The kenkey economics of the mining industry

Mining involves the identification and extraction of valuable minerals from the earth. Mined products include precious metals such as gold, silver and platinum; industrial metals such as copper, nickel and iron; food and agricultural minerals such as potash, phosphate and salt and other materials such as coal, gravel and sand.

EXPLORATION DRILLING HELPS TO DEFINE THE SCOPE AND QUALITY OF MINERAL RESOURCES.

Exploring to identify mineral resources is the first step in a mining project. Geologists – specially trained scientists who are familiar with the properties of materials that make up the earth, including those of mineral containing rocks – help to identify locations that have the potential to contain large mineral deposits. Soil and rock samples from a promising location are tested in special labs to verify the composition and concentration of desired minerals. When results are encouraging, exploration drilling is undertaken to unearth more information about the potential size and quality of the mineral deposit. Exploration drilling penetrates the earth at depth in order to extract a core that can be analysed for mineral properties.

The drilling process can be long and costly. Drilling equipment is expensive and requires highly skilled operators. Because of the high cost involved, exploration drilling is usually conducted in stages. The initial stage is focussed on obtaining information on mineral containing deposits over a broad area. In order to cover a broad area at a minimum cost, there are usually large gaps between exploration drilling points at the initial stage. When results are encouraging, more capital is allocated for drilling at tighter distances. Further drilling activity is concentrated on specific locations that show the greatest mineral potential. Drilling at tighter distances helps to create a better understanding of the structure and quality of the mineral containing ore body under the earth. The exploration process can take up to several years to complete. Depending on the size of the prospective area and the level of detail required, the cost of exploration drilling can range from tens of millions of dollars to several hundred million. The construction and development of a mine is a highly capital intensive venture that is unlikely to go ahead without in-depth information about the quality and scale of recoverable mineral resources.
The analysis of drilled rock and soil samples helps to provide an estimate of mineral resources contained in a deposit. The resource statement also provides information about the quality of the mineral deposit. The quality largely depends on the grade or concentration of minerals. For example, a good iron ore deposit may contain 60% iron content and a good gold deposit may contain 5 grams per ton of ore (i.e. 5g per 1,000,000g of ore). The resource statement is a scientific best guess of the size and quality of a mineral deposit. This is because it is not economically feasible or practical to drill every inch of the prospective area in order to obtain more complete mineral information. The lack of complete information means that there may be surprises about the properties of the deposit that can only be uncovered when actual mining activity begins.



THE COMMERCIAL VIABILITY OF MINES. WHEN DOES IT MAKE ECONOMIC SENSE TO EXPLOIT MINERAL RESOURCES?

When the exploration process yields adequate resources of desirable quality, a feasibility study is undertaken to decide on whether building a mine to extract the mineral would be commercially viable. Feasibility studies involve deciding on the appropriate mining technology (based on the properties of the mineral deposit) and estimating the cost associated with constructing a mine and providing all the necessary infrastructure. The feasibility study would also estimate the production profile (a schedule of annual mineral production), as well as, the cost of production over the projected life of the mine. For a mining project to be commercially viable or economically attractive for investors, it has to generate sufficient cash flows to pay an attractive return on the large amounts of capital required to build and operate a mine.

Mine construction together with the installation of associated infrastructure is the most capital intensive phase of a mining project. The cost of developing a mine depends on the size of the resource, the annual production target, accessibility (remoteness and depth) of the mineral deposit, access to electricity and water and costs associated with transporting products to end markets. Depending on these factors, the total cost of developing a mine could range from tens of millions of dollars to several billion.

Due to the high cost of developing and extracting mineral resources, it may not be economically viable to exploit all large and high grade mineral deposits. For example, in traditional gold mining countries such as Australia, Ghana and South Africa, a number of large and high grade gold deposits are left unexploited because after several decades of mining, the high cost associated with accessing these deep gold deposits – some as deep as 3km – makes them uneconomic to mine. For bulk minerals such as iron ore, bauxite and coal, because of the high cost associated with developing adequate rail and port infrastructure for transporting bulk minerals to end users, some rich deposits – especially when they are located in remote regions – may remain unexploited.


MINING IS A HIGH “FIXED-COST” INDUSTRY.

A substantial proportion of the services and labour employed in operating a mine is “fixed” in nature and not directly linked to short-term changes in the quantity of minerals produced or changes in mine revenue. Costs incurred in extracting minerals include: the cost of powering and maintaining mining equipment and associated infrastructure, the cost of mine supplies such as chemicals used for metal processing and explosives used for rock blasting, and the cost of labour employed in providing the extensive range of services that are critical to a mine’s operation. Mining involves a high level of team work. Inadequate staff or services in one area of a mine can have a major knock-on impact on the productivity as well as the safety of the entire mine. As a result, a considerable proportion of the labour cost or employee base of a mining operation is “fixed” and not affected by short-term changes in production levels. Because of the high “fixed-cost” nature of mining, a modest reduction in revenue (from falling metal prices or declining production volumes or both) can translate into a disproportionately large drop in profits. On the other hand, in periods of rising prices (and higher production), the “fixed-cost” nature of mining can amplify profit growth.

THE MINING COMMODITY CYCLE.

For the most part, mining companies produce undifferentiated products (commodities) and therefore they have limited scope to influence prices in an industry that is global and highly competitive. Commodity prices are largely determined by the level of demand for metals and other minerals in relation to the available production capacity (i.e. supply) at a particular time. In periods of robust global economic growth, commodity prices can rise sharply in response to higher demand for metals and other commodities. In an environment of rising or high commodity prices, mining becomes more profitable and there is greater appetite for expanding production at existing mines and developing new mines.

The process of expanding the production capacity of existing mines (i.e. brownfield expansion) may take several years while the process of prospecting, exploring and developing a new mine (i.e. greenfield projects) can be much longer. The long period of time involved and the large amount of capital required to expand existing mines and to develop new ones restrict supply growth in the short-term. In an environment of strong global demand, the inherently slow supply response can help sustain high prices over extended periods and generate attractive returns for investors in the mining industry. However, over the long term, as existing mines complete their multi-year expansion projects and newly developed mines come into production, commodity prices may fall to more sustainable levels.


Source: The Kenkey Economist, Bloomberg

In an environment of weak global economic growth, commodity prices tend to fall to reflect the lower level of demand in relation to available production capacity. When there is excessive production (in relation to demand), prices can fall to very low levels. Low prices discourage investment in mine development and may force the least efficient (i.e. the high cost producers) to shut down. Even though all mines earn roughly the same revenue (price) for each standard unit of mineral produced, their operating costs can vary substantially. The operating cost of a mine depends on the accessibility of the mineral deposit, the grade or mineral concentration in the earth and the mining method used to extract the deposit (e.g. open pit vs underground mining). The industry cost curve for a metal or mineral shows how various mines and mining firms are positioned relative to each other on a cost of production basis. All mines benefit from rising commodity prices and suffer when prices fall but mines that have the lowest operating costs (usually mines with high grade and easily accessible mineral deposits) are better positioned to withstand the commodity cycle. In general, because of the high “fixed-cost” nature of mining, a sharp fall in commodity prices may force many mines to shut down.
All stakeholders that depend on mining for income are affected by the commodity cycle. Stakeholders in the mining industry include: mining firms, their employees and shareholders/owners, governments that are beneficiaries of royalties and other taxes paid by mining companies, suppliers of equipment and services to the mining industry and local communities where mining is a primary source of employment. To varying degrees, all stakeholders benefit from rising commodity prices and may face less attractive economic prospects in an environment of falling prices.
Investing in the mining industry can be rewarding, especially when the investment coincides with a period of rising commodity prices. However, the large amount of capital required, the high fixed-cost nature of the industry and the long period involved in exploring and developing a mineral deposit increase financial risks associated with an investment in the mining industry. Other sources of investment risk include: uncertainty in geology arising from imperfect information on the structure and quality of the resource, cost escalation risks during mine construction phase, mine safety and environmental risks, uncertainty in mine taxes and royalties paid to local governments and risks associated with labour cost pressures. Due to the high financial risks involved, access to capital for investment in the mining industry can be challenging, especially in an environment of low commodity prices.

THE PRODUCTIVITY AND PROFITABILITY OF A MINE DECLINES WITH AGE
Mines are designed to access the richest and most profitable parts of a mineral deposit in the early years of production. This means that, in an environment of stable commodity prices, the profitability of a mine will decline over its operating life. Furthermore, because of the non-renewable nature of the resource, once the minerals in one part of the deposit have been extracted, mining activity will be restricted (i.e. production will fall) unless miners have access to other – and often deeper – parts of the ore body. The process of creating access to unmined portions of the mineral deposit is usually very expensive and takes time.
As a mine ages, it tends to be less profitable (or more costly to operate) because the richest and most accessible deposits have been depleted. Because of the non-renewable nature of mineral deposits, the stated annual profit of a mine, as shown in financial statements, may not represent a sustainable measure of profitability. Stated profits may overstate the cash generation potential of a mine because the method of computing profits for financial reporting purposes does not account for the high capital intensive investment required to provide access to new mining areas, an essential expenditure, without which production levels cannot be sustained. The cash generated by a mine, after accounting for the capital expenditure required to maintain production levels, provides a more accurate measure of sustainable levels of profitability.
The economics of the mining industry share many similarities with that of the petroleum industry. Both industries are concerned with extracting useful non-renewable resources from the earth.

The Kenkey Economist (kenkeyeconomist@yahoo.com)
Kenkey Economics publications are aimed at promoting economic literacy.