- 1 Metals and Mining Industry Primer
- 2 Mining Industry Operating Summary
- 3 Valuation of Metals and Mining Companies
- 4 Metals and Mining Metrics, Ratios and Terms
- 5 Metals and Mining Credit
- 6 Related Reading for Metals & Mining
Metals and Mining Industry Primer
Mining Industry Overview
Mining is a primary industry which involves the extraction of ore (rock with an economic amount of mineral content) and coal. After the ore is mined, it is refined into metal for industrial and commercial use. For most global investment banking franchises, metals and mining is a sub-sector of a Basic Materials or Natural Resources (along with oil & gas) coverage group – however, we have chosen to segregate M&M on this website reflecting mining’s prominence in Canadian industry and finance and in-line with Canadian investment banking industry verticals.
Mined products are the building blocks of society, from automobiles (aluminum – from bauxite, and steel – from iron ore), construction (steel, zinc, copper for wiring and conductivity), healthcare (copper for antimicrobial properties, rare metals, lead), transmission, energy to infrastructure.
The key commodities to know in the mining space are:
Precious Metals: Gold (could be a grouping itself), Silver, PMG (Platinum, Palladium, Rhodium etc.)
Base Metals: Copper, Aluminum, Zinc, Lead, Nickel, Tin
Rare Earth Metals
Bulk Commodities: Iron Ore, Metallurgical Coal (feedstock for steel)
Despite the end of the big construction boom in China where bankers made very large amounts of money, mining is still a good industry to be in as urbanization continues to be a large secular shift (and there are still billions of people in rural areas who will be transplanted to cities across India, China and Africa). Also, now that the refining capacity is there but the construction needs are not as high, China has become very efficient in creating a secondary sector, being a net importer of metals but refining them to value added products or commoditized metals and becoming a net exporter of that.
The universe of mined and refined material traded commercially is vast, and the drivers for pricing for each of these vary. However, the business model of any mining company is fundamentally the same.
Most modern-day mines are large enterprises requiring large amounts of capital to establish. As a result, large mining corporations typically dominate the sector. There is a large concentration of miners on the Toronto Stock Exchange due to Canada’s attractiveness in raising capital for the industry due to its established legal frameworks, competitive tax, and favorable royalty regime.
Mining companies primarily raise capital through issuing equity on an exchange and subsequently investing the money into mines throughout the world, so due to the TSX acting as a magnet for mining companies, corporates with operating mines and core assets in jurisdictions outside of Canada will choose to list in Toronto.
The profitability of the mine and the revenue that an operator will receive is largely dependent on the long term price of the underlying mineral. Each mine has an amount of extractable ore tonnage of a certain grade.
Large cap miners (BHP/Rio) usually have a diversified enough project base with new projects coming online while others decline to have a more consistent cash flow. These names are very savvy and often recalibrate or rationalize their project portfolios with non-core asset sales to ensure growth and continuity. Treasury at BHP and Rio are also very cognizant of when to issue debt opportunistically to smooth cash flows and preserve dividends.
Mining Industry Operating Summary
The Metals Cycle
The need for any metal is about supply and demand. Commodities are some of the most interesting real life manifestations of microeconomics (firms and when they begin and stop production). The main difference between factories and mines is that mines work with a finite resource, so when a mine runs out of copper, it must explore and develop a new mine (or expand the current mine) to continue its level of production.
In an imaginary scenario, demand for copper is at an equilibrium, and will continue to be as mine declines (older mines run out of copper and shut down), as measured by tonnes of copper produced, equals new production coming online (new mines starting up or mine expansion). If a small supply reduction occurs (a mine undergoes an unexpected outage), copper inventories (in London and Shanghai, mostly, but everywhere else as well) will be drawn down and the price will rise a little but overall supply and demand will be balanced.
If a large supply shock kicks in (war breaks out between Peru and Chile and major projects shut down), the supply curve shifts left and demand destruction takes place – some consumers of copper will be forced to use a substitute or discontinue their business as it no longer clears their margins.
In reality, the situation is much more complex with many more players than just miners and consumers of copper – there are speculators, middlemen (banks and physical commodity traders), and storage capacity owners. Certain miners will hedge their prices over long periods of time using off-take agreements, as they need to ensure that their mine is economic and meets returns for investors. Spot prices are very different from futures prices because futures prices are dependent on hedging activity.
As the world continues to consume copper at the same pace (and although scrap copper is used, construction goes up at a much higher rate than can be satisfied by salvaged copper), copper grades decline. As a good example, when the gold rush began people stumbled onto giant gold nuggets in the middle of streams. The low hanging fruit is gone now, and each new copper vein operated on that is known is going to have a lower grade (pounds of copper per tonne of ore).
The timing of mining, depletion and demand spikes (China’s construction boom) and lulls is never certain, forcing the copper market to go into oversupply and undersupply repeatedly. This cyclicality is inextricably linked to global industrial production and mining stock prices tend to be leading indicators. Undersupply is cured by demand destruction and drive new capital expenditures on mines that will come online later. Oversupply is cured by producers who have costs above the global copper price shutting down their mines.
It is important to remember that the world’s vehicle currency is still the US Dollar, and practically all commodities continue to be priced in dollars. A Canadian gold producer in Timmins, Ontario will have their operating costs in Canadian Dollars but will realize US$ equivalent when it sells the commodity. Any boost to the US$ will magnify earnings and vice versa. Overall, a strong dollar will depress a basket of commodities (otherwise it would be too expensive for non-US consumers to purchase these commodities).
Mining Project Life Cycle
Economically viable mineral volume in a mine can be classified as the mine’s resources, and further broken down into measured, indicated and inferred resources. The three grades are differentiated through sampling. Sampling can be done through the components of a drill test or observing the composition of outcrops or other evidence. From the circumstantial evidence, geologists can give a reasonable estimate for how much of a desirable mineral is in the mine.
After a feasibility study, the measured and indicated resources can be classified as proven and probable reserves. This solicits a much lower discount rate as there is high confidence of the existence of the minerals and they have been demonstrated to be economically extractable. Inferred resources are ignored as they are not commercially viable.
A higher quality ore reserve will have a higher composition of the desired mineral within the ore. The ore itself can be separated into the commercial component (desirable minerals) and the gangue minerals (waste).
Any mineral development depends on proven and probable reserves. Cost is determined by the number of pounds or ounces mined and processed while revenues only come from the pounds or ounces of metal produced. Accordingly, the recovered grade of the ore is important in valuing a project. Profit is more sensitive to changes in revenue due to the cyclicality and variability in the commodity cycle as opposed to costs which are fixed in the short run.
After operations cease, the company will have an environmental liability and will have to decommission the contaminated mine site. This will factor into the mine’s return.
Once the feasibility study is complete, detailed engineering can begin and then a production decision can be made. Any movement in the timing for these stages (Preliminary Economic Assessment, Feasibility Study, Permitting, etc.) can shift the share price dramatically for a mining explorer, as timing affects NAV.
Once facilities are commissioned, major miners can take on project specific debt – usually in the form of project finance.
Banks do not care about resources, as they do not get to participate in any of the upside. Banks will write in tight debt service coverage ratios (DSCR) which will be satisfied by the metal sales the miner has contracted out to an offtaker (commodity traders and sometimes even bank commodity arms will do that, winning on two fronts), and ensuring repayment.
The interest on this is always LIBOR + a margin, or a floating rate – miners will often swap this out to fixed as there is more certainty (also done with the bank). The margin for smaller miners can be 10% or more, which is very lucrative for banks. Banks may want miners to hedge in as much of the very variable components of their operations to ensure there is no cash flow volatility (diesel, electricity to run the mine).
After all of that, production begins.
What is the NI 43-101?
Mining investors talk about the NI 43-101 all the time. It is the required format for any reporting for a mining company that discloses information on a Canadian securities exchange. Technical reports will be conducted by a geologist and outline assumptions for reserves and resources and other information relevant to a mining investor. The report is largely interchangeable with the JORC, which is the Australian standard.
Popular Mining Methods
Open Pit Mining
Open pit mines are the gigantic, sprawling craters in the ground with trucks driving in a circular perimeter to haul extracted tonnage to mills. Open pit mines are best for low-grade (relatively less commercial material per ton or ore), bulk tonnage (large amounts of ore mined) operations.
Underground mines are more difficult to engineer and require high grade ore to justify the capital expenditure. Underground mines will be in an area with certainty of high density veins. Depending on the geological features of the veins, different underground mining methods will be used (methods differ greatly in cost).
Cut and fill is a popular underground mining method, where rock is blasted and then backfilled with the waste material while ore is mined. Other methods include long-hole stoping & room and pillar.
Mined Ore Processing Methods
Ore is sent to a mill and crushed and grinded by grinding media (steel balls and rods) before being separated into a purer mixture of the commercial metal. As this is expensive and there is fixed capacity, this is for higher grade ore.
Heap leaching uses chemicals to extract metals from the ore. Certain chemical reactions absorb the commercial metal. This method is cheap but erodes byproduct metals and is good for mines where ore grades are low.
Valuation of Metals and Mining Companies
There are two major differences between mining valuation and conventional valuation for run-of-the-mill companies: 1) The discount rate; 2) Zero terminal value. These two are reflected in the DCF driven valuation metric for miners – Net Asset Value or NAV.
Mining companies do not use the Capital Asset Pricing Model that is common for most DCFs – especially gold companies. Mining net present value will use a standard discount rate with a floor discount rate commonly used for the mined commodity plus a risk factor.
Gold is the best example for why this is used in place of CAPM – the yellow metal has a zero or negative beta due to its role as a safe haven asset. Gold and Platinum Group Metals (PGM) will have a floor discount rate of 5%, which will be adjusted upwards for political risk and stage of development (the difficulty of the geography is already baked into costs of extraction in the projected cash flows). Base or industrial metals (copper, tin and zinc) have the same rule – except the floor is 7 or 8%.
There is also no terminal value for the NAV model (“normal” companies will assign a terminal value based on an exit multiple and some will use a perpetuity value for the business past the forecast period) because the idea is that the mine is operated until it is depleted. There will be option value for expansion embedded in the price, as good properties will see the resource convert into reserve as more data comes out, elongating mine life (producing miners tend to trade above their NAV to account for this option value).
Key to remember is that these two distinctions are for mining only, and not necessarily metals. Net Asset Value is for extraction industries (mining and oil exploration & production) where there is a finite resource – steel, smelting and refining are EV/EBITDA garbage-in, garbage-out companies just like Lululemon.
Net Asset Value for Mining Companies
Model assumptions are required before the NAV can be calculated. Note that the NAV concept is the same as with oil and gas.
First the Net Present Value (NPV) of each individual mine in the miner’s portfolio needs to be calculated. The NPVs are calculated considering these factors:
Commodity price over the mine life – If the project is a gold mine, a gold price that the company will receive must be assumed. Usually, a long-term price will be assumed, but if there are strong views on price and a short life, more granularity can be layered into the model. Depending on the company’s hedging strategy, a hedge can ensure that the price received will be exactly the one in the model.
Development costs – If the mine is not already producing ore, preparing the asset for extraction is costly. The total cost figure depends on various factors, including the size of the mine, the geology, refining options and distance to market. Depending on where the majority of the resource is and the subsequent configuration of the planned mine (cut and fill, room and pillar – open pit or underground etc.), the variance can be enormous.
Purchases of heavy equipment (Caterpillar, Komatsu/Joy Global) will be required as trucks and excavators do much of the heavy lifting (literally). During mining booms, purchase costs will be high as heavy equipment OEMs and their dealers (Finning International/Toromont) have large backlogs to service. During mining busts, used equipment may be purchased at a discount and product servicing may be moved in-house.
For development costs, labour is usually in the currency of the mine’s domicile. However, the purchase of material and equipment to construct the mine is usually in US$ and may be hedged away.
Labour – Mining continues to be a relatively dangerous job compared to working in an office and miners require fair compensation. Depending on the jurisdiction of the mine, labour costs can vary greatly. A Canadian mine with safety best practices, low wealth inequality and strong labour laws will have higher labour costs than a mine in a developing country. Labour and other operating expenses can usually be FX hedged if predictable. In an emerging market, labour volatility and unrest will be higher, and the possibility of strikes and other unforeseen events may make assumptions unreliable (although this is accounted for in the discount rate instead of here).
Fuel – The image of Caterpillar trucks hauling ore tonnage back and forth from the mine is well known. These dump trucks require enormous amounts of diesel. Much of the other machinery on the mine sites also consume significant fuel volumes, making fuel a mainstay in mining company financial statements. Fuel can be hedged, but hedging policy needs to be consistent with the mined resource hedging strategy, otherwise the mining company may be taking on inadvertent positions.
Hedging oil (usually Brent) is cheaper than hedging diesel directly, but comes with basis risk. We illustrate this with a mining company that is long oil (pays a certain amount to receive x amount of Brent crude), when it requires diesel. If a fall in other crude derivatives (gasoline, kerosene) drag down the price of crude but diesel demand rises, the company may receive cheaper oil and must purchase more expensive diesel.
Discount Rate – This will depend on the risk of the project and is the function of various risk factors. Compared to other industries, mining is associated with a wide range of country risk premiums despite the corporate being domiciled in Vancouver or Toronto. Chile, Canada and Australia are the gold standards for being low-risk, stable jurisdictions and have strong and tested legal frameworks. Operating a mine in Russia will come with substantial amounts of political risk due to weaker remedies for breach and unfamiliar business practices. The rest of the risk is project risk, which considers factors including, but not limited to, reserves (grade, tonnage, life of mine), configuration, decommissioning liabilities, and labour relations.
Valuing the corporate
The value of the actual corporate (NAV) is the sum of the mine NPVs (the cash flows multipled by the discount factors for each mining project) and adjusting for other capital structure components. An analyst would sum up the NPV of all the mines in the portfolio, subtract debt and debt-like structures and add cash, the value of the hedge book and investments.
Once the NAV is known, these metrics are commonly used for valuation in metals & mining:
EV/EBITDA is primarily used for large, stable and diversified miners such as BHP Billiton, Rio Tinto, Glencore and Vale. For these companies, mining project life is well defined and cash flows are relatively predictable. If one mine goes under, this will not have an outsized effect on EBITDA because there are several mines across several commodities being extracted concurrently.
Additionally, only senior gold producers and large diversified miners can issue corporate level debt, so enterprise value is not necessarily a meaningful figure for junior and intermediate miners. Junior and intermediate miners can sometimes tap into high yield debt markets if they have sufficient size and if debt capital markets are open to them, but usually will need to issue equity or equity-linked notes (convertible bonds, mandatory convertibles). Corporate banks may offer bridge financing between the time when the equity or equity-linked notes are issued and announcement.
Price/Net Asset Value
P/NAV is more popular for miners that focus on one or two commodities – it ascribes value given to each ounce of gold or whatever the relevant unit metric is for the metal. Where the P/NAV multiple trades at is dependent on how de-risked or unrisked the mining asset is (when the next stage is reached, the profits become less uncertain). With each stage of development, the P/NAV multiple will trade higher – from feasibility (preliminary economic assessment, pre-feasibility & feasibility) to construction to production to project expansion.
Most explorers, developers and junior producers will be evaluated on P/NAV. The P/NAV for explorers can be 0.3-0.5x, so that there is a healthy risk premium embedded.
The highest P/NAVs are the royalty companies, with Franco Nevada usually occupying the premier valuation followed by Silver Wheaton. Royalty companies or streamers are perceived by the market to have low operational risk. Depending on how wide and diversified the portfolio is, the streamer will trade at a premium (Franco Nevada vs single commodity Sandstorm Gold). Also, the higher the negotiated net smelter return (NSR), the higher the premium (usually 2% NSR but 3% is possible).
Often, equity analysts will quote a risked NAV, unrisked NAV and bluesky NAV. A risked asset means it has not secured financing or there is some other impediment to production. Unrisked assets will trade higher, as alluded to above. Bluesky NAVs are unrisked NAVs given ideal commodity prices and FX and are best ignored by a prudent analyst.
Price to Cash Flow – T+1, T+2
Price/Cash Flow is the second most popular metric for most non-global, diversified miners. Usually Price/Cash Flow is looked at from a one year out and two year out basis. P/CF will also heavily consider the country risk for the miner, as assets in developed nations are more likely to see work stoppages due to labor shortages, strikes and other unforeseen production delays.
Other valuation metrics include EV/P1 Reserve, EV/P2 Reserve, and EV/Resource.
Shareholders tend to believe quarterly dividends are permanent, and dividend cuts are perceived to be negative signaling. More and more, miners are turning to special dividends to return value to shareholders if there has been good cash flow and no opportunistic acquisition available.
Analysts do use P/E and P/CF for larger stocks, but they are poor indicators of future cash flow and is not particularly telling.
The most important thing to note about mining equity investing (not necessarily mining credit as you will set a floor) is that the relative value versus peers may be irrelevant if the commodity price tanks (unless there is a pairs trade, in which case it’s still risky due to the following) due to the tendency of mining stocks to move in-line with the underlying commodity.
A copper stock will fly when copper spikes and sink when copper falls because a copper miner is a leveraged bet on copper. The R-squared (or movement in the stock price explained by movement in copper for people who were not paying attention in statistics), is very high. This does not matter for a credit thesis, as the yield is safe as long as copper is above a floor price.
Modeling the Cash Flows of a Gold Mine
After layering in assumptions, cash flows will need to be modelled out. Using a gold mine as an example, each year a certain amount of ore is extracted. The extracted tonnage is subtracted from the total tonnage that is to be extracted from the mine. The amount of ore extracted is based on the operating history of the mine. If the mine is new, a risked discount to the design rate of the mine will be used as the volume of production.
The gold yield from each ton of ore depends on the grade of the ore, as measured by x ounces of gold per ton. We do not expect full recovery of all of the valuable material within the ore, so a certain amount will be thrown out along with the gangue material. The gold yield must be discounted by a recovery factor.
The actual gold extracted will be multiplied by the realized price of gold to get to the revenue line. Royalties and other commodity taxes are stripped out to get to net revenue.
After getting to net revenue, operating expenses are subtracted (the previously mentioned fuel and labour as well as the costs to refine the ore so that the gold can be isolated) to get to EBITDA. Again, there is tremendous variance in operating cost ranges based on the geology and geography of the mine and the necessary treatment of the ore. Depreciation and depletion expenses are taken out to get to operating profit.
Corporate taxes are paid at this level to the relevant regulatory bodies and governments, with the resulting figure being net income.
To get to cash flow, we add depreciation to net income but subtract capital expenditures (the development costs mentioned above). This net cash flow is discounted to get to the NPV of the mine.
At the end of modeling the project, a sensitivity analysis comparing differences in assumptions is performed to see how much room for error there is before projects become uneconomic.
Metals and Mining Metrics, Ratios and Terms
Total Cash Costs
“Direct” costs to extract an ounce of gold which are usually classified as operating expenses (mining and processing, but only cash expenses). All of these measures will fall as production ramps up as many fixed costs are spread out over the production and processing and mining benefit from economies of scale.
All-In Sustaining Cash Costs
Sustaining capital expenditures are added to total cash costs as a more accurate measure of the cost of extraction as without the sustaining capex production would cease.
Considers all the costs throughout the mining cycle.
Depending on the gold deposit, a ton of gold ore will usually have other commercial minerals (as well as punitive minerals which are costly to extract and have little commercial value) – gold ore usually will have silver (copper ore will often have gold), so when these are taken out during processing they can be sold off, improving the economics of the mine. Often, AISC are shown on a gold only basis as well as net of byproducts, which will lower the AISC as the byproduct credit is subtracted from the cost.
There is a similar concept in natural gas extraction in oil and gas, as liquids rich gas can lower the breakeven of production, to the point where you have “negative breakevens”. The silver production can be sold off in a streaming agreement as a funding source.
Byproduct vs Coproduct
When primary production is split between two metals, it does not make sense to have byproduct costs with one metal in focus, or breakeven economics will always be positive. For companies such as Silver Standard or Hecla Mining, coproduct costs are used for investment decisions with a blended gold-silver price in the ore.
Gold Production (thousands of ounces)
Very important in measuring the scale of the company. Barrick and Goldcorp have millions of ounces of production a year.
Gold Equivalent Production
The company evaluates the amount of byproduct (mostly silver) mined, and the value is divided by the price of gold to give an equivalent number of ounces. Of course, depending on the price of those commodities vs gold, this number fluctuates.
Metals and Mining Credit
Mining credit is particularly interesting because of the cyclical nature of the business, the different supply-demand dynamics of different commodities and the unpredictability of cash flows. As was seen post-financial crisis and the Chinese shift from manufacturing and construction to services (post 2014), mining has seen peaks and troughs where the peaks allow companies to access questionably cheap credit and the troughs result in financial distress, waivers, bankruptcies and consolidation.
The death of coal has also presented itself as an interesting development in credit, as some of the largest names such as Peabody and Alpha Natural Resources have filed for Chapter 11 Bankruptcy (and many other notable coal pure play listed in the US) – indicating that even the most conservative stress scenario may not be enough.
Similar to other natural resource sectors such as oil and gas, mining company profitability movements will be an amplified version of the underlying commodity produced and sold. Depending on how close the commodity is to the cost of production, the greater the swing in profit. At a very base level, the lower the company lies on the cost curve for extracting the resource globally (provided easy access to markets, and for most mining outputs it is much easier to transport than oil as it is dry bulk and can be easily freighted across a variety of logistical methods), the less credit risk there is.
Since commodities as a whole are at the mercy of global supply and demand mechanics that can change very quickly for a variety of reasons, the amount of debt that gives comfort to a credit investor is much lower than that of a less volatile business. However, there are several other considerations that should be looked into that shine a light on creditworthiness before looking at capital structure and where each source of capital falls in pecking order.
Scale – A BHP Billiton with vast operations, global knowledge and know-how, and opportunistic logistics network is going to be better positioned than a junior pure play. When things go poorly, asset sales are possible and when things are going well, opportunities to realize value on weak assets via spin-off are possible.
Diversification – Having a variety of outputs smooths cash flow volatility, and better performing metals in the portfolio can help sustain a lossmaking business unit when it is at a cost above the commodity price, but should be well positioned after consolidation. As with energy, some mines are more difficult to stall for technical or legal reasons. If every business unit is experiencing weakness in the underlying commodity, this may not save the company.
Position on Cost Curve – A company that is lower on the cost curve has a much larger buffer for the commodity price to fall before it fails to meet return hurdles. A company very low on the cost curve has much more operational flexibility, and in markets where there is significant share (BHP and Rio in Iron Ore), they can aggressively price and increase output in a time of oversupply, forcing consolidation and a new equilibrium.
Consumers – A diversity of end user demand is important. Dependence on China and the subsequent shift in economic direction has been sobering for many miners.
Geography and Political Environment – Although listed in Toronto and Vancouver (for a strong legal framework and favorable tax regime), many mining assets are in politically unstable jurisdictions. Even in Canada and the US, mines are rife with unionism, strikes, political wrangling and environmental concerns. Having profitable mines in developing countries without strong legal frameworks may result in problems limited to bickering and uncertainty to full expropriation. From a credit perspective, a low cost, long-life mine in Canada would be ideal.
Reserves – The absolute number for reserve size is important. The longer the life of the mine (reserves vs production), the higher the grade of the ore and the lower the cost of separating the saleable commodity speaks to the quality of the reserve. Similar to energy, the cost of developing undeveloped reserves is a relevant factor.