Evaluation and Acquisition of Deposits

8/10/2019 Evaluation and Acquisition of Deposits

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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 andcountry 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 betweenthe 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 orderto 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).


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(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

c o m p o u n

d f a c t o r

A F

0

0,1

0,2

0,3

0,4

0,5

0,6

0,7

c o m p o u n

d f a c t o r q -

n

e=AFt-i

( )n-

n q=i+11


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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 concentrateddeposit in the first 9 years.

Fig. 2 : Copperproject with the option of 2 different terms


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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


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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 thevendor. 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 isfrequently possible to mine grades within the first

years that are approximately 10 % richer than the

average value overall (fig.4).


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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


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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 costdegression 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 tonnagetotal (4)

Various investigations have shown that real average

capacities comply with this formula but that there isa 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 capitalinvestments 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 companiesBHAPPU and GUTMAN found in 1995 that interest

rates aquiered (IRR) varied between 11 and 16 %

with an average of 12,5 % (Tab. 2).


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Tab. 2: Minimum Required Rate of Return ( Bhappu, 1995 )

Primary Commodity Minimum RealRequired 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 calculatedin 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 allowsthe interest rate i to be calculated (Wellmer, 1992).

Fig. 5 is an example of this for German brick clay

deposits.


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Fig. 5 : Compound rates for the net present value calculation based on thecomparison of the purchase price and the royalties on the purchaseof 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 asglobal 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. Thehigher 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:


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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 stability10 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 )

P u r c

h a s e p r i c e

i n U S $ / o z


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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 )


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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$

P r i c e p a i

d p e r

l b m e t a l c o n

t e n

t o r

o u n c e p r e c i o u s m e t a l c o n

t e n

t i n t h e

d e p o s

i t i n U S

$

Zn/Pb Cu Ni Au

Fig.8 : Comparison of purchase price with market price


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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 paybackperiod 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 bxay = . 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


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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 ofadequate 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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References

Andrew, R.L. (1994): Australian Companies - The New Multinationals, AusIMM Bulletin, Nr. 5,

Ainsworth, J. (1991): Financing mining projects in the 1990s , MEM September 1991. Ainsworth, J. (1990): Some Aspects of Financing Mining Projects, AusIMM Bulletin,

Nr. 6, September 1990. BA Australian Limited : Investment Evaluation, Financing and the Cost of Capital.,

September 1994. Barnard, F. (1998): Mining Royalties: What are they and where are they going? pp. 16-18,

SEG Newsletter N 32, January 1998. Bhappu, R. (1995): Mineral Investment Decision Making, E & Mj, July 1995 Samis, M. & Poulin, R. (1998): Valuing management flexibility: A basis to compare the stan dard DCF and MAP valuation frameworks, CIM Bulletin, Vol.91, N 1019. Stein, V. (1991): Die Bewertung von Lagersttten der Steine und Erden, speziell in den stlichen Lndern

der Bundesrepublik Deutschland. - Geol. Jb. A 127. Supplement to Mining Journal, London, October 4, 1996. Wagner, M. (1999): konomische Bewertung von Explorationserfolgen ber Erfahrungskur- ven.- Geol. Jb. Sonderhefte, SH 12: 225, 102 Abb., 68 Tab.; Hannover (im Druck). Wellmer, F.-W. (1992): Rechnen fr Lagerstttenkundler und Rohstoffwirtschaftler, Teil 1, Verlag Sven von Loga, Kln. Wellmer,F.-W., Atmaca,T., Gnther,M., Kstner,H., Thormann,A.(1994): The Economics of Sediment -

Hosted Zinc-Lead Deposits; Aus Fontbote,L. & Boni,M.: Sediment - Hosted Zn-Pb Ores, Special Publication

No.10 of the Society for Geology Applied to Mineral Deposits. Whateley, M.K.G. & Harvey, P.K. (1994): Mineral Resource Evaluation II: Methods and Case Histories, Geological Society Special Publication No. 79.

Evaluation and Acquisition of Deposits

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