Operating & Recurrent Maintenance Costs

Operating and Recurrent Maintenance Costs

• Fixed Costs (FC) are incurred regardless of production levels.
• Fixed costs include equipment maintenance, parts, and push-back plan stripping for mine expansion, potentially involving capital expenditures requiring depreciation.
• These are recognized under Allowable Capital Expenditure (ACE) items.
• Variable Costs (VC) are directly proportional to the level of production.
• The Profit and Loss (P/L) Statement recognizes VC, including recurrent operating and maintenance costs, depreciation and amortization expenses, and interest on debt capital under thin capitalization rules.

Categories of Recurrent Costs

• Operating and maintenance costs occur during the production period.
• Fixed Costs include licenses, indirect costs, property, land and acquisition fees, taxes, fixed overheads, wages, salaries, payroll taxes, fixed services, interest expenses, and depreciation (non-cash) expenses.
• The intensity of the mine or oil and gas project designs and financial arrangements influence fixed costs.
• Variable Costs consist of mining, milling, and service and admin costs.
• A mining sector project will operate as long as the contribution margin (price minus variable cost per unit) is zero or positive.

Capital Investment Costs

• Capital costs are needed to establish a mine to a productive capacity.
• They need to bring a mining, oil, or gas project to production
• They are for working capital when a project is not generating revenues.
• Recurrent operating and maintenance costs are operating costs to produce a marketable commodity
• These are mostly related to production.
• Both cost categories may utilize equity and debt capital financing, especially during initial development, production, and for working capital.

Capital Investment Cost Stages

• Pre-production stage includes exploration and feasibility studies, which are amortized.
• Mine access involves stripping and shaft sinking development.
• Mine construction includes mine equipment, site preparation, workshops, power and water facilities, mine office, store, road improvements, water supply, accommodation camps, and towns.
• Mill construction involves crushing, grinding, flotation, drying facilities, and tailing disposal.
• Working capital supports 3-6 months of operation.
• Production stage includes replacement or upgrading and non-current equipment maintenance.
• Production includes major modification of mine plans, capacity expansion, and conversion from open pit to underground mining
• Closure stage involves salvage and site rehabilitation.
• Capital investment appears as capitalized assets on the Balance Sheet (B/S).

Amount and Timing of Capital Flows influences

• The mining method and design (open pit or underground).
• The scale of operations and capital intensity / automation
• In underground mining, development must precede ore extraction.
• Capital costs generate current expenses through non-cash accruals (depreciation and amortization) and cash basis (interest expenses if funded with debt).
• The capital cost must be recovered through capitalization, not expensed, at the shortest possible timing.

Sourcing Capital Costs

• Mine development is risky and needs understanding of financing.
• Investment decisions involve comparing projects based on merits assuming 100% equity ownership.
• Financing decisions enhance shareholder equity returns via advantageous leverage and tax shields, and compatibility with financial risk.
• Portfolio decisions optimizes corporate objectives through integrated investment strategies, synergies, joint ventures and advantageous mine designs
• Large resource companies are more credit-worthy than small companies for raising capital on these projects.

Sourcing and Securing Financial Capital - Conventional Debts

• Long-term loans or debenture issues are secured by a "senior" claim the firm's assets, limiting further borrowing
• Short to medium-term loans, bank overdrafts, and financial leasing agreements
• Gold loans and advance sale contracts can finance for a gold mine
• Project finance is secured by the fortunes of a specific project.
• This setup reduces risk exposure for the parent holding company.
• The new mine's capital cost must not be tied to the existing mine.

Quasi-Equity and Hybrid Instruments

• Limited-resource finance includes operating leases (contract mining), convertible and non-convertible long to medium-term, unsecured and zero-coupon notes, and preference share issues.
• These are secured by subordinate claims on the firm's assets.
• Lenders bear less risk, with the project itself and shareholders bearing risks; secured debt financing is low-cost for corporations (4.5% or 3%).
• Interest futures and hedging stabilize interest rate risk.
• Farmin/farmout, JV operations, and contract mining reduce financing risks.
• Loan terms should match the investment life financed.
• Short-term debt (bank overdraft) should finance working capital or obligations.
• Medium to long-term debt should finance long-lived mine development, equipment, and land at lower rates.
• Long-term loans should not finance short-life assets.

Debt Facilities

• Trading Banks: Secure long-term production assets and mine development.
  • Overdrafts finance working capital fluctuations early in a resource project,
  • Bill acceptance and discount facilities finance working capital.
  • Medium term needs are rolled over every 30 to 180 days at slightly higher rates than overdrafts
  • Term loans (3-10 years) finance long-term capital expenditure.
  • Interest rates vary within 0.5%-1.0% above current overdraft rates.
• Merchant Banks:
  • Bill acceptance and discount facilities provided
  • Term loans are provided for up to five years with floating rates.
  • Floating rate indexed to commercial bill or bank's prime rate.
  • Financial Leasing is provided for equipment with a 10-20 year lifespan.
  • Costs for financial leasing are generally below commercial loan rates.

Gold and Commodity Linked Loans

• Gold and commodity linked loans generally last up to five years.
• Lenders offers bullion held or converted into cash, in the form of physical gold (20-30% of mine production).
• Lending fees in US$ 1-3% p.a.; guarantee fees are 0.5-2.5% daily, and based on gold loan market value.
• Borrowing enhances gearing and expected equity return and increases variability by imperiling interest and loan repayment ability.
• High gearing (debt capital higher than equity) boosts return but increases debt cost.
• If a firm's debt/equity ratio exceeds industry averages, the lender faces greater financial default risks.
• Marginal capital cost increases limit the firm's loan capacity and raising its cost.

Loan Financing Specifics

• 75% loan financing refers strictly to initial capital costs for mine development and overburden stripping.
• Loan periods range from 5-7 years, and mine lives must range from 10-20 years.
• The average level of debt over the mine's life is lower (40%).
• Thin capitalization rules may apply to restrict the debt/equity capital composition.
• Mining developments have historically been funded by equity capitals.
• Since the 1960's high-volume mines such as iron ore and coal have been substantially financed by debt capital.
• Loan financing can exceed 75% of total capital and security has risen mainly through the negotiation of sales contracts.
• Sales are subject to annual/periodical price negotiations or a floor price, or annual/periodical increases or lowest long-term average prices.

Financial Structure of Resource Companies

• A firm with a large asset base is creditworthy, reducing debt finance costs.
• The cost of debt (RD) is reduced since interest expenses are deducted before the taxable income
• A higher is the rate of return on equity funded by debt (D) as opposed to equity (E).
• This is financial leverage, encouraging debt to reduce tax liability.
• Host governments restrict the amount of debt used to limit taxation.
• The Weighted Average Cost of Capital (WACC) measures the combined opportunity cost of financing a mining project.
• WACC is a suitable discount rate if project risk is to the host firm, and is funded by both debt (D) and equity (E) capital
• WACC is a suitable discount rate to the debt interest rate if the model applies 100% equity, the discount rate should be the cost of equity or the minimum average rate of return.

WACC example

• Discount rate calculation
• Risk free rate: 4.5%, Beta: 1.5%; Global mining industry rate:7%; the capital sourced from 50% commercial loan at 15% the other 50% comes from debt
• Effective tax rate: 30%.
• Step 1: Re = 4.5% + 1.5%*(7%-4.5%) = 8.25%
• Step 2: WACC = (50/(50+50])8.25(1-0.3)*15% - 9.38%
• WACC declines % declines with debt rises from zero, and reaches a plateau and starts rising again when suboptimal debt levels are reached indicating 100% debt increases the cost of capital, exposing the project to financial risk.
• The WACC is only applied when a project is funded by a combination of debt and equity capital.