The Festering Sore of Mine Cost Inflation


Things move slowly in the mining world, with major projects often lasting a decade or more between first discovery and first production. But shareholder losses can move in with stunning speed as faster-moving metrics like product prices and construction costs inflict their scars upon these slow-moving behemoths.

Compared to the gut-wrenching collapse in commodity prices during the financial megacrisis of 2008, the price environment today looks strong by comparison. Copper prices, for example, are trading near their pre-crisis peak. The price of silver has more than tripled from its 2008 low of beneath $10 per ounce. Under normal conditions, one might rightfully expect the valuations of major pending mining projects to rise in tandem, but quite the opposite has transpired. Some changes are clearly coming way too fast for an industry this slow, and the standout change I wish to focus upon today is the prevailing cost to construct a large mining project.

I have previously discussed some of the devastating cost increases that have decimated shares of major gold miners, resulting in an absolute imperative for significantly higher gold prices even just to sustain current global mine supply. According to outgoing AngloGold Ashanti CEO Mark Cutifani, once you factor in the industry's cost of capital, the prevailing gold price stands right at the breakeven level with respect to the industry's comprehensive all-in cost structure. Shares of Barrick Gold -- the world's largest gold miner -- are languishing in unspeakable weakness after the miner lost control of construction costs for major world-class projects like Pascua Lama. Kinross Gold has suffered a similar fate after costs for an array of aggressive growth projects launched well beyond the company's reach.

This week, the industry's latest sticker price shocker came from an unusual source as Mongolian President Tsakhia Elbegdorj decried the rapid escalation of projected total costs for his nation's flagship mining project: Oyu Tolgoi. According to the Mongolian government, the projected cost for Oyu Tolgoi has skyrocketed to $24.4 billion from project operator Rio Tinto's earlier projection of $14.6 billion. As 34% stakeholder in the project, the Mongolian government revealed clear frustration this week at the degree to which its anticipated investment gains have been materially eroded by that nearly $10 billion increase in capital costs. Shareholders of Turquoise Hill Resources can likely empathize, as the stock representing the remaining 66% interest in Oyu Tolgoi languishes near its 52-week low even as the mine approaches commercial production by mid-2013!

As an investor with heavy exposure to a mining industry where similar cost inflation has truly run rampant, I must say that I share a profound sense of disappointment at the industry's widespread failure to more effectively project and adapt to such sweeping increases to the industry's prevailing cost structure. If one clear lesson can be gleaned from miners' underwhelming predictive prowess, certainly the typical modeling methods used to project mine construction costs must be tossed out the window and thoroughly reconstructed. That applies equally to senior management teams and to the third-party consultants who prepare project feasibility studies and other economic assessments. I've learned the hard way that investors must approach miners' touted project budgets (and related estimates of net present value) with extreme scrutiny and caution. Although the mining industry continues to offer a world of opportunities for dramatic investment gains from carefully selected stocks, the broader investment landscape remains a mine field of incomparable hard knocks.

In a cost-escalation trend this severe, no major miner is immune. But the right time to strike is often in the wake of a major revision to forward cost projections. Goldcorp recently released just such an update, providing one of five key reasons that I can see to leap into the shares of this historical outperformer. Click here for our detailed analyst report to discover more about this standout operator in the gold industry.

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