Thursday, July 26, 2007

Exploring Declining Grade

In 1905 the Bingham Canyon mine opened mining a copper grade of 2%. Last year the grade they mined was 0.63% and the reserves they have left to mine have a grade of 0.54%. In 2003 Goldcorp’s Red Lake mine mined a gold grade of 77.5 g/ton, and 28 g/ton in 2006. These are a couple examples of a trend of declining grade in individual mines and within the industry as a whole as the best deposits tend to be mined first. This post looks at declining grade in a single mine. I suspect that declining grade affects costs exponentially rather than linearly, and I will examine that next post.

There is no question that grade is related to profitability. Looking back to Goldcorp’s 2003 financial reports, when it was much simpler company with just two gold mines, Wharf and Red Lake, it is absurdly easy to see the contrast in the two mines. For 2003 the Wharf mine had an operating profit of $100,000 and on the $24,900,000 in revenue, it left an operating margin of 0% reported on the financial reports. The average grade mined for the year was 0.9 g/ton. Red Lake had an operating profit of $153,000,000 on $224,000,000 in sales, or a monstrous 68%!

Indeed, in 2003 Goldcorp reports that from the 602,845 ounces it produced, 532,028 from Red Lake and 70,817 from Wharf, earnings were $85.7 million with an average gold price of $364. At a price of $600/oz, assuming 40% of the increase goes to taxes, at this rate you’d expect 600,000 oz of gold to earn about $170 million, or each 100,000 oz of gold produced to earn just over $28 million. If you correct for the fact that the Wharf ounces contributed nothing to earnings -- all $85.7 million in earnings came from Red Lake’s 532,028 ounces – Red Lake would have earned about $30 million per 100,000 oz had gold been $600/oz. Goldcorp actually earned more that year by selling off stockpiled gold, but that is an independent action in terms of individual mine’s profitability.

In 2006 Goldcorp’s Red Lake produced 665,600 oz, had an average price of $609 and contributed $177.1 million to the earnings. That is below the $203 million one would expect if Goldcorp had remained as profitable assuming 40% going to taxes. In fact, only 32% went to taxes and controlling interests, so with 32% used instead, one would expect $216 million towards earnings. The calculation I did here was:

($30 million +(($609-364)/oz)*(1-0.32)*100,000oz/$1,000,000)*(665,600oz/100,000oz))

where the $30 million per 100,000 oz was calculated above, the $609-364 is the increase in gold price realized, the 1-0.32 gives the 68% that should go to earnings, the 100,000oz/$1,000,000 converts the number to millions of dollars per 100,000 oz and the 665,600oz/100,000oz corrects the number of ounces to what Red Lake actually produced.

To put this change of how much more Red Deer ought to have earned based on how well it did in 2003, use the calculation $216/$177 -1 = 22%. There would be 2-3% inflation per year, but overall, profitability per ounce at Red Lake declined at a rate of 6.8% per year.

But even that does not include Goldcorp’s vision for 2006. They write in their summer 2004 Outlook:

It is December 2006, and the winter freeze has already engulfed Ontario’s northwest, but operations at Goldcorp’s Red Lake Mine are running at a feverish pace with the completion of a new 7,150-foot shaft that now gives greater access to the world’s richest gold deposit.

The $100 million project, which was completed on schedule and within budget, has increased production from 510,000 to 700,000 ounces per year and lowered costs from $80 per ounce to $70 per ounce. What’s more, the shaft has been constructed with excess capacity so that when ongoing exploration uncovers additional reserves, production will be able to increase accordingly. This will help achieve Goldcorp’s ultimate goal of increasing the company’s annual production to 1 million ounces.

Their vision was to reduce cash costs by $10/oz, which at that 32% tax rate should add even another $6.80*665,600/1,000,000 = $4.5 million, or, ignoring that they missed their production target by 5%, earnings ought to have been $220 million, or 24% more than they achieved.

Missing their production goal by about 5% is a relatively minor problem. But their cash costs of $195/oz are 179% above there vision!

How can a vision go so wrong?

In 2003 they mined 242 thousand tonnes of ore and in 2006 they mined 769 thousand tonnes of ore, a 218% increase, but because of the decline in ore grade they only mined an extra 25% more gold.

The costs are given per ounce of gold produced, but the numbers may make more sense trying to look at them as cost per ton.

So, in 2003 the grade was 77.5 grams per ton, or 77.5/31.1 = 2.49 oz per ton. With costs of $80/oz, $80*2.49= $199/ton. So the cost per ton of ore processed was $199.

In 2006 the grade was 28grams per ton, or 28/31.1 = 0.90 oz per ton. With costs of $195/oz, $195*0.90= $175/ton, or a decline of almost 14%, almost identical to the 14% decline in costs outlined in Goldcorp’s vision.

In this example, the rising price of gold has completely hidden perilously increasing costs due to declining grade and enabled a healthy profit margin to be maintained, but it is a rapidly declining margin relative to production, cost per oz of gold increased 179%!

Goldcorp’s remaining proven and probable reserves average 22.24 g/ton. They have 1.55 million ounces at a grade of 41.48 g/ton, and then the probable grade declines to 18.57 g/ton for 3.64 million ounces. If we use the $175/ton of ore processed, the cost per ounces for mining a 41.48 g/ton gold ore grade would be (31.1/41.48)*175 = $131 per ounce of gold. The 18.57 g/ton would have a cost (31.1/18.57)*175 = $293 per ounce of gold, and considering the average of the grade, 22.24 g/ton you get cost per ounce of gold of $245.

What this means to investors is that failing to pay attention and assess the quality of the reserve grade and whether it is maintaining, improving or declining could cost you dearly in your investments. It means that you absolutely cannot look at a gold stock, or any other metal for that matter, and mentally calculate that if they are doubling their production profits should double. It also means that the values of assets in the ground are highly dependent on grade. This simple look suggests that Goldcorp’s 1.55 million ounces of proven reserves in Red Lake are worth about $160/oz more than the probable reserves of 3.64 million ounces, and by the time Goldcorp starts mining the reduced grade, gold will need to be about $830/oz to maintain profits at Red Lake, not improve profits.

It is utter nonsense to add up the reserves and resources of grossly different metal grades and come up with some kind of valuation without correcting for the grade quality.

Many things affect profitability, but declining grade seems to be is the most ignored or unrecognized source of implosion of value and earnings.


Michael said...

Your thesis is extremely flawed in the case of Goldcorp by not taking into account that the decrease in grade is only due to the merge of the Goldcorp and Placer Dome mines in Red Lake.

Deborah said...


You are welcomed to explain why the 700,000 oz target was missed and why the cost per oz went up 179%.

I read the reports and they show a grossly declining grade being mined at Red Lake and out of control increased mining costs.

It simply isn't good for investors.