A very interesting article, talking about the practise of high grading, which is being practised, and has been many times, when times get tough. It has further negative implications on the supply side. It does not come without its costs and implication further down the track. Worth a read...
Miners "Extend and Pretend" on Production: Michael Kosowan
By Henry Bonner ([email protected])
Key points: Big mining companies have been mining the best areas of their deposits. What’s left is costly to recover, and yields smaller rewards.
Michael Kosowan joined Rick Rule as an Investment Executive at Sprott Global Resource Investments in 2000. While continuing to work at Sprott Global Resource Investments, Michael is now also licensed as an Investment Advisor at Sprott Private Wealth LP in Toronto.
Michael recently spoke at the Toronto Resource Investment Conference.
Mining companies took steps to increase profitability in the short term, says Michael. The strategy depended on using up the best resources quickly, in a way that made the mine less productive over its remaining lifetime.
Here’s an excerpt from Michael’s talk, “Sins of the Past - Seeking Salvation through the Juniors:”
It has been ugly out there for the mining sector over the last two years. Stock prices are at low valuations not seen since 1999.
Perhaps the most troubling fact is the following: gold majors are trading at the same prices they did 12 years ago, when gold was $350 per ounce!
The challenges to the mining industry are becoming fairly well known.
They include but are not limited to:
- Low grade acquisitions
- Inability to control and properly account for operating costs
- Capital expenditure over-runs
- Poor assessment of foreign country risk (wage issues/strikes) and the taxes they may incur
Dragged down by these problems, the seniors have become incapable of generating higher profits or increasing their share price, even in the face of ever increasing gold prices.
And in spite of their recent and prolonged pain, I am not prepared to say major mining companies have suffered enough.
I believe that this industry’s response to the challenges has led to an even graver future… Because the solution that many mining companies adopted was “high grading” of their deposits.
“High grading” is the act of changing the mine plan by selectively extracting the highest grade material. In a phrase: “take the best and leave the rest.”
This was an extremely seductive option for companies since it raised their short term profits.
But the strategy can be debilitating in the long run.
When a miner deviates from the original mine plan, which was intended for mining the entire deposit, it becomes much more expensive to later change the mine plan in order to capture the rest of the deposit.
Because of this expense, it can become uneconomic or too technically challenging to retrieve parts of the mine that would have been recoverable under the original plan.
My analysis indicates that high grading wastes as much as a third of the deposit on average.
So the total amount of ore extracted can decrease dramatically when miners adopt the high grading method.
Downgrading the non-high grade ore and leaving behind resources renders the validity of the economic studies null and void. Small wonder there is so much suspicion surrounding newly minted pre-feasibility studies, documents which provide a plan for mine management to extract the deposit. Some of these studies have as much credibility as fairy tales.
Miners now “extend and pretend.” They mine ever-higher quantities of low-grade ore to keep up their production, but at costs higher than originally expected. This keeps up the illusion of a productive mine even though the new ore is much less profitable.
Miners are hoping that higher commodity prices will come to their rescue, making the expense of mining the low-grade portions worthwhile.
But what if the commodity price doesn't rise? “This model will fall flat on its face and senior gold companies will continue to struggle to generate profits for many years ahead,” says Michael.
So what tipped Michael off to this apparent misstep in long-term planning?
There are two key indicators that high grading has occurred, says Michael: the targeting of high-grade areas, and a pronounced drop-off in the average grade being mined as a result of high grading.
We’ll expand on these points in our next update….
Key points: Major mining companies have mined out the best portions of their reserves. Current production is less profitable because of lower grades and higher costs. The strong need for fresh resources could make certain juniors with discovery potential attractive now.
In our previous post, Michael Kosowan, an Investment Executive at Sprott Global Resource Investments and Investment Advisor at Sprott Private Wealth LP in Toronto, described “high grading” in the mining industry, and why he believes it could damage the long-term prospects of big mining companies.
As Michael explained, “high grading” consists in changing a mine plan in order to recover only the best portions of the overall resource. Over the life of the mine, however, there is more waste and less revenue from the deposit.
What tells us that “high grading” is occurring?
There are two indicators of high grading, says Michael:
1. The fall-off in average grade being mined from the world’s largest gold operations
2. Development of “bulk underground mining methods”
Michael explains:
The average grade of ore being processed over the last 12 years for the major deposits around the world has fallen by roughly 75% - from 4 grams of gold per ton to 1 gram per ton!
There are very few new high grade projects. Current gold production is being fueled by old mines expanding their current operations. The expansion of these mines is generally cheaper than building a new mine. In many cases the production from these old mines is barely profitable (if at all), but to mining companies it is production nonetheless.
The senior mining companies, under pressure to deliver financial results, turned to doing the unthinkable.They mined out and emptied their own “jewel box” – taking out the best of the ore first. Once the highest grade volumes were gone, they expanded operations at the high expense of changing the mine plan, but producing ever lower grades of ore.
This is a road to economic oblivion! The long-term prospects of the miners are completely dependent on increasing commodity prices, since the lower-grade material is often unprofitable if the commodity price does not continue to rise.
And what if those commodity prices don’t go up? Simply, this model falls flat on its face. Senior gold companies continue struggling to generate profits for many years in the future.
This brings me to the second indicator of high grading, which is the broad use of the “bulk underground mining method.” I am highly familiar with this method, since as component of completing my Master’s degree I helped improve the efficiency of the bulk mining technique. I was working at the time for mining giant INCO, in Sudbury, Ontario. INCO ended up adopting the method and putting the theory into practice.
At that time, it was being used to mine out remnant pillars in some of the Sudbury basin’s greatest mines. Remnant pillars are by definition ‘low grade.’ Salvaging low grade in world class deposits has economic merit, but I suspected its days were numbered.
The problem with the bulk mining method is that it does not allow for full extraction of the deposit – so you are not getting 100% recovery. But the method is cheap on a per-ton basis.
With today’s economic stressors, underground bulk mining has come into vogue again, but at the cost of the overall profitability of a mine throughout its lifetime.
Some of the world’s greatest deposits are transitioning from “open pit” to underground mining scenarios. These are truly legacy mines like Freeport’s Grasberg mine, Codelco’s Chuquicamata, and Rio Tinto’s Bingham Canyon.
But the process of mining the rest of the deposit is much more expensive than initially planned, and the ore is of much lower grade. This means major mining companies struggle to keep up production, spending higher amounts of money to get to ore of decreasing economic value.
So how we can use this situation to our best advantage?
Well, let’s recap what I have said:
• There are many fewer quality ounces of gold left in these aging legacy assets.
• Senior gold operations are desperate for new discoveries because they have been mining their high grade.
• Their working business model has now become wholly dependent on rising gold prices.
Shareholders of senior miners expect the companies to make as much cash as possible each quarter. They often suggest that the miners should not take on exploration risk with their capital, but instead focus on producing efficiently and at low cost.
The area of finding new deposits is unarguably the domain of the junior companies.
Although seniors previously undertook exploration on their own, they now utilize the talent in the junior mining companies by subcontracting to them or buying major positions in their shares. Juniors who discover new quality deposits may be well rewarded as a result of the need for fresh ounces to mine.
If you have the ability to take on the risk associated with these companies, Michael believes that juniors who have the potential to deliver a valuable deposit may make interesting investments now.
P.S.: How do you evaluate these companies? Read our investment guide here.
Michael Kosowan has recently moved to Toronto Ontario, where he has joined Sprott Private Wealth team as an Investment Advisor. Having worked alongside Rick Rule since 2000, he will now lead the investment advisory initiative for resource equities in the Toronto office. Michael holds a Master’s Degree in Mining Engineering and is a licensed professional engineer. He is also a registered representative in both Canada and the United States.
Michael holds a Master’s Degree in Mining Engineering and is a licensed professional engineer. He is also a registered representative in both Canada and the United States.
With his extensive experience in resource investing, Michael is able to provide insights and knowledge critical in helping clients select and understand their investments.
You will find Michael as a speaker at several natural resource conferences, on webcasts and radio interviews discussing the companies that he follows.
Canadian clients can contact Michael e-mail him at [email protected] or call 1.866.299.9906.
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