Digging deeper with financial engineering to counter risk

Dennis Buchanan, emeritus professor of mining geology and senior research fellow at Imperial College London, forecasts consolidation of existing investments within the mining industry as the world economy continues to shudder from the 2008 financial crash

In my view, the international mining industry is at something of a watershed with focus on growth since 2006 changing over the last year to optimisation of existing investment. Prior to the financial crisis of 2008, growth was achieved mainly through mergers and acquisitions.

Valuations placed on the assets before the financial crisis were demonstrated to have been manifestly inflated. This is reflected in the massive impairment write-downs that started in 2009 and continue to the present.

Coinciding with this, the industry has seen some well-publicised changes at the chief-executive level of the major mining companies, with the new incumbents often bringing operational experience to the appointment.

The revised business strategy appears to be that of consolidation within existing operations. The major mining companies know they can do little about market demand, but they can enhance shareholder value by focusing on cost management (both operating and capital).

The key driver for many major base-metal operations is the transition from open pit to underground mining based on block and panel caving. Chilean copper mines are achieving higher underground production rates utilising new technologies and better knowledge of cave behaviour.

To ensure success, conventional engineering is blended with financial engineering to identify how timing is critical in optimising return on investment. Financial models of case studies undertaken at Imperial College demonstrated the effect of key technical variables associated with transition from open pit to underground mining.

These studies demonstrated how financial engineering can be used to offset risk associated with operational issues. An integral part of this study was the development of concepts that consider the impact on the original financial performance indicators, such as net present value, of unexpected delays in meeting production targets.

Recent events in the South African mining industry have all the hallmarks of a major change in the political and commercial landscape. The concept of “cheap” labour-intensive mining was always an illusion. The Rustenburg-centred platinum mining industry, based on underground mining of the narrow Merensky and UG2 horizons, is going to have to mechanise, train up well-paid teams of skilled operators, provide decent family housing and reduce underground shift numbers by a significant factor.

The problem in the Rustenburg area is the narrow reefs that are just over a metre wide; if the stopes [excavated chambers] are going to be wide enough to handle even low-profile mining equipment, dilution will increase and head grades will drop. Reduction in operating costs per tonne needs to offset loss of head grade if the strategy is to succeed.

If mechanisation is implemented, this will have social implications as unskilled labour makes way for skilled operators. These operational changes will inevitably draw attention to the potential of the Platreef [in Limpopo, South Africa] with high-grade zones, which are at least ten metres wide and amenable to both open pit and mechanised low-cost underground room and pillar mining operations.

On the revenue side consumers will also have to start paying a lot more for platinum or find substitute metal to place in vehicle catalytic converters.

Gold mines are in a class of their own; high-grade deposits with metallurgically simple ores are normally good investments regardless of supply and demand considerations.

Value release for industrial minerals, such as iron ore, is completely dependent on infrastructure, including dedicated rail links and deep-water harbours. This will almost certainly require the involvement of international organisations, like the World Bank, for the development of projects such as the various West African iron ore deposits.

The same applies to coal deposits, such as those found in Mongolia. Release of value arises from building power stations, an electrical grid and rail connections that are not core businesses for a mining company.

More smelting capacity in South Africa requires further investment in electrical power generation, but the private sector cannot compete with Eskom, the public sector utility, on cost. Nickel concentrate from the Nkomati Mine in South Africa is shipped to Finland for smelting rather than locally.

If supply shortages arise for metals and minerals, as is likely, then prices will rise to the benefit of existing producers, but I do not see any significant increase in production in response, just consolidation and optimisation of investment in existing operations.

The major changes that have taken place in the international mining industry over the last decade have significantly increased the demand for professionals with skills that blend technical and financial engineering with a business perspective.

This was behind the launch in 2006 of the Imperial College MSc in metals and energy finance, a combined Faculty of Engineering and Business School degree. Graduates are in high demand by the natural resource teams of investment banks, new business development of both mining and petroleum companies, as well as the technical and financial consultancies. Imperial College’s School of Professional Development also delivers around a dozen courses each year in the field of mining finance.

Professor Dennis Buchanan’s current research interest lies in addressing the underlying technical principles applying to mineral projects and demonstrating how these influence financial modelling; he has worked as a mining geologist in gold and platinum mines in South Africa, and has wide experience as a consultant to the industry.