Valuations are traditionally done in boom times and bust times, and they are done very differently in both times. I am going to go over how to value a mineral property in a full market cycle. I am not going to focus on any one project, but I will draw conclusions that can be applied to most any project.
First off, a mineral property should be viewed not as a discounted cash flow asset, but rather as a set of real options. Let me start by going over what shapes those options and how to deal with them. In this update I want to lay out the variables I think about when I do this type of work: project size, capital costs, and commodity pricing.
Project Size
Size does matter. I know you all have been told that it does not matter how large your asset is, but really the people who do your books do care. A property has a binary valuation depending on the size of it. The question of how small a project you can develop will depend on the capital required to get to a minimum amount of production. To take an extreme example, a 100 million tonne iron ore body that needs a 1,000 km railroad will never be developed. A 10 billion tonne asset such as Serra Sol that only needs a 100 km extension to a rail line to be developed will always be developed.
The issue about size is threshold. If you do not have enough size to support the capital invested, you will never have a mine. It is sort of like a roller coaster at Disneyland–you have to be so big to ride. The old rule of thumb was your needed 30 years of production at an economic scale. If you are a low capital scavenger of brownfield like Portman, this does not apply, but for any greenfield project this is a good test to undertake. So if you want 8 million tonnes of ore production out of a mine, you had better have 240 million tonnes of product in the ground. Not ore, product, and of course the first thing that happens in a boom is people do not do proper conversion of resource to product (processed reserves).
Capital Costs
The amount of capital required for development also matters. Now let’s be precise. If you cannot service the debt from the mine, it does not matter how big the ore body is. A simple calculation is in order here: Take the capital cost of the project and divide by five. So if you have a $1 billion project, you end up with $200 million going to debt service. The free cash flow from the project has to be greater than 20% of the capital required to build the mine.
Now how you get the free cash flow number will heavily depend on the commodity price used. In a bull market that price can be very high, but you have to pick a floor on that number. You have to know the price of iron ore or copper at which the mine will not work. You have to know that the unit production cost is well in excess of the “cash cost” of production. I am not saying that you have to do your DCF (discounted cash flow) on the valuation of a project with the floor number, but you have to understand that if you have cash costs of $25 per tonne of product and the 10-year floor is $15, you must have a decent plan on hedging for that, or else you will go out of business during a down dip.
Commodity Pricing
To develop commodity prices, I like to look at a few different things.
How leveraged is the sub-industry? Leverage adds to volatility because with leverage, people have to produce in a full market cycle. You do not shut down if you have a bond payment to make. A highly leveraged industry will work for the debt holders. Even if your own project is unleveraged, you will be working to the tune of steady production and not steady pricing, a tune that will be set by your most leveraged competitor.
How elastic is the demand? Can people live without the commodity? Copper is one such thing where people start to figure out how to live without it. I have written in the past of substitution of copper for aluminum in wiring. I expect at $3 and more per pound, thrifting has to continue. The question is, just how much can demand decrease?
Let’s take the elasticity of demand of oil. If the price of oil goes to $6 per gallon in the U.S., I can assure you that demand will drop. Heck, at $4 demand dropped. When you build your model, you have to figure out if demand will fall apart at a certain price.
My own theory here is that you have to figure out the ratio of the input cost to the end product’s price. So to take an extreme inspired by the fact that I am sitting at an airport, if the price of gravel doubled, people would still expand an airport if there was demand for the airport. The gravel is required for strong foundations, and it is not priced very highly as a percent of the cost of the project.
The more that the product input cost affects the end product and the more nonessential the product is, the more elasticity of demand. So if the price of a one carat diamond went to $15,000, I can assure you that demand for the stones would drop. If the price of a one carat diamond went to $1,000, the demand would spike. In contrast, if the price of gravel went to $2 per tonne, about the same amount of gravel would be used as if it went to $20 per tonne.
How elastic is the supply? This is the next thing that I take into account when I figure out how to value a mining project. I like things like potash where starting new mines is a $2 billion or more concept and not every Tom, Dick, and Harry can start one. These make for excellent assets to own. The problem, of course, is getting the $2 billion, and that creates a barrier for most junior players that is insurmountable. We will cover access to capital later on.
How concentrated is the industry? Now here is something interesting. I do not like industries with one major player and lots of smaller fish. I like strong oligopolies rather than an industry structure with a 50% market share player and lots of 1-4% players. The thing is, the small players do not really care about cleaning up after themselves, and they will make a real mess if it helps them in the short run. I also like real fragmented markets where everyone has to work on their own and no one party can mess with the game.
In markets where there is one almost dominant player, that player rarely can effect enough market control to stabilize prices, and everyone else is in the business of taking from that dominant player. An example of such a market and player would be platinum and Anglo Platinum. Anglo Platinum should own the business, but they do not because they are dancing for every little guy.
Once you have commodity pricing, capital costs, and project size, you can start to build out valuations. I am going to write another update on stages, but let’s sum up a conclusion here. When you start to figure out how to value a project, work out on a worksheet the questions that I have laid out above, then make a decent bet around the project.
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