Note: it is a technical article. If you hate even basic maths, please, go for a walk...
In the mining industry, production costs, at which any company extracts
and process its metals, are one of the most important metrics. There are two
ways to get knowledge about these costs.
Firstly, an analyst can calculate accounting costs of production using
financial statements the company publishes. These statements provide credible
and standardized information.
Secondly, an analyst may study the so-called non-IFRS reports published
by a majority of mining companies. In most cases these statements provide
detailed information on cash costs of production.
To analyze any mining company and its costs the investors should study
both statements.
But there are at least two problems an analyst will face when studying financial
statements or non-IFRS reports:
·
Financial statements mirror book-keeping entries,
which do not include such issues as, for example, sustaining capital spending.
Apart from that, some issues as, for instance, general and administrative
expenses or depreciation and amortization are reported on the overall basis
while only a part of these costs is related directly to extraction and
processing.
·
Non-IFRS cash costs reports do not include depletion,
amortization and depreciation, which are non-cash measures. It means that cash
costs do not measure how much of an asset’s value has been used up in the
production process (sustaining capital expenditures, which are an element of
all-in cash costs, solve the problem only partially).
Finally, both measures, financial statements and non-IFRS reports, are constructed
on the net revenue basis. This is a problem, which is not widely spotted
(although some authors are well aware of it). In my
opinion, a proper analysis of production costs incurred by any mining company
should start from gross revenue. It is especially valid when a company produces
concentrates of metals, where treatment and refining charges are significantly
high.
In this article I am using the gross revenue approach to analyze
production costs of a mining company. I have chosen Orvana Minerals Corp () as
an example of a mining company producing concentrates of metals.
Orvana Minerals.
(OTC:ORVMF; TSX: ORV.TO)
Orvana Minerals is a medium gold / silver / copper producer operating
two mines. One of them, El Valle –Boinas/Carle, is located in Spain and another
one, Don Mario, in Bolivia. In 2014 Orvana produced around 84 thousand ounces
of gold, 890 thousand ounces of silver and 21 million pounds of copper.
Similarly to a majority of mining companies, Orvana presents detailed
information on its production costs in its financial statements; the company also
reports non-IFRS measures in the Management Discussion sections of its
financial statements.
Let me present these measures.
Financial reports.
Below I present part of the 2014 Consolidated Statement of Income (all
calculations relate to the year 2014):
source: Orvana Minerals 2014 Annual Report
To calculate the accounting production costs I have added up the
following issues: Mining costs, Depreciation and amortization, General and
Administrative, Exploration and Community relations. Impairment charge is a
one-off issue therefore I am not including it into my calculations. “Other
expenses” include one-offs as well (as, for example, Union payments, which
relate to the period 2002 – 2012) therefore they are excluded from my
calculations. Finance costs and Derivative instruments gain are financial
measures, which are not correlated with mineral extracting and processing – therefore
they are excluded as well.
Additionally, looking at General and Administrative expenses one can
find an issue called Foreign exchange expenses ($242 thousand in 2014) –
because these costs are financial issues I have excluded them as well.
After adding up the above described issues I find out that Orvana
incurred costs of production of $140,285
thousand.
Now, to find out how much it costs to produce one ounce of gold, I have
to divide production costs related to gold production by the number of gold
ounces sold. Here is the first problem because I have to know what part of
production costs relates to the gold production only. It is information, which
is not available in financial statements of any mining company. Therefore, to
solve this problem, mining companies offer some adjustments, of which, to make
things as clear as possible, I have chosen the method based on the so-called gold equivalent ounces. It is a
theoretical short-cut because mining companies do not produce equivalents of
gold – they produce gold, silver, copper etc. To calculate gold equivalents
ounces one has to find out how many gold ounces a company could sell for the consideration
obtained for metals other than gold (in the Orvana’s case there are two such
metals: silver and copper). The table below shows the way I calculate it:
As the table shows, Orvana produced 139,254 gold equivalent ounces.
Now, dividing production costs by gold equivalent ounces I may find out
that Orvana incurred production costs of $1,007 per gold equivalent ounce.
Non-IFRS measures
In its Non-IFRS section of the 2014 Management Discussion (page 31) the
company presents cash operating costs, all-in sustaining costs and all-in
costs. According to that section, in 2014 the company incurred all-in costs of
$1,075 per ounce of gold. Orvana presents these costs on a by-product and gold
ounces sold basis.
Simple Digressions proposal
First of all, to calculate production costs I am using gross revenue numbers.
What does it mean? Let me explain.
In 2014 Orvana sold the following amounts of metals:
·
Gold: 79,858 ounces
·
Silver: 833,594 ounces, which is equal to 13,051 gold
equivalent ounces (see table 1)
·
Copper: 18,935 thousand pounds, which is equal to
46,344 gold equivalent ounces (see table 1)
The company was selling its metals for the average realized gold price
of $1,287 per ounce. Therefore in 2014 gross revenue was $179,220 thousand
(multiply the gold price by gold equivalent ounces sold). In its 2014 Annual
Report the company reported sales of $142,285
thousand. The difference is $36,935
thousand. Why gross revenue is different from sales reported in the
company’s financial statements? Let me cite the company’s definition of
revenue:
“Revenue represents gross revenue derived from the
sales of metals in the applicable period less treatment, refining, penalties
and payable metals deductions associated with such sales, plus or minus
realized final payment amounts relating to metals sold in prior periods, plus
or minus mark-to-market adjustments based on unrealized price fluctuations at
period end relating to metals sold in the current or prior reporting periods
prior to receipt of final payment for such sales.”
Orvana (and a majority of mining companies) does not specify exact
figures included in the difference between gross revenue and revenue reported
in the company’s financial statements. But it is not a very important issue.
The most important thing is that an analyst is able to calculate that
difference. From now on, let me call that difference “Gross Revenue
Difference”.
One small digression on
treatment charges and payable metals.
Investors should remember that Orvana sells part of its production in
the form of metal concentrates (the rest is being sold as doré). When a company
sells concentrate, it is paid for the so-called metals payable (for example a miner
could be paid for only 95% of silver included in the concentrate – in this case
the rest, 5%, is a fee paid to the smelter). Additionally, due to the fact that
concentrates are non-standard substances, they have to be processed individually.
Processing costs money - the more the concentrate is hard to process, the
higher fee / penalty paid for that operation.
Below I am discussing the way I calculate production costs using gross
revenue approach.
Gross accounting costs of
production.
To calculate gross accounting costs of production I make only one adjustment
– Gross Revenue Difference must be added to the accounting costs calculated in
the section “Financial reports”. Therefore in 2014 Orvana incurred gross
accounting costs of production of $177,220 thousand. Dividing this figure by
gold equivalent ounces (139,254) I find out that it cost $1,272 to produce one ounce of gold equivalent.
This cost is much higher that that calculated using standard accounting
($1,011 per gold equivalent ounce).
Non-IRFS measures
To calculate cash cost of production, similarly to the section above, I
take into account gross revenue. To simplify the matter I assume that these
sales are cash sales – a company sells its metals and the consideration is paid
at the time of a sale. Then, I adjust cash flow from operations (reported in
the Cash Flow Statement) through excluding all working capital issues – in result
I get “clean” cash flow generated by the mining operations.
Let me get figures. In 2014 Orvana reported cash flow from operating
activities of $34,731 thousand; the company also reported a decrease in
non-cash working capital of $2,541 thousand. Therefore cash flow from
operations excluding working capital issues) was $37,272 thousand. Now, the difference between gross sales and cash
flow from operations ($179,219 thousand minus $37,272 thousand = $141,947) is
equivalent to cash spent on mining and processing. Additionally, cash spent on
mining and processing should be increased by the so-called sustaining capital
expenditures (these expenditures are necessary to keep the mine working). In
2014 the company spent $10,719 thousand on these expenditures therefore total
cash cost of production stands at $152,666
thousand. Dividing this figure by gold equivalent ounces I can calculate cash cost of production per ounce of gold
equivalent, which stands at $1,096.
Comparing costs of production.
Below I am comparing costs of production reported by the company and
those calculated by Simple Digressions:
|
Orvana
|
Simple Digressions
|
accounting costs
|
1,011
|
1,273
|
cash cost
|
1,075
|
1,096
|
As it is easily spotted, costs of production calculated by Simple
Digressions are higher than those reported by the company.
Finally, the most interesting part...Below I am presenting
margins recorded by Orvana in the first quarter 2015 and full years 2014 and
2013 (please, note that the company’s accounting period ends on September 30).
As the table shows, margins recorded by the company have been in a
steady decrease since 2013. It is no wonder – since 2011 both gold and silver
prices have been going down as well. But 1Q 2015 saw a negative surprise. Orvana
not only became unprofitable (negative profit margin of $80 per gold equivalent
ounce) but it also was losing cash ($20 on each gold equivalent ounce sold).
What happened? Surely lower gold, silver and copper prices were contributing
factors. But other visible factors should have had a positive impact on the
company results. For example, gold feed grades reported at El Valle
Boinas/Carle were higher than in 2014. Production reported by El Valle
Boinas/Carle in 1Q 2015 was comparable to that reported in 1Q 2014. The Don
Mario mine was performing quite well as well. But looking at gross revenue
reported in the first quarter 2015 one could spot something quite peculiar. Gross
Revenue Difference was much higher than in1Q 2014. What is more, this measure
accounted for 26.0% of gross sales (in 1Q 2014 it accounted for only 18.4% of
gross sales). If in 1Q 2015 Orvana was able to maintain Gross Revenue
Difference at the level similar to that reported in 1Q 2014 it would have reported
an accounting profit of $13 per gold equivalent ounce. What is more, the
company would have reported a positive cash margin of $73 per gold ounce
equivalent.
