In Part 1 of my report, I indicated some of the challenges in valuing the large mining projects that are being developed by junior mining companies. It is important to understand that mining technical reports and feasibility studies are commissioned and prepared by independent consultants. They are meant for the use of the company in making internal development decisions. Major mining companies have these studies compiled using their own internal models. They use discount rates that actually reflect their true cost of capital. They have every major risk evaluated and discounted using proprietary data and guidelines. They use realistic timelines for permitting and construction of the project. These studies are never released to the public and are distributed only on a confidential basis to partners or bankers. For a major mining company to release this information would be the equivalent of a construction company revealing their matrix for bidding jobs or a private equity firm their buyout models.
On the other hand, the junior mining companies are using these studies as marketing tools to support their stock price. Unlike the majors who want a realistic conservative evaluation, the JMCs are generating studies that are primarily for public consumption. After the Bre-Ex scandal in 1997, which almost destroyed the Canadian Mining Industry, stock exchanges around the world instituted strict requirements for the valuation of mining assets. Canada set up parameters for drilling, metallurgy and reserve estimates with NI 43-101. Compliance also includes the disclosure of exclusions, project risks and cost estimates. Australia did the same with ValMin. The American Stock Exchange and the SEC set maximum metal prices at a 3-year average. All the exchanges required the public filing (within 45 days) of the study if any details are disseminated to the public.
One thing that the exchanges have failed to regulate is the “discount rate” used in these studies. Most studies are compiled on a 100% equity basis to determine a net present value [NPV] of the future cash flows. A discount rate, typically provided by the company, is applied to reflect interest rates, inflation, financing expense and the cost of equity capital. This “true cost of capital” is lower for companies with assets and cash flow other than that being financed. The discount rate has a compounding effect in reducing the net present value of future cash flows. For instance, a $2.6B NPV, for a 22 year mine, is reduced to $1.1B at a 5% discount, $600MM at 8% and $200MM at 10%. For Novagold to quote a NPV at a 5% discount is probably not anywhere near their true cost of capital to develop Galore Creek.
It is also important to note that while these large medium grade deposits may produce impressive NPVs, the internal rates of return [IRR] are far less impressive. This is because the capital costs to develop these remote deposits include extraordinary expenses for access, construction and production. Project delays can also have a significant impact on NPV and IRR. The larger the capital costs, the greater the impact.
I am going to dig deeper into the recent Feasibility Studies released by Northern Orion (NTO) and Novagold (NYSEMKT:NG) in an attempt to value their assets as a potential partner. Both companies have indicated that they will pursue joint venture partners to help finance, build and operate these projects. While NTO has not released any potential terms, NG has indicated to shareholders that they expect to sell 40% of Galore Creek for $200MM. Of course these numbers are generated from the NPV discounted at only 5%. Rather than look at the NPV, I am going to evaluate both projects based on the IRR. The feasibility studies include sensitivity analysis that allows for adjustments to the IRR for cost increases and exclusions.
Northern Orion has been developing its Agua Rica property since 1994. For most of that time they were partnered with BHP Billiton (NYSE:BHP) who owned 72%. From 1994 to 2003 they spent over $55MM drilling and doing a feasibility study in 1997. In 2003, BHP sold their interest to NTO for $12.6MM. They kept no royalty or “back-in” rights to the property. NTO has spent an additional $40MM to advance the project and released its updated feasibility study in November.
Here are the highlights from the Company’s press release:
• Proven and Probable reserve of 731 million tonnes of ore
• 90,000 tpd open pit operation at a 1.89 to 1 strip ratio
• 23 year mine life, with higher grade ore over the initial 10 years
• Un-escalated capital cost of $2,055 million
• Approximate annual production
o Years 1-10: 365 million lb/yr copper, 135,000 oz/yr gold and 15 million lb/yr molybdenum
o Life of Mine [LOM]: 300 million lb/yr copper, 125,000 oz/yr gold and 16 million lb/yr molybdenum
• Project Economics
o Operating cost of $6.82/ton milled, or negative $0.73/lb copper (net of credits), FOB port of exit
o Internal Rate of Return [IRR] of 20% (100% equity)
o Post-tax Net Present Value [NPV] at a 8% discount rate of $1.9 Billion
o 2.9 year capital payback
What the Company fails to highlight is:
• Only 45% of the reserves are Proven.
• 72% of the reserves are considered “dirty ore” with high levels of arsenic and zinc.
• The 90,000 tpd mill and 10km conveyor system will challenge the limits of current technology.
• While the NPV of the project is impressive, the un-escalated internal rate of return is only 20%
Agua Rica is what is described a medium grade copper/gold/molybdenum deposit. The mine site is on the rainy side of the mountains in fairly rugged terrain in northwest Argentina. There is little room for waste rock at the mine and the tailings could not be environmentally managed with dams. Construction of access/haul roads and power lines will be difficult. Therefore the new mine plan was devised to crush ore and waste rock at the mine and transport it along 10km of conveyors “through the mountain” to the arid valley at Campo del Arenal for processing. This includes a 5.5km tunnel. Waste rock and filtered tailings are transported an additional 10km, on conveyors, and stacked in the Cazadero Valley. In the life of the mine, Agua Rica will generate 1.6B tons of waste. Local residents are already protesting and claim that this waste could pollute the aquifer for the entire region. Also, water for the plant would have to come from the same aquifer, which is already being strained by the nearby Alumbera Mine. The environmental impact study for Agua Rica may not be fast-tracked in 8-10 months, as the Company has indicated.
The capital cost for the mine has grown from $1B in June of 2005 to just over $2B. Much of this increase was due to the plan changes to transport the ore discussed above. Since many of these, and other infrastructure, costs are fixed; it appears that the production was increased to 90,000tpd, from a more manageable 68,000 tpd, to make the economics work. To achieve this production the mine is expected to operate 24 hours a day, 347 days a year. Not much down time for what has become a very complex mine. The Company is also downplaying the high arsenic levels in the ore, especially in later years. The smelters will levy penalties for the arsenic and zinc (zinc can not be removed from the concentrate due to environmental concerns). More importantly, the copper may not be marketable, in later years, if clean concentrate is available from other mines. In addition, the study excludes the costs for continued drilling to prove up probable reserves as well as the right of way acquisition for a 200km slurry pipeline, access road and power lines. The study also has no allowances for any social development or public relations work and excludes the cost of the Environmental Impact Statement, including its permitting.
That is all I am going to report about the potential problems at Agua Rica, even though there are more issues. All mines have problems and this is clearly a ‘world class” sized asset. Maybe BHP just really messed up selling 72% for $12.6MM in 2003.
Let’s move on to the economics. As I indicated in Part 1, the study has no allowances for increases in capital or operating costs from June 2006. The timing of construction is very tight and any delays will have a significant impact. Operating costs for labor, electricity and fuel are sure to increase over the 23-year mine life. The $2B in capital cost is not going to be 100% equity, so there will be financing costs. And lastly, any price paid upfront by a JV partner would, in essence, be an increase in the capital cost (to the partner). From the sensitivity analysis, in the Feasibility Study, a 20% increase in capital costs translates into a 4% reduction in the IRR. Likewise, a 20% increase in operating costs equates to a 3% reduction in IRR.
So as a potential partner, I might look at the economics like this:
1. If I pay $200MM for 50%, that is a 20% increase in my capital costs of $1B right out of the blocks. Without adjusting for the time value of my money until production, that is -4% from the IRR.
2. I am going to finance $600MM of my capital costs. That will cost me roughly $200MM. (using a very low rate of 7.5% for 5 years). That’s -4% from IRR.
3. I am going to assume a very conservative annual 2% rise in operating costs over 20 years, not compounded. That is an average 20% increase. (-3% from IRR)
4. Lastly I am going to assume a 20% increase in capital costs for a project this size, this complex and with significant exclusions. (-4% from IRR)
Using three-year average metal prices, allowed by the SEC, the IRR for Agua Rica is 20%. However, my reductions total 15%, leaving a 5% IRR. Even using current metal prices of $2.50 copper, $27, moly and $600 gold the IRR would be about 29%, but only 14% after my adjustments.
Now let’s take a look at the Galore Creek Project. Novagold, optioned GC from Rio Tinto (RTO), in 2003. The price was $20.3MM, paid over 8 years. Rio Tinto and Anglo American (AAUK) had been developing the property for over 30 years. They retained no royalties or “back-in” rights.
Galore Creek has its own set of challenges for economic development. I have pointed out some of these issues in two previous reports. This project sits high in the mountains of British Columbia. Unlike other existing mines and projects in the area, GC is located on the western side of the mountains. Access, power and the slurry pipeline will have to traverse some very rugged terrain. The mine area and access road are prone to extremely high snowfall, avalanches, flooding and seismic activity. The access road will include a 4.3km tunnel, beneath the glaciers, that will connect BC with the Alaskan Peninsula. Construction/operating risk at Galore Creek is substantial. Only by reading the full report can one get an idea of the potential problems at this project. Despite this, Novagold has commissioned a study that fast tracks construction in three years and calls for 24/365 operations. Good Luck!
Novagold has taken an interesting approach to “highlight” their study. They had the first five years of production isolated in the report. That makes for good press releases, but potential partners will undoubtedly look at “life of mine” numbers. Annual production is estimated at 432,000,000 pounds copper and 341,000 ounces gold, at a copper cost of $.37, in the first 5 years. Total mine production is 5.8B pounds, so production in years 6-22 averages 214,000,000 pounds. Annual gold production drops to about 110,000 ounces and net copper costs average about $.70. I would guess that the last 10 years of this mine look pretty bleak. Of course, annual numbers are not available in the Galore Creek study. (They are published in the most studies). Like NTO, they assume no price increases after June 2006 and only 45% of reserves are proven.
So, what we have is another “world class” sized asset that a major mining company spent decades exploring and sold for $20MM in 2003.
Galore Creek sensitivity analysis is slightly different from Agua Rica. A 20% increase in capital costs decreases IRR by 2.6%. A 20% increase in operating costs results in a decrease of 2.4%. But, GC has an additional risk in $USD/$CAN exchange rates. (The Argentine Peso is essentially tied to the $USD) A 20% increase in the $CAN decreases IRR by 4.5%. The study uses a three-year average of .81 exchange rate for the life of the mine. The Company will contend that a higher $CAN also means higher metal prices. Perhaps, but banks will require some significant hedges to borrow the capital to build the mine. This will leave the operating costs exposed to significant currency risk.
So as a potential partner, I will make the same assumptions I did with Agua Rica and include a 10% currency adjustment. (The $CAN is currently at .85 and was as high as .90 last fall). This gives me total deductions of 13.8%. So the base case IRR is reduced from 10.6% to –3.2%. Using SEC metal prices, the after-tax IRR for Galore Creek is 19%. As a conservative potential partner, my figure is more like 5%, the same as Agua Rica. Even at current metal prices, my adjusted IRR is less than 10%. I might add that the operating plan for Galore Creek, using 24 hours a day, 365 days a year, is absolutely ludicrous and should warrant a larger adjustment. It should also be noted that there are several other projects in development in western BC. This could cause further problems meeting construction timelines, as availability of labor, supplies and equipment is becoming tight.
Time will tell if Northern Orion and/or Novagold can find joint venture partners. I do not believe a minority interest in either of these projects can be sold for anywhere near the NPV in their studies. A $2B mine, in today’s market, is a very risky undertaking. The often-quoted valuation method of the late Julius Baring is, “buy up to 10% of the value of in-situ reserves using current metal prices”. However, I think that only applies to reserves that can eventually be extracted economically. It appears to me that both these projects are pushing the “edge of that envelope”.
In Part 3 we will take a look at some of the projects that are attracting joint venture partners.
Disclosure: The author is long NTO and has no current position in any other companies mentioned in this report.