Covid-19, Inflation and Mine Valuations

This article is taken from GTDT Practice Guide: Mining 2022. Click here for the full guide.

Introduction

In previous editions of this publication, we have presented our views on the potential valuation impact of the covid-19 pandemic and the disruption caused by covid-19 on the energy transition. Both of our previous chapters focused on long-term structural changes to the mining industry caused by covid-19, but in the two years since the start of the pandemic, inflation has become an acute macroeconomic issue that has had wide-ranging effects on the industry and beyond. In this chapter, we will discuss common mine valuation concepts and how inflation impacts mine valuations generally, then apply those concepts to the specific issue of valuations of copper and gold projects with reference to case studies for both.

In our review of both markets, we have found indications that the upcycle trends in the mining sector have likely increased the valuation of individual projects in the short term owing to increases in commodity prices that reflect spot demand. However, increased commodity prices have been matched by increased inflation, demand destruction and the onset of a market downcycle. Due to the outsized inflation response in this current market cycle, a larger than normal market correction is possible, with valuations going from high peaks to distressed in a relatively short time frame. Ultimately, the supply and demand response by miners and mining companies will drive the valuation narrative for this cycle.

Mine valuation concepts

It is important to define the terms that we are using throughout this chapter. When we discuss the impact of inflation on mining projects, we are particularly interested in the impact on their valuation. First, we should establish a standard of value, which frames the valuation by defining what considerations were included by the valuator.

In the mining space, the International Mineral Valuation Committee (IMVAL) is an organisation of other regional regulatory organisations that oversee valuations in the industry across the globe. In this capacity, IMVAL has developed the IMVAL Template, which provides common standards and guidelines that can be applied in any jurisdiction. The IMVAL Template refers to a ‘Basis of Value’, which is akin to the standard of value discussed above, and states that it ‘commonly refers to Market Value, but can also refer to other Bases of Value such as Fair Value, Fair Market Value, Special Value or Synergistic Value.’²

In our experience, Market Value, Fair Market Value, and Fair Value are common and are often used interchangeably. However, each defined term has its own particularities that makes it useful in different contexts. Market Value is defined by the International Valuation Standards Council (IVSC) as ‘the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s-length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently, and without compulsion.’³ It is typically understood that this Market Value definition attempts to present the actual sale value of an asset, net of expenses to market it, assuming a reasonable amount of due diligence. The IMVAL Template adopts the IVSC’s definition.⁴

Fair Market Value has many definitions, but the most commonly used one that we are aware of (per the United States Internal Revenue Service) is ‘the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.’⁵ Compared to the Market Value definition above, this Fair Market Value does not specify that the notional transaction should only include considerations that parties at arm’s length would make and does not include efforts to market and sell the asset. This is typically understood to be a more hypothetical exercise than what is considered by the Market Value definition above.

The IVSC also offers the simplified OECD definition of ‘the price a willing buyer would pay a willing seller in a transaction on the open market’. Unlike the previous definition (or the definition of Market Value), the OECD’s Fair Market Value definition further removes clauses related to reasonable knowledge of the facts, instead substituting that clause with a consideration of what would occur in an ‘open market’. In contrast to the IVSC, the IMVAL Template does not use this definition and instead only refers readers back to the definition of Market Value, treating them as interchangeable.⁶

Finally, the IVSC defines Fair Value as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.’⁷ However, the IMVAL Template notes that this definition is typically used for purposes of financial reporting and that Fair Value is a nebulous term that has definitions that ‘can vary significantly and may be the result of legislative action or those established by courts in prior cases’.⁸

For purposes of this chapter, we will consider the value of a project to be its Market Value, (ie, the value that the seller of a project may actually receive in a transaction).

Overview of commodity cycle dynamics through inflationary environments

No valuation should ignore where the underlying asset and its cash flows may be within the overall business cycle, and even more so for commodity-linked assets, which often experience cycle extremes both in their speed and the magnitude of peak-to-trough corrections (known as ‘super-cycles’). Even more so, understanding the cycle response in the context of inflation will illuminate valuation effects and implications that might be expected through inflationary environments.

At the bottom of an upcycle, inflation expectations may put upward pressure on metal prices. With higher prices, mining valuations tend to move up as they attract capital and realise increasingly positive cash-flow margins as the commodity price increase front-runs cash costs, which may in turn cause miners to bring short-cycle marginal supply online. In terms of valuation implications, mining companies should update project valuations (and observers should reflect these trends in their Market Value estimates) with revised metal price outlooks and input cost assumptions, including capital and operating costs. Early on during the cycle, these commodity price increases contribute to upward pressure on global consumer prices (up 7 per cent to 8 per cent in 2022), which in turn causes central banks to raise interest rates.⁹ Higher interest rates negatively correlate to metal prices, stunting valuations and making it harder for miners to fund projects, paring and correcting the cycle.

Miners may react to rising prices with a positive supply response, greenlighting or starting new projects as their economic viability shifts against a refresh of the underlying cash flows. The combination of supply response and, often, demand destruction due to rising consumer prices may cause commodity prices to fall, tightening spreads and denuding miners of the higher margins experienced initially in the cycle (when supply decisions were made). As the cycle progresses, miners’ input costs (namely diesel, electricity, labour and chemical) begin to rise. These cost increases put downward pressure on mining valuations as margins compress. And timing is rarely – if ever – in sync. Supply responses may take years to develop, often causing global production to overshoot demand.

Because commodity prices are reflections of spot conditions and are not anticipatory assets, like equities, demand for commodities may keep climbing even in an environment of falling overall demand due to supply constraints, spurring miners to build. Inflation, however, triggers demand destruction, as noted above, and may hasten the inflection of the cycle from one of rising demand to one of falling demand, and with it falling prices. Therefore, we would need negative growth (demand destruction) or a significant upside supply response to bring prices down. These timing effects and supply-demand reactions thrust commodities into super-cycle tendencies, making valuation even more sensitive to cycle timing.

Another consideration is the impact of currency fluctuations on mine valuations. Most commodities are priced and sold in US dollars, which itself influences not only demand-side and supply-side responses across non-US currencies, but will have outsized impacts on valuation as foreign exchange becomes more volatile during inflationary environments. As an example, a strong US dollar puts downward pressure on demand for metals for non-US dollar buyers, which serves to lengthen the down cycle from consequential demand reductions. Observers and practitioners of mining valuation will be well-served to account for overall currency impact when conducting mine valuations, including inflation across countries and relative changes in foreign exchange rates.

Historical inflation assumptions and their impact on mine valuation

Often, credible valuations are time-sensitive, highly detailed exercises, and confidential. Although they are often built on public data, individual valuations typically have significant amounts of proprietary information and underlying assumptions. Further, valuations are a key form of intellectual capital for many industry analysts resulting in them being kept behind paywalls.

So, what kind of actionable information is publicly available? There are of course quarterly and annual filings of publicly traded mining companies. The management discussion and analysis section of the annual filings tends to provide non-financial information such as operating asset performance, key considerations and risks, and other details that inform valuation practices and methodologies. Several national governments have also passed legislation aimed at providing investors and other stakeholders with relevant information to assess the performance of mining projects. In Canada, National Instrument 43-101 (NI 43-101) governs ‘[a]ll disclosure of scientific or technical information made by an issuer, including disclosure of a mineral resource or mineral reserve, concerning a mineral project or a property material to the issuer’.¹⁰ These technical reports often take the form of pre-feasibility or feasibility studies that purport to demonstrate the technical and economic viability of a project.

Specifically, NI 43-101 establishes an obligation for ‘reporting issuers’ to file technical reports for each project or asset that the company controls and provides guidance for the form and content of these reports.¹¹ The ‘Contents of the Technical Report’ section includes several items that should be included in technical reports, including Item 22 entitled ‘Economic Analysis’. The Economic Analysis section is often found within technical reports, and NI 43-101 notes that it should include several assumptions, inputs and calculations that would typically be found in a valuation (ie, inputs and assumptions around forecasted cash flows, applicable discount rates, the net present value (NPV) of discounted cash flows).¹² Many mining companies publish the results of their technical reports in terms that will liken a particular project’s NPV with its Market Value; NI 43-101 provides information about the asset’s resource characteristics, which is considered basic data and forms the fundamental inputs on which valuations are built.

In our experience, while the economic analyses that are found inside technical reports have several characteristics that resemble valuations, they do not usually consider all the relevant factors required to calculate Market Value. For example, technical reports typically discuss the risk factors facing potential projects, including uncertainty around title, permitting, social licence, and macroeconomic conditions. However, when it comes to estimating the NPV of the project, these significant uncertainties are often assumed to be overcome outright, not included as potential reductions in the cash flows or increases in the discount rate. Typically, it is only at a corporate portfolio level where discount rates are adjusted to reflect these risk characteristics, and what is reported in technical publications may not make clear any adjustments for influencing factors. In this way, technical reports often present a binary picture of a project as either economically feasible or unfeasible (although economically unfeasible reports are unlikely to be published), assuming that uncertainties are made certain and that expectations are met.

Take inflation, for example. Inflation is accounted for in cash flows in one of two ways, by presenting those cash flows in nominal terms or real terms. When forecasted cash flows are presented in nominal terms, they represent the dollars of the time that they are earned (eg, cash flows in 2030 represent the actual value of cash expected to be earned including the effect of inflation out to 2030). Whereas cash flows presented in real terms remove inflation by pegging the entire forecast to a reference year and inflation is assumed to be offset entirely (eg, a forecast done in 2022 estimates cash earned in 2030, but will not include any growth due to inflation). Many technical reports make the simplifying assumption to present forecast cash flows in real terms rather than nominal terms.

In Copper Mountain Mining Corporation’s Eva Copper Project located in Australia, the NPV was estimated to be approximately US$256 million using a discount rate of 8 per cent.¹³ Inflation was listed as a key input, but a simplifying assumption was made to remove inflation from the forecast: ‘Nominal 2018 dollars with no inflation and on a constant dollar basis.’¹⁴ Implicitly, the technical report assumes that the costs of operating the Eva project are expected to grow at effectively the same rate as the value of revenue generated by the project.

Despite these differences, we believe that the technical reports published by mining companies can be a good proxy for the Market Value of a project in the absence of a robust valuation exercise, although such an exercise should be preferred if the data and opportunity are available.

Covid-19 global pandemic and its impact on inflation

In a stable inflationary environment, it may be appropriate to assume that price growth would remain consistent with cost inflation. In the United States, a stable level of inflationary growth year-over-year was assumed to be in the range of 1.5 per cent to 2 per cent. Consistent with those expectations, from January 2012 to January 2020, the Consumer Price Index (CPI) for all urban consumers published by the United States Bureau of Labor Statistics increased by an average of 1.6 per cent year-over-year.¹⁵

The covid-19 pandemic caused and was followed by supply chain disruptions across all industries including mining. In order to provide support to citizens and companies impacted by the pandemic, governments approved and distributed large-scale fiscal stimulus packages. The combined impact of the above has led to multi-decade-high levels of inflation worldwide. Following a slow recovery due to the covid-19 pandemic through 2020, from January 2021 to January 2022 the CPI grew from 261.582 to 281.148, an increase of 7.5 per cent.¹⁶

The mining sector has not been immune to this inflationary wave. The Federal Reserve Bank of St. Louis aggregates price data for a variety of industries and specialty areas in their producer price indexes (PPIs).¹⁷ These PPIs track changes in the price for certain commodities and input costs. Between January 2018 and January 2020, the ‘Copper, Nickel, Lead, and Zinc’ PPIs decreased from 395.3 to 347.2, while ‘Gold’ increased from 333.5 to 390.9.¹⁸ From January 2020 to January 2022, the ‘Copper, Nickel, Lead, and Zinc’ PPIs increased to 468.2, while the last observation of the ‘Gold’ PPI dated December 2021 increased to 445.3, evidencing marked increases in commodity prices following the onset of the covid-19 pandemic.

Naturally, in times of high commodity price growth, costs tend to also increase as demand for services and equipment increases in the industry. As shown by the ‘Mining Machinery and Equipment Manufacturing: Parts and Attachments for Mining Machinery and Equipment’ PPI, before the pandemic, the rolling 12-month average growth rate for some input costs was 1 per cent from January 2013 through March 2020. However, following the onset of the pandemic, the growth rate of the PPI began rising to 2.9 per cent for the rest of 2020, became 5.7 per cent in 2021, and then 14.8 per cent through July 2022.¹⁹

Much of these cost increases can be traced to changes in key categories of mining inputs. For example, the average PPI for ‘No. 2 Diesel Fuel’, a large contributor of costs to most mining assets in both fleet and fixed plant operations, has risen year-over-year by approximately 80 per cent and 62 per cent, respectively, for 2021 and YTD 2022 to the end of June as shown in the table below.²⁰

In light of these unusual inflationary pressures, mining companies have adapted their development plans accordingly for the issue. The technical reports published since the start of the covid-19 pandemic have followed suit. For example, in announcing its updated pre-feasibility study for Seabridge Gold’s KSM Gold Project located in Canada, the company’s CEO noted the following:

We have redesigned KSM for an inflationary environment. The themes for this PFS are capital and energy efficiency. The mine plan is simplified to bring total capital down below 2016 estimates despite inflation by reducing sustaining capital. We have accomplished this by eliminating underground mine development which is deferred to future years. Important steps have also been taken to make the project less dependent on oil, especially diesel fuel, which is an inflationary hot spot and likely to remain so. We have done this by maximising the use of low cost, green hydroelectric energy.²¹

However, Seabridge Gold does not appear to have instructed its technical experts to provide any further adjustments to account for the forecast uncertainty caused by the current high inflation environment.

Based on the above and our understanding of market cycles in the mining industry, we would expect that, in the short term, increased commodity prices would spur growth in operating asset valuations and Market Values. However, if inflation continues and demand is muted, Market Values could trend downwards as costs increase and commodity prices enter a downcycle.

Current inflation trends in copper and gold mining

The actual results of operating assets can provide further information about how inflation is directly impacting specific mines. For example, ‘mining cash costs’ measure a basket of production costs per unit of mining output and can be used as a standardised metric to compare the production efficiency and quality of the resource of different mines. This basket of costs includes items such as production site costs, transportation, treatment, refining, and royalties.

When calculating cash costs, if a company generates more than 80 per cent of its total revenue from a primary metal, other metals it produces are considered by-products, and the associated revenues can be deducted from the costs of producing the main commodity via cost credits. On the other hand, when a company generates less than 80 per cent of the total revenue from a primary metal, all metals it produces can be considered co-products, each carrying the cost of production in proportion to their revenue contribution.

Mining companies report cash costs using the by-product and/or the co-product method, which typically yield non-Generally Accepted Accounting Principle (GAAP) measures of mining costs. Both of these measures tend to underestimate primary metal cash costs due to the impact by-product credits or cost apportionment, both of which are driven by the revenue (and prices) generated by the non-primary metal(s).

The covid-19 pandemic was followed by supply-chain disruptions as well as large-scale fiscal stimulus, which led to multi-decade-high levels of inflation worldwide. As discussed above, mining sector PPI components reveal costs are rising very fast and potentially accelerating. However, reported by-product copper cash costs for six of the leading publicly traded copper miners show a decline of 8.8 per cent in 2020 followed by an increase of 2.6 per cent in 2021.²² The data is summarised in the table below.

Table 1: Annual by-product copper cash costs for six leading miners 2013–202123

The decrease in cash costs during the pandemic is primarily explained by the impact of by-product credits. As commodity prices rose sharply in 2020 and 2021 while costs were lagging, which is to be expected in the early phase of a commodity upcycle, the impact of price rises in copper by-products such as gold and molybdenum more than offset inflation on the cost side.

To isolate the changes in cash costs from the impact of by-product price changes, we analysed copper cash costs for the same six miners, taking into account all production, transportation, treatment and refining costs as well as royalties paid. The sum total of those costs is divided by the total copper production volumes of those miners. Under this adopted definition of cash costs, the observed trend is consistent with the overall PPI trends described above, with cash cost increases of 9.8 per cent and 13.6 per cent in 2020 and 2021, respectively. The annual data from 2013 to 2021 is summarised in the table below.

Table 2: Annual copper cash costs divided by copper volumes (excluding by-product credits)24

Performing the same analysis on a quarterly basis shows sequential cost decreases in the last three quarters of 2019 followed by increases in seven of the next nine quarters. Not only have increases accelerated in 2021, but the trend appears to have continued into the first quarter of 2022, where cash costs increased by 5.7 per cent. It appears that accelerated cost increases, which typically lag commodity price rises and appear later in the commodity upcycle, have emerged sooner and at a much higher level than was anticipated, with pandemic-related exogenous variables being a likely contributing factor.

Table 3: Quarterly copper cash costs divided by copper volumes (excluding by-product credits)25

Next, we analyse cash costs for the seven largest publicly traded gold miners.²⁶ In cash costs, we include mining, processing, production taxes, and royalties calculated per gold troy ounce sold on a by-product basis. We observe a similar inflationary trend; after declining during four of the six years in the 2013–2019 period, cash costs increased by 3.0 per cent in 2020 and by 9.0 per cent in 2021. The data is summarised in the table below:

Table 4: Annual by-product gold cash costs for seven leading miners 2013–202127

Performing the same analysis on a quarterly basis shows the annual increases in 2020 and 2021 have been followed by a quarterly acceleration in the first quarter of 2022, with cash costs increasing by 9.8 per cent compared to the prior quarter. Again, the table below provides the summary data for this analysis.

Table 5: Quarterly by-product gold cash costs for seven leading miners Q1 2019–Q1 202228

In summary, there have been large increases in mining costs for copper and gold, which have been masked by by-product credits due to an even stronger rise in commodity prices. Profit margins have expanded as they typically do in the early stages of an upcycle leading to elevated valuations for many of the mining companies. Normally, we would expect that these factors would be reflected in Market Value determinations with valuation dates in and around this time. Indeed, share prices (which reflect some consensus of the Market Value of the publicly traded shares of a company as a whole) of Antofagasta, First Quantum Minerals, Southern Copper, and Newmont Corporation reached all-time highs late 2021 to early 2022.

However, there are clear indications of emerging headwinds, which have in the past led to sharp declines in mining valuations:

• Inflation levels are at multi-decade highs and are already forcing the hand of central banks worldwide into a much more aggressive than typical monetary tightening cycle. In the past this has led to deeper and longer recessions as well as large and protracted commodity demand destruction. In turn, this could lead to a faster and deeper correction in commodity prices.
• Mining cost increases since the start of the pandemic and through the first quarter of 2022 have come in much faster and at a higher level than they typically do in commodity upcycles. In the past, mining costs have displayed relatively high stickiness (ie, inelasticity where costs do not decline at the same rate as commodity prices).

The combination of emerging downside price pressures (indeed copper has meaningfully reduced from its highs as of the time of writing) and persistently high mining costs may cause profitability to decline sharply should a global economic soft- or hard-landing materialise. This could cause a very rapid derating of mining companies from peak to distressed valuations. While commodity price booms and busts have occurred in the past with some cyclical regularity, it is the variety of cost increases observed in this cycle that may lead to a much steeper than normal contraction in profit margins and valuation multiples.

The ultimate outcome of this valuation narrative also depends on the supply response by miners. A strong supply response, akin to what was seen in the 2002 upcycle, would add additional pressure over the medium- to long-term valuation outlook (and would be to a large degree commodity specific). Alternatively, a subdued supply response may keep certain metals, like copper, in tight markets, supporting higher prices for longer. We see a number of factors that, at this time, may be constraining miners from exhibiting the elastic supply response that some predicted, or was evidenced in prior upcycle environments, including:

• management conservatism that has been built through experience of the last cycle, where miners over-built in response to high prices in the 2000s and have significantly underperformed total shareholder returns;
• ESG influence has limited investor allocations to mining companies, limiting capital inflows and making it harder for miners to fund projects;
• miners have seen time-to-first product protract as requirements such as permitting has become harder (up by years); and
• talent for building new assets is limited and restricted to miners who are able to pay high wages for the few experts who are available.

Taken together, these bottlenecks to new supply would support mine valuations even with cost increases as they would put upward pressure on prices. Market Value conclusions related to individual mining projects must therefore consider both the demand and supply response.