Miners ‘extend and pretend’ on production: Michael Kosowan

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 price 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.

P.S.: Interested in natural resource investing? Click here for Rick Rule’s free Guide to Natural Resource Investing.

Michael Kosowan has recently moved to Toronto Ontario, where he has joined the 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.

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 resource sector.

Canadian clients can contact Michael e-mail him at [email protected]or call1.866.299.9906.

US clients can contact Michael email him at [email protected] or call 1.800.477.7853.