Due Diligence Mining Investments

7/28/2019 Due Diligence Mining Investments

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Agricola Consultants

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DUE DILIGENCE IN MINING INVESTMENTS

By M. Norman Anderson and Harleigh V. S. Tingley; The authors are directors ofAnderson Genssler & Schwab, Inc., Management Consultants, headquartered at 645Madison Avenue, New York, N.Y. 10022-1065, U.S.A.

(Source: Mining Journal, April 1988)

The authors consider the many factors involved in making a good minerals investmentand explain the need for a businesslike due diligence review before committing majorcapital expenditure to a new project.

How times have changed in the mining business! Ten to fifteen years ago, metals andother minerals appeared about to become so scarce as to threaten to limit world

economic growth. Minerals prices, profits and new projects soared. Even second rateproperties were profitable and investment risks were all but ignored in our haste to servethe markets.

In the early 1980s almost all minerals markets collapsed. Many miners, since 1981,have lived in a depression: demand and prices tumbled, profits vanished; some highcost mines shut down; and survivors tightened their belts admirably. Some survivingmines were 'high graded', thereby shortening their lives. Except for gold and platinumwhich recovered rather quickly and prospered, (indeed some of the euphoria of theearlier days appears to have spilled over into gold and platinum mining), very few, new,replacement mines have been brought on stream during this period.

Today, finally, all metal markets are generally pretty healthy -- coal and other mineralsalso show signs of recovery. Although we are not likely to see the euphoria of the 1960sand 1970s return, there is more buoyancy and more new projects are up for funding.

But, in that framework, if the investors are to avoid some of the pitfalls of the past, duediligence of mining investments has to take some important, new perspectives.

What makes a good minerals investment?

The answer appears deceptively simple. Only quality properties should be brought intoproduction. But what is a 'quality' property? Why is it that a Canadian 0.5% Cu ore bodyis among the lowest cost copper producers in the world while a 5% Cu deposit

discovered 25 years ago in Zaire still remains untapped?

The difference between a quality and second rate property is not just grade or geologyor strip ratio or rock condition or deposit size or metallurgy or labour attitudes or labouravailability or labour skills or market timing or demand or competition or terrain or climateor infrastructure needs or political considerations or construction costs or capitalavailability -- the list could go on for pages. Rather, it is a combination of all the above.If all are satisfactory and fit together you have a quality property. But if even one factorpresents too serious a risk, then investor beware -- or at least be aware, and make yourdecision accordingly.


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Gold miners have judged the money making potential of their new projects very wellthese past three or four years. Really, it has been hard to be wrong in gold recently. Butwhat does one do when copper goes from 65[/lb to plus $ 1.00 as it has in recent

months? Does it lead to judging new copper opportunities like gold opportunities havebeen judge of late? We think not! Not yet. But as more and more old copper mines andzinc mines are depleted, and if our economy continues strong, a prolonged period ofhigher base metal prices may develop. Investors today are looking for that trend.

However, the prudent investor who believes (as we do) that better times may bereturning will still insist upon an investment analysis or feasibility study to assessinvestment risks, and base his decision upon the results of that study. But beforecommitting funds the prudent investor will also insist upon an independent due diligencereview, not only of accounting and legal functions (which are not the subject of thisarticle) but, of the study's technological, operating and business assumptions.

Why due diligence?

Why the double protection? Because of certain singular characteristics of the miningbusiness and mining investments. Among these are:

Mine investments are large -- even small mines don't come cheap.

A mine investment has a certain ultimacy about it. You can't retrofit the grade or(realistically) the mine plan or metallurgy if the mine doesn't live up toexpectations.

Mining, unusually, involves many kinds of risks. It involves most risks common to

all businesses, plus heavy doses of physical, political, climactic and other risksthat few other industries must face.

You can't see through rock. Mining investments are built on reserves which youcan't see and which are seldom homogeneous. To determine reserves preciselyis economically not feasible. To approximate them accurately takes a highdegree of skill.

Every mine is different. Mining is site specific -- you have to put the mine wherenature put the ore, and deal with whatever geology, rock conditions, metallurgy,topography, society, politics, etc., is there. Many factors are involved and eachmine's risks are different.

Risk factors change over time. Due to the length of life of mine investments, therisk profile steadily changes. What begins as a reserves risk may develop into amining risk or political risk or competitive risk or labour risk.

Mining offers unique opportunities to unscrupulous promoters. The investor can'tsee the reserve through the rocks, can't count the parts per million in the grade,and often can't easily get to the site.

Optimism (or perhaps we should say Overoptimism) is one of the greatest risks.Optimism permeates the mining business. Optimism has led to some startling


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(and sometimes surprising success stories, but overoptimism has been thesource of many failed investments. (As Simon Hunt once said, 60% of all minesprofess to be in the low cost quartile.)

Risks of overoptimism

Overoptimism is a risk because many of those in the business have to be optimists inorder to do their jobs well.

The exploration geologist has to be optimistic to spend his life looking for a goodmine. Can you blame him for hoping that the mineralization he does find is alittle larger and a little richer than it is?

The mine geologist knows that the whole mining operation depends on hisfinding reserves. Can you blame him for discounting those first hints that the

orebody might be playing out, and taking a few risks that may be wrong in theprocess?

The mining engineer developing a new mine must believe in it. Can you reallyexpect him to have the drive and spirit to make a go of the mine and still beclinically objective about its potential risk? (Risks to the engineer are barriers tobe overcome, not reasons for stopping.)

Similarly, the marketer. The next order is always coming. The price is alwaysgoing to rise next week. No good marketer could have survived the past fewyears without some optimism in his heart.

However, overoptimism can lead to unfortunate consequences even in well managedcompanies. For example, a US mining company well known for its skill in explorationand mining recently reduced a major reserve by 10% with the terse statement, 'Graderecoveries in the deposit were less than had been expected . . . because several highgrade intercepts were given too much influence in the reserve calculation.' Theconsequences: higher costs and a shorter mine life. In these days of slim margins, thathurts.

The consequences of overoptimism can be very large. The molybdenum producers'overly optimistic forecasts of steel production a few years ago cost them hundreds ofmillions of dollars.

Or on an even grander scale, the oil companies' misperception about the miningbusiness cost some of them thousands of millions in mining investment losses.

Due diligence in mining

Traditional due diligence has been conducted on a functional basis principally in terms oflegal due diligence, accounting due diligence, and financial analysis. However essentialthese are, they are not enough -- for example:


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The legal review assures the investor that rights to the reserves are secure --absolutely essential to an investor, but of limited import if the deposit isuneconomic.

The accounting audit assures the investor that past profits have been accuratelystated -- essential but of limited use if those profits were earned in conditions thatno longer exist.

Financial analysis identifies potential financial returns -- but is of limited use if notsolidly grounded in a real understanding of geological, mining, or metallurgicalrisks.

We believe that the investor should take a business approach to due diligence.

What is a business approach to due diligence in mining? Simply stated, it is sitting down

and putting all the facts together before you spend a fortune on a new mine. It is oftendone in six levels of effort:

Reserve verification is the initial step. Are the reserves as represented? It is thejob of the due diligence consultant to first verify the reserve evaluation processand then identify and quantify the impact of the optimism on the geologist'sassessment, (but without being pessimistic either, which would kill every projectthat comes up for consideration). Level one due diligence hopefully concludeswith verification of the reserve estimate.

Level two due diligence identifies and seeks to assess all project risks. Inaddition to reserve risks, these may be metallurgical, mining, infrastructure,

environmental, climatic, political, logistical, etc. It concludes with an assessmentof whether the project risks in total are manageable.

Next on the scale is a forecast of the probability of development and projectprojections being met -- will the project be completed on time and on budget, andwill it produce scheduled tonnages and recovery at projected costs. Thisnecessitates an assessment of management's ability to meet all the present andpotential risks to the project -- a critical judgment for the investor.

Level four provides competitive assessment of the project or business. Here thedue diligence effort moves beyond the project itself to assess its strengths andweaknesses as against the strengths and weaknesses of the competition and

concludes with a verification of business viability and risks.

Level five consists of an assessment of future markets (1) in general, and (2) aspertinent to the particular project -- will there be sufficient demand and price forits products?

Level six is the financial assessment -- what are the cash flows and what are therisks to that cash flow. This is the ultimate objective of the due diligence -- and iswhat the investor must know before making his investment. But the financialassessment is only as good as the technical, operating and commercialassessments that underlie it.


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Skills requirements

The skills required for due diligence reflect the risks of the business.

Geological and mining skills; due diligence starts with assessing the reserves.Thus, geological and mining skills not those on an MBA, are prerequisites.

Technical competence in a variety of scientific and engineering deisciplines isrequired to assess risks to the project as a whole.

Operating management skill is needed to make the judgment as to whether risksare manageable and whether management can attain development andoperating goals.

Political assessment and management skills are necessary, as appropriate to thelocal environment.

Market analysis skills are another very important prerequisite.

International skills are needed. Mining is an international business. Minerals,like red wine, travel very well. Due diligence skills must be equally international.

Business and commercial competence. Ultimately, the decision to develop or notdevelop is a business decision and must consider financial, commercial andphysical risks.

In conclusion

Consider these thoughts on what makes for a good due diligence job:

Realism. However valuable modern techniques of geophysics, core drill ing, andgeostatistical analysis, they can also give a false sense of security. What isneeded more is broad experience in studying and interpreting drill data and,because nothing yet can see through rock, a modest amount of scepticism tooffset the euphoria that always surrounds new opportunities.

Breadth is required. The due diligence team must be able to integrate all theissues into a single conclusion.

Objectivity. The due diligence consultant must guard against undue optimism (orpessimism) in his own conclusions as well as in the conclusions of others. Andhe must not allow his judgment to be swayed by any interest of his clients --except his interest in a fair appraisal.

And finally, age and experience are necessary to put it all together. Due diligence inmining is not a young man's game.

Due Diligence Mining Investments

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