
o Peak Funding
o Payback Period
o DCF Break Even
o After Tax Cash Flow
o Tax Shield
o Cash flow volatility

The essence of the cash flow investigation is to determine the business rationale for
the project and to test the assumptions around the value drivers, namely: Price,
Volume, Grade, Costs and Capital Investment. The key components that affect these
key drivers are revenue factors, cost factors and investment factors.

Capital Investment (1)

The capital investment has the single most significant impact on value. The
expenditure is certain, relative to revenue generated from product sales. Elements
that require attention are magnitude and timing of capital spend. The magnitude of
spend has to be checked against the basis of estimate. It is crucial that the total
spend considers both the initial investment and continuing or sustaining capital
(stay in business capital).

The timing of the investment is critical. The basis of the cash flow expenditure must
be understood and appropriate for the level of study under review. Secondly where
projects are marginal, efforts to delay capital expenditure should be investigated to
enhance the value of the project.

Timing (2)

The project schedule of timing capital payments is critical to the impact on DCF
valuation metrics. The rule is to delay cash outflows and speed up cash inflows.
Hence the longer the capital investment cash outflows the greater the benefit to the
project. Key variables to consider are:
ü Schedule/timing
ü Critical path
ü Contingency i.e. amount and timing of contingency
ü Escalation factors applied
ü Units rate and aggregation of estimate
ü Volumes/quantities
ü Design

Build-up of production (3)

The production build-up/ramp-up is the foundation to the cash engine of the cash
flow model. Key areas to interrogate are:
ü Macro Design
ü Micro designs
ü Learning curve factors (generally applied to efficiencies)
ü Linkages between underlying software estimating packages
ü Skills i.e. are critical skills available?
ü Staff – accommodation, training, medical and social impacts
considered
ü Flexibility, is there sufficient reserve face availability to sustain
production targets
ü Control Systems in place to support the steady state
Life of Operation (4)

The life of the operation is generally dictated by the type of ore body being
considered. Obviously the longer the life the greater the security of future
operational pipeline and the better the ability of the project to deliver promised
returns in a cyclical metal market. It is important therefore to have an
understanding of the regulatory regime and to ensure that the future mineral rights
have security of tenor. The life of the operation will also impact on sustainable
development, hence a further desire for long life projects.

Cash Margin (5)

The Discounted Cash flow is supported by the principle of maximizing cash flows.
The key components of this are:
ü Revenue Factors:

ü Products
When considering a mining project the following has to be given
consideration in the valuation
o Product Types;
o Products Prices;
o Location of the mine to markets;
o Product Quality;
o Marketing;
o Grades;

ü Volumes: A number of questions relate to volumes:

§ Capacity:
§ Life of mine

ü Multiple reefs: If more than one ore horizon is being mined, is the
horizon with the greatest value scheduled upfront and not being
displaced by ore of lesser value?

ü Royalties and taxes

It is not uncommon that government taxes in the form of royalties are levied
against mining projects. It is important to ascertain the nature and extent of
 royalties that are applicable and to ensure that the valuation considers
them. The availability of a tax shield often has a positive impact on projects

ü Exchange Rate
Fluctuations in exchange rates affect the valuation in local currencies. The
valuation model assumptions must be consistent with the official corporate
view. This factor, in conjunction with the price assumptions, usually has the
most significant impact on the project. Often projects rely on weakening
exchange rates.

ü Cost Factors
It is important to consider the composition of costs and ascertain whether
they are consistent with industry benchmarks. Notwithstanding, a sanity
check should also be undertaken to compare future costs projections with
historical achievements, to ensure that the cost estimate follows on
seamlessly from current operations. Where there are exceptions, a
coherent plan of action should be accompanied by an explanation on how
the targets will be achieved.
There is often a dislocation between the technical decisions included in the
projects and the operating cost. It is recommended that activity costing is
used rather than responsibility based cost or cost by element. It is easier to
tie activity cost to the technical decisions.
• The key cost drivers for activity costs typically considered are:

o Mining Costs
§ Development
§ Stoping
§ Tramming
§ Hoisting
§ Maintenance
§ Environmental
§ Geotechnical
o Processing Costs
o Overheads Costs
o Transportation Costs
o Refinery Costs
 The fixed and variable components should be clearly understood as well as the
cost drivers. Operating cost is a key component in determining the optimality of the
project. Operating costs are often determined at the end of the project in a reactive
manner, rather than letting it play a pivotal role in the optimisation process.

3. Time value of money

One of the standard ways usually accepted by project leaders to add value is to
improve the capital utilisation by reducing the deviser (capital). This may not always be
the best solution. If revenue could be brought forward through accelerated or even
increased capital, the trade-off study may suggest the capital to be increased.

The following diagram (figure 4) shows the impact of discounting on the cash flow
(dotted line). It suggests that the value could be added if capital is delayed on a just-in-
time basis (JIT). The risk associated with such a delay should however be clearly
understood. Bringing mining production forward would also add value by accelerating
the build-up (pink area) or spring boarding from existing infrastructure (red area).
Figure 4

Value curve diagram

Furthermore, issues or risks in the early years have a significantly larger impact than
those expected at the end of the life of mine. Many discussions about rehabilitation
cost have taken a significant effort and time of the project team but in reality the impact
may be minuscule on the valuation. However, care should be taken as some critical
issues are not reflected in the cash flows.

4. Optimising mine design

The following section addresses some of the generic the mining economics trade-off
studies that could be considered during a pre-feasibility study. Both the concept of the
cash flow DNA and the time value of money should be considered during this trade-off
process. These trade-offs are usually simplistic and conducted on an iterative basis.

Matching the cost signature to the orebody signature

Every ore body has a orebody signature terms of its grade tonnage curve. Every mine
design also has a cost-volume curve. One of the first trade-offs should be conducted
to match the two curves to ensure that the optimal value is unlocked.

The following figure (5) shows a simplified cost-volume curve

Figure 5

Cost-tonnage curve
The above graph (Figure 5) is probably an over simplification of the cost tonnage curve
and is used for illustrative purposes only. In reality the curve is far more uneven as a
result of the relevant ranges of fixed cost (also referred to as semi fixed cost).

Increasing volumes reduces the operating costs expressed in a cost per unit. This has
an impact on the reserves and grade is determined on the grade tonnage curve.
Higher volumes will result in lower cut-offs suggesting an increase in reserves and
hence a longer life. Selective mining suggests a reduction in reserves at an increase in
trade achieved and hence an improved profitability. Trade-off studies using the above
tools would indicate what the optimum volume and optimum cut-off would be as
reflected in the following diagram.
. Figure 6

Value optimisation Diagram

In order for this exercise to be conducted the variability, predictability and selectivity of
the orebody needs to be clearly understood. It should also be conducive to selective
mining. Platinum ore bodies seldom lend themselves to selective mining.

Maximum capacity

A further derivative of the concept of optimal volume is to consider designing the

infrastructure to a 100% fit. Is it better to run equipment at full capacity than to sterilise
production opportunities, or over design to facilitate further upside opportunities.
Saving capital and sterilising future potential has a huge impact on the return of the
project. This may be a "penny wise pound foolish" decision. For example, recent
exercises have indicated that hoisting capacity should be over designed if there is a
chance that it that the footprint can deliver more than the "nameplate" associated with
the infrastructure.

Optimal volume

Many papers have already been written on the topic of optimal volume. In fact,
specialists can often not agree the concept of optimality. If however the concept of
discounted cash flow is c onsidered the following trade-offs could be considered. These
concepts are not necessarily mutually exclusive:
• Depth of shaft;
• Optimum volumes;
• Optimal number of levels; and
• Optimal strike distance.
Some extracts from previous studies are included in this paper. These studies attempt
to illustrate how these trade-offs are approached.

Optimal depth

The optimal economic depth should be determined up front. Deeper shafts take longer
and are expensive, however, deeper shafts open more reserves, require more levels or
an increased inter level spacing. Practicality suggests that 10 levels are probably the
maximum that could be handled on the shaft. The inter-level spacing should also be
optimised. These trade-offs would be a function of square metres per development
metre, and the ability to mine over back lengths.

• Optimal Volume – smaller volumes tend to be more expensive per unit but less
risky. High volumes on the other hand are cheaper per unit but additional risks
are introduced. The optimal economic volume adjusted for risk needs to be
determined up front.
The following graph is an example of optimal volume trade-offs that were
conducted for a Platinum operation. What became clear in this operation is that
very large volumes (tonnage) became less attractive due to the long sinking
process that destroyed much of the benefit, as a result of a very deep shaft.
 IRR

13.0%

12.0%

11.0%

10.0%

9.0%

8.0%

7.0%

6.0%

5.0%

Shaft 1: 100 ktpm Shaft 2: 150 ktpm Shaft 3: 200 ktpm Shaft 4: 250 ktpm Shaft 5: 300 ktpm Shaft 6: 350 ktpm

IRR
•

• Optimal strike length. If shafts are too close the life per level is
reduced which may negatively impact on the amortisation cost of this
infrastructure. If they are too far apart, one may be locked up for too
long. Exercises that were conducted suggest that allowing less than
2 km on either side destroys value, however, distances in excess of
3 km did not add value and compounded the risk.

• Number of levels. Concentrated high volume mining on a

limited number of levels improves cost efficiencies but
increases the risk. The optimal economic trade off should be
determined, in conjunction with the depth of the shaft.

IRR

12.5%
12.0%
11.5%
11.0%
10.5%
10.0%
9.5%
9.0%
8.5%
8.0%

Shaft 1: 250 ktpm 8 Levels Shaft 2: 250 ktpm 10 Shaft 3: 250 ktpm 12 Shaft 4: 250 ktpm 14 Shaft 5: 250 ktpm 16
Levels Levels Levels Levels

IRR
 The above graph shows an example of such a trade-off.
The standard requirement for a 250-ktpm shaft is 10 levels. If the shaft is
sunk deeper than 10 levels, the operational risk reduces but a penalty is
paid in terms of capital and timing.
It appears that roughly 2% of IRR is sacrificed for every level added without
the immediate benefit of additional production.

These exercises may also include sinking the shaft in stages, utilising a
deeper ventilation shaft as a secondary sinking base. This staged approach
will allow the infrastructure to unlock the resources but the cost of unlocking
such resources will also be delayed.

Cost of mitigating risk versus benefit accrued

It is important to consider risk from a probability perspective to determine

the true cost of the risk. It is possible to under or over-estimate the cost of
a risk if the safety side is considered on its own.

The suggested risk = Risk Cost = consequence x probability

Figure 7 below is a well-known risk and cost trade-off explanation.

Optimal

Benefit
Risk

Cost to mitigate

Risk mitigation versus benefit curve

The above figure shows that as you spend more money to mitigate risk, the losses are
reduced. However, there is a cut-off point, at which the expenses may exceed the
benefits. This should be kept in mind if a system is designed to mitigate losses. The
law in South Africa states that “reasonably practical” risk management is considered
beneficial.

The key observation for this project is that a balance between the cost of mitigating risk
and the residual risk encompassed in the project needs to be clearly understood. This
is often not the case.

Sustainable economics

In recent times there has been a renewed focus on what impact the project has on
other stakeholders. The following graph reflects some components in the potential
value unlocked in an orebody. The main components are:
Revenue: is value added to the country fiscal, usually in terms of foreign exchange
over the life of the project. This value would not be realised if the orebody was not
mined. These impacts the balance of payments and forms the "seed" for further
financial activity in the country.

Social value: - Up to 50% of operating costs is translated into salaries for employees.
Every employee supports around five other people and their joint needs results in the
establishment of further economic activity, which has a multiplying effect estimated up
to 10 times the seed value.

Local and national industries: - The establishment of a new industry creates the
need for equipment and material to such an organisation. This adds value to the local
and national industries but also has a multiplying effect.

Import: - some projects have a high import component, which adds value to other
parts of the world. This often includes high-level technology equipment and material.
This has a negative impact on the host country's balance of payments.

Taxation: - The State is the custodian of the mineral wealth on behalf of the nation in
most countries. An economic rent is paid to the State in the form of taxation, royalties,
fees and secondary taxes. This wealth is used to create infrastructure and support for
the nation.

Shareholder return: - Any investor requires an acceptable return commensurate to

the level of risk for each investment. The measure of the discounted cash flow is
standard practice. The reward for the shareholder is measured in terms of the NPV
plus the minimum opportunity cost of money as determined by the discount rate.
Figure 8

Distribution of proposedvalue unlocked at Amandelbult 4 Shaft

90000

80000

70000

60000
R million

50000

40000

30000

20000

10000

Cashflow
STC
Revenue

Opportunity

NPV
Off mine opex

Ongoing capex
On mine opex

Project Capex

Tax

cost
Value components within an investment.

Project Philosophy

The following diagram shows the model that has been successfully used in
several projects. Any technical issues / designs / risks are subjected to an
economic trade off. The cycle is repeated until optimality is achieved.

This process has recently been improved by further enhancing value of

projects by focusing on items that really make a difference to the bottom
line. In other words, the starting line would be an analysis of the key risks
and opportunities in the project, which will form the basis of a selection of
technical studies.
 5. Conclusion
The biggest risk associated with any mine is that the ore body is extracted and little or
no profits are made due to a sub-optimal mine design.

The best way to achieve success is to plan to achieve it. From a shaft perspective, this
is best done in the concept and pre-feasibility phases. This is where the basic design
is determined and best practices are included.

The NPV or discounted cash flow is the most acceptable tool for determining the value
of a project. The NPV suggests that due to the opportunity cost of money, profits
should be brought forward to optimise returns. This is achieved by delaying cost to
decrease the impact and by bringing the extraction of reserves forward to maximise
revenue and to improve profitability.

The risk based, least regret method of decision making is encouraged. The techno
economic models need to be used continuously during the evaluation and design
phases to eliminate unnecessary work and expense. It will also focus effort on the key
drivers of the project.
It is our duty as custodians of the orebody to unlock maximum value for all
stakeholders. The use of mining economics during the study process is a valuable tool
that could facilitate an informed decision making process that will drive value within
projects.
Acknowledgement
Anglo is acknowledged for allowing this paper to be published. Mr Craig Hutton
is also acknowledged, as he has contributed to this paper in terms of his
understanding of the project DNA.

The University of the Witwatersrand and specifically the Mining Department for
the work in the GDE courses that the planted the seed for this work.