On Mining Capital Costs

“It’s my own belief that this [capital cost] creep will ultimately result in boosted commodity prices, because a lot of assets that were scheduled to be in production by now are not even close,” says Egizio Bianchini, co-head of metals and mining at BMO Capital Markets.

Companies are having enough trouble just replacing their own reserves and production. To take one example, approximately 440 tonnes of gold have been produced from new mines over the past decade, according to Mineral Economics Group. By comparison, production from existing mines has dropped by roughly 600 tonnes.

But even if one assumes the outlook for metals is positive, more volatility seems assured. The last couple of years have demonstrated that events that have nothing to do with mining (like the Lehman Brothers collapse, the Eurozone crisis or hedge fund flows) can have outsized impacts on the sector.

“I think the bull market trend will continue, but you’re going to have a cycle of mini-booms and mini-busts that won’t favour the buy-and-hold investor,” Mr. Stephenson says. “You can’t just buy this stuff and go away onto a desert island, because it will kill you.”

Financial Post

Capitol Cost Creep may be defined as the the decline in the Net Present Value of a company in a low interest rate environment, specifically when short term interest rates decline below 0.5%.

A decline in Net Present Value on a forward basis increases your discounting factor more than increases in your commodity price. This has long term implications for any producer of commodities, forseeably for ten years. Most commodities are priced in at their inflation adjusted-averages or below going back many years. There is no scenario for any particular commodity to advance beyond inflation.

The great exception to this rule has been gold. In gold mining companies, their commodity price adjusts with inflation, under negative real interest rates. The two notable times when this occurred was when interest rates were maintained above 8% during inflationary times, or fell below inflation during mega bear conditions.

The implication for gold miners is that Internal Rates Of Return advance in parabolic fashion. So if you set the lowest cut-off grade possible and process the most ore possible, then you are making absolutely certain that your returns do not reflect the advantages of the gold price.

This is the exact reason why anyone should be leery of promoters with assays that range over 200m. with a grade below 2 g/t., or cut-off grades of 0.3 g/t. You need the best possible grade under all circumstances supported by a reasonble cut-off grade.

This favours an underground scenario that can maintain robust grades. Secondly, a gold mine must pay dividends as equity price returns will follow the bear market adjusted for inflation.

-F6