Mineral Economics 2nd Ed. Monograph 29. Ausimm

Mineral Economics Second Edition Monograph 29

Mineral Economics Australian and Global Perspectives Second Edition, Monograph 29

Edited by Philip Maxwell with the assistance of Pietro Guj

Published by: The Australasian Institute of Mining and Metallurgy Ground Floor, 204 Lygon Street, Carlton Victoria 3053, Australia

© The Australasian Institute of Mining and Metallurgy 2013 No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form by any means without permission in writing from the publisher. The Institute is not responsible as a body for the facts and opinions advanced in any of its publications.

ISBN 978 1 921522 87 1

Desktop published by: Kristy Burt, Claire Lockyer and Kylie McShane The Australasian Institute of Mining and Metallurgy

Compiled on CD ROM by: Visual Image Processing PO Box 3180 Doncaster East Vic 3109 Australia

foreword Some six years ago I had the pleasure of writing the foreword for Australian Mineral Economics, the predecessor and first edition of Mineral Economics: Australian and Global Perspectives. At that time I noted that the original volume was a welcome new source of information and insights for those interested in understanding the behaviour of metal industries and other non-energy mineral markets. Apparently many agreed with me, as all the hard copies and CDs that The Australasian Institute of Mining and Metallurgy produced of this volume were sold, and a second run of CDs is nearly exhausted as well. This new volume, like the original, is a timely and welcome addition. Since 2006 mineral commodity markets have evolved in several important ways. At that time we were focusing on the recent rise in real metal prices after many years of decline. Today we are watching as prices fall after nearly a decade of pursuing a brisk upward trend. Lithium, indium, rhodium and a number of other minor metals are now attracting much greater attention as new technologies demand their special properties. China and other developing countries have emerged to capture a large share of global mineral demand, challenging in the process the historical dominance of the United States and other developed countries. China has also become a major producer of steel, copper, rare earths and many other important mineral commodities. At the same time, in other ways things remain more or less the same. Metal prices remain volatile. Many developing countries still struggle to use their mineral wealth in a manner that best promotes economic growth and development. Many commentators continue to worry about depletion and the long-run availability of nonrenewable mineral resources. Environmental and sustainability issues associated with mining have not gone away. The effects of speculation and investor demand on spot and futures markets, along with a host of other financial topics, remain as relevant as ever. Yet, despite the seeming permanence of these issues, the discipline of mineral economics has not been asleep. New studies and analyses continue to throw new light on these long-standing issues. At the same time, I think, it is fair to say that the flow of good articles and books on the non-fuel mineral commodities is still quite limited, particularly compared to what is available for petroleum and other energy resources. For these reasons the new edition of Mineral Economics, which both updates and extends the original volume, is a very useful contribution, for which Philip Maxwell, Pietro Guj and the group of international scholars in the field of mineral economics that he has assembled to create this new volume deserve our thanks. While its special focus on Australia is useful, as Australia is one of the world’s major mining countries, the chapters that follow are of interest and relevant to mineral industries and markets around the world. For anyone wanting to better understand their behaviour, for anyone searching for an introduction to the field of mineral economics, this volume, like its predecessor, will be an invaluable resource. John E Tilton Boulder, Colorado

preface Minerals and energy have played a major role in the world throughout its recorded history. Key minerals and materials have given their names to extended periods where newly adopted technologies have brought major improvement to human well-being measured by population growth, income and other indicators. In the modern era, this role continues as mineral resources are produced and consumed in record amounts. With high resource prices, there have been several occasions in recent years, when the minerals and energy sector has accounted about six per cent of world GDP (worth more than US$3 trillion). As a major resource producer, in the 2010 - 11 financial year, Australia’s estimated mining GDP stood at more than A$117 billion (about nine per cent of its GDP). Importantly as well mineral exports play a key role in influencing the economic prosperity in Australia and perhaps 50 other nations around the world. Many other nations depend importantly on a secure and stable source of mineral imports to supply their manufacturing industries. When The AusIMM published Australian Mineral Economics in 2006, there had been no significant Australian monograph in the field since the mid-1980s. In endeavouring to fill a perceived gap in the literature, we responded to a request from our colleague, Peter Lilly, in late 2003, to compile such a study on behalf of The Australasian Institute of Mining and Metallurgy. This second edition seeks to update our contribution in the light of some of the significant developments since 2006. The field of mineral economics owes its origins in part to engineering economics, a course taught for almost a century in many engineering schools around the world. Engineering economics combines traditional economic analysis applied to the resources sector with associated fields such as project evaluation, risk analysis and management. Since this is a volume aimed broadly at mineral sector professionals, our approach has been, at least in part, to embrace this approach. We have drawn inspiration from other places as well. The AIME volume, The Economics of the Mineral Industries, which appeared in four editions, is an interesting model. Additionally, the published notes of Brian Mackenzie, who delivered an annual short course in mineral economics for WMC Resources and the Australian Mineral Foundation for more than two decades, offered further useful insights. Perhaps the greatest influence, however, has been the experience of offering our own coursework Master’s program in Mineral Economics at the Western Australian School of Mines (at Curtin University) between 1993 and 2008.1 The opportunity to interact with mining executives and professionals during this time and subsequently has shaped the approach for this volume. After the initial introductory chapter, the remainder of the volume is divided into five main sections. They are: • • • • •

Minerals and the world economy Minerals – consumption, production and markets Mineral finance and investment Minerals and public policy Mining and local communities.

The first, second, fourth and fifth sections have a distinct economic flavour, while the third section focuses on financial analysis, project evaluation and risk assessment. Philip Maxwell has played a major role in the economics chapters and Pietro Guj is largely responsible for the finance area. Yet several other authors have also made important contributions. All have lectured on the Master’s program as either visiting or resident faculty, or both. They are Phillip Crowson, Rod Eggert, Frank Harman, Peter Howie and Allan Trench. Details of their background and experience appear in the following list of contributors section. It is important also to thank colleagues who have joined us in reviewing key parts of the monograph. As well as being chapter authors, Rod Eggert, Peter Howie and Frank Harman also acted as reviewers of chapters written 1.

This program has subsequently become the Master’s program in Mineral and Energy Economics, which is now offered by the Graduate School of Business at Curtin University.

by other contributors. Other reviewers included Graham Davis (Colorado School of Mines), Marcelo Machado da Silva (Brazilian Development Bank), Oliver Maponga (UN Economic Commission for Africa), David Humphreys (University of Dundee), Bryan Maybee (Curtin University), David Norris (Department of Mines and Petroleum Western Australia), Laurie Reemeyer, Malcolm Wedd (Heathgate Resources), Scott Pegg (Indiana University Purdue University Indianapolis), Galina Ivanova (Central Queensland University), Ciaran O’Faircheallaigh (Griffith University) and Anne Sibbel (RMIT University). We greatly appreciate the constructive comments that each has provided and we have endeavoured to incorporate many of the improvements that they have suggested. Thanks also to John Tilton (Colorado School of Mines and Catholic University of Santiago), who has written the Foreword to this and the earlier edition. We also express our gratitude to The AusIMM for supporting this project. Kristy Burt has been a patient and encouraging production manager and thanks also to Jenni Stiffe for her assistance. We are very grateful to our sponsors who have made the publication of this monograph possible. Last but certainly not least, we thank our wives, Mary and Luisa, for their support and encouragement. We trust that our final product makes a positive contribution to the appreciation of mineral economics issues in Australia and more broadly. Philip Maxwell and Pietro Guj

contributors Phillip Crowson Phillip Crowson graduated with first class honours in economics from Cambridge University in 1961 and pursued a career in industry. He retired as Chief Economist of RTZ-CRA at the end of 1996. He had held the post for over 15 years, having joined RTZ’s Economics Department in July 1971. Prior to that he had spent ten years working as an economist in various UK chemical companies. During his time with RTZ Mr Crowson served on many mineral industry organisations, including periods as President of the Mining Association of the UK, and as Chairman of the European Copper Institute. On his retirement he was a director of several Rio Tinto subsidiaries, and he was an invited director of the London Metal Exchange for 12 years until May 2000. Mr Crowson is an honorary professor and a professorial research fellow at the Centre for Energy, Petroleum and Mineral Law and Policy at the University of Dundee, Scotland, where he teaches a course on Mineral Resources Policy and Economics for graduate students. He has written many articles and papers on various aspects of the mining and metals industry and has published several books, including The Minerals Handbook (ten editions), Inside Mining, Astride Mining and Mining Unearthed.

Roderick G Eggert Roderick G Eggert is Professor and Director of the Division of Economics and Business at the Colorado School of Mines, where he has taught since 1986. Between 1989 and 2006, he was Editor of Resources Policy, an international journal of mineral economics and policy. He received the 2010 Mineral Economics Award of the American Institute of Mining, Metallurgical and Petroleum Engineers. Professor Eggert has a BA in earth sciences from Dartmouth College, a MS in geochemistry and mineralogy from Penn State University and a PhD in mineral economics also from Penn State. His research and teaching focus on mineral economics and public policy, including mineral exploration, metal demand, mining and sustainable development, mineral and metal markets, mining taxation and critical minerals and materials.

Pietro Guj Pietro Guj is a Research Professor in the ‘Progressive value and risk analysis’ research theme at the Centre for Exploration Targeting (CET); a joint venture between the University of Western Australia, Curtin University and the mining industry. He is also an Adjunct Professor in Mineral Economics at Curtin Graduate School of Business. He was formerly the Deputy Director-General of the WA Department of Minerals and Energy (DME) (1997 - 2002), following five years as Director of the Geological Survey of WA. While at DME he played a key role in supporting and regulating the exploration, mining and petroleum industry in WA including administering mineral and petroleum royalty policy and collection. Prior to joining DME, he spent seven years as a finance executive for the Water Authority of WA. In his earlier professional career he worked for approximately 20 years in geology and mineral exploration for a variety of commodities in Australia (with MIM Holdings), South Africa, Namibia, West Pakistan and Afghanistan. His undergraduate training in geology was at the University of Rome, which was followed by a PhD degree in geology from the University of Cape Town. He also holds an MBA degree from the University of Western Australia. His particular interests include mineral policy (particularly the international competitiveness of mining regulatory and fiscal regimes) and advanced financial evaluation and risk analysis of exploration and mining projects, subjects in which he has published and consulted widely internationally.

Frank Harman Frank Harman was a member of the Economics Department at Murdoch University in Perth between 1977 and 2003. He has taught the natural resource economics component of the Curtin University Mineral Economics program in both Kalgoorlie and Chile. He served on a number of Western Australian government commissions of inquiry, including the Commission on Government (1994 to 1996) and the Electricity Reform Task Force (2001 to 2002). He was also on the Board of the gold mining company, Resolute Resources between 1994 and 2000. Frank holds Bachelor’s and Master’s degrees in Economics from the University of Western Australia and completed his PhD at McMaster University in Canada. He has retired to Yorkeys Knob in Far North Queensland

Peter Howie Peter has recently joined the Graduate School of Public Policy at Nazarbayev University in Astana, Kazakhstan. Prior to accepting his present position, Peter taught for seven years at Mount Royal College, which is located in Calgary, Canada. In addition, Peter taught for two years at the Kazakhstan Institute of Management, Economics and Strategic Research and one year at the University of Montana. He has also lectured in the Master’s of Mineral Economics program at the Western Australian School of Mines at Curtin University of Technology and worked in the private sector as a project geologist. He holds a BSc degree from the University of British Columbia, an MBA from McGill University, and MSc and PhD degrees in Mineral Economics from the Colorado School of Mines. Peter’s recent research interests have been in energy issues within transition economies with Kazakhstan as a case study.

Philip Maxwell Philip is Emeritus Professor of Mineral Economics at the Western Australian School of Mines at Curtin University. Between 1992 and 2009 he was Metana Minerals Professor in Mineral Economics and Mine Management at WASM. In this post, he coordinated the Master’s program in Mineral Economics, which attracted a student body from throughout Australia and internationally. He was a Visiting Professor at the University of Chile each year between 2001 and 2012 and has been also been a visiting lecturer in several other universities and industry programs during his career. Prior to accepting the Metana Minerals Professorship in 1992, Dr Maxwell was Head of the School of Economics and Finance at Curtin University. His previous academic appointments were at Deakin University, the New South Wales Institute of Technology and the Gordon Institute of Technology. He holds a BEc degree from the University of Sydney, an MEc from Macquarie University, and MA and PhD degrees in Economics from the University of Georgia. Philip’s recent research interests have been in considering the relationship of minerals to economic development, the regional economic impacts of mining and in analysing mineral commodity markets such as nickel, lithium and phosphates.

Allan Trench Dr Allan Trench is a Professor of Mineral and Energy Economics at the Graduate School of Business, Curtin University and Research Professor at the Centre for Exploration Targeting, University of Western Australia. He is an independent non-executive director to a number of listed emerging resources companies and the Perth representative for CRU Strategies, the consulting division of independent global mining and metals advisory CRU Group. Allan is a regular speaker at international conferences on the minerals sector and is the author of nine books on mining equities, commodity analysis and mineral industry management. He holds degrees in geology, geophysics, mineral economics and business administration.

sponsors The Australasian Institute of Mining and Metallurgy would like to thank the following sponsors for their generous support of this volume.

Principal Sponsor

General Sponsor

ab

principal sponsor AngloGold Ashanti Ltd AngloGold Ashanti Ltd is the world’s third largest producer of gold with 20 operations in ten countries. Headquartered in South Africa, the company is listed on the Johannesburg, New York, London and Ghana Stock Exchanges and the Australian Securities Exchange. The company employs approximately 60 000 people globally and produces more than four million ounces per annum. Its well-funded, industry-leading exploration team continues to focus on making significant, high-value gold discoveries in the existing and emerging gold regions of the world. AngloGold Ashanti’s gold operations span surface and underground mines in the Americas, South Africa, Continental Africa and Australia. Approximately 54 per cent of the company’s gold production comes from underground operations, and the company’s Mponeng mine in South Africa is the world’s deepest, with mining taking place at 3900 m below surface. In Australia, AngloGold Ashanti operates the Sunrise Dam Gold Mine, near Laverton in Western Australia and the Tropicana Gold Mine (AGA 70 per cent and manager, Independence Group NL 30 per cent), 330 km eastnortheast of Kalgoorlie in WA, which is scheduled to pour first gold in the December quarter 2013. Discovered in 2005, in a region not previously considered prospective for gold, Tropicana is the most significant Australian greenfields gold discovery of the past decade. The new mine is expected to produce up to 490 000 ounces per annum in its first three years of operation. As at 30 December 2012, the Mineral Resource1 totalled 7.89 million ounces of gold. Driven by its vision to be the leading mining company, AngloGold Ashanti’s mission is to create value for its shareholders, its employees and its business and social partners through safely exploring, mining and marketing its products. The company has five core strategies to grow and create wealth sustainably: people are the business, maximise margins, manage the business as an asset portfolio, grow the business and embrace sustainability principles. Recognising that the process used to achieve results is as important as the results themselves, AngloGold Ashanti’s activities are governed by its values: • safety is our first value • we treat each other with dignity and respect • we value diversity • we are accountable for our actions and undertake to deliver on our commitments • the communities and societies in which we operate will be better off for AngloGold Ashanti having been there • we respect the environment. These elements underpin Project ONE, the company’s business framework, which is a consistent operating model that reaches every corner of the organisation, bringing together people and technical systems to realise AngloGold Ashanti’s vision. This operating model defines the technical, commercial and social aspects of the business and prescribes how they interact in order to deliver the company’s business goals. Project ONE provides a framework to ensure consistency and efficiency in all processes with the aim of enhancing operating performance and control. For more information about AngloGold Ashanti Ltd, please visit the company’s website at http://www.anglo goldashanti.com 1.

For full details of the JORC-compliant Mineral Resource Estimate see AngloGold Ashanti’s announcement of 4 December 2012, which is available at http://www.anglogoldashanti.com

contents 1

Mineral Economics – An Introduction

Philip Maxwell

1

Minerals and the World Economy 2

Some Foundations

Philip Maxwell

11

3

Minerals and Development

Philip Maxwell

21

4

Trade in Minerals

Philip Maxwell

39

Minerals — Consumption, Production and Markets 5

Mineral Demand – The Theory in Practice

Peter Howie

51

6

Mineral Supply – Exploration, Production, Processing and

Philip Maxwell

67

Phillip Crowson

79

Recycling 7

Mineral Markets, Prices and the Recent Performance of the Minerals and Energy Sector

Mineral Finance and Investment 8

An Introduction to Mineral Finance

Pietro Guj and Allan Trench

107

9

Mineral Project Evaluation – Financial Modelling and Discounted

Pietro Guj

125

Pietro Guj

145

Cash Flow Analysis 10 Mineral Project Evaluation – Dealing with Uncertainty and Risk

Minerals and Public Policy 11 Mineral Policy – An Introduction

Philip Maxwell and Pietro Guj

179

12 Mineral Taxation and Royalties

Frank Harman and Pietro Guj

191

13 Mining, Sustainability and Sustainable Development

Roderick Eggert

215

M i n i n g a n d L o c a l C o mm u n i t i e s 14 Stakeholders, Local Communities and Regions

Philip Maxwell

231

15 Minerals and Regional Development

Philip Maxwell

237

16 Mining and Indigenous Populations

Philip Maxwell

253

17 Occupational Communities – The Mineral Sector Workforce

Philip Maxwell

269

Glossary of Terms

281

Subject Index

293

Name Index

301

extended contents Chapter 1  Mineral Economics – An Introduction

Philip Maxwell

Definitions of economics and the economic way of thinking................................................................................................. 1 Economics and mineral economics................................................................................................................................................... 2 The focus of mineral economics......................................................................................................................................................... 4 Some key questions in mineral economics.................................................................................................................................... 6 The structure of this volume................................................................................................................................................................ 6 References................................................................................................................................................................................................... 7

Minerals and the World Economy Chapter 2 Some Foundations

Philip Maxwell

Mineral exploitation, production, distribution, consumption, trade and related economic concepts..................11 Measuring economic production and living standards...........................................................................................................13 Economic growth and development..............................................................................................................................................15 Periods of history and minerals.........................................................................................................................................................17 Mineral consumption and economic development..................................................................................................................17 Complicating factors with mineral production and consumption......................................................................................19 References.................................................................................................................................................................................................19

Chapter 3  Minerals and Development

Philip Maxwell

The importance of mining in different nations...........................................................................................................................21 The ‘conventional’ view – minerals are a blessing......................................................................................................................22 An alternative view – minerals are a curse....................................................................................................................................23 Some background discussion.....................................................................................................................................................23 The resource curse thesis.............................................................................................................................................................27 Institutional and policy issues....................................................................................................................................................29 Some case studies..................................................................................................................................................................................31 The Australian experience............................................................................................................................................................31 The case of Chile..............................................................................................................................................................................34 The position of non-mineral economies.................................................................................................................................36 References.................................................................................................................................................................................................36

Chapter 4 Trade in Minerals

Philip Maxwell

Why trade takes place...........................................................................................................................................................................39 Minerals and energy production and trade..................................................................................................................................40 Australian production and trade in minerals...............................................................................................................................42 Transport costs and the direction of minerals and energy trade..........................................................................................45

Minerals trade and exchange rates..................................................................................................................................................46 References.................................................................................................................................................................................................48

Minerals — Consumption, Production and Markets Chapter 5  Mineral Demand – The Theory in Practice

Peter Howie

Introduction.............................................................................................................................................................................................51 The final-product demand curve and the level of consumption..........................................................................................52 Final-product demand and its determinants........................................................................................................................53 Mineral resources and derived demand........................................................................................................................................54 The mineral demand curve..........................................................................................................................................................54 Shifts in the mineral demand curve.........................................................................................................................................56 Elasticity of mineral demand.............................................................................................................................................................57 Own-price elasticity of mineral demand in the short run................................................................................................58 Income elasticity of mineral demand in the short run......................................................................................................61 Cross-price elasticity of mineral demand in the short run...............................................................................................61 Elasticity of mineral demand in the long run........................................................................................................................62 Conclusions..............................................................................................................................................................................................64 References.................................................................................................................................................................................................64

Chapter 6  Mineral Supply – Exploration, Production, Processing and Recycling

Philip Maxwell

Some introductory remarks...............................................................................................................................................................67 Short-run and long-run supply..................................................................................................................................................67 The mineral supply process.........................................................................................................................................................68 Supply curves....................................................................................................................................................................................69 Resources and reserves........................................................................................................................................................................69 Mineral supply – individual products, main products, co-products and by-products.................................................70 Key determinants of primary mineral supply..............................................................................................................................71 Individual and main products.....................................................................................................................................................71 By-products.......................................................................................................................................................................................74 Co-products.......................................................................................................................................................................................75 Secondary materials – the economics of recycling...................................................................................................................75 The supply of new scrap minerals.............................................................................................................................................76 Old scrap mineral supply..............................................................................................................................................................76 Total mineral supply..............................................................................................................................................................................76 References.................................................................................................................................................................................................78

Chapter 7  Mineral Markets, Prices and the Recent Performance of the Minerals and Energy Sector

Phillip Crowson

Market structure – competitive markets.......................................................................................................................................79 Market structure – imperfect markets............................................................................................................................................80 Departing from the competitive model..................................................................................................................................80 Alternative pricing arrangements.............................................................................................................................................83 The rise and fall of cartels....................................................................................................................................................................85 Producer pricing.....................................................................................................................................................................................88 Exchanges.................................................................................................................................................................................................91 The London Metal Exchange.......................................................................................................................................................92 Recent trends in mineral markets....................................................................................................................................................97 References.............................................................................................................................................................................................. 103

Mineral Finance and Investment Chapter 8 An Introduction to Mineral Finance

Pietro Guj and Allan Trench

Financial objectives and financial management..................................................................................................................... 108 The role of financial managers................................................................................................................................................ 109 Sources and application of funds.................................................................................................................................................. 109 General considerations.............................................................................................................................................................. 110 Main sources of funds................................................................................................................................................................. 110 Sources of equity................................................................................................................................................................................. 111 General considerations.............................................................................................................................................................. 111 Off-market sources of initial equity....................................................................................................................................... 111 On-market sources of equity.................................................................................................................................................... 112 Resource sector initial public offerings are generally small.......................................................................................... 113 Criteria for inclusion in a stock market index..................................................................................................................... 113 Innovative investment vehicles for the resources industry.......................................................................................... 114 Fiscal and policy incentives...................................................................................................................................................... 114 Joint venture farm-outs............................................................................................................................................................. 115 Specialty finance (royalty) companies.................................................................................................................................. 115 The cost of equity – balancing risk and return......................................................................................................................... 115 Sources of debt ................................................................................................................................................................................... 117 Some general considerations.................................................................................................................................................. 117 Long-term debt............................................................................................................................................................................. 117 Short-term debt............................................................................................................................................................................ 118 Hybrids between equity and debt................................................................................................................................................ 119 Project finance...................................................................................................................................................................................... 119

Some introductory considerations........................................................................................................................................ 119 Risk underpinning........................................................................................................................................................................ 120 The financial structure of mining companies........................................................................................................................... 121 Cost of debt, financial leverage and financial risk............................................................................................................ 121 Financial structure of mining companies............................................................................................................................ 121 Conclusions........................................................................................................................................................................................... 122 References.............................................................................................................................................................................................. 123

Chapter 9  Mineral Project Evaluation – Financial Modelling and Discounted Cash Flow Analysis

Pietro Guj

What is it worth? – types and uses of financial valuations................................................................................................... 125 General issues................................................................................................................................................................................ 125 Market- and cost-based evaluations..................................................................................................................................... 126 Fundamental or technical evaluation................................................................................................................................... 127 Income-based valuations and discounted cash flow models............................................................................................. 127 The basic discounted cash flow model characteristics and structure....................................................................... 127 Constructing a simple discounted cash flow model of a mine in nominal dollars............................................... 130 Project valuations are at a point in time – discounting cash flows............................................................................ 132 Reconciling cash and financial accounting accrual figures in a discounted cash flow model......................... 133 Modelling debt and financial leverage................................................................................................................................. 134 Converting a discounted cash flow model from nominal to real dollars................................................................. 136 Modelling the preproduction period.................................................................................................................................... 136 Comparison of mutually exclusive projects with different lives........................................................................................ 140 Inherent weaknesses and common traps in discounted cash flow analysis................................................................. 141 Conclusions........................................................................................................................................................................................... 143 References.............................................................................................................................................................................................. 143

Chapter 10  Mineral Project Evaluation – Dealing with Uncertainty and Risk

Pietro Guj

Introduction – beyond discounted cash flow/net present value analysis...................................................................... 146 Risk analysis – identifying and quantifying financial risk: expected value, sensitivity and scenario analyses................................................................................................................................................................................. 146 Probabilistic financial models and Monte Carlo simulations.............................................................................................. 148 Attitudes to risk – from expected value to expected preference value (certainty equivalents) and pricing of risky projects............................................................................................................................................................ 150 Understanding the nature of risk and risk-neutral expected returns........................................................................ 150 From risk-neutral to risk-averse investment decisions................................................................................................... 151 Risk preferences and the price of risky investment opportunities............................................................................. 152 Risk spreading through joint ventures........................................................................................................................................ 153 Bayesian (decision trees) and progressive risk and value analysis.................................................................................... 155 Size distribution of mineral deposits and the Zipf law................................................................................................... 159

From static discounted cash flow / net present value to dynamic real option valuations....................................... 160 A different logic............................................................................................................................................................................. 160 Types of real options in mining projects.............................................................................................................................. 160 The market has been effective at setting real option values........................................................................................ 161 Using the Black and Scholes formula to estimate the real option value of the Sally Malay project.............. 162 Modern asset pricing using commodity forward prices....................................................................................................... 163 Fundamental real option principles – value consistency, no-arbitrage and replicating portfolios............... 163 Commodities forward prices as certainty equivalents................................................................................................... 164 Using binomial lattices in valuing real options in practice........................................................................................... 166 Valuing an expansion option with the binomial lattice and binomial tree methods using the ‘risk-neutral’ probability.................................................................................................................................................................... 168 Binomial lattice method............................................................................................................................................................ 168 Binomial tree method................................................................................................................................................................. 168 Valuing tonnage-grade trade-offs................................................................................................................................................ 170 Valuing a farm-in/out sequential/compound option............................................................................................................ 171 Differences between real option value using binomial trees and ‘hybrid’ real option value decision trees........................................................................................................................................................................................ 172 Strategic real option value considerations................................................................................................................................ 174 Conclusions........................................................................................................................................................................................... 174 References.............................................................................................................................................................................................. 175

Minerals and Public Policy Chapter 11  Mineral Policy – An Introduction

Philip Maxwell and Pietro Guj

The aims and practice of economic policy................................................................................................................................ 179 The context of mineral policy......................................................................................................................................................... 181 Mineral policy in practice................................................................................................................................................................. 183 The transition of mineral policy since 1950............................................................................................................................... 185 The post-1960 surge in public ownership........................................................................................................................... 185 The swing back to private ownership................................................................................................................................... 187 The rise of China........................................................................................................................................................................... 187 Some other current policy realities........................................................................................................................................ 188 Towards a competitive regulatory and fiscal regime for exploration and mining...................................................... 188 References.............................................................................................................................................................................................. 189

Chapter 12  Mineral Taxation and Royalties

Frank Harman and Pietro Guj

Introduction.......................................................................................................................................................................................... 192 Minerals sector taxation............................................................................................................................................................. 192 Why are there special taxation and royalty regimes for the minerals sector?........................................................ 192

Contents of this chapter............................................................................................................................................................ 192 A note on terminology............................................................................................................................................................... 193 Economic rent...................................................................................................................................................................................... 193 Economic rent and normal profit........................................................................................................................................... 193 Economic rent and scarcity....................................................................................................................................................... 194 Economic rent, scarcity and the minerals sector ............................................................................................................. 194 Pursuing economic rent............................................................................................................................................................. 195 Design principles for the taxation of mineral rents................................................................................................................ 196 Economic efficiency..................................................................................................................................................................... 196 Equity................................................................................................................................................................................................ 196 Administrative cost...................................................................................................................................................................... 197 Transparency.................................................................................................................................................................................. 197 Stability............................................................................................................................................................................................ 197 Taxes designed to capture economic rents........................................................................................................................ 197 Evaluating mineral taxation and royalty systems.................................................................................................................... 199 An initial assessment................................................................................................................................................................... 199 Problem areas................................................................................................................................................................................ 200 International experience with the taxation of mining rents............................................................................................... 201 Relevant constitutional powers in Australia.............................................................................................................................. 203 Ownership and control of mineral resources..................................................................................................................... 203 Powers to raise mineral taxes................................................................................................................................................... 203 Current mineral taxation regimes in Australia.......................................................................................................................... 204 Tax and royalty regimes in the Australian states, the Northern Territory and the Commonwealth............... 204 Other issues in the collection and use of economic rents in Australia..................................................................... 209 Commonwealth company income tax........................................................................................................................................ 211 Deductibility of exploration expenditures.......................................................................................................................... 211 Depreciation of capital expenditures.................................................................................................................................... 211 Other issues.................................................................................................................................................................................... 212 Mineral revenue policies for the future....................................................................................................................................... 213 Note on the literature................................................................................................................................................................. 213 References.............................................................................................................................................................................................. 213

Chapter 13  Mining, Sustainability and Sustainable Development

Roderick Eggert

Introduction.......................................................................................................................................................................................... 215 Sustainability and sustainable development............................................................................................................................ 216 Mining and environmental sustainability.................................................................................................................................. 217 Mining and economic sustainability............................................................................................................................................ 218 Mining and social/cultural sustainability.................................................................................................................................... 219 Public policy – principles and concepts...................................................................................................................................... 220

Putting sustainability and sustainable development into practice in mining.............................................................. 222 Final thoughts...................................................................................................................................................................................... 224 Notes on the literature............................................................................................................................................................... 224 References.............................................................................................................................................................................................. 224 Appendix A: The Mining, Minerals and Sustainable Development project: nine key challenges.......................... 225 Appendix B: The International Council on Mining and Metals sustainable development framework................ 226 Appendix C: Summary findings of the Extractive Industries Review............................................................................... 226 Appendix D: Ten Principles of the Global Compact................................................................................................................ 227

M i n i n g a n d L o c a l C o mm u n i t i e s Chapter 14 Stakeholders, Local Communities and Regions

Philip Maxwell

Mining and its stakeholders............................................................................................................................................................ 231 Local communities and mines........................................................................................................................................................ 232 Occupational, residential and Indigenous communities............................................................................................... 233 Mining regions..................................................................................................................................................................................... 234 Australia’s regional framework and its mining regions.................................................................................................. 235 References.............................................................................................................................................................................................. 235

Chapter 15  Minerals and Regional Development

Philip Maxwell

Some introductory considerations............................................................................................................................................... 237 Socio-economic indicators for local communities and regions.................................................................................. 237 Summary socio-economic measures for small areas...................................................................................................... 239 Economic impact assessment........................................................................................................................................................ 241 Economic (export) base analysis............................................................................................................................................. 242 Input-output analysis.................................................................................................................................................................. 243 Computable general equilibrium models........................................................................................................................... 247 Social impact assessment................................................................................................................................................................ 247 Origins and development......................................................................................................................................................... 247 Conducting a full social impact assessment....................................................................................................................... 248 Some examples of recent social impact assessments..................................................................................................... 248 References.............................................................................................................................................................................................. 250 Appendix – the structure of and solution to the input-output model............................................................................ 250

Chapter 16  Mining and Indigenous Populations

Philip Maxwell

The world’s Indigenous populations............................................................................................................................................ 253 Mining and the Indigenous world................................................................................................................................................ 254 Indigenous Australia ......................................................................................................................................................................... 255 Some historical background.................................................................................................................................................... 255 Recent comparative data........................................................................................................................................................... 256

Indigenous Australia and mining.................................................................................................................................................. 259 An overview.................................................................................................................................................................................... 259 The Mabo case and more recent developments.............................................................................................................. 260 Indigenous employment policies........................................................................................................................................... 263 Looking to the future.................................................................................................................................................................. 263 References.............................................................................................................................................................................................. 263 Appendix – two case studies.......................................................................................................................................................... 265 Roebourne in the Pilbara........................................................................................................................................................... 265 The Argyle diamond mine and the East Kimberley region........................................................................................... 267

Chapter 17 Occupational Communities – The Mineral Sector Workforce

Philip Maxwell

Introduction.......................................................................................................................................................................................... 269 Mining’s occupational community........................................................................................................................................ 269 Mining employment in developed and developing nations....................................................................................... 270 The formal mining sector.......................................................................................................................................................... 271 Artisanal and small-scale mining............................................................................................................................................ 271 Mineral sector employment in Australia..................................................................................................................................... 273 Historical trends............................................................................................................................................................................ 273 Employment, value added and wages in mining............................................................................................................. 273 Occupational and educational structure............................................................................................................................. 274 Location issues.............................................................................................................................................................................. 274 Important mineral sector workforce issues............................................................................................................................... 275 Gender imbalance........................................................................................................................................................................ 275 Maintaining a supply of well-trained professionals......................................................................................................... 275 The growth of fly-in, fly-out workforces............................................................................................................................... 277 Summary and conclusion................................................................................................................................................................ 279 References.............................................................................................................................................................................................. 279

Glossary of Terms

281

Subject Index

293

Name Index

301

HOME

chapter 1 Mineral Economics – An Introduction Philip Maxwell Definitions of economics and the economic way of thinking Economics and mineral economics The focus of mineral economics Some key questions in mineral economics The structure of this volume

Definitions of economics and the economic way of thinking Economics, and the economic way of thinking, have had an important influence on business and government affairs for at least the last two centuries. The Scottish author Adam Smith espoused the foundations of modern economic thought in 1776. His famous volume – The Wealth of Nations1 – ushered in a revolution in economic thinking. His ideas formed the basis of the new academic field of political economy, which writers such as Jevons (1879, p 8) renamed as economics some one hundred years later. In the early pages of his book, The Worldly Philosophers, Heilbroner (1972) traces the rise of economics to the emergence of the market system in the wake of the Industrial Revolution, which began in the middle of the eighteenth century. Prior to that time, the organisation and survival of society had largely depended on tradition and authoritarian rule. The discipline of economics developed strongly during the 20th century, with economists applying its principles to many areas and industries. One of these industries was mining. For at least the last 50 years, undergraduate students in mining engineering programs around the world have taken one or more courses in mineral economics, or engineering economics, as part of their curriculum. Graduate coursework programs in mineral economics have also developed in a number of wellknown universities. 1

Its full title is An Inquiry into the Nature and Causes of the Wealth of Nations.

Mineral Economics

At one level MacKenzie (1987, p 2) sees mineral economics as ‘the application of economics in the study of all aspects of the mineral sector’. More recently, Gordon and Tilton (2008, p 4) have suggested that: Mineral economics is the academic discipline that investigates and promotes understanding of economic and policy issues associated with the production and use of mineral commodities. To understand its focus more clearly it is useful to briefly consider the definition of economics, and its evolution2. The ancient Greek scholar, Xenophon, first used the term economics some 2500 years ago to describe the field of household management, known today as ‘home economics’. By using the term political economy, Smith and the classical economists who followed in his footsteps over the next century of so, sought to extend the study to the level of nations by focusing attention on the production, distribution and consumption of wealth. As the nineteenth century proceeded, writers in the field focused also on utility and the discussion of individual economic welfare. One of the most widely used early definitions of economics was that of Alfred Marshall, in his influential volume, The Principles of Economics (1890, p 1) which notes that: POLITICAL ECONOMY or ECONOMICS is the study of man in the ordinary business of life; it 2

A useful recent reference is the paper by Backhouse and Medema (2009) from which some of the following discussion is drawn.

1

chapter 1 – Mineral Economics – An Introduction examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing. Thus it is on the one side a study of wealth; and on the other, and more important side, a part of the study of man. This is a broad definition and, as such, it attracted debate. In seeking to clarify the nature of the economics discipline, Robbins (1932, p 16) offered an alternative perspective with his so-called scarcity definition as opposed to Marshall’s materialist definition. This was that: Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses. Backhouse and Medema (2009, p 225) note that critics initially argued that the definition was too broad because: ... it failed to divide economics sufficiently from other social sciences ... and too narrow because it: ... was too heavily tilted toward theory and left little, if any, room for empirical analysis, history, and institutions – and it essentially wrote ethics out of economics. Yet most writers of modern principles economics textbooks have embraced this scarcity definition. Without scarcity, there would be no need for markets. Everything would be free and uncontested. It provides a reference point for new students to consider and digest the subsequent theories and models of classical and neoclassical economics, the two major schools of thought. They present it in a slightly extended version such as: Economics is the study of how people and society choose to employ scarce productive resources to produce goods and services and distribute them among various groups in society. (Waud et al, 1996, p 6) This is, however, not the last word. Non-traditional economists, such as John Kenneth Galbraith, take an even broader view. In his volume The New Industrial State (1978, p 417) Galbraith notes that: In economics, ••

Economic theory – the study which deals with the way prices, output and incomes of individuals, firms and the economy at large are decided – is one area of specialisation. •• The corporation is another. •• Decision theory – how decisions are reached in complex organisations – is yet another and more modern field. Writers in the field of mineral economics such as MacKenzie (1987), and practitioners more generally, have tended to embrace a broader definition in the 2

Galbraithian mould. We consider why and how this has happened in the third section of this chapter. Before doing so, we consider the place of mineral economics in the broader context of the study of economics more generally.

Economics and mineral economics The rise of economics during the twentieth century occurred in several dimensions. At one level there has been division of the discipline between microeconomics and macroeconomics. Microeconomics is the study of economic decisionmaking by consumers, households, firms and government, and the way in which these relate to the operation of markets. Its focus has been on areas such as supply and demand, on the organisation of markets and on industry regulation. Microeconomics also informs us about the decision-making activities, not always benevolent, of government officials. Macroeconomics, by contrast, is concerned with the operations of national economies and the world economy. Its focus has been on measures of economic performance such as Gross Domestic Product (GDP), inflation, investment, saving, economic growth, the balance of payments and the distribution of income and wealth. It is also concerned with the formulation of fiscal, monetary and other areas of national economic policy to manage these variables. There has also been strong interest in areas such as international trade and finance, economic development, financial markets and institutions, public finance, labour markets, economic systems, urban and regional economics, natural resource economics, environmental economics, economic history, law and economics, and the history of economic thought. Many economists make their careers by specialising in one of these fields3. In a rather different way, there has also been a growing interest in the economics of many major industries. Fields such as agricultural economics, transport economics, health economics, communication economics, tourism economics, cultural economics, energy economics and mineral economics also are now distinct subdisciplines. The study of these areas have emerged because of: •• the overall size of these industries •• their importance to specific economies and regions •• different specific characteristics, which make them worthy of separate analysis. In 2010, the minerals and energy sectors accounted for around US$3000 B of world production. This was about five per cent of the world’s estimated GDP4. Importantly 3 4

It can also be noted that the broader discipline of finance has become an area of applied microeconomics in the past four decades. Originally suggested by the US economist, Simon Kuznets (1934), Gross Domestic Product (GDP) has been the most commonly used measure of production over a given time period (eg a year) for the past half century. Mineral Economics

chapter 1 – Mineral Economics – An Introduction as well, international minerals trade has consistently accounted for more than ten per cent of the value of world merchandise trade since 1960. During the past decade it has exceeded 15 per cent in two or three years, when mineral and energy prices were particularly high. Mineral production and trade is of great significance in as many as fifty nations, and it is the dominant industry in many sub-national regions around the world. Some indication of this importance for selected economies can be seen in Table 1.1. The contribution of the minerals and energy sector to their GDP estimates for 2008 is reported in Table 1.1, as is their contribution to exports and to total imports. Notice how the minerals and energy sector as a percentage of GDP varies from almost zero in

economies such as Japan, Germany and Korea to more than 30 per cent in major oil- and gas-producing nations as well as economies such as Botswana and Papua New Guinea. In several nations mineral exports account for well over half of total exports, while they are also key imports in Japan, Korea and many European nations. Another recent view of the importance of minerals and energy on a ‘broad’ regional basis appears in Table 1.2, which contains estimates of mineral and energy ‘value added’ for each of the world’s continental groupings for the years 2002 and 2007. This shows the importance of Asia as the major source of minerals and energy in recent years. The notable increase in magnitude for every continent between 2002 and 2007 reflects the minerals boom, which emerged after 2003.

Table 1.1 Estimated size of the minerals sector in selected economies, and the extent of international minerals trade – 2008 (source: United Nations, World Trade Organization, various other sources). Country

Minerals Gross Domestic Product (US$ bill)

Total Gross Domestic Product (US$ bill)

Minerals Gross Domestic Product/total Gross Domestic Product

Mineral exports/ total exports

Mineral imports/ total imports

Large developed economies USA

275

14204

0.020

0.098

0.257

Japan

4

4909

0.001

0.048

0.428

Germany

8

3652

0.003

0.058

0.189

South Korea

2

929

0.002

0.113

0.403

China

173

4326

0.040

0.038

0.271

India

30

1217

0.024

0.244

0.456

Indonesia

56

514

0.109

0.363

0.285

Australia

72

1015

0.071

0.597

0.172

Brazil

59

1612

0.037

0.222

0.239

Canada

141

1400

0.101

0.353

0.160

South Africa

25

277

0.092

0.354

0.257

Chile

30

169

0.175

0.639

0.288

Peru

13

127

0.104

0.521

0.196

Large developing economies

Key mineral exporters

Selected small developing mineral economies Papua New Guinea

3

8

0.352

0.438

0.162

Botswana

5

13

0.390

0.075

0.198

Namibia

1

9

0.158

0.393

0.170

Ghana

1

16

0.076

0.158

0.134

Zambia

1

14

0.041

0.795

0.283

Saudi Arabia

269

468

0.575

0.899

0.070

Russia

128

1607

0.080

0.731

0.042

Iran

118

385

0.307

0.842

0.097

Nigeria

76

212

0.359

0.923

0.050

Norway

119

450

0.292

0.756

0.138

Venezuela

92

313

0.294

0.956

0.025

Selected energy economies

Mineral Economics

3

chapter 1 – Mineral Economics – An Introduction Table 1.2 Estimated contribution of the minerals sector to total value added in each continent – 2000 and 2007(source: United Nationsa). 2002 Continent

2007

Amount (US$ bill)

Per cent of total value added

Amount (US$ bill)

Per cent of total value added

Africa

93

16.7

294

23.8

Asia

418

4.8

1212

8.7

Europe

291

3.1

567

3.3

North America

358

3.3

651

4.3

Oceania

32

7.1

87

8.6

South America World

73

8.7

225

10.8

1293

4.1

3066

5.9

a. These estimates are derived from UN Statistics (unstats.un.org) by subtracting manufacturing (ISIC D) and estimated utilities (notionally 1.5 per cent of GDP unless otherwise available) (ISIC E) from mining, manufacturing and utilities (ISIC Classes C-E).

A difference between minerals and many other commodities is that they are factor inputs rather than final consumer goods. With one or two notable exceptions, manufacturers demand them because of the particular attributes they possess. Desirable qualities of different minerals may include things such as strength, durability, chemical and thermal stability, ductility, heat conductivity, resistance to corrosion, plasticity and lubricity. Minerals differ widely in their physical and chemical characteristics. The standard classification of metals, non-metals and energy minerals provides one indication of these differences. An appreciation of the diversity of minerals produced and consumed is possible by reviewing relevant webpages of the United States Geological Survey5. Their analysts regularly assess the status of at least 50 metals, 50 non-metals and seven or eight major energy minerals that are mined or drilled on a regular basis around the world. They vary widely in value with oil in 2010 being worth perhaps US$2 trillion, while some of the smaller minerals are worth perhaps as little as US$10 M each year. Another useful classification of minerals – that used by the United Nations Conference on Trade and Development (2007, p 84) – appears in Figure 1.1. MacKenzie (1987, p 6) argues that the main special characteristic of the minerals sector that justifies its study as a separate sub-branch of economics relates to the issue of geological endowment. The implications of a fixed endowment for economic analysis relate to patterns of optimal use, the optimal timing of this use, increasing scarcity and conservation.

•• fixed in location (they may be discovered in remote locations and need to be moved to intermediate- and end-use markets). Another supply-side matter of interest is recycling. While most energy minerals can be consumed only once, metals and some non-metals can be profitably recycled using old-scrap and new-scrap sources. Recycling may also be more environmentally friendly. Garnaut (1995) adds a further perspective on the special nature of minerals when he describes five characteristics of mines that make them a special focus of government policy and administration. These are: 1. they can generate economic rent6 2. they are often established most efficiently on a very large scale 3. their development is often highly capital intensive 4. they have unusually large local, environmental, social and economic impacts 5. their national economic impact varies greatly over relatively short periods of time.

The focus of mineral economics While one can justify the study of mineral economics in terms of the rise of the economics discipline, the emergence of mineral economics has also been influenced by the development of parallel subdisciplines such as engineering economics. In their preface to a successful US textbook in the area, Riggs, Bedworth and Randhawa (1996, xv) note that: The curriculums of most professional schools (of engineering) include a course in applied economics under such titles as engineering economy, financial management, managerial economics and economic decision-making.

MacKenzie notes in particular that mineral deposits are: •• initially unknown (they must be discovered) •• fixed in size (they are non-renewable) •• variable in quality (they often must be extracted using new technologies) 5

4

The relevant web site is http//www.usgs.gov

These courses typically appear in the latter part of the undergraduate curriculum. In mining schools, they 6

We shall see later in Chapter 3 that this is ‘a surplus in excess of the minimum profit required by shareholders in a company or firm to stay in business’. Mineral rents receive further attention also in Chapter 14. Mineral Economics

chapter 1 – Mineral econoMicS – an introDuction

FIG 1.1 - A classification of minerals following United Nations Conference on Trade and Development (2007).

have often been called mineral economics. Though hardly subdisciplines of economics, they have tended to define the field of mineral economics in the eyes of many mining professionals. Their emphasis has typically been on decision-making at the operational level, usually with a focus on minimising or optimising costs, in the context of investment decisions. Where they are taught well, mining professionals often rank such courses among the more useful taken in their undergraduate study. Students completing them also often then expect that subsequent study of mineral economics will largely be focused on issues or project evaluation and related areas of applied financial analysis. While postprofessional programs in mineral economics do tend to contain a strong emphasis on financial analysis, they combine this with study of mainstream economic issues, which arise from the special nature of mineral markets, and the other features that the geological endowment constraint places on the study of the discipline. Gordon and Tilton (2008) trace the origins of the modern study of mineral economics to a collaborative effort between the Brookings Institution and the US Bureau of Mines in 1932. This led to the publication of an edited volume by Tyron and Eckles (1932) titled Mineral Economics: Brookings Lectures. After World War II there was growing concern over the implications of the geological endowment in the United States for strategic mineral supply. A parallel development was the foundation of the first mineral economics program at the College of Mineral Sciences at Pennsylvania Mineral economics

State University in 1946. Since that time the study of mineral economics have moved around the world. Several governments has established formal interests in the field and there are a small number of university programs offered in the United States, Australia, Chile, South Africa and Europe. A group of consulting firms also specialise in mineral economic issues. Many professionals who take mineral economics courses are seeking to move into more senior managerial roles. It seems desirable, therefore, that any comprehensive treatment of the area should address the strategic, operational and human resource management issues that relate specifically to resource sector companies, as well as providing a suitable overview of the legal environment in which these firms operate. These elements relate quite neatly to Galbraith’s broader definition of economics, with its focus on economic theory, the corporation and decision making. It is instructive to complete this introductory discussion by making one further important point. MacKenzie (1987, p 8) identifies two main requirements for the practice of mineral economics. They are: 1. knowledge of the principles of economics and associated analysis techniques 2. understanding of the technical characteristics of the mineral sector that are of significance from an economic viewpoint. The focus of discussion in this chapter has been on the first of these issues, but the second point is also 5

chapter 1 – Mineral Economics – An Introduction important. It is often necessary to appreciate the technical issues relating to a mining or energy project to apply economic and other principles to its analysis. Business, law and economics graduates will find it difficult to undertake the depth of analysis necessary to analysis minerals sector issues unless they extend their technical knowledge in areas such as geology, mining methods and mineral processing.

What forces have been driving change in mining’s interaction with local communities? How important is international trade in minerals and energy? What role has major changes in transport costs played in international minerals trade? How does recent growth in mineral and energy trade compare with growth in other areas of international trade?

A well-trained mineral economist will apply economic principles, in combination with suitable technical knowledge, to analyse resources available in a fixed endowment. She, or he, will consider issues such as how to use minerals, when to use them, how to mine them, when to recycle them and how to regulate them.

What are the sources of competitive advantage of the Australian minerals sector? What are the key factors that influence the demand for different metals?

Some key questions in mineral economics Writing about mineral economics in 1950, Gordon and Tilton (2008) identified the key areas of interest as mineral markets, project evaluation, depletion and long-run availability of minerals, strategic minerals, monopoly policy with respect to aluminium and steel, and international commodity agreements. In the ensuing 60 years, the mineral economics ‘playing field’ has changed, but many of these topics remain of great interest and importance. Mineral market analysis and project evaluation are both still central areas of focus. These have been joined by topics such as the relationship between mineral exploitation and development and the associated concepts of the ‘resource curse’ and ‘Dutch disease’. Other important areas include mineral taxation and royalties; sustainable development and mining; minerals trade and transport; the issue of how mineral rents should be shared between local communities, regions, nations and companies; and the economics of innovation in the mining sector. We address most of these areas in this volume and after reading it closely, you should be able to answer the following questions in a professional way. Does an abundance of mineral resources make a country rich? What effects do mineral-based resource booms have on different economies? What factors influence the discovery and exploitation of minerals around the world? What did the discovery of gold do to the Australian economy? Why has the resources sector been important to economies such as Australia, Canada and Chile in the recent past? Or has it been important? What factors determine the contribution of mineral production to sustainable economic well-being? What influence has greater environmental regulation had on the supply of minerals? 6

How important are joint production issues in the analysis of mineral supply? How has recycling affected the supply of major metals in the recent past?

The structure of this volume In compiling this monograph, our aim is to provide a balanced and up-to-date view of the approaches and techniques that mineral economists use to appreciate the resources sector. While the bias of this volume is towards the Australian mineral and energy sector, the discussion often takes a broader perspective. Mining is a global industry and if this volume is to provide value to its readers, it must be internationally focused. The 16 chapters that follow this introduction are organised in five main sections. They are: 1. minerals and the world economy (three chapters) 2. minerals: consumption, production and markets (three chapters) 3. mineral finance and investment (four chapters) 4. minerals and public policy (three chapters) 5. mining and local communities (four chapters). Philip Maxwell has played the coordinating role with the first, second and fifth sections. Pietro Guj is responsible for the Mineral Finance and Investment section. The coordination of the minerals and public policy section has been shared. Our contributions have emerged from our association with the Graduate Coursework program in Mineral Economics at the Western Australian School of Mines7 at Curtin University. One of the features that assisted the quality of our program offerings over the past decade has been the contribution from colleagues from other institutions, both in Australia and overseas. It is particularly appropriate, therefore, that several of these visiting faculties, together with other selected colleagues, are also contributing to this volume. They include Rod Eggert (Colorado School of Mines), Phillip Crowson 7

This program has recently been transferred to Curtin’s Graduate School of Business. Mineral Economics

chapter 1 – Mineral Economics – An Introduction (University of Dundee), Peter Howie (Nazarbayev University), Allan Trench (Curtin University and and the University of Western Australia) and Frank Harman. Several others have acted as reviewers. Their insights enhance the quality of the pages ahead. We thank them for their contributions.

References Backhouse, R and Medema, S, 2009. On the definition of economics, Journal of Economic Perspectives, winter, 23(1):221-233. Galbraith, J K, 1978. The New Industrial State, third edition revised (Houghton Mifflin: Boston). Garnaut, R, 1995. Dilemmas of governance, in Mining and Mineral Resource Policy in Asia-Pacific: Prospects for the 21st Century (eds: D Denoon, C Ballard, G Banks and P Hancock), p 61-66, Canberra. Gordon, R and Tilton, J, 2008. Mineral economics: Overview of a discipline, Resources Policy, 33(1):4-11. Heilbroner, R, 1972. The Worldly Philosophers, fourth edition (Simon and Schuster: New York).

Mineral Economics

Jevons, W S, 1879. The Theory of Political Economy, second edition (Macmillan: London). Kuznets, S, 1934. National Income, 1929-1932, 73rd US Congress, second session, Senate document no 124, p 7. MacKenzie, B, 1987. Mineral Economics: Decision-Making Methods in the Mineral Industry, 5-17 July, Adelaide: Australian Mineral Foundation. Marshall, A, 1890. Principles of Economics (Macmillan: London). Riggs, J L, Bedworth, D B and Randhawa, S U, 1996. Engineering Economics, fourth edition (McGraw-Hill: New York). Robbins, L, 1932. An Essay on the Nature and Significance of Economic Science (Macmillan: London). Tyron, E G and Eckles, E C (eds), 1932. Mineral Economics: Brooking Lectures (McGraw-Hill: New York). United Nations Conference on Trade and Development (UNCTAD), 2007. World Investment Report: Transnational Corporations, Extractive Industries and Development, Geneva. Waud, R, Maxwell, P, Hocking, A, Bonnici, J and Ward, I, 1996. Economics, third Australian edition (Longman: Melbourne).

7

Minerals and the World Economy

HOME

Chapter 2 Some Foundations Philip Maxwell Mineral exploitation, production, distribution, consumption, trade and related economic concepts Measuring economic production and living standards Economic growth and development Periods of history and minerals Mineral consumption and economic development Complicating factors with mineral production and consumption

Mineral exploitation, production, distribution, consumption, trade and related economic concepts Several processes always occurring within any economy determine the economic wellbeing of its citizens. They include production, distribution, consumption and trade. Our interest in this volume is with how minerals and energy exploitation impinge on these processes. It is typical, initially at least, to think of the ways in which people use minerals and energy in the process of producing goods and services. But the distribution of the proceeds of resource wealth and the consumption of mineral and energy resources are very important as well. Furthermore, the sale and purchase of minerals and energy through interregional and international trade plays an important role in increasing people’s welfare. Let us begin by taking a production view of things. Over any given period, (eg a year), we can think of what an individual, a firm, a region, a nation or the world produces in terms of a production function in which the output generated is a function of the economic resources used as inputs. Economists have typically denoted these resources as land, labour and capital. The state of technology may also be included as an additional factor but in the short run, this will be reflected in the nature of the capital stock and the quality of the labour force. In a similar vein, Alfred Marshall included organisation as a production factor. Mineral Economics

Some natural resource economists have included the environment (or environmental services) in their group of inputs. Recognising the value of each of these alternative specifications, let us hypothesise here that: Economic output = f (land, labour, capital, environment) But what do economists mean by land, labour and capital? •• Land refers to all of the natural resources used in production. As well as land itself it includes water, forests, fisheries, oil, gas and mineral deposits. •• Labour denotes the skills and capabilities used by humans in the production process. •• Capital describes all of the manufactured aids used in the process of production1. The environment reflects the quality of the natural world around us. It is responsible for the quality of the air that we breathe and the water that we drink, and the way that we utilise it affects the food that we eat and the materials that we use to build shelter for ourselves. 1

It has become increasingly common practice to identify land as natural capital, labour as human capital and capital as physical capital.

11

chapter 2 – Some foundations The services that the environment provides are also an input to production. It is also a ‘sink’ for our wastes and if this aspect is overused, the environment can adversely affect our ability to produce. Critics argue that most mining and oil companies neglected environmental issues until quite recently2. They did so because their main focus was on profits and dividends to shareholders, and governments did not actively regulate pollution. These companies were not alone in their practices. Many manufacturing firms did little to treat wastes, discharging them into the nearby atmosphere, or into rivers, lakes or the sea with minimal treatment. In many parts of Australia and elsewhere, past and even present farming practices have resulted in erosion and reduced soil fertility. This occurs even today in several developing nations. Over the past 30 years there has been a major change in the position of corporations generally and mining companies particularly. They have embraced the principles of sustainable development and corporate social responsibility in their treatment of environmental issues and their relationships with the local communities in which they operate3. The following statement by McDivitt and Jeffrey, in Vogely (1976, p 16), reflects an interesting economic perspective about the impact of mining on production: … mineral development can contribute to the three major factors of production - land, through bringing into action otherwise dormant resources in the country; capital, both through attracting outside investment capital to the country and through providing new money some of which can be used for local investment; and labor, through upgrading local skills and implanting concepts of entrepreneurship. That is, mining uses machines, labour, and minerals themselves to produce further capital (buildings, bridges, machinery, etc). In this process, worker skills are upgraded and innovation takes place, enhancing the labour pool for mining’s own use or for its use in other sectors. If they were rewriting this passage today, the two authors may also have included a reference to environmental quality issues and to sustainable development. In any economy, the issue of distribution – the way in which different individuals or groups share production – is also important. Issues relating to the fairness or equity in the distribution of income and wealth usually generate controversy. This happens within families, smaller regions, states and provinces, and nations, and also between nations on the world stage. Governments use the proceeds of taxation and royalty collections to redistribute this income and wealth. 2 3

12

Small-scale and artisanal miners tend to continue doing this even today. For two different accounts of this situation see International Council on Mining and Metals (2012) and Hilson (2012).

The discovery and exploitation of minerals brings major new activity to mining regions. Debates typically arise as to: •• How much should accrue to investors (often from other places) who have risked their money to develop new oil wells or mines? •• How much of the windfall should be shared with local and regional residents? •• How much should government redistribute to citizens in other regions or states? These controversies are often the source of continuing uncertainty. When they are resolved in a satisfactory way, all stakeholders can share the returns from new mineral and energy production. Hence one might argue that the great mineral wealth of the Eastern Goldfields, the Pilbara, and the other mining regions of Western Australia have been distributed effectively over more than a century. It has enhanced the income and general fortunes of the average citizen of WA’s mining regions. A large royalty stream, together with payroll tax receipts has assisted the finances of the Western Australian government. Greater individual and company income taxes, as well as resource rent royalties, have contributed to the welfare of Australians more broadly. Even without the hand of government to redistribute income and wealth through the fiscal system, many past mineral discoveries have brought a more even distribution of income. This was the case with the Victorian, New South Wales and Western Australian gold rushes in the nineteenth century. Blainey (2003, p 62) notes that: Gold checked, and for a time, reversed Australia’s tendency to become a land that favoured the big man. Whereas Australia’s first natural asset, the sheeplands, was grasped by a few thousand men, its second rich natural asset, the goldlands was divided among hundreds of thousands of men. Where mineral windfalls involve labour-intensive mining activity there is increased opportunity to share income and wealth more equally4. But as minerals then become less amenable to labour-intensive mining and require greater amounts of capital, there is the opposite tendency for the distribution of income and wealth to become more unequal. A continuing issue regarding our future, concerns the way in which production and consumption relate to one another. Consumption involves individuals and households (the private sector) and also government using up goods and services. If a society consumes less than it produces, (ie spends less than its income) in any given time period, its members (both the private and public sector) can save the residual 4

Elements of this argument apply widely to labour-intensive small-scale mining activities in developing nations. Mineral Economics

chapter 2 – Some foundations and invest it to ensure production continuing in the future. Saving and investment are important additional concepts in the economist’s lexicon. Saving refers to the amount generated from abstaining from consumption in any given period, while investment is spending on capital formation, both physical and human. New investment, that increases a nation’s or region’s physical and human capital, typically provides the basis for further economic growth and development. If citizens consume what they produce, or more than they produce by borrowing against future expected production, their capital stock will fall and so will production, if other things are equal. We typically are impressed with the ‘economic miracle’ nations whose strong growth and development is attributable to domestic saving, which finances wise investment in new physical and human capital. The economic performance of Japan, Korea, Taiwan, Singapore, Hong Kong and now China in the latter part of the twentieth century have drawn great praise from most commentators. Where nations have large mineral and energy resource endowments, much of which may have only recently been discovered, there also seems considerable potential to invest the profits from its exploitation. Such endowments form part of a natural capital base. Some natural capital is renewable, while some is not. It is normal to think of agricultural land, forests, fisheries and solar, wind and tidal energy as renewable resources, and to classify minerals and many other energy sources as non-renewable resources. Despite their finite nature, and as we have already noted, it is possible to recycle many minerals in a profitable way. If minerals are produced, and consumed, and they cannot be recycled, their stock will decline5. As we shall see, how the citizens of a country or region allocate the proceeds of mineral exploitation to current consumption and investment is an issue, which is of interest to many people. We typically see such debate in discussions about minerals and sustainable development. The final key concept in this section is trade. Trade takes place because it makes individuals, companies and nations better off. By specialising in the things they can do best, these groups can exchange part of their production for a variety of goods and services that will enable them to reach a higher standard of living than without trade. Trade takes place: •• within regions (eg a nickel miner in the Western Australian Goldfields town of Laverton sells ore or concentrate to the Kalgoorlie nickel smelter) •• between regions (eg a silver, lead and zinc mining company operating in Broken Hill, New South Wales, rails zinc concentrate for refining to the Port Pirie smelter in South Australia) •• between nations (eg a mining company operating in New Caledonia ships its lateritic nickel ore to 5

Technological change and development of course makes it more possible to access lower grade deposits over time.

Mineral Economics

the Yabulu nickel refinery near Townsville, North Queensland in Australia). As we saw in the final two columns of Table 1.1 and will also discuss in Chapter 4, exports of minerals and energy play an important part in increasing the economic and social welfare of many nations. Perhaps fifty countries have significant mining industries and many of these are significant international exporters. The remaining nations depend on key mineral and energy imports to supply their factories, build their general infrastructure and facilitate their housing and other building construction. Mineral exports were particularly important in Australia from the early 1840s until the beginning of World War I. Subsiding dramatically after 1914, mineral trade again rose dramatically after 1960. Sustained international competitiveness in many parts of the industry underpinned Australia’s strong economic performance in the last part of the twentieth century and in the first decade of the new millenium. This situation seems certain to continue for many more decades. In a complementary way, countries such as Japan and Korea, that produce few minerals, depend on a secure and reasonably priced minerals and energy supply. This is critical to the downstream industries on which these nations depend for the prosperity of their citizens.

Measuring economic production and living standards Following the widespread adoption and use of national accounting frameworks throughout the world after 1950, it has become standard practice to measure economic production by estimating Gross Domestic Product, commonly known as GDP. First suggested in 1933 by the Harvard University professor, Simon Kuznets, Gross Domestic Product is a measure of the market value of final goods and services produced in an economy during a given period6. It is most usual to discuss GDP estimates for a year. Each nation’s central statistical agency computes official estimates of its GDP, typically in terms of its national currency. In the case of Australia, this organisation is the Australian Bureau of Statistics. Australia’s officially estimated GDP in the 2010 - 11 financial year was around $A1300 B. This meant that GDP per capita for each of Australia’s 22.3 million inhabitants in that year was a little more than $A58 000. As shown in Table 1.1, when comparing GDP between nations, the established practice is to convert estimates in terms of national currencies into $US, using prevailing exchange rates. These estimates appear again in Table 2.1 for 2008. 6

The GDP measure differs conceptually from Gross National Product, which refers to the estimated value of final goods and services produced in a given period by a country’s citizens. International agencies such as the World Bank have recently commenced using another measure (Gross National Income (GNI)) in making international comparisons of economic size and growth between nations.

13

chapter 2 – Some foundations Notice the dramatic differences in the size of the economies in Table 2.1 as shown in their GDP estimates. The United States accounted for more than 20 per cent of the world’s GDP – which was more than $US60 trillion in 2008. Australia’s GDP was about six per cent of the US total, and it was about 100 times the size of the GDP of Papua New Guinea. Table 2.1 Key production and living standard indicators for selected economies – 2008 (source: International Monetary Fund). Country

GDP ($US billion)

GDP per capita ($US)

GDP per capita at PPP ($US)

Large developed economies USA

14 204

47 393

47 393

Japan

4909

38 271

33 957

Germany

3652

44 729

35 539

South Korea

929

19 162

27 681

Large developing economies China

4326

3404

5999

India

1217

1021

2789

Indonesia

514

2238

3980

Australia

1015

48 950

38 396

Brazil

1612

8625

10 512

Canada

1400

45 064

39 080

South Africa

277

5685

10 442

Chile

169

10 197

14 592

Peru

127

4446

8595

Key mineral exporters

Selected small developing mineral economies Papua New Guinea

8

1293

2095

Botswana

13

7552

14 907

Namibia

9

4297

6639

Ghana

16

739

1518

Zambia

14

1252

1461

Selected energy economies Saudi Arabia

468

19 108

23 489

Russia

1607

11 690

15 941

Iran

385

4573

11 026

Nigeria

212

1401

2162

Norway

450

94 196

53 361

Venezuela

313

11 288

12 717

The GDP measure has several limitations. Importantly it does not include adjustments for capital consumption, depreciation of natural capital, or environmental degradation. It fails, also, to include estimates of the value of non-market goods such as work at home. Hence the contributions to production of women and men who are homemakers and raise families are not included. Also excluded is the work of volunteers who contribute generously to the functioning of many 14

community organisations. For example in a study using 1997 data, the Australian Bureau of Statistics (2000) estimated that unpaid work in Australia could be valued at about 48 per cent of GDP. Estimates of actual GDP per capita, and GDP per capita at Purchasing Power Parity (PPP) for our selected economies also appear in Table 2.1. GDP per capita gives one measure of the standard of living of the average citizen of each nation. With an average per capita income of more than $US94 000, the average citizen in oil rich Norway appears dramatically better off than citizens of any other nation in the table. The average Ghanaian, with per capita income of $739 in 2008, seems the poorest. Citizens of the US, Germany, Australia, Canada and Japan all did well in terms of this measure. The PPP adjustment in GDP per capita takes account of cost of living differences between nations. It is based on continuing activities associated with the work of the International Comparison Program of the World Bank. The benchmark for the PPP measure is the cost of living in the USA. GDP per capita in the US was $US47 393 in 2008. Its GDP per capita at PPP was, of course, also $US47 393. Compare this with the situation in Australia. Over the past two decades, most would judge that the cost of living in Australia has been higher than in many other nations. While estimated GDP per capita in Australia in 2008, at $US48 950, was higher than in the US, it fell to $US38 396 after PPP adjustment. This was well below the US figure. On this basis, the standard of living of the average US citizen seemed considerably higher than his or her Australian colleagues. In the case of countries such as Chile and South Korea, living costs in 2008 were lower than in the United States. This shows up in higher GDP/ capita at PPP levels with these nations, than their GDP per capita estimates. For Chile, GDP per capita in 2008 was $10 197. GDP per capita at PPP was $14 592. In South Korea, GDP per capita was $19 162 and GDP per capita at PPP was $27 681. Low living costs in developing nations may double or even triple the GDP per capita estimate at PPP. Notice how GDP per capita at PPP is higher than GDP per capita for each of the small developing mineral economies in Table 2.1. Notwithstanding the significant contributions to overall production of volunteer groups and stay at home partners in a country such as Australia, the size of the informal economy is of considerably greater relative importance in developing nations. Hence, even after adjusting for Purchasing Power Parity, it is still likely that any comparison of living standards using GDP per capita at PPP between an affluent developed nation, such as Australia or Japan, and a poorer developing mineral economy in Africa will overstate the difference between them. Mineral Economics

chapter 2 – Some foundations While it is clear, therefore, that the average citizen of a nation such as Ghana is poor, his or her production will in reality exceed the estimate of $1518 in Table 2.1 by a higher percentage than it does for the average Australian citizen. GDP per capita at Purchasing Power Parity comparisons between nations are at best only an approximate indicator of economic welfare differences. The limitations of GDP and its associated measures have stimulated a number of alternative approaches and adjustments to reflect a country’s economic size and stage of development in a more effective manner7. But this statement itself begs the question of what development really means.

Table 2.2 Recent economic growth and human development in selected economies (source: World Bank, United Nations Development Programme). Country

Average annual economic growth (%) 1980 - 1999

Average annual economic growth (%) 2000 - 2009

Human development index 2010

Large developed economies USA

3.3

2.1

0.902

Japan

2.9

0.7

0.884

Germany

2.2

1.0

0.885

South Korea

7.4

4.8

0.877

Economic growth and development

Large developing economies

When commentators discuss the economic growth of a nation, a region or the world, they usually are referring to the percentage rate of growth in total production over a given period such as a year (or a quarter).

China

10.0

10.0

0.663

India

5.6

7.2

0.519

Indonesia

5.4

4.7

0.600

Australia

3.3

3.4

0.937

Brazil

2.0

3.0

0.699

Canada

2.8

2.4

0.888

South Africa

1.6

3.5

0.597

Chile

5.2

3.3

0.783

Peru

1.7

4.7

0.723

On some occasions, however, they may alternately refer to: •• the percentage rate of growth in per capita production of the average citizen over a given time period, and more recently •• the rate of growth of productivity, or output per worker. Yet, since about 1960 it has become standard practice to measure economic growth by computing percentage changes in real Gross Domestic Product. We use the term ‘real’ to indicate that the GDP has been adjusted for changes in the rate of inflation. National statistical agencies use the GDP deflator, based on the level of prices of all new domestically produced final goods and services in an economy in a given period to make this adjustment. Some estimates of average annual growth rates, based on simple averages, for the periods 1981 to 1999 and 2000 to 2009, appear in Table 2.2. Todaro (1989, pp 86 - 87) points to traditional views that development or economic development takes place over an extended period (of say ten years or more) when an economy is able, following a period of mediocre economic performance, to: •• bring about annual rates of growth exceeding five per cent •• generate consistent growth in its real GDP per capita. Hence, according Table 2.2, we might argue that, between 1980 and 1999, nations such as China, South Korea, India, Indonesia, as well as the two mineral rich nations of Botswana and Chile all experienced significant economic development. China, India, Ghana, Russia and Nigeria all met this criterion between 2000 and 2009. 7

There has been a growing movement, led by ecological economists to incorporate ‘green’ concepts into the national accounting framework. One prominent example of this comes from the World Bank, which now publishes the adjusted net saving measure.

Mineral Economics

Key mineral exporters

Selected small developing mineral economies Papua New Guinea

3.1

2.6

0.431

Botswana

8.5

4.2

0.633

Namibia

2.7

4.3

0.606

Ghana

3.3

5.4

0.467

Zambia

0.8

4.9

0.395

Selected energy economies Saudi Arabia

1.0

3.0

0.752

Russia

-4.9

5.6

0.719

Iran

3.0

4.8

0.702

Nigeria

1.9

5.6

0.423

Norway

3.1

2.0

0.938

Venezuela

1.4

3.0

0.696

But the Todaro view also seems implicitly to assume that, during a significant development period, the structure of an economy will change, with the emergence of major new and competitive industry sectors (eg mining, manufacturing, services, etc). The achievements over a longer period of Japan, China, South Korea and Singapore, and more recently of Thailand, India, Indonesia and Vietnam provide examples of significant economic development taking place. Nations such as the United States, Britain, Germany, France, Canada and Australia have also experienced economic development surges in this way. In each of these later cases, the mineral sector made a significant contribution to this development. 15

chapter 2 – Some foundations During the 1970s, a broader view emerged concerning the dimensions of the concept of economic development. Writers began to consider economic development in terms of reducing poverty, income inequality and unemployment when an economy was experiencing consistently strong real GDP growth over an extended period. In his extended definition, Todaro (1989, p 88) argues that: Development must … be conceived as a multidimensional process involving major changes in social structures, popular attitudes and national institutions, as well as the acceleration of economic growth, the reduction of inequality, and the eradication of absolute poverty. Associated with this interest in a broader definition of economic development, several economists have proposed the use of socioeconomic indicators to measure development. One of the notable early measures in this area was Morris’s Physical Quality of Life Index (based on life expectancy at age one, infant mortality and literacy). Following this approach, the United Nations Development Programme began reporting estimates of the Human Development Index (HDI) in its annual Human Development Report8, which first appeared in 1990. The HDI measure is based equally on: … a country’s average achievements in three basic aspects of human development: health, knowledge, and income (United Nations Development Programme, 2011). It can range between zero and one. The UNDP provides further details concerning the recent computation of this measure on its web site. Estimates of the Human Development Index for our selected economies in 2010 appear in Table 2.2 and movements in the HDI from 1980 to 2010 are reported in Table 2.4. Table 2.3 UNDP classified 169 countries. Level of human development

No of countries

Very high (≥0.788)

42

High (0.677 to 0.784)

43

Medium (0.488 to 0.669)

42

Low (≤0.488)

42

In its Human Development Report 2010, the UNDP classified 169 countries as shown in Table 2.3. It is notable that Norway (a major oil and gas exporter) had the highest HDI value of any nation in 2010, while Australia (a major mineral exporter) ranked second. Another key minerals and energy exporter, Canada, was the eighth ranked nation. Major change in HDI levels occurred in nations such as China, South Korea, India, 8 The Human Development Report is readily available in downloadable form from the UNDP web page. (http://www.undp.org).

16

Table 2.4 Movements in Human Development Index values for selected economies – 1980 to 2010 (source: United Nations Development Programme). Country

1980

1990

2000

2005

2010

Change 1980 2010

0.810

0.857

0.893

0.895

0.902

0.092

..

0.782

..

0.878

0.885

N/A

Japan

0.768

0.814

0.855

0.873

0.884

0.116

Korea (Republic of)

0.616

0.725

0.815

0.851

0.877

0.261

Large developed nations United States Germany

Large developing nations China

0.368

0.460

0.567

0.616

0.663

0.295

India

0.320

0.389

0.440

0.482

0.519

0.199

Indonesia

0.390

0.458

0.500

0.561

0.600

0.210

Major mineral exporters Australia

0.791

0.819

0.914

0.925

0.937

0.146

Brazil

N/A

N/A

0.649

0.678

0.699

N/A

Canada

0.789

0.845

0.867

0.88

0.888

0.099

South Africa

N/A

0.601

N/A

0.587

0.597

N/A

Chile

0.607

0.675

0.734

0.762

0.783

0.176

Peru

0.560

0.608

0.675

0.695

0.723

0.163

Small developing mineral economies Papua New Guinea

0.295

0.349

na

0.408

0.431

0.136

Botswana

0.431

0.576

0.572

0.593

0.633

0.202

Namibia

N/A

0.553

0.568

0.577

0.606

N/A

Ghana

0.363

0.399

0.431

0.443

0.467

0.104

Zambia

0.382

0.423

0.345

0.360

0.395

0.013

Saudi Arabia

0.556

0.620

0.690

0.732

0.752

0.196

Russian Federation

N/A

0.692

0.662

0.693

0.719

N/A

Iran

N/A

0.536

0.619

0.660

0.702

N/A

Energy economies

Nigeria

N/A

N/A

N/A

0.402

0.423

N/A

Norway

0.788

0.838

0.906

0.932

0.938

0.150

Venezuela

0.611

0.620

0.637

0.666

0.696

0.085

Indonesia, Botswana, Chile, Peru and Saudi Arabia after 1980. With the exception of South Korea, each of these nations is a significant minerals producer. Mineral exploitation was apparently consistent with increasing life expectancy9, better education and higher incomes in these countries over this three-decade period. By contrast, the significance of HDI increases in countries such as South Africa, Russia, Papua New Guinea, Zambia and Venezuela was less impressive. South Africa and Zambia faced particular difficulties with the HIV/AIDS epidemic that adversely affected life expectancy, while Russia struggled with its transition to the free enterprise system. In an era when the minerals and energy sector has become a more global industry, the HDI is a useful initial 9 The exception was Botswana, which struggled for more than a decade with the HIV/AIDS epidemic. Mineral Economics

chapter 2 – Some foundations measure to assess the likely operating environment a mining company might face if it commences operations in a new nation. Recent increases in a country’s HDI may also indicate greater potential for the profitability of new mineral projects in a previously difficult jurisdiction. Other things being equal, it should be more attractive to invest in a more developed nation, but making a judgment about development should involve assessing several other issues. Consistent with the Todaro definition above, such things as social and institutional stability and honesty, income and wealth distribution trends, and poverty levels interact with the status of mineral policy and the extent of a country’s mineral endowment in doing this in an effective and professional way.

Periods of history and minerals Minerals and energy have played a major role in the history of the world. This is apparent simply by noting that many periods have been characterised by material or energy names. Reflecting the role of changing technology, the use of key minerals as a principal ingredient of tools, or power, in periods bearing their names brought improvement in terms of human wellbeing, as measured by population growth and other indicators. This shows up clearly in Table 2.5, a summary table adapted from Wilson (1994, p xi). Wilson (1994, p xiii) also argues that: The history of metals is the history of civilisation. The two are inseparable; each depends on the other for its development; when one stumbles the other falters. Ever since Neolithic man learned the secret of winning metals from ore-bearing rock, metals have Table 2.5 Different periods in history (source: derived from Wilson, 1994). Period

Dates

Homo Erectus

500 000 years ago

Homo Sapiens

200 000 years ago

Stone Age

30 000 to 4000 BC

Neolithic (New Stone Age)

SW Asia 9000 to 6000 BC Europe to 4000 BC

Chalcolithic (copper-stone) period

4000 to 3000 BC

Copper Age

Began 3000 BC

Bronze Age

Began 2500 BC

Iron Age

Began 1000 BC

Coal Age

Began AD 1600

Industrial Revolution (based on coal, iron and steam)

AD 1750 to 1850

Oil Age

Began AD 1875

Atomic Age

Began AD 1945

Information Age

Began AD 1960

Mineral Economics

dominated the world’s political, social and economic evolution. For 5000 years they have been the major factor in the flowering of a people’s culture, the key to their industrial power and their influence in world affairs. There seems much to this argument, though modern oil and gas producers would also associate themselves with these views. A brief review of ancient history illustrates how members of the prominent civilisations effectively used new technologies in processing metals such as copper, iron, gold, silver and tin as a basis for enhancing both the quality of life of their citizens, as well as their military strength. The emphasis on the latter area seems to have been of central importance in the domination of surrounding populations. This applied in varying ways to the Sumerian, Babylonian, Assyrian, Persian, Greek, Carthaginian, Roman and Chinese civilisations. With the fall of the Roman Empire around 450 AD, the use of metals dwindled as the world of Europe and the Middle East descended into the ‘Dark Ages’ period. Though new uses of minerals and energy began slowly emerging after 1500, it was the arrival of the Industrial Revolution in the United Kingdom from about 1750 that heralded the widespread modern uses of minerals and energy. The establishment of heavy industry, the widespread use of coal and more recently oil and gas as its major energy sources, and the rise of materials such as steel, aluminium and a range of more exotic metals, have all been part of this picture. The Industrial Revolution has led to consumer societies in which minerals and energy are used in ways and at levels that were previously unimaginable. Associated with this have been major technological advances in exploration, mining and particularly mineral processing. Advances in transport technology have also created a global minerals economy, and as we shall see in the next chapter, this has hastened the economic development of nations such as Australia in a dramatic way.

Mineral consumption and economic development As economic development has proceeded there has been a significant rise in mineral consumption. This has been particularly the case over the past half century. With world population and real GDP now standing at or near their highest levels, the production and consumption of most minerals are now also at record levels. Some estimates of the consumption of key minerals for selected years between 1960 and 2009 appear in Table 2.6. The ratios shown in the final row indicate the extent of change in mineral consumption since 17

chapter 2 – Some foundations Table 2.6 Estimated annual world consumption of key minerals – selected years 1960 to 2009 (source: ABARES, US Geological Survey). Year

Steel Aluminium Copper (Mt) (kt) (kt)

Lead (kt)

Zinc (kt)

Nickel Oil (kt) (mbd)

1960

347

4940

3926

3080

3114

272

26 000

1970

595

12 177

7294

4502

5013

549

46 066

1980

716

18 051

9396

5392

6289

798

61 731

1990

770

24 056

10 789

5411

6664

901

66 830

2000

840

32 500

14 850

6655

8892

1123

76 280

2009

1100

34 765

18 367

8600

10 367

1183

84 077

Ratio 2009/ 1960

3.17

7.04

4.68

2.79

3.33

4.35

3.23

1960. Notice that aluminium has easily the greatest rate of increase, followed by copper and nickel. The rate of increase in steel, oil and zinc has been relatively more subdued. Yet with the emergence of China and India as leading economic powers, the growth of iron and steel use has been notably strong since 2000. Even unfashionable lead, which is now used much less than previously in paint and gasoline, increased by more that 150 per cent over the period, with its major application now being in motor vehicle batteries. In considering the relationship between mineral consumption and economic development the concept of intensity of use has been used by several authors. Suggested by Wilfred Malenbaum in 1975, its formula is: Mineral consumption Intensity of use (IU) = Real gross domestic product It is possible to compute the intensity of use of all minerals. To facilitate comparisons between minerals IU, it is useful to state each in index form, setting the value to 100 in a selected base year. So, using data from Table 2.6, while the actual IU of steel moved from (347 Mt/$US13 440 B = 0.0258 Mt/$US B in 1960) to 595 Mt/$US$18 960 = 0.0314 Mt/$US B in 1970, this shows up as an increase in intensity of use from 100 in 1960 to 121.6 in 1970. By comparison aluminium grew from 100 to 174.7 over the same period, while lead moved only from 100 to 103.1. Estimates of IU movements if Table 2.7 Movements in the intensity of use in key minerals for selected years between 1960 and 2009. Year

Steel

1960

100.0

Aluminium Copper 100.0

Lead

Zinc

Nickel

Oil

100.0

100.0

100.0

100.0

100.0

1970

121.6

174.7

131.7

103.6

114.1

143.1

125.6

1980

100.1

177.1

116.0

84.8

97.9

142.2

115.1

1990

81.5

178.8

100.9

64.5

78.6

121.6

94.4

2000

69.4

188.6

108.4

61.9

81.9

118.4

84.1

2009

73.2

162.3

107.9

64.4

76.8

100.3

74.6

18

key minerals in index terms are reported in Table 2.7 on a decade by decade since 1960. As any nation becomes more developed it initially uses minerals with higher degrees of intensity. Poor nations use minerals and energy at relatively low rates. But as they emerge in a major development push, they build roads, airports, railways, houses, public buildings and factories and their citizens buy new cars, televisions, air conditioners, computers, refrigerators and many other goods. Their intensity of use of minerals expands dramatically. By the time they become developed economies, they derive larger amounts of income from service industries, which do not use minerals so intensively, and their minerals intensity of use tends to decline slightly. Sometimes posited as an ‘inverted U’, Figure 2.1 describes the likely shape of the curve relating a nation’s (or region’s) stage of economic development to its minerals and materials intensity of use. Intensity of use

Stage of economic development

Fig 2.1 - Minerals intensity of use and economic development.

Developed nations have climbed a steep intensity of use hill and then their intensity of minerals use tends gradually to subside. Western Europe, the USA, Canada, Japan, Australia and New Zealand have experienced that phase. The United Kingdom, Germany and France began the process during the 19th century and are now well past their peaks. The United States started a major development surge in the latter part the 19th century and is now also well beyond its IU summit. South Korea began a major development surge after 1970 and has recently reached a peak. Australia experienced an initial development surge after its Gold rushes in the latter half of the 19th Century and then after 1945. The recent surge in the Gulf States (UAE, Qatar, etc) is another example of nations experiencing the climb. China has been undergoing the climb since 1978 but still does not seem to have reached the top of its ‘hill’. India is also ascending but is at a lower point. The dramatic rise in mineral consumption over the past decade has been linked to the major populations in these nations. The position of the IU-development curve may also shift between different time periods because of the effects of technology on mineral use. Mineral Economics

chapter 2 – Some foundations Table 2.8 Some issues with mineral production and consumption. Issues Locations of deposits and their implications Mineral rent

Chapters 4 (trade); 6 (supply); 17 (workforces) 3 (minerals and development); 11 (mineral policy); 12 (taxation and royalties)

Impact of technology

5 (demand); 6 (supply)

Nature of competition

7 (markets)

Indigenous populations

16

Environment/sustainable development

13

Smaller regions

14 - 17

Complicating factors with mineral production and consumption A variety of factors make the study of mineral production, mineral consumption and mineral economics generally more complex but also more interesting. As we have noted already in this chapter, one of these is the non-renewable nature of minerals and energy resources. Others include: •• the fixed locations of deposits (often in remote areas) •• the economic rent that they generate •• the impact of technological change on both the supply and demand side

Mineral Economics

•• the competitive behaviour of mineral producers and purchasers •• effects of mineral development on indigenous populations •• the environmental impact of mining and its mitigation. We discuss the relevance of each of these issues in the coming chapters – often on more than one occasion. Table 2.8 provides a brief guide, should you require it.

REFERENCES Australian Bureau of Statistics, 2000. Unpaid work and the Australian Economy, 1997, Catalogue no 5240.0, Canberra. Blainey, G, 2003. The Rush that Never Ended, fifth edition (Melbourne University Press: Melbourne). Hilson, G, 2012. Corporate social responsibility in the extractive industries: Experiences from developing countries, Resources Policy, 37(2):131-137. International Council on Mining and Metals, 2012. Available from: <www.icmm.com>. McDivitt, J and Jeffrey, W, 1976. Minerals and the developing economies, in Economics of the Mineral Industries, third edition, pp 3-32 (AIME: New York). Todaro, M, 1989. Economic Development in the Third World, fourth edition (Longman: New York). United Nations Development Programme, 2011. The human development index [online]. Available from: . Wilson, A J, 1994. The Living Rock (Cambridge: Woodhead).

19

HOME

Chapter 3 Minerals and Development Philip Maxwell The importance of mining in different nations The ‘conventional’ view – minerals are a blessing An alternative view – minerals are a curse

Some background discussion

The resource curse thesis

Institutional and policy issues

Some case studies The Australian experience The case of Chile The position of non-mineral economies

THE IMPORTANCE OF MINING IN DIFFERENT NATIONS With the demise of colonialism, the political geography of the world has been changing. Australia recently celebrated its centenary of self-government. When we became independent in 1901, there were perhaps 50 autonomous nations. While many of today’s countries in Europe and the Americas were already sovereign states, Africa was still largely a colonial bastion, and much of Asia was in a similar position. A dramatic change began on the African continent from 1960 onwards. There are now more than 50 independent countries in Africa. There have been parallel developments in Asia associated with the independence of India and Pakistan in 1947, of the South East Asian nations, and most recently as a result of the break-up of the Soviet Union. Teams from more than 200 nations marched at the opening ceremonies of the Olympic Games in Sydney in 2000, Athens in 2004 and Beijing in 2008. While perhaps 30 members of this group are microstates (places such as Monaco and Andorra), we noted in the last chapter that the United Nations Development Programme (various years) published estimated Human Development Index values for 169 of these nations in its Human Development Mineral Economics

Report 2010. Many of these have either significant mineral endowments or mineral dependence or both. While geologists estimate mineral endowments with statements of reserves and resources, there are several ways of assessing mineral dependence. Three recent assessments – those of Davis (1995)1, Eggert (2001) and Eggert (2003) appear in Table 3.1. Eggert (2003) focuses only on non-oil and gas mineral producers. Our view is that where minerals and energy account for 25 per cent or more of a country’s merchandise exports, an economy depends significantly on the nonrenewable resources sector. For the second half of the 19th century, the first decade of the 20th century and for much of the past 50 years, Australia has met this criterion to be a mineral dependent economy. In the 2002 - 03 financial year, for example, the minerals and energy sector, as defined in the Australian and New Zealand Standard Industry Classification code, accounted for over four per cent of Gross Domestic Product and almost 40 per cent of exports. If one 1

This taxonomy was also used by Nankani (1979), Gelb (1988) and Auty (1993).

21

chapter 3 – Minerals and development TABLE 3.1 Some classifications of mineral dependent nations. Author

Criteria (and year or period)

Number of countries

Minerals GDP/GDP ≥8% and Mineral exports/total merchandise exports ≥40% (1990)

22

Eggert (2001)

Mineral exports/total merchandise exports >25% (1999)

34

Eggert (2003)

Non-fuel mineral exports/total merchandise exports >10% (1990 - 1999)

37

Davis (1995)

defined mining somewhat more broadly to include basic metal processing and mining services, the share of GDP rose to more than eight per cent. Following the minerals and energy boom after 2004, these percentages rose dramatically. By 2009 - 10 the ratio of minerals and energy GDP to total GDP was 6.2 per cent and minerals and energy exports were almost 66 per cent of total exports. Using export data from the 1990s, there were 44  countries listed in Table 3.2 that met our mineral dependence criterion. They consisted of 21 hard rock mining nations, and 23 economies that depended strongly on oil and gas production. Additionally the table includes 15 other marginal or potential mineral dependent nations. Our criterion for ‘marginal mineral dependence’ is a level of exports between ten and 25 per cent of total merchandise exports. There are additionally a group of five or six African nations which have either significant mineral potential that has yet to be developed, or if developed previously, have subsequently been adversely influenced by major political upheaval. So, while there are 59 countries on our list of actual, marginal or potential mineral dependent nations, the group might even expand further. Against this background it is a worthwhile exercise to reflect on recent views about the way in which the expansion or contraction of minerals activity will influence the development process.

THE ‘CONVENTIONAL’ VIEW – MINERALS ARE A BLESSING There has been a generally accepted view that the discovery and exploitation of minerals should assist

the economic and social fortunes of the nation or region that possesses them. As long as the exploitation of these resources is properly managed, the greater the quantity of minerals available, the more economic growth should be generated and greater development achieved. After mineral reserves are exhausted, economic growth and development will be constrained. Yet wise investment of the proceeds of mineral exploitation during the exploitation phase should ensure a different but sustainable economy after the lode has run out. Tilton (1992, p 1) notes that: … the returns from mineral exploitation can be used to build airports and highways, stores and factories, schools and hospitals, and homes and parks. They can enhance political stability by addressing regional and tribal grievances and in various ways bolster economic growth. Mining and mineral processing can also generate jobs, provide opportunities for the development of domestic skills, encourage the creation of associated industries, and provide other beneficial side effects or linkages for the local economy. He goes on to observe that: History documents that mineral resources can indeed facilitate economic development. The Industrial Revolution began in England and quickly spread to Germany and the United States partly because these countries were well endowed with coal and other natural resources. Saudi Arabia and other Middle East oil-producing countries are more recent examples of the positive role mineral wealth can have in economic development.

TABLE 3.2 A revised classification of mineral dependent developing nations. Source: Eggert (2001, 2003) and United Nations Development Programme (2003). Value of HDI

Hard rock

Oil and gas

Marginal or potential

0.800 - 0.849

Chile

Qatar, Kuwait, UAE, Trinidad and Tobago

Cuba, Belarus

0.750 - 0.799

Suriname, Jamaica, Peru

Libya, Colombia, Venezuela, Saudi Arabia, Kazakhstan Oman

Bulgaria, Macedonia, Russia

0.700 - 0.749

Ukraine, Jordan, Uzbekistan

Azerbaijan, Ecuador, Iran, Algeria

Guyana, Armenia, Kyrgyzstan

0.600 - 0.699

South Africa, Tajikistan, Bolivia, Mongolia, Namibia, Botswana

Syria, Indonesia, Gabon, Egypt

Morocco

0.500 - 0.599

Ghana, Papua New Guinea, Togo

0.400 - 0.499 <0.400 Total nations 22

Mauritania, Guinea

Cameroon, Yemen, Nigeria

Zimbabwe, Tanzania, Senegal

Zambia, D R Congo, Mali, Niger

Angola

Mozambique, Burkina Faso, Sierra Leone

21

23

15 Mineral Economics

chapter 3 – Minerals and development A major mineral windfall has the potential to stimulate economic growth, raise incomes and bring increased investment in human and physical capital, which will ensure a nation’s longer-term economic and social success2. In this process it also can spur technological development though the innovation and incubation of technologies. Additionally it can bring lateral migration to other industries, and can enhance linkages with these sectors. This can occur through cluster development around particular minerals and the associated backward, forward and side stream linkages. Furthermore, though mining activities have historically damaged the environment in significant ways, suitable attention to environmental stewardship can minimise this impact.

in influencing the process of development for mineralrich economies3. These are: 1. External market forces such as declining real mineral prices, declining terms of trade of mineral producing nations and mineral price volatility. 2. Internal economic stresses which, in particular, lead to reduced economic growth because of Dutch disease effects. 3. Forces of political economy that adversely affect the integrity of national institutions and make an economy work less efficiently. These forces may foster corruption, lead to excessive rent seeking by affected local communities and small regions, cause civil wars or delay desirable investments in human capital development.

This optimistic view of the impact of major mining activity seems to apply to many nations, with Australia and Chile being positive examples. We consider each of these cases later in the chapter.

Let us consider each of these areas in turn.

External market forces The view of most scholars writing in this area is that real mineral prices, ie mineral prices adjusted for the effects of inflation, followed a downward trend during the period between 1870 and 2000.

AN ALTERNATIVE VIEW – MINERALS ARE A CURSE Some background discussion

Two studies in this area are the highly respected Barnett and Morse (1963) monograph and the paper by Sullivan et al (2000). The former study covers the period between 1870 and 1957 while the latter focuses attention on data from 1900 to 1997. One of the key Sullivan et al (2000) diagrams, covering a composite index of prices for gold, copper, iron ore, lead, zinc and seven industrial minerals between 1900 and 1997 appears in Figure 3.1. While there was considerable price variation from year to year, there was a clear downward trend during the 20th century.

Despite increases in measures such as the Human Development Index in many mineral-rich developing nations, some influential observers have argued that the economic performance of the world’s mineral economies over the past four decades has not been impressive. There are also some interesting historical examples of minerals-poor nations outperforming minerals-rich nations.

For example, by concentrating on trade, rather than mineral exploitation, the Netherlands economy, with few natural resources, grew and developed more More recently, Svedberg and Tilton (2006) have quickly than mineral-rich Spain in the 17th century questioned these broad findings in a study of the real as well as its own resources, Spain in that period had price of copper between 1870 and 2000. Stimulated by access to great mineral riches in its colonies in the New #$%&$!'()*%+)*!%,!-./%0.-1!%,!+23!,%4+%5%&'+3!%+!3$.!6+%3.-!73'3.,8!!92#.0./1!'!-%,&),,%2+! the findings of Boskin et al (1996), who suggested a 25!'()*%+)*!:/%&.,!%,!%+&()-.-!;.&'),.!25!%3,!.&2+2*%&!,%4+%5%&'+&.8! World. ! historical upward bias in the US Consumer Price Index,

567&89'(--1':'(**

<0./'((1!3$.!3/.+-!25!%+5('3%2+='->),3.-!:/%&.,!,$2#+!%+!3$.!&2*:2,%3.!%+-.?! In a different setting, Switzerland, Japan, Singapore, -.&(%+.-!3$/2)4$2)3!3$.!"@ they suggested3$!&.+3)/A8!!B$.!),.!25!*%+./'(!*'3./%'(,!%+!3$.!6+%3.-!73'3.,! that a similar upward bias in the value South Korea and Taiwan were resource-poor miracle %+&/.',.-!-)/%+4!3$%,!3%*.5/'*.!32!*..3!3$.!+..-,!25!3$.!.&2+2*A8!!B$.!-.&(%+%+4!(2+4= of the US Producer Price Index (their price deflator) economies in the late 20th century. In the same period, 3./*!:/%&.!3/.+-!%,!3$.!/.,)(3!25!'-.C)'3.!,2)/&.,!25!,)::(A1!&2*:.3%3%2+1!'+-!/.-)&3%2+!%+! had influenced real price estimates of copper over this 3$.!&2,3,!25!:/2-)&3%2+8!   the economies of mineral-rich nations such as Zambia, ,+* the Democratic Republic of Congo, Sierra Leone, Angola, Nauru, Guinea, Papua New Guinea and Jamaica ,** performed poorly after achieving their independence. (+* Similarly the mineral-rich South American nations such as Peru, Bolivia, Ecuador, Colombia and Venezuela also (** had less than impressive economic growth rates in the period from 1970 until the late 1990s. +*

In their review of this discussion the authors of Breaking New Ground, the final report of the Mining, Minerals and Sustainable development project (International Institute for Environment and Development, 2002), identify the interplay of three broad groups of factors

*

For a clear exposition of this argument see Davis and Tilton (2005).

Mineral Economics

(-(*

(-,*

(-.*

(-/*

(-+*

(-0*

(-1*

(-2*

(--*

,***

3&4%

!

2

(-**

Figure   Fig 3.13.1   - A composite price index for key industrial and metal commodities !"#$%&'()''D2*:2,%3.!:/%&.!%+-.?1!%+!&2+,3'+3!EFFG! -2(('/,8 (United States) – 1900 1997 (source:aSullivan et cal,ommodities   2000). A  composite   price   index   for  kto ey   industrial   nd  metal   –  United   ! States  -­  1900  to  1997  

3

Eggert (2001) used a version of this taxonomy in his paper.

23

chapter 3 – Minerals and development period. Their calculations suggested that the ‘real’ real copper prices in 2000 were either at similar or higher levels (depending on assumptions about inflation bias) than they had been in 1870. In the conclusions to their paper, Svedberg and Tilton suggested also that trends in the long run real prices for petroleum, lead, zinc and tin were similar to those of copper. By contrast, the real prices for aluminium, nickel and silver seemed to have fallen over time. Over the past decade, there has been a dramatic upswing in the real prices of most minerals. These have had a positive effect on the prospects of established and potential mineral producing nations. Another measure of the impact of external market forces is movements in a country’s terms of trade. A nation’s terms of trade are the ratio of the price of its exports to the price of its imports. Changes in their terms of trade provide a measure of the perceived difficulties or advantages facing countries that depend on natural resource based exports. Averaging almost 40 per cent of total exports annually, minerals and energy have been Australia’s major export category for the past half a century. As can be seen from Figure 3.2 – estimated by the Australian Bureau of Statistics – until 2000, our terms of trade were falling. This situation was similar to that of many of the mineral dependent developing nations. It implied that such nations needed to produce more and more over time to cover their import expenses. Yet what matters is profit (or rent), not price. If the price of a commodity is falling more slowly than its costs, then the declining terms of trade can be coincident with improving welfare. This seems to have applied to Australia. Also, particularly since soon after 2000, mineral price trends began rising strongly. The terms of trade of many mineral exporting nations rose significantly after 2003.

New York Mercantile Exchange (NYMEX or COMEX). It is relevant both for government policy makers, as well as for mining and oil company executives. Governments prefer stable and predictable flows of taxes and royalties to assist national economic management. During periods of high mineral prices, politicians’ expectations about the future are typically optimistic. Indeed they may well be over-optimistic. Governments in mineral-rich nations may be tempted to borrow large amounts to finance development in other sectors of the economy, expecting that revenue flow will easily meet debt repayments. When mineral prices fall, this has often brought major external debt problems. Shareholders count on mining company executives producing healthy profits, while the broader community expects them to be good corporate citizens, whether at local, regional or national level. Part of this latter expectation relates to environmental management, part to contributing to local communities and regions, and part to paying taxes and royalties. Mining company workforces anticipate competitive working conditions in the often remote and difficult conditions in which mines and oil wells are located. Senior managers and company boards face major challenges to satisfy each group of their stakeholders. In their study of metal price volatility for the six metals traded on the London Metal Exchange between 1972 and 1995 – aluminium, copper, nickel, lead, tin and zinc (Brunetti and Gilbert, 1995) found that volatility had remained relatively stable over the period. There had been high volatility associated with two periods of tight demand. Nickel prices had tended to be the most volatile and copper the least volatile among the group. With greater speculation in mineral markets, the price volatility of key minerals in the past decade has increased.

(("#

Internal economic stresses

(""#

Much of the discussion in this area has focused on whether or not a nation experiences the Dutch disease. This describes the distortions that take place in an economy as result of a temporary or sustained increase in export earnings. First used by journalists in The Economist magazine in 1977, the term ‘Dutch disease’ refers to the experience of the Dutch economy during the North Sea oil and gas boom in the mid-1970s. A large minerals and energy discovery4 will typically:

'"# &"# %"# $"# !"# ('$"#

('$!#

('%"#

('%!#

('&"#

('&!#

(''"#

(''!#

)"""#

)""!#

)"("#

Fig 3.2 - Australia’s terms of trade – 1960 to 2010 (2008 = 100).

Figure  3.2  

Australia’s  Terms  of  Trade  –  1960  to  2010    (2008  =  100)  

The volatility of mineral prices – their movement around a long-term price level or trend - is also an issue. This seems particularly the case for gold, as well as for the mineral commodities traded in terminal markets such as the London Metal Exchange (LME) and the 24

•• increase a nation’s mineral exports (or reduce its mineral imports) •• raise the real exchange rate of its currency •• drive up wages and inflation, at least in the shortterm. 4 As Corden (1984) notes, Dutch disease may also emerge because of a once off ‘exogenous’ technical improvement in the ‘booming’ sector or an ‘exogenous’ rise in the price of its product on the world market relative to the price of imports. Mineral Economics

chapter 3 – Minerals and development It may also: •• increase wealth and income inequality. Higher exchange rates make it difficult for the nonmineral sector ‘tradeable goods’ local industry to compete with imports, which have suddenly become cheaper in terms of the local currency. While the booming sector (eg mining) will typically cope with this situation, ‘lagging’ industries, such as agriculture and manufacturing, will struggle. As a result, they may have to cease or severely contract their operations. When the boom subsides, and exchange rates return to lower levels, it may be difficult to re-establish these industries. Corden and Neary (1982) and Corden (1984) developed a series of Dutch disease models, which analysed an economy that consisted of three sectors. These were: 1. a booming tradeable goods sector (say mining) 2. a lagging tradeable goods sector (say manufacturing and agriculture) 3. a non-tradeable goods sector (services/government/ construction). They identified two main channels through which Dutch disease operates. The first is a resource movement effect, where the booming sector attracts capital and labour from the other sectors with higher wages and drives up wages in each. Resource movements from the lagging sectors into the booming mining sector undermine the diversity of an economy and lead to dependence on fewer industries.

We noted in Chapter 1 that mines generate economic rent, but we have not yet discussed the concept in detail. Two equivalent definitions of economic rent are as follows: 1. it is a surplus in excess of the minimum profit required by shareholders in a company or firm to stay in business, or 2. it is the payment that any good (commodity) or service receives in excess of its supply price when a market is in equilibrium. In their well-known treatise, Garnaut and Clunies Ross (1983) provide the following definition of mineral rent: Mineral rent may be defined as the returns in excess of those needed to attract factors of production into the mining industry in the long run. It is the revenue remaining after all costs have been deducted. These costs include exploration outlays, expenditures on mine establishment and cash operating costs. Unlike the accountant’s notion of costs, economic costs include the returns on capital invested which are just sufficient to attract the capital to the enterprise. It is typical to illustrate economic rent using a diagram such as Figure 3.3 where the supply curve for producing mines is shown by SS’, and the equilibrium price that clears the market is P. The economic rent generated in this case will be given by the area of the triangle SPQ’.

But there is also a spending effect, where additional income generated in the booming sector is spent in other parts of the economy. Increased spending from the booming sector and the effects of inward migration increase the size of the domestic market for lagging industries and may allow them to reap the benefits of greater economies of scale. Though identified for the Dutch economy and popularised by authors such as van Wijnbergen, the ‘Dutch disease’ has a much longer history and has applied in many other economies. There is now extensive literature identifying the effect of the phenomenon in Australia, Nigeria, Indonesia, Botswana, Chile, Mali, Saudi Arabia and many other nations.

Forces of political economy In addition to the potentially negative impacts of external economic stress, and internal economic pressures associated with Dutch disease, mineral-rich developing nations may also be subject to political forces which arise from a number of interrelated causes. These may foster corruption, lead to excessive rent seeking by affected local communities and small regions, cause civil wars or delay desirable investments in human capital development. Mineral Economics

Fig 3.3 - The rent of mines in a competitive market.

Let us think for a moment what this means in the context of the operation of the Western Australian gold industry. As this chapter is written, the price of gold is more than $US1600/oz. There are about 40 gold mines operating in the state. It is possible to generate a supply curve similar to SS’ for these producers. The amount produced in the state has been around 200 t/a (say six million ounces) for much of the past 25 years. This corresponds to the distance 0Q. 25

Chapter 3 – MIneralS and developMent The lowest cost producer in the state has an average cost, of say, $US400/oz, while the most marginal mine produces at over $US1600/oz. The first producer will generate an economic rent of $US1200+ per ounce, while the second reaps no rent. Producers in between will generate varying amounts of rent. Hence if Australia’s largest gold mine – the KCGM super pit in Kalgoorlie – produced 600 000 oz of gold in 2012 at a total cost (plus acceptable return on capital) of say $1000/oz, it would generate 600 000 × $600+ or more than $US360 M of economic rent. It is possible, in principle, for government to tax away all of this rent and redistribute it to other parts of the economy, while the mine still operates at its present capacity. Yet, as shall see in Chapter 13, it is practically feasible for government only to access part of this amount. Important for the present discussion, are the key points about mineral rent made by Garnaut (1995). They are: • •

•

mineral rent can be absorbed by any party which has veto power over mine development, or mineral rent can be dissipated by uncertainty as conflict between holders of the veto power raises the supply prices of inputs into production, or both of these things can happen.

Any group of people who can delay or prevent the approval, construction, or operation of mines or oil and gas wells can exert this pressure. Members of local communities close to a mine, for example, may wish to obtain more of the rent to ensure what they perceive to be their long-term sustainability. Members of nearby Indigenous populations may take a similar view. Where new mineral development interferes with their cultural heritage, they may try to prevent it taking place. Conservation and environmental groups may seek either greater environmental regulation, which is more costly to the mining companies, or propose that mines not proceed at all because they will cause irreparable long-term damage to the surrounding physical environment. Whether rent-seeking behaviour is excessive or not depends in large part on how each veto holding party perceives the outcome of negotiations about the sharing of rent. If a mining company is considering starting a new mine in a mineral rich developing nation, there will be negotiations with local Indigenous and other communities, regional governments, national governments, environmental lobby groups and perhaps some other non-government organisations (NGOs). Each group will have the ability to seek rent payments in varying degrees. Some of their demands may be so large that they eliminate the profitability of the project. Senior executives of a mining company will have to be confident that a project will be profitable if it is to proceed. There are many cases where companies do not 26

proceed with mineral resource development projects because they judge that claims on economic rent will be excessive. The potential of considerable new riches may also distort policy-making processes and encourage corruption. A standard definition of corruption is ‘the misuse of public or entrusted authority for personal gain’ (World Bank, 1997). So corruption can occur in both the public and private sectors. Transparency International (2011) makes annual estimates of the perceived level of corruption in a broad cross-section of countries. In 2010 they estimated their Corruption Perception Index for 178 nations. The range of the measure is from zero (extreme corruption) to ten (a total lack of corruption). Perceived corruption is considerably less in developed than in developing nations. One recent study on mining and corruption by Petermann, Guzmán and Tilton (2007), for the period from 1998 to 2002, found that fuel and non-fuel mineral exports affected corruption differently. Corruption increased as fuel exports increased. But non-fuel mineral exports were associated with increased corruption only in poor countries, particularly those exporting high value mineral commodities, such as diamonds and gold. In richer countries, such as Australia non-fuel mineral exports were associated with reduced corruption. While at the early stages of development advances in per capita income in mineral economies were associated with increasing corruption, greater economic development, reflected by rising per capita incomes, ultimately reduced corruption. So, at least for non-energy mineral exporting nations a relationship between corruption and development of the as shown in Figure 3.4 seemed to apply. The message for any company considering resource sector investment in a developing mineral economy is clear. ‘Expect greater levels of corruption than if you are investing in a developed nation’.

 

FIg 3.4 - Non-energy mineral exports and corruption.

 

Figure   3.4         government and well-formed institutions Stable Non-­energy   mineral  are exports   and  corruption   in any nation more likely to facilitate the orderly development of a competitive minerals and energy sector. When such institutions do not exist, or they

Mineral economics

chapter 3 – Minerals and development have been undermined because of political change, then excessive rent seeking and corruption may emerge. When most African nations became independent, few had properly formed institutions and there were not many well educated citizens with the background and experience to lead them effectively. In a somewhat different fashion, the demise of the Soviet Union was associated with institutional breakdown, the rise of criminality and corruption in many of its former republics. Where newly independent mineral-rich nations consist of disparate ethnic and cultural populations, institutional structures are poorly formed, and human capital levels are low, there have been larger numbers of civil wars. Ross (2001, p 15) identified 14 civil wars in resource rich nations between 1965 and 2000. Nine were in Africa (in nations such as Angola, Algeria, Mozambique, Nigeria, the Democratic Republic of Congo (formerly Zaire), Liberia and Sierra Leone), two in Indonesia (Aceh and West Papua), two in the Middle East (Iraq and Yemen) and one in Oceania (the Bougainville conflict in Papua New Guinea). The practice of colonising nations drawing geographical boundaries, which did not coincide with ethnic and cultural homogeneity, in combination with weak institutions, has also often been associated with military coups and poor government. In Chapter 2, we saw the argument by McDivitt and Jeffrey (1976) that mineral exploitation has the potential to upgrade labour skills and implant concepts of entrepreneurship and we have commented on this possibility in this chapter as well. Yet authors such as Gylfason (2001) have argued that higher levels of natural resource abundance have been associated with lower levels of investment in education. Using data for the period between 1980 and 1997, he argued that natural resource rich nations neglected the development of their human resources, spending lower percentages of their national income on education.

The resource curse thesis It became apparent in the late 1970s that the economic performance of several developing nations with large mineral and energy endowments, measured particularly in terms of real GDP growth, did not apparently coincide with traditional expectations. As a result a new argument emerged. It is that, despite the positive experiences with mineral exploitation and economic development with some of the countries previously mentioned (eg Australia, Canada, USA, Norway, Chile, etc) that a mineral windfall brings net economic loss to a developing nation. As a result of a mineral resource windfall, the combination of the: •• external market forces •• internal economic stresses Mineral Economics

•• forces of political economy that erode the integrity of national institutions and make an economy work less efficiently results in an outcome which is captured schematically by Figure 3.7. Nankani (1979) observed this generally for all mineral exporting economies, while Gelb (1985) considered the situation in the oil-rich economies. Although Gelb found mixed outcomes in his country case studies, Gelb et al (1988) subsequently posited the existence of a ‘Resource Curse’ thesis for the oil-rich developing nations. Auty (1993) extended the argument that a resource curse applied also in most of ‘hard rock’ developing mineral economies. In an econometric study of the economic growth experiences of 97 nations between 1970 and 1989, Sachs and Warner (1995) provided further empirical insight. They have subsequently published further papers in the area and several other authors have written about these issues. Before proceeding further, it is useful to reflect on the generally understood meaning of the resource curse hypothesis. Auty (1993) argues that the essence of the resource curse view is that: ... the economic performance of nations with a significant mineral (or other natural resource) endowment may be worse than those without such endowments. Atkinson and Hamilton (2003, 1793) perceive that it is: ... the paradoxical but seemingly robust finding of a negative and significant relationship between natural resource [abundance]5 and the growth rate of per capita gross domestic product (GDP). Sachs and Warner (2001, p 827) describe ‘the curse of natural resources’ simply as ‘the observation that countries rich in natural resources tend to perform badly’. If growth in real GDP, or real GDP per capita, is a reasonable proxy for economic performance, then it would seem that minerals may have been a curse since 1970 for those nations that possess them. The combination of external market forces, internal economic stresses and distorted processes of policy-making during the three decades until 2000 combined to bring this about. One could describe such an outcome in terms of the simple diagram depicted in Figure 3.5. After the initial upward impact of the new resource development, the negative impacts associated with falling mineral prices, price volatility, Dutch disease, corruption and poor policy decisions come into play. By the time that the economy has adjusted, it is behind where it would have been without the resources windfall. It then begins to grow at the same rate, as it would have without the mineral windfall. This is the key argument – that it is behind where it would have been. 5

The absence of ‘abundance’ or a similar word from the definition seems to have been a typographical oversight.

27

chapter 3 – Minerals and development The first of these variables, the logarithm of GDP per capita in the initial year, has been used in many studies to allow for the observed tendency of affluent countries to grow more slowly than poor countries. Their additional initial variables reflected: •• trade policy openness •• average annual rates of change in the terms of trade •• gross domestic investment as a percentage of GDP Fig 3.5 - A simple view of the resource curse hypothesis.

One way of classifying the empirical studies about whether minerals have been a curse or a blessing is to use the following three-part taxonomy: 1. the case study based analyses of growth in real GDP per capita of by Gelb (1985) and Gelb et al (1988) and by Auty (1990, 1991, 1993 and 1994) 2. the regression-based econometric analysis of growth in real GDP per capita associated particularly with the key study by Sachs and Warner (1995), several further studies by the same authors, and a series of related studies by authors such as Gylfason (2001), Atkinson and Hamilton (2003) and Lederman and Maloney (2002) 3. the more broadly based comparative data analyses authors such as Davis (1995). The studies by Gelb and his colleagues focused on the oil rich economies that had emerged in the wake of the OPEC oil price rises in the 1970s. Though Auty’s initial papers were on oil and gas rich nations, much of his subsequent work has concentrated on the non-oil ‘hard rock’ mineral economies. Both Gelb and Auty argued that the average GDP per capita growth of mineral and energy rich nations from the 1970s onwards had been disappointing. Their contributions have attracted considerable attention. Yet it has been the subsequent contributions of Jeffrey Sachs and Andrew Warner that have had the greatest impact so far on the debate about whether minerals are a blessing or a curse in developing nations. In their 1995 study, they used multiple regression analysis for a cross-section of 97 developed and developing nations between 1971 and 1989 and considered factors that explained differences in real GDP per worker growth (for the economically active population). While interested particularly in the impact of natural resource dependence (among which minerals are a major contributor) they also considered a number of other variables. Their model takes the form: Growth in real GDP per capita (of economically active population) = γ (Log GDP per capita in initial year) + a (natural resource exports/GDP) + β’ (additional variables) 28

•• bureaucratic efficiency (indicating ‘corruption, red tape and judicial independence’) •• income inequality. In their later studies, they have reported results for slightly different variables and time periods. After allowing for the impact of all of the above factors, Sachs and Warner find that a negative relationship remains between resource abundance and economic growth. This is the ‘resource curse’ effect. With more widespread availability of key macroeconomic data from nations around the world since 1970 it is now possible to run the Sachs and Warner regressions to cover the three decades until 2000. Such regressions generally continue to support the Sachs and Warner initial conclusions for the period between 1970 and 19896. In the light of our above historical observations about the positive impact of mineral development of nations such as Australia, these findings come as a surprise. But Sachs and Warner (1995, p 1) argue as well that: The oddity of resource-poor economies outperforming resource-rich economies has been a constant motif of economic history. In the seventeenth century, resource-poor Netherlands eclipsed Spain, despite the overflow of gold and silver from the Spanish colonies in the New World. In the 19th and 20th centuries, resource-poor countries such as Switzerland and Japan surged ahead of resource-rich countries such as Russia. In the past thirty years the world’s star performers have been the resource-poor Newly Industrialising Economies (NIEs) of East Asia – Korea, Taiwan, Hong Kong, Singapore – while many resource rich economies such as the oil-rich countries of Mexico, Nigeria, Venezuela, have gone bankrupt. Even though there are problems with the availability of reliable historical data on Gross Domestic Product and natural resource intensity differences between nations, Lederman and Maloney (2002) have recently taken up he empirical issue of considering their relationship in earlier periods. They use the GDP data of Maddison (1995) during five periods: 1. 1820 - 1870 (19 countries) 2. 1870 - 1913 (23 countries) 3. 1913 - 1950 (32 countries) 6

The basis of this claim is from regressions undertaken by al Rawashdeh (2004). Mineral Economics

chapter 3 – Minerals and development 4. 1950 - 1973 (37 countries) 5. 1973 - 1989 (37 countries). They also assume (probably somewhat unrealistically) that the ratio of natural resource exports to GDP for the nations involved between 1820 and 1970 had remained constant at 1970 levels. Because of data limitations, they did not include additional variables in the specification of their model. With this simpler specification, they found a positive relationship between real GDP growth and natural resource exports as a percentage of GDP between 1820 and 1870, and between 1913 and 1950. There were negative relationships between 1870 and 1913, 1950 and 1973, and 1973 and 1989. But t values were only significant at the five per cent level in the final two periods. While tentative, these findings question the validity of the Resource Curse hypothesis thesis over longer periods. Despite their preliminary nature, these findings seem consistent with what has happened in countries such as Australia. Two other empirical studies by Gylfason (2001) and Torvik (2002) have extended the Sachs and Warner analysis. Gylfason argued that, on average, nations with higher percentage levels of natural capital7 (subsoil mineral and energy assets, farming and grazing land, forests and fisheries) experienced slower growth in real GDP per capita between 1965. He posited that natural capital apparently ‘crowds out’ human capital in these nations, with fewer resources allocated to education spending. In his paper, Torvik argued that natural resource abundance crowds out entrepreneurial activity. Many commentators have expressed doubt about whether GDP is the most appropriate measure of total production. For example, it excludes productive non-market activities, as well as those in the informal economy. Any measure of production should also allow for the capital depreciation. For these reasons, national accounting systems struggle to measure production in developing nations. Hence, comparing GDP per capita levels between nations are often misleading, even after allowing for purchasing power parity differences. As briefly noted in Chapter 2, a more fundamental critique of GDP accounting has arisen from ecological economists whose alternative measures suggest that production is declining. An alternative approach is to explain and analyse variations in a broader range of variables that reflect economic and social development. Since development involves several dimensions other than income growth, this might involve econometric modelling that seeks to explain variations in variables other than income – eg human development indices. At a more rudimentary level it may simply involve broad data comparisons. 7

The source of Gylfason’s natural capital data was World Bank (1997).

Mineral Economics

Using this later approach, Davis (1995) focused on the experiences of 79 developing nations (largely in the period between 1970 and 1990). Using the criteria outlined in Table 3.1, he defined 22 as mineral economies throughout the period, while 57 were ‘never-mineral’ economies. A summary of his findings appears in Table 3.3. TABLE 3.3 The development progress of long-term mineral economies and never-mineral economies – results from Davis (1995) (source: Davis, 1995). Mean values

22 mineral economies

57 nevermineral economies

Life expectancy (% increase – 1960 to 1991)

31.5

26.2

Infant mortality rate (% decline – 1970 to 1990)

48.9

36.5

Calorie supply increase per capita (% increase – 1965 to 1990)

21.1

9.1

Primary school enrolment (% increase 1970 to 1990)

20.7

16.0

Adult literacy rate (% increase – 1970 to 1990)

47.9

36.0

Human development index (% increase – 1970 to 1990)

23.1

20.3

Davis found greater progress in increased life expectancy, infant mortality decline, nutritional increase, and primary school enrolment and adult literacy rate increases among the developing mineral economies than their ‘never mineral’ counterparts. The percentage increase in the Human Development Index between 1970 and 1990 among developing mineral economies was also higher than among the ‘never minerals’ developing economies sample8. While these findings focus on alternative measures, they may not be at odds with the resource curse view. In the above empirical tests in might be argued that the resource curse only refers to trends in economic welfare, and not their levels. It may be possible to have slow growth and yet have higher development indicators. So where does this leave the empirical debate? Despite the important contributions of authors such as Sachs and Warner in developing a body of econometric analysis about the impact of minerals and energy development on economic growth, much remains to be considered. Further econometric analysis might profitably be extended to consider variations in a wider range of development indicators. If such analysis supports the findings of authors such as Sachs and Warner, whose major interest has been in explaining variations in GDP and GDP per worker growth, then the resource curse hypothesis will be on stronger ground. Supporters of the traditional view doubt that such analysis is possible.

Institutional and policy issues Despite the prognosis of the Resource Curse hypothesis, the historical experiences of nations such as Australia, 8

This trend is unlikely to have continued since 1990 because of the adverse impacts of the HIV/AIDS epidemic on life expectancy in many mineral rich African nations.

29

chapter 3 – Minerals and development which moved from developing to developed status over a relatively short time period suggests that the combination of a favourable mineral endowment, well organised and operated institutions and appropriate government policy can and has led to favourable development outcomes. It is these later elements to which we now turn. The discussion in this section also has links to a more detailed review of mineral policy in Chapters 11 and 12. If one embraced the resource curse hypothesis, mineral rich developing nations would be better off not to exploit their mineral wealth. Yet, as well as the apparently depressing list of bad news stories associated with the economic fortunes of mineral economies, several developing nations have derived positive benefit from mining in the past two decades. Two of the most prominent are Chile and Botswana. Each has received considerable attention in the academic literature9. Others such as Ghana, Namibia, Peru and Tanzania can be added to this list. Chile’s recent experience is of particular interest because, as well as exhibiting strong economic growth, the nation’s recent record with other development indicators has been impressive. Poverty has fallen appreciably, life expectancy has risen to levels similar to those of developed nations, literacy rates are high and the level of post-secondary education has been rising significantly. A summary of some of these trends appears in Table 3.4. Also, notwithstanding the continuing strength of the copper industry, other parts of the economy have been developing strongly and several now are competitive. One way to assess the economic experience of such nations is in terms of the rudimentary framework of Weber-Fahr (2002), which suggests that economic performance (encompassing somewhat more than strong economic growth) in mineral rich nations will depend on both the quality of economic management and the quality and stability of key institutions. The quality of economic management in any nation depends on a number of factors. The calibre and experience of the civil service is important. So is the integrity and training of the politicians who make up the government. This will come under significant challenge if Dutch disease accompanies a resources boom. A simple conceptual formulation might be that: Quality of economic management

= f (quality of civil service & politicians

Level of corruption

Nature of policy

Relative size of resources windfall)

Factors affecting the quality and stability of a nation’s institutions include the size of its human capital stock, 9

30

See for example Auty (1993) on the situation in Botswana, and Maxwell (2004) for a discussion about Chile.

TABLE 3.4 Relative movements of key quality of life indicators in Chile. Source: Maxwell (2004) and World Bank (1993), United Nations Development Programme (2003). Indicator

Chile

High income nations

World

1977

67

75

64

1990

72

77

66

2000

75.3

78

67

2010

79.1

Life expectancy (years)

Infant mortality rate (no per '000 live births) 1970

78

20

85

1990

17

8

52

2000

10

6

2010

9

Adult literacy rate (per cent) 1990

93

95.5

60

1999

95.5

N/A

64

2010

98.6

Percentage of age group in tertiary education 1970

13

36

13

1990

15.6

33

11

1999

37.5

N/A

N/A

Percentage income share of top decile 1990

45.2

N/A

1998

45.3

N/A

2009

42.8

Percentage of population below the national poverty line 1992

21.6

1998

21.2

2009

15.1

Human development index

Very high HD nations

Gap

1980

0.630

0.766

0.136

1990

0.698

0.810

0.112

2000

0.749

0.858

0.109

2010

0.802

0.888

0.086

national ethos about issues of equity such as poverty, income and wealth inequality and the extent of ethnic and cultural differences within the population. It is possible, therefore to hypothesis a relationship of the form: Institutional quality and stability

=f (Human capital stock

Poverty and inequality

Cultural homogeneity

Political harmony)

Joining these two equations together, one might therefore argue that: Mineral Economics

chapter 3 – Minerals and development Economic performance Human capital stock

= f (Policy environment Poverty and inequality

Relative size of resources windfall Cultural homogeneity and political harmony)

where the policy environment variable incorporates a combination of the quality of the civil service, political decision-makers and policies formulated, as well as a lack of corruption. The policy environment, human capital stock and extent of cultural homogeneity and political harmony are all positively related to the process of development. The relative size of the resources windfall and the level of poverty and inequality are inversely related. How a nation develops its mineral energy resources will depend on the interaction of these positive and negative forces. In the case of Chile, it seems clear that the nation has been able to perform well in each of the factor areas, except reduced income inequality, that affect the development process10. There have been some other notable recent contributions to the discussion about public policy have been the World Bank mining group and Richard Auty (the former seem to ascribe more to a resource blessing view with minerals, while the latter sees them more as a curse).

SOME CASE STUDIES The Australian experience Australia’s experience with minerals and energy seems to fit in well with the conventional view. Perceived in terms the key inputs to production, as described in the McDivitt and Jeffrey quotation in the last chapter, as well as in terms of Tilton’s above commentary, the discovery and exploitation of minerals transformed Australia. It moved her from undeveloped to developed status over a relatively short period11. Moreover, the exploitation of minerals underpinned major growth of the Australian economy for much of the second half of the 20th century. This contribution is continuing in the current century.

the first significant economic stimulus from mining, just six years after that colony’s foundation. But it was the gold rushes in New South Wales and Victoria in 1851 that dramatically transformed the Australian colonies. As Blainey (1966) contends, some of the key factors that initially held back the discovery and exploitation of minerals in Australia were poor roads, lack of a railway system, unnavigable rivers and distance from major markets. Yet it was an unlikely and short-lived geographical advantage – the relative proximity of ports like Sydney to California – that acted as a catalyst for emergence of the Australian gold rushes. The discovery of gold near San Francisco in 1848 led to the California gold rushes. Although is more than 10 000 km away on the other side of the Pacific, the 10 week journey by ship from Sydney to San Francisco was less than the 13 week journey around Cape Horn from New York12. For a brief period Sydney became a significant supply port for California. The Australians, who flocked across the Pacific to join the rush, noticed the similarity of the terrain with that in New South Wales. One person who made the trip without success was Edward Hammond Hargraves. Returning to Sydney, the entrepreneurial Hargraves travelled to Hill End (some 280 km west of Sydney and close to the town of Bathurst) where he showed some local shepherds how to search for gold. In collaboration with two of these men, he discovered the yellow metal on 12 February 1851. Hargraves subsequently returned to Sydney, where he advised the Colonial Secretary of New South Wales that he had discovered gold. In his colourful quote, Shaw (1966, 65) captures the atmosphere effectively: On 3 April 1851, occurred an event which radically changed the character of the Australian colonies and tremendously hastened their development. Edward Hammond Hargraves officially notified the Colonial Secretary of New South Wales that he had discovered gold near Bathurst. It was a memorable day. Its effects were tremendous. There was an immediate rush to New South Wales from the other colonies; to stop this a committee of Victorian businessmen on 9 June offered a reward of £200 for the discovery of gold within 200 miles of Melbourne. It was claimed next day. By the end of the year (1851) rich fields near Ballarat and Bendigo and other minor discoveries made Victoria, not New South Wales, the magnet for the diggers.

The British established their first settlement in Australia at Port Jackson (Sydney) in 1788 with a small group of convicts and a military detachment. But mineral exploitation made little contribution to the continent’s development until the 1840s. By this time, separate colonies had been established in each of the regions that became Australia’s six states at Federation in 1901. The discovery of copper in South Australia in 1842 provided

The summary information in Table 3.5 provides some insight into the effect of major mining discoveries and subsequent mineral exploitation on Australia’s population growth. This impact has also been associated

10 For a more detailed discussion on this issue see Maxwell (2004). 11 Several economic historians have written authoritatively about the topic. Notable among them have been Blainey (1966, 2003), Sinclair (1976) and Shaw (1966).

12 There were no roads or railways, which traversed the United States at that time. The Panama Canal was not completed until 1914, though a railway following a similar route to it was finished in 1855.

Mineral Economics

31

chapter 3 – Minerals and development TABLE 3.5 Mining and Australian population growth 1788 - 2011. Year

Total population (mill)a

M/F ratio

Main events in preceding period

1788

0.001

na

Convict settlement (New South Wales)

1800

0.005

2.63

Convict settlement

1820

0.034

2.44

Dominance of whaling, emergence of agriculture (Foundation of Tasmania in 1803)

1840

0.190

2.02

Decline of whaling. Agriculture strong, new colonies (Queensland, Victoria, South Australia, WA)

1850

0.405

1.43

New colonies emerge. Irish famine, Copper mines in South Australia

1860

1.146

1.40

Gold Rushes (Bathurst, Ballarat, Bendigo etc)

1870

1.648

1.21

Mining strong, emergence of railways, faster ships

1880

2.231

1.17

Continuation of above trends. Emergence of Tasmanian mines, telegraph service

1890

3.151

1.16

Broken Hill rush, new gold finds, railway boom

1900

3.765

1.11

Major national recession, bank failures, Western Australian gold rush

1911

4.455

1.08

Federation, continued strength of mining

1921

5.435

1.03

First World War, copper boom

1933

6.629

1.03

Stock boom of 1920s, decline of mining and mining towns, beginning of Depression

1947

7.579

1.004

Effects of Depression, Second World War

1954

8.986

1.032

Post-war boom, major new migration, promotion of manufacturing, uranium mines

1961

10.548

1.022

Strong economic growth, migration, manufacturing, major bauxite finds

1971

13.067

1.022

Continued mining expansion, new finds of iron ore, off-shore petroleum, nickel, coal

1981

14.932

1.005

Mining boom, stagflation, major rises in oil prices

1991

17.085

0.99

Resurgence of gold mining. Iron ore, coal, nickel and copper maintain strong performance

2001

19.50

0.98

Recessions at beginning and end of decade. Mining retains strong domestic profile. Australian mining companies invest offshore

2011

22.65

0.992

Major mining boom after 2003 with rise of China, emergence of India and world economic prosperity. Financial crisis in 2008 and 2009 but recovery in 2010

Sinclair (1976, p 79) notes: ... the discovery of alluvial gold must be regarded as a major discontinuity. The significance of this for the course of Australian economic development was heightened by the rapidity with which gold was extracted from the ground. Australia became the world’s leading gold mining nation as production rose from zero in 1851 to more than 90 tonnes in 1856. It then declined gradually to around 50 tonnes per annum in 1865. Blainey (2003, p 62) observed that: Possibly no other country in the world has been so quickly transformed by metals; the normal growth and achievement of several decades were crammed into one. Australia ceased to be a land of exile in British eyes and became a respectable field of migration and [beginning with capital-intensive underground mining in 1886] investment. .... The swift growth of population widened the market for Australian manufactures and foodstuffs. It stimulated farms and factories and workshops and cities. Gold drew population into the interior and attracted railways from the ports. Bendigo and Ballarat in 1862 got the continent’s first upcountry railways, and cheap transport stimulated farming. The impact of the gold rushes shows up in the estimates of average annual real GDP growth and GDP per capita growth that appear respectively in Figures 3.6 and 3.7. Since the Australian government began producing the national accounts in a formal way only during the 1950s, the earlier estimates come from Butlin (1962), and McLean (2004). They cover ten-year periods and therefore do not reflect considerable annual variations in the rate of growth.

a. Aboriginal population not included until 1971.

with sustained economic growth and associated economic development. Even though the British government established six colonies during the first 50 years of settlement, the European population grew slowly until 1840, when it stood at 190 000. This growth related particularly to Australia’s status as a convict destination, the rise and fall of whaling and the development of agriculture. While the European population more than doubled to 405 000 by 1850, partly as a result of the discovery of copper in South Australia, it was gold that brought dramatic change. 32

Fig 3.6 - Estimated percentage average real GDP growth in the Australian

Economy on a decade by decade basis - 1830 to 2010.

As also can be seen also from Table 3.5, Australia’s population almost tripled between 1850 and 1860, and it continued to grow significantly in the following decades. In addition to stimulating the development of key industry sectors such as agriculture, manufacturing, Mineral Economics

chapter 3 – Minerals and development TABLE 3.6 Estimated gross domestic product per capita (in 1990 Geary Khamis dollars)a for selected nations - 1820 to 2006. Source: Maddison (1995), Groningen Growth and Development Centre (2011). Year

Fig 3.7 - Estimated percentage average real GDP per capita growth in the

Australian economy on a decade by decade basis – 1830 to 2010.

construction and transport, the 1850s Gold Rushes inspired other major mineral discoveries. These new finds included gold in several areas of Queensland from the late 1860s, tin in northern New South Wales during the 1870s, copper, gold and tin in Tasmania between the 1870s and 1890s, gold in the Northern Territory in the 1870s, and gold in Western Australia from the early 1880s. By 1900, following the Western Australian gold rushes of the 1890s, Australia’s gold production had risen to close to 100 t/a. Most Australian colonies satisfied the measures of mineral dependence suggested above by Davis (1995) for much of the period between 1851 and 1914. Not only did Australia’s Gross Domestic Product per capita increase dramatically during the 1850s. It grew during every succeeding decade (except the 1890s) until the beginning of World War I (see Table 3.6). Although coal, gold iron ore and base metal mining continued in established areas such as the Hunter Valley, the Illawarra, the Latrobe Valley, Broken Hill and the Eastern Goldfields of Western Australia, mining declined in its relative and absolute importance. By 1960 the minerals and energy sector accounted for little more than one per cent of Gross Domestic Product and only around five per cent of exports. This compared with the situation one hundred years earlier in which Butlin estimated that mineral production had accounted for more than 15 per cent of GDP and perhaps 80 per cent of exports. Two key series of events then occurred. In 1960, the British government decided to join the European Free Trade Association. This led in 1973 to UK membership of the European Economic Community (now the European Union). This had a negative effect on the competitiveness of Australian agriculture. But offsetting this, the rise of the Japanese economy, followed by the emergence of the Asian Tiger economies of South Korea and Taiwan, created an offsetting opportunity for the Australian minerals and energy sector. Associated with this new opportunity, there were major discoveries of: Mineral Economics

Australia

Chile

1820

518

694

1840

1374

751

1860

2894

1094

1870

4138

1290

1880

4285

1890

4458

1900

Japan

South Korea

USA

UK

669

600

1257

1706

N/A

N/A

1588

1749

N/A

N/A

2178

2830

737

604

2445

3190

1740

863

N/A

3184

3477

1966

1012

N/A

3392

4009

4013

2194

1180

N/A

5079

4492

1910

5210

3000

1304

815

4916

4611

1920

4766

2768

1696

1092

6602

4548

1929

5263

3455

2026

1118

6899

5503

1940

6166

3236

2874

1600

7010

6856

1960

8791

4270

3986

1226

11 328

8645

1980

14 412

5680

13 428

4 114

18 577

12 931

2000

21 732

10 309

20 738

14 375

28 467

20 353

2006

24 343

12 516

22 462

18 356

31 049

23 013

a. The Geary Khamis method computes a hypothetical unit of currency with the same purchasing power as the US dollar at a hypothetical point in time (eg 1990).

•• coal (in New South Wales and Queensland) •• iron ore in Western Australia •• oil and gas in the Bass Strait, on the North West Shelf of WA and in the Cooper Basin in South Australia •• bauxite in Western Australia and Queensland •• nickel in Western Australia and Queensland •• copper and other base metals in Queensland and South Australia •• diamonds in Western Australia •• mineral sands in Western Australia. Australia emerged as a world-class producer and exporter in many of these areas. This was particularly the case for iron ore, bauxite and alumina, and mineral sands, where it soon ranked as either first or second in production. While Australia was not the largest coal producer, the high quality of the hard coal in the East Coast mines made it the leading exporter in this market. Even in the field of oil and gas, the significant finds in the Bass Strait and then on the North West Shelf gave Australia a greater level of self-sufficiency in petroleum, and made it a significant exporter of natural gas. As part of the Bretton Woods gold exchange standard that governed the international exchange rate system in the 1950s and 1960s, gold had a fixed price of $US35/oz. Under this regime Australian gold production languished. In the 1950s and early 1960s at just over 30 t/a, it was less than a third of what it had been in 1900. But worse was to come. The rise of inflation in Australia, combined with a strong Australian dollar in 33

chapter 3 – Minerals and development the early 1970s, made gold mining even more marginal. By 1976, Australian gold miners produced only 15 t and in 1980 only 17 t. The twin towns of Kalgoorlie and Boulder, which had stood as the nation’s ‘gold capital’ for more than 80 years, survived on the newly emerging nickel sector. But the demise of the Bretton Woods system also led a change in the status of gold, with citizens of many nations now able to purchase it as a private asset. In the uncertain 1970s, dominated by unexpected events such as the OPEC oil price rises and the Iran hostage crisis, the demand for gold rose, and so did its price. By 1976 it had reached $US160 per ounce. By 1979 it was $US300/oz. In 1980, it peaked at $US800 per ounce. Furthermore, by this time, the value of the Australian dollar had also fallen back from its high levels of mid1970s. Even though many of the near surface high-grade deposits had been exploited, the emergence of metallurgical processes such as carbon in pulp leaching, in combination with greater exploration and the development of open cut mining in a major way, brought a dramatic re-emergence of the Australian gold sector. With its price holding at around $A500/oz for much of the past two decades, Australia emerged again as a major gold producer. In 1990, its miners produced 244 t, more than double the amount of ninety years earlier. At its peak in 1997, Australian mines produced more than 300 t. In 2010 production stood at 266 t. Through its Industry Commission, the Australian government published a major study of the minerals and energy sector in 1991. It noted that: An indication of the importance of mining and earlystage minerals processing to the Australian economy is that these industries account for almost a tenth of national output (and an even higher proportion of investment spending) while employing just over 2 per cent of the workforce. During the 1960s, the proportion of mineral resource sector exports started to rise again. In 1974 they passed thirty per cent for the first time since the period immediately prior to World War I. They remained at this level for three decades before rising even further during the post 2004 minerals boom. Not only has mining emerged domestically in a major fashion. Australian-based mining companies began investing internationally in a major way in the 1990s. By 1999, Australian-based companies were active in about 80 nations – see for example Maponga and Maxwell (2000). The mining services sector has also emerged as a major source of international competitiveness, with Australian mining professionals now travelling throughout the world to provide their services.

The case of Chile As in Australia, there was a significant and long-standing Indigenous population before European settlement. 34

The Spanish conquest began in 1536 when Diego de Almagro ‘discovered’ Chile. Permanent settlement commenced four years later when Captain Pedro de Valdivia travelled from Peru with 150 followers, subdued the local Indigenous population, and founded Santiago on 12 February 1541. This expansion was driven in significant part by an interest in finding new mineral wealth. Unlike Peru, which was rich in gold and silver, exploitable mineral deposits were less apparent in Chile at the time of European settlement. As time went on, some gold and silver was mined and gold was also panned from alluvial diggings. But, though it had some good agricultural land, Chile was relatively poor during most of its colonial period, which spanned about 275 years. Significant demographic and economic growth began only in the 18th century. By the time of independence in 1818 the new nation’s population stood at a modest 890 000. After independence, the rise of minerals stimulated the emergence of the modern Chilean state. In the remainder of the 19th century this occurred initially with silver (mainly from the large mine at Chañarcillo), then copper and finally nitrates. Copper has been particularly important again since about 1910, with Chile has been the world’s main copper producer over the past 15 years. O’Brien (1994) attributes the rise of copper after 1850 in Chile to several factors. Importantly Charles Lambert introduced the reverberatory furnace to process sulfide ores. High quality imported coal became available to fuel the smelters and local coal production also emerged. Copper prices were strong. In 1878, Chilean mines (largely owned by domestic interests) produced more than 52 000 t, which was 44 per cent of the world’s copper output. By that time, the nation’s population had reached 2.3 million. The successful industry created a new wealthy class of Chileans who invested many of their assets in railways, agriculture (including viticulture), banking, and later in guano and nitrate. The copper fields in the north also created a market for agricultural production in the centre and south of the country. A brief chronology of the development of the Chilean mining industry appears in Table 3.7. Despite its victory in the War of the Pacific in 1879 and the annexation of the Tarapacá and Antofagasta regions from Peru and Bolivia respectively, Chilean copper mining declined after 1880 as the US industry emerged in a dramatic way. By 1900 the US accounted for 54 per cent of world copper output, while Chile had only five per cent of production (though copper production had declined only by about half in actual terms from 52000 t in 1878 to 27000 t in 1900). During this period, Chilean entrepreneurs devoted their limited infrastructure, manpower and financial resources to the Mineral Economics

chapter 3 – Minerals and development

TABLE 3.7 Mining and Chile – a brief chronology. Year

Total population (mill)

Main events in surrounding period

1541

0.00015

1818

0.89

Chile gains independence

1830

1.06

Silver production emerges and grows until 1855 (200 t/a in 1855)

1850

1.44

Copper production increases rapidly. Chile main producer until 1880. Domestic coal production also begins

1880

2.3

Copper production declines, while nitrate production rises. Access to nitrate fields enhanced by success in War of the Pacific (1879 - 1884)

1900

2.97

Nitrate production dominates mineral industry from 1880 to 1920. Fall dramatically after WW1 when synthetic nitrates introduced

1920

3.83

Revitalisation of copper industry. US investment at El Teniente (1904), Chuquicamata (1913) and Potrerillos

Pedro de Valdivia founds Santiago. Colonial period for next 275 years. Gold production becomes significant in later colonial period

1930 - 1950

4.37 - 6.1

1950 - 1965

7.61

Industry re-emerges in post-war era

1965

8.58

Partial nationalisation of copper mines begins

1970

9.50

Allende socialist government elected. Mines nationalised

1973

10.02

Military government. New foreign investment guidelines. Nationalised mines stay

1990 - 2010

13.17 - 17.0

Depression and WWII depress copper prices and industry struggles

Democratic government returns. Surge in new mineral investment. Dramatic rise of copper again. Expansion of other minerals such as molybdenum, lithium etc

more profitable nitrate industry. As a result the average estimated per capita incomes of Chileans at the turn of the new century were relatively impressive having risen from $694 in 1820 to $2194 by 1900. Yet while the impact of the expansion of mining and other industries on Chilean per capita incomes in the 19th century (see Figure 3.9) was significant, it was considerably less than in Australia. While Maddison’s estimates suggest that per capita incomes were similar in both nations in 1820, Chilean average incomes in 1900 stood at only about 50 per cent of Australian levels. Furthermore the distribution of income and wealth appeared significantly more unequal in Chile than in Australia in 1900. Though the nitrate industry fell away after World War I, major investment by US interests in the early years of the 20th century provided an important key to the re-emergence of the Chilean copper sector. William Braden bought El Teniente in 1904, and Guggenheims purchased Chuquicamata in 1913. Both were worldclass mines that used new technologies. By 1928, when El Teniente, Chuquicamata and the new Potrerillos mine were each operating, Chile produced almost 290 000 tonnes of copper (back to 16 per cent of world production). The onset of the Depression (when copper prices fell) reduced the positive impact of copper production on economic welfare. The events of World War II continued this impact. In the immediate post World War II era, US interests continued to dominate Chilean copper production. With the rise of independence movements in many colonial nations, Chileans began considering nationalisation as a future development option in the national interest. In Mineral Economics

taking this view they wished to reduce the excessive profits repatriated to foreign shareholders. O’Brien (1994, p 9) observes that one manifestation of this was the development of a ‘national smelter’ at Paipote in Copiapo in the 1950s to support domestically based copper production, and then of the Ventanas smelter north of Viña del Mar in the early 1960s. The decline in Chile’s share in world copper production from 19 per cent in the 1940s to just over ten per cent in the 1960s led in the mid-1960s to a widely supported view that nationalisation would lead to a greater chance of expanding national production. This led to the ‘Chileanistion’ (partial nationalisation) on the copper industry between 1964 and 1969, during the Presidential term of Eduardo Frei Montalva. By 1969, the Chilean state held majority shares in each of the major copper mines (51 per cent ownership in Chuquicamata, El Teniente and El Salvador, and 70 per cent in Andina). With the election of the Allende socialist government the industry was completely nationalised in 1970, and a newly former state-owned company, now Codelco, took control of copper production. In September 1973, a military government took power in a coup d’état. They held power until the restoration of democracy in 1990. Although the installation of the military regime brought a return to free enterprise policies, the established nationalised copper mines remained in public hands. The government introduced a new favourable foreign investment regime particularly with the passage of Decree Law 600 in 1974 and then Decree Law 1748 in 1977. Yet during the 1970s and for much of the 1980s foreign-based companies were reticent to take advantage of this. 35

chapter 3 – Minerals and development Some mineral investment by foreign corporations started to take place from the early 1980s and it increased dramatically in the 1990s. Largely as a result of this, after vying with the US for the position of leading copper producing nation during the 1980s, Chile has been the dominant copper producer since the early 1990s. Her share of world newly mined production, which averaged about 15 per cent in the 1980s, increased dramatically to almost 35 per cent by the late 1990s. It has held this position during the last decade. In 2010, Chilean mines produced 5.5 Mt contained copper metal in ore – about 34 per cent of world production. About 70 per cent of this output came from privately owned mines. Chile is now also a major producer of molybdenum and the leading producer of lithium and iodine. Gold production is expected to rise again significantly in the near future. The increase in mining activity since the late 1980s has been associated with strong economic growth (see Table 2.2 above), a significant increase in Chile’s Human Development Index (Table 2.3) reflected in increases in life expectancy, literacy levels and GDP per capita at PPP, as well as a reduction in poverty levels. One recognition of Chile’s recent development progress was its acceptance as a new member of the Organisation for Economic Co-operation and Development (the Parisbased ‘club of developed nations’) in early 2010.

The position of non-mineral economies While perhaps 50 nations produce and export minerals in a significant way, the remainder of the more than two hundred countries of the world today are net mineral importers. For those with major manufacturing sectors, it is particularly important to ensure a stable, secure and competitively priced supply of minerals to meet the needs of their downstream sectors, as well as of their citizens more generally. Indeed, government agencies in nations such as Japan, take a formal interest in this area. Where mineral-rich nations have favourable foreign investment regimes, there has been significant foreign direct investment in their mineral sectors to make this situation more achievable. In the case of Australia, companies based in nations such as Britain, the United States and Canada, have been traditional investors in the mining sector. In the post-World War II era Japan, South Korea and China have also taken prominent investment positions in operating and developing Australian mines. Perusal of annual publications such as the Minerals Yearbook of the United States Geological Survey (various years) indicates the extent of these positions, particularly in iron ore, coal and even bauxite/alumina/aluminium, the base metals and heavy mineral sands. As we have seen above, US interests took a strong interest in developing several major Chilean copper mines before 1970.

36

REFERENCES al Rawashdeh, R, 2004. Personal correspondence. Atkinson, G and Hamilton, K, 2003. Savings, growth and the resource curse hypothesis, World Development, 31(11):1771–1792. Auty, R M, 1993. Sustaining Development in Mineral Economies: The Resource Curse Thesis (Routledge: London). Barnett, H J and Morse, C, 1963. Scarcity and Growth: The Economics of Natural Resource Availability: Resources for the Future (John Hopkins Press: Washington). Blainey, G, 1966. The Tyranny of Distance (Sun Books: Melbourne). Blainey, G, 2003. The Rush that Never Ended, fifth edition (Melbourne University Press: Melbourne). Boskin, M, Dulberger, E, Gordon, R, Griliches, Z and Jorgenson, D, 1996. Towards a more accurate measure of the cost of living, Final report to the Senate Finance Committee from the Advisory Commission to study the Consumer Price Index, 4 December, Washington. Brunetti, C and Gilbert, C L, 1995. Metals price volatility, 1972-95, Resources Policy, 21(4):237-254. Butlin, N G, 1962. Australian Domestic Product, Investment and Foreign Borrowing, 1861 – 1938/39 (Cambridge University Press: Cambridge). Corden, W M, 1984. Booming sector and Dutch disease economics: Survey and consolidation, Oxford Economic Papers, 36:359-380. Corden, W M and Neary, P, 1982. Booming sector and deindustrialization in a small open economy, Economic Journal, 92:825-848. Davis, G A, 1995. Learning to love the Dutch disease: Evidence from the mineral economies, World Development, 23(10):1765-1779. Davis, G A and Tilton, J E, 2005. The resource curse, Natural Resources Forum, 29:233-242. Eggert, R G, 2001. Mining and economic sustainability: National economies and local communities, report no 19, October, Mining, Minerals and Sustainable Development Project, London, International Institute for Environment and Development. Eggert, R G, 2003. The mineral economies: Performance, potential problems and policy challenges, UNCTAD Module One, June, 31 p. Garnaut, R, 1995. Dilemmas of governance, in Proceedings Mining and Mineral Resource Policy in Asia-Pacific: Prospects for the 21st Century, pp 61-66 (The Australian National University: Canberra). Garnaut, R and Clunies Ross, A, 1983. Taxation of Mineral Rents (Clarendon Press: Oxford). Gelb, A H, 1985. Are oil windfalls a blessing or a curse? Policy exercises with an Indonesia-like model, discussion paper, Research Department, World Bank. Gelb, A H and Associates, 1988. Oil Windfalls: Blessing or Curse? (Oxford University Press: New York). Groningen Growth and Development Available from: .

Centre,

2011.

Gylfason, T, 2001. Natural resources, education and economic development, European Economic Review, 45:847-859.

Mineral Economics

chapter 3 – Minerals and development International Institute for Environment and Development (IIED), 2002. Breaking new ground, final report, Mining Minerals and Sustainable Development, London. Lederman, D and Maloney, W, 2002. Open questions about the link between natural resources and economic growth: Sachs and Warner revisited, Working papers Central Bank of Chile 141. Maddison, A, 1995. Monitoring the World Economy (Organisation for European Co-operation and Development: Paris). Maponga, O and Maxwell, P, 2000. The internationalisation of the Australian mineral industry in the 1990s, Resources Policy, 26(4):199-210. Maxwell, P, 2004. Chile´s recent copper-driven prosperity: Does it provide lessons for other mineral rich developing nations?, Minerals and Energy, 19(1):16-31. McLean, I, 2004. Australian economic growth in historical perspective, The Economic Record, 80(250):330-345. Nankani, G, 1979. Development problems of mineral exporting countries: A background study for World Development Report 1979, World Bank Staff Working Paper, No 354, Washington. Natural Resources Canada, various years. Canadian Minerals Yearbook (Ottawa). O’Brien, J, 1994. Undoing a myth: Chile’s debt to copper and mining, International Council on Metals and the Environment, Ottawa. Petermann, A, Guzmán, J I and Tilton, J, 2007. Mining and corruption, Resources Policy, 32:91-103. Ross, M, 2001. Extractive sectors and the poor, report, September, Oxfam America, Boston.

Sachs, J and Warner, A, 2001. Natural resources and economic development: The curse of natural resources, European Economic Review, 45:827-838. Shaw, A G L, 1966. The Economic Development of Australia, fifth edition (Longmans: Melbourne). Sinclair, W A, 1976. The Process of Economic Development in Australia (Cheshire: Melbourne). Sullivan, D, Sznopek, E, John, L and Lorie, A, 2000. 20th century US mineral prices decline in constant dollars, United States Geological Survey open file report 00-389, Washington. Svedberg, P and Tilton, J, 2006. The real, real price of nonrenewable resources: Copper 1870-2000, World Development, 34(3):501-519. Transparency International, 2011. Available from: . Torvik, R, 2002. Natural resources, rent seeking and welfare, Journal of Development Economics, 67:455-70. United Nations Development Program, various years. Human development report 2003, New York. United States Geological Survey, various years. Minerals Yearbook (Washington). Weber-Fahr, M, 2002. Treasure or Trouble? Mining in Developing Countries (World Bank and International Finance Corporation: Washington). World Bank, 1997. Expanding the Measure of Wealth: Indicators of Environmentally Sustainable Development (The World Bank: Washington). World Bank, 1993. Investing in health, world development report (Oxford University Press: Oxford).

Sachs, J and Warner, A, 1995. Natural resource abundance and economic growth, Development Discussion Paper No 517a, Harvard Institute for International Development.

Mineral Economics

37

HOME

Chapter 4 Trade in Minerals Philip Maxwell Why trade takes place Minerals and energy production and trade Australian production and trade in minerals Transport costs and the direction of minerals and energy trade Minerals trade and exchange rates

Why trade takes place When people, companies or nations freely trade goods and services with one another, they increase their respective levels of economic welfare. They normally use money1 – serving in its role of a medium of exchange and a unit of account – to facilitate these exchanges. A simple diagrammatic analysis, such as that in Figures 4.1 and 4.2, illustrates how two parties, who choose to trade with one another at an agreed rate of exchange, can move to a higher level of welfare. For the purposes of this example, we assume that one of the parties sells minerals, while the other sells all other final goods and services. We consider only the first party to keep the example as simple as possible. Assume a production possibility frontier DAE where there is full employment of the factors of production. The economic actor (person, company or country) will maximise welfare at that point on the frontier that coincides with the highest community indifference curve in Figure 4.1. Three indifference curves (CIC1, CIC2 and CIC3) show increasing levels of welfare for the actor. In this simple economy the highest level of satisfaction can be achieved at point A, where the production possibility curve is tangent to CIC2, which represents the highest attainable level of welfare in these circumstances. Now, let us call our actor Smith. Smith has the opportunity to trade with another actor, Jones, at an exchange rate given by the slope of the line BC in Figure 4.2. Smith chooses therefore to move around on the production possibility curve from A to B, producing more minerals and less other goods and services. 1 It is also possible undertake barter trade or counter trade to achieve a similar result though the use of money tends to eliminate the ’coincidence of wants’ condition. Mineral Economics

Minerals

CIC1

CIC2 CIC3








Other goods and services

Fig 4.1 - Before trade in Smith’s simple economy. Minerals




CIC2 CIC3



 














 





 












Other goods and services

Fig 4.2 - The gains from trade – a simple view.

Smith then sells MBMC of minerals to Jones for GBGC of other goods and services, thereby moving along the 39

chapter 4 – trade in minerals trading possibilities curve BC to the point C. At point C, Smith receives more minerals and other goods and services that before trade and is clearly better off. He (or she) has reached a higher community indifference curve (CIC3) as a result of trade. By using the same methodology it is possible to draw a diagram to show that Jones will also be better off as a result of trade. Opening up to trade has led to a resource boom in the minerals sector, and there will be a contraction of the ‘other sector’. This is, of course, an optimal reallocation of factors of production. So even though there is a shrinking sector, there are welfare gains. Whether trade takes place within a nation, in an intraregional framework (within say the Sydney metropolitan area) or an interregional context (between say the Pilbara region of Western Australia and the Illawarra region of New South Wales), or it flows across international frontiers (between the Pilbara and China) does not matter in a welfare changing sense. Yet movements of goods and services internationally are typically more complex because different countries often have different currencies, and they erect trade barriers2. The extent of interregional and international trade has grown over the past two centuries as the world has moved more and more towards becoming a global economy. From time to time these trends have been reversed by war, politics and the business cycle.

There is now a broad field of specialisation within economics that considers the area of international trade. The pioneer of modern international trade theory was David Ricardo who, in The Principles of Political Economy and Taxation in 1817, developed the idea of comparative advantage. He used this concept in his classical theory to explain trade between nations. According to Ricardo, countries tend to export those goods and services where their margin of superiority is greater, or their margin of inferiority smaller, than their trading partners. Comparative advantage arises because of technological differences in production between nations. Ricardo’s famous example considered trade between England and Portugal. Even though Portugal was a more efficient producer of both wine and cloth, he argued that each country would gain from trade when Portugal exported wine (and imported cloth) and England exported cloth (and imported wine). One limitation of the original Ricardian model was that it was restricted to differences in the productivity of just one factor of production (labour). Also it did little to explain the determinants of comparative cost differences. In developing the neoclassical theory of international trade, largely attributed to three economists (Eli Heckscher, Bertil Ohlin and Paul Samuelson) extended Ricardo’s theory. They did this by recognising that countries are endowed with many factors of production but in different proportions, and 2

40

It is also possible for trade barriers to exist between states within nations.

arguing that these explain differences in international costs and form the basis for international specialisation. In his explanation of the Heckscher-Ohlin-Samuelson (HOS) model, Grubel (1981, p 24) states that: … a country exports goods which intensively use the factor of production with which it is relatively well endowed, and imports the good using intensively the factor with which it is relatively poorly endowed … Remembering the nature of the economist’s production function, what this implies is that a country relatively rich in capital will export capital-intensive goods and import labour-intensive goods. In a similar vein a natural resource intensive country such as Australia will export minerals (and agricultural goods) and import manufacturing goods. The theory of international trade has now moved considerably beyond the neoclassical model3, with ‘new’ trade theory based on imperfect competition and economies of scale being developed by economists such as Krugman (1979). This has helped to explain intraindustry trade where countries export and import similar products and increasing trade between developed economies (North-North trade). But as Davis and Vásquez Cordano (2011) have recently argued, product differentiation is applicable only to certain minerals (eg gem quality diamonds), and most minerals traded are homogenous products. Increased trade between developing economies (SouthSouth trade) and from natural resource-rich nations to resource poor nations has in the past been explained quite effectively by the HOS model. Against this background, our interest in the remainder of this chapter is in considering the importance and direction of minerals and energy trade, and in assessing Australia’s role and the role of other nations as mineral exporters and importers. The next two sections consider these issues in further detail. Because transport costs play an important role in mineral trade, we discuss this issue in the fourth section of the chapter. The final section focuses on the importance of exchange rates as a determinant of comparative advantage in minerals trade.

Minerals and energy production and trade National statistical agencies typically estimate the value of mining activities within their geographical boundaries to cover the activities of firms engaged in: •• the extraction of minerals •• the exploration for these minerals •• a variety of services to mining and mineral exploration •• the development of new mining projects. 3

For a further discussion of international trade theory it is useful to consult one or more of a large number of international economics textbooks. Mineral Economics

Chapter 4 – trade in Minerals Extraction occurs using such processes as underground and open cut mining of coal and metal ores, dredging, quarrying, the operation of oil and gas wells and of evaporation pans (for minerals such as salt) and the recovery of minerals from ore dumps and tailings. It typically also includes preparing the resultant crude materials for marketing with activities such as ‘milling, dressing and beneficiation of ores, and screening, washing and flotation’ that are performed at or near a mine site. Mining excludes activities relating to refining or smelting of minerals and ores, which typically are included in manufacturing as ‘basic metal processing’. Hence the nickel ore produced by Lightning Nickel from its mines at Kambalda in Western Australia is concentrated at the nearby BHP Billiton-owned Nickel West Concentrator to, say 25 per cent nickel metal. This is still part of the mining process. When the nickel concentrate is then smelted to nickel matte (70 per cent nickel) at the nearby Kalgoorlie Nickel Smelter and finally to nickel metal at the Kwinana Nickel Refinery near Perth, it is defined as manufacturing. Despite its limitations, discussed in Chapter 2, it is common practice to use Gross Domestic Product as the standard measure of the size of an economy in any given period. The World Bank estimated world gross domestic product (GDP) to be just over $US63 trillion in 2010. The contribution of the minerals and energy sector to GDP varies depending on the prevailing prices of minerals and energy commodities, as well as their level of production. The estimates presented in Table 1.2 suggest a 4.1 per cent share in 2002, which rose to 5.9 per cent in 2007, when the value of the sector’s output was around $US3 trillion. The current percentage share and monetary values are around five per cent. Note that this percentage varies greatly across countries, and within regions of countries. As input into final goods and services, most mineral production is traded, either within regions, between regions or between nations. With strong growth in the world economy, as well as an increase in number of nations, mineral and energy exports have increased significantly since 1950. In this chapter we follow the practice of the World Trade Organization (2010, p 204), which reports international trade in fuels and mining products, covering the two digit categories of the Standard Industrial Trade Classification (SITC) outlined in Table 4.1. As can be seen in Table 4.2, manufacturing exports grew at a higher average annual rate than exports of fuel and mining products during the six decades after 1950. A closer look in Figure 4.3 during the period since 1980 shows how the value of mineral exports declined before 1985, then increased slowly until 1997, surged between 2002 and 2008, dipped after the Global Financial Crisis and have recently recovered. Manufactures, by contrast and agricultural goods have been much more even in their growth during the same period. Mineral economics

TablE 4.1 Two digit Standard Industrial Trade Classification categories covering international mineral trade. Standard Industrial Trade Classification no

Description

27

Crude industrial minerals and crude fertilisers

28

Metalliferous ores and scraps

32

Coal, coke and briquettes

33

Petroleum and petroleum products

34

Gas, natural and manufactured

68

Non-ferrous metals

TablE 4.2 Average annual percentage growth of exports (by volume) in main categories and in real gross domestic product – 1950 to 2010 (source: World Trade Organization). Trade category

Rate of growth (per cent)

Agriculture

3.5

Mining

3.9

Manufacturing

7.2

Total exports

5.8

Gross Domestic Product

3.6

Fig 4.3 - Key categories of merchandise exports in $US B – 1980 to 2010

(logarithmic scale on vertical axis).

The value of fuel and mining exports (and imports) has been associated with wide movements in mineral prices linked to periods of underinvestment in mineral exploration and development and the dramatic emergence of the Asian economies over this period. As a result their percentage contribution to total merchandise exports since 1980, while always significant, has varied quite widely. Standing at 28.7 per cent in 1980, it declined to 9.8 per cent in 1998 before recovering to around 20 per cent between 2006 and 2010 (see Figure 4.4). Between 1980 and 2010, international exports in fuel and mining products grew from less than $US600 B/a to around $US3.025 trillion/a. While accounting for an annual average of only about four per cent of World Gross Domestic Product, they were, on average, 17 per 41

Chapter 4 – trade in Minerals Further perusal of the merchandise trade percentages of key exporters and importers in Tables 4.3 and 4.4 highlights the economic importance of mineral resources trade to major exporting and importing nations.

ausTralian producTion and Trade in Minerals

Fig 4.4 - Fuel and mining exports by value as a percentage of total

merchandise exports 1980 to 2010.

cent of world merchandise trade and 13 per cent of world merchandise and services trade over this period. So international trade in minerals is considerably more significant than its share of the value of total production. In 2010, fuel exports amounted to $2.348 trillion, while mining product exports were $677 B. Some further interesting data, derived from World Trade Organization (2010), appear in Tables 4.3 and 4.4. These tables focus respectively on exporters and importers of fuel products and mining products for the year 2008. Note that international trade in fuels accounted for more than 80 per cent of total international trade in minerals and energy in this year. Table 4.3 shows that Russia and Saudi Arabia are clearly the leading fuel exporting nations, but that each of the top 15 producers had exports worth $US 60 B or more in 2008. While this group accounted for 58.1 per cent of total production, it is apparent that many other nations are also active fuel exporters. Another important observation is that many of the top fuel exporters have a very high export dependence on fuels. For nine of the top 15, fuel accounted for more than 60 per cent of exports. On the importing side, there was also a notable dependence on fuels, with the USA, Japan, South Korea, India, Singapore, Spain and Taiwan all spending more than 20 per cent of their total import allocations in this area. Appearing in Table 4.4, international exports of mining products are led by Australia, followed by the USA, Germany, Chile, Canada, Russia, Brazil and China. Among the top exporting nations only Australia, Chile, South Africa and Peru showed significant export dependence. As one might expect, China was clearly the world’s leading importer of mining products in 2008, followed by Japan, Germany and the United States. Several other Asian nations (South Korea, Taiwan and India) and European nations (Italy, the United Kingdom, France, Belgium, Turkey, Spain and the Netherlands) were also large importers. Among the leading mining products importers, only China exceeded ten per cent of its total merchandise imports with mining products. 42

We have seen already in Chapter 3 the important role that minerals and energy have played in the development of the Australian economy since European settlement. Initiated particularly by the Gold Rushes in the 1850s, by Federation in 1901 the new nation’s mineral economy had expanded into a number of other areas. Although minerals production and trade subsided in importance in the first half of the 20th century, a major resurgence from 1960 until the present time has re-established Australia as one of the world’s leading mineral producing and exporting nations. Furthermore recent best estimates show that Australia’s mineral reserves4 remain at high levels for a wide range of minerals. Organisations such as the Australian Bureau of Resources and Energy Economics (BREE) and the Australian Bureau of Statistics (ABS) publish official data on Australian mineral production and trade. The ABS publication International Trade in Goods and Services, Australia (2011, cat no 5368.0), provides current information on the commodity composition and direction of Australian international trade in minerals and energy. The United States Geological Survey also collects and publishes available official information in a timely manner for most nations. Utilising these sources, the estimated value added by the minerals industry in Australia during 2010 was $120 B (United States Geological Survey, 2011). Using the World Trade Organization (2011) definition, Australian mineral industry exports in 2011 amounted to just over $145 B, which was about 63 per cent of total exports. With a broader definition including non-monetary gold exports and basic metal processing exports (normally included with manufacturing), one could argue that Australian mineral exports were nearly 70 per cent of its total merchandise exports in this year. China’s mineral demand after 2000 had a major effect on raising these percentages. Further details of different three-digit SITC categories of exports appear in Table 4.5. The major contributions to exports of iron ore (21.4 per cent) and coal (18.6 per cent) stand out in this table, with significant input also from oil and gas, gold, aluminium and copper. In the decade after 2000, iron ore and coal rose from being just major export categories to notable dominance. Dramatic price increases for these minerals, followed in recent years by strong production increases, brought 4

There is further discussion about mineral reserves in Chapter 6. Mineral economics

chapter 4 – trade in minerals Table 4.3 Major fuel exporting and importing nations in 2008 (source: World Trade Organization, 2011). Exporters

Table 4.4 Major mining products exporting and importing nations in 2008 (source: World Trade Organization).

Value ($US bill)

World share

% of merchandise trade

World

2862

100.0%

21.6

Russia

307

10.7%

65.7

Saudi Arabia

281

9.8%

Exporters

Value ($US bill)

World share

% of merchandise trade

World

668

100.0%

4.3

Australia

52

7.8%

28.0

89.7

USA

49

7.3%

3.8

Canada

126

4.4%

27.6

Germany

45

6.7%

3.1

Norway

114

4.0%

67.7

Chile

42

6.3%

60.1

UAE

103

3.6%

49.2

Canada

35

5.2%

7.8

Iran

93

3.2%

82.0

Russia

26

3.9%

5.5

Kuwait

83

2.9%

95.0

Brazil

25

3.7%

12.8

Venezuela

78

2.7%

93.8

China

24

3.6%

1.6

Algeria

78

2.7%

98.1

South Africa

22

3.3%

29.0

USA

77

2.7%

5.9

UK

20

3.0%

4.4

Nigeria

75

2.6%

91.7

Japan

19

2.8%

2.4

Angola

66

2.3%

98.9

Belgium

16

2.4%

3.3

Singapore

63

2.2%

18.5

France

16

2.4%

2.6

UK

60

2.1%

18.2

Peru

13

1.9%

43.0

Australia

60

2.1%

31.9

Netherlands

13

1.9%

2.3

1664

58.1%

Top 15

417

62.4%

Top 15 Importers World

Importers 2922

100.0%

21.8

World

696

100.0%

4.3

USA

502

17.2%

23.2

China

138

19.8%

12.2

Japan

268

9.2%

35.1

Japan

60

8.6%

7.8

China

169

5.8%

14.9

Germany

57

8.2%

4.7

Germany

164

5.6%

13.6

USA

56

8.0%

2.6

South Korea

143

4.9%

32.7

South Korea

33

4.7%

7.5

France

117

4.0%

16.9

Italy

27

3.9%

4.9

India

116

4.0%

36.7

UK

22

3.2%

3.5

Singapore

87

3.0%

27.3

France

21

3.0%

3.0

UK

82

2.8%

12.9

Taiwan

19

2.7%

7.9

Spain

81

2.8%

20.3

Belgium

19

2.7%

3.9

Italy

79

2.7%

14.2

India

17

2.4%

5.5

Netherlands

77

2.6%

15.6

Turkey

17

2.4%

8.3

Belgium

73

2.5%

15.5

Spain

16

2.3%

4.1

Taiwan

62

2.1%

25.7

Netherlands

14

2.0%

2.8

Canada

51

1.7%

12.4

Canada

13

1.9%

3.2

Top15

2071

70.9%

Top 15

529

76.0%

this outcome. Whether this situation continues into the future will depend on longer-run mineral prices. Because minerals are typically inputs into the manufacture of final goods, it does not necessarily follow that a major mineral-producing nation will also export these resources. An alternative is to establish downstream processing, which then provides a platform for manufactured exports. These will add potentially greater value and profit for domestic Mineral Economics

producers, as long as the net present values of such activity are positive. Although policymakers and commentators have actively promoted the valueadding argument in many mineral-producing nations, the realities of comparative advantage are that such manufactures (whether produced for export or as import replacements) tend not to replace mineral exports in any significant fashion unless they are in countries with major internal markets. 43

chapter 4 – trade in minerals

Table 4.5 Australian mineral exports by value and as a percentage of total merchandise exports in 2010 (source: Australian Bureau of Statistics, 2011). 3 digit SITC

Description

A$ mill

%

272

Stone, sand and gravel

107

0.05

278

Other crude minerals nec

220

0.10

281

Iron ore and concentrates

49378

21.36

282

Ferrous scrap

722

0.31

283

Copper ore and concentrates

5036

2.18

284

Nickel ores, concentrates, mattes

891

0.39

285

Bauxite and alumina

5294

2.29

286

Uranium

678

0.29

a

287

Other base metal ores and concentrates

4482

1.94

288

Non-ferrous waste and scrap

864

0.37

289

Precious metals (exc gold) ores and concentrates

888

0.38

321

Coal

42968

18.59

325

Coke and related coal products

154

0.07

333/334

Petroleum and crude oil

12939

5.60

342/343

Natural gas

10506

4.55

Iron and steel products

1510

0.65

66/67

flexibility of response to demand, the market for byproducts and, most importantly, costs of production. All of these factors made the comparative advantage in steel production lie with nations such as Japan, Taiwan and Korea. It has recently moved to China in a most significant way. Even when Australian-based companies such as BHP Billiton have made partial attempts at downstream processing of iron ore, they have often struggled to make significant profits. The difficulties with high construction costs at the Port Hedland hot briquette iron plant, and ongoing technical difficulties with its operation, provide a recent example of the challenges in changing comparative advantage. While change over time does take place, the nature of the process is often difficult to predict. It may happen gradually, suddenly, or not at all. The importance of minerals and energy exports since 1970 stands out in Figure 4.5. Following the entry of Britain to the European Common Market (now the European Union) in 1960, Australian farmers faced difficult trading conditions. The manufacturing sector subsequently struggled as the Australian Government reduced tariffs. The strong export performance of the minerals and energy sector (in the spirit of the argument in Figure 4.2) in this changed environment has been impressive.

681

Silver and PGM

245

0.11

682

Copper metal

3160

1.37

683

Nickel metal

644

0.28

684

Aluminium metal

4409

1.91

685

Lead metal

788

0.34

686

Zinc metal

935

0.40

689

Other non-ferrous metals

204

0.09

$


971

Non-monetary gold

14436

6.25

$


Mineral exports (World Trade Organization definition)

145512

62.95

$


Mineral exports (more broadly defined)

161648

69.85

Other merchandise exports

69685

30.15

Total merchandise exports

231143

100.00

a. Data from 2009.

Consider, briefly, the case of iron ore. Together with Brazil, Australia has been one of the two major producers of high quality iron ore to world steel producers since the 1960s. The overwhelming majority of Australian production has come from the remote Pilbara region in Western Australia. In a hypothetical exercise, Stewardson (1992) considered Australian iron ore and steel exports for the 1990 - 1991 financial year. He estimated that if Australian producers converted all of their iron ore exports into steel that export values would have represented a third of the internationally traded steel market. Stewardson argued that achieving this level was not possible because of factors such as market structure, transport costs, the availability of other factors of production, speed and 44

$


  




  

   



$
$
$


$
$
!


!


! 


! 


!!


!!











Fig 4.5 - The key role of Australian resource sector exports 1969 - 1970 to

2009 - 2010 (source: ABARES).

Minerals have consistently contributed more than 40 per cent of Australia’s merchandise exports and more than 30 per cent of Australia’s total exports (which also include exports of services) since 1975. Between 2005 and 2011 these contributions rose dramatically again. They seem destined to hold at these higher levels for the foreseeable future, though there will certainly be a downturn again. In concluding this section it is important to note that Australia imports some minerals, particularly oil, in which she is currently not self-sufficient. While exporting lighter grade crude oils, these are more than offset in value by heavier grade crude oil imports from the Middle East. Australian oil and gas imports in 2010 amounted to an estimated $28.26 B, in comparison to Mineral Economics

chapter 4 – trade in minerals estimated oil and gas exports of $23.44 B in oil and gas exports.

Transport costs and the direction of minerals and energy trade Our discussion about the economics of value adding in the preceding section laid some of the groundwork for analysing the direction of Australia’s mineral and energy trade. Comparative advantage is the key to understanding this. If Australian iron ore producers despatch most of their output to China, Japan, South Korea and Taiwan, while Brazilian producers send most of their ore to Europe and North America, this is a reflection of the respective comparative advantage that producers in each nation hold. Some of this comparative advantage is affected by transportation costs of goods from the point of production to the final destination5. An important factor that influences comparative advantage and the extent of resources trade is a mineral commodity’s value to weight ratio. Sending Australian gold anywhere in the world is comparatively inexpensive. Even though security may be an issue, it is a relatively straightforward matter to send a bar of gold to London, New York, Mumbai or Hong Kong and sell it there. The cost of transport is relatively small. By contrast, trading lower value commodities profitably across international frontiers is a more contentious issue if a business is trying to make and maximise profits. While the price of gold may be US$1700/oz, the price of a tonne of high quality iron ore mined in the Pilbara will be perhaps US$150/t. Once this ore is mined, producers must send it to a port where it will be shipped to the customer in a city such as Kobe, Anshan or Pohang. The producer typically bears the cost of delivering the mineral to the port, while the buyer is responsible from that point onwards. Before the recent dramatic rises in the price of iron ore, the cost of transporting it had the potential to be more than its sale price. Historically this meant that steel makers in places such as North America and China favoured local mines, even though the quality of their ore was inferior to that coming from high-grade mines in distant nations. Gold can travel easily all over the world. Even though nickel concentrate is less valuable – say $US2000/t – it has recently been profitable to ship Australian nickel concentrate (say ten to 15 per cent nickel metal) from ports such as Esperance in Western Australia to Finland and Canada. A similar situation applies with shipping mineral commodities such as alumina, zinc concentrates, copper concentrates, lead, ilmenite and rutile to other nations. Lower value commodities such as coal and iron ore have traditionally been more constrained in their movements. Large shipments of Australian iron ore to Europe must compete with supplies from closer 5 For a useful recent discussion of transportation costs and international trade see Hummels (2007). Mineral Economics

places – such as Sweden, Ukraine, Mauritania, Brazil, India and South Africa. This has the capacity to make Australian iron ore less than competitive. While, at one end of the spectrum precious mineral producers sell gold, diamonds and the platinum group minerals in global markets, industrial minerals such as gravel, sand, cement and aggregates typically trade only in local and regional markets. Only occasionally do they move across international frontiers. The simple inverse relationship between the market value of minerals and the transport cost to value ratio in the diagram in Figure 4.6 provides an insight into the importance of transport costs. Let us describe this as a transport cost market value curve. While the transport cost to value ratio for gold and platinum group metals may be 0.01 or 0.02, even from faraway places, the value of this ratio for commodities such as iron ore and coal from remote parts of the world may be quite close to one. For example, the cost of transporting a tonne of coal from the gates of an open cut mine in Central Queensland to Europe may be 50 per cent more than the cost of mining it. Market value Gold, PGMs Base metals Base metal concentrates Oil and gas Iron ore Coal, fertilisers Construction materials

Transport cost to value ratio

Fig 4.6 - Mineral commodity values and transport costs.

For international trade to occur in a case such as this: •• either the quality of the distant mineral commodity must be considerably higher than that available from nearer to the market place •• transport costs must have fallen enough to no longer outweigh the difference in processing cost •• or both factors must apply. In his influential paper on bulk trade and maritime transport costs, Lundgren (1996) observed that: Since the 1950s a transport revolution has occurred comparable to events of the late nineteenth century when sailing ships were replaced by steam vessels. Freight rates for bulk products have decreased 65 to 70 per cent due to improved maritime technology. Formerly separate markets for bulk products have been unified globally. Reduced maritime transport costs in the immediate post World War II period led to a leftward shift in the 45

Chapter 4 – trade in Minerals transport cost market value curve and a corresponding increase in the potential size of markets for minerals produced in previously remote locations. Commenting on these trends, Radetzki (2008) notes that: The economic impact of the new bulk transport technology was very substantial, and especially so for the mining industries … Freight rates for Brazilian iron ore to Europe declined from $24 per ton in 1960 to $7 in the early 1990s. At the same time, the much shorter shipping costs for iron ore from Narvik in Norway to Germany were reduced from $8 to $4 … The freight rate as a proportion of total price for US coal in Western Europe was reduced from more than 30 per cent to less than 15 per cent in the 30-year period. The consequence was a fast evolution of global markets for these low-cost products. Long distance maritime iron ore trade rose from 23 per cent of world production in 1960 to 36 per cent in 1990, and for coal from 2 per cent to 9 per cent (Lundgren, 1996). These shares continue to grow. Reduction in internal transport costs (mainly rail and road) and increases in the efficiency of ports in mineral producing nations initially tended to lag behind the dramatic reductions in shipping costs. Yet in nations such as Australia, the implementation of a national competition policy in the early 1990s increased efficiency and established greater competitiveness in this area as well. Crowson (1998, p 202) provides another insight into the importance of transport costs in the exporting of coal to major markets in the mid-1990s. His data show rail/barge, shipping and average mining costs in US dollars from key producing regions to both the Japanese and European markets. These are reproduced in Figure 4.7a for Japan and Figure 4.7b for Europe. In the case of Japan the sum of production and transport costs from the two main Australian coal mining regions – Queensland and New South Wales was slightly higher than for Wyoming, South Africa and Indonesia at this time. Presumably this was offset either by higher quality, or more certainty of long-term supply, or both, from the Australian mining regions. The non-Australian producers had a more pronounced cost advantage to European destinations (see Figure 4.7b). Major improvements in transport technology have a significant effect on country and company competitiveness in the minerals sector. The present and future status of the transport system determines the countries with which producers of lower value commodities such as iron ore, coal and fertilisers are able to trade profitably. The data presented in these figures provides a useful background to explain why Australia trades many of its higher valued commodities throughout the world, while its lower value commodities have had more 46

Fig 4.7 - The importance of production and transport costs for coal sold in the

(a) Japanese and (b) European markets in 1995.

limited markets. Hence its major markets for coal and iron ore are in major Asian nations, while it faces more serious competition in Europe from African and South American producers in Europe. Yet transport costs alone do not entirely explain the direction of minerals trade. The quality of a nation’s or region’s mineral endowment is also important, together with the status of environmental policy, its regulatory environment and the absolute and relative levels of exchange rates and movements in them. The combinations of changes in environmental legislation and increased difficulties in gaining mining permits in Europe and North America have adversely affected the ability of companies to open and operate mines in several nations on these continents. As this has occurred, it has been necessary to import minerals from other parts of the world to meet domestic needs.

Minerals Trade and eXchange raTes Suppose that Australians decide to import goods or services from Japan. Typically they must pay for these either in Japanese Yen or sometimes with a third currency such as the United States dollar. They will typically use their Australian dollars to buy these. The reverse situation applies when Australian resource companies export their ore, concentrate, metal or liquefied natural gas to Japan. They usually want to be paid in Australian dollars. Japanese customers will use Yen to buy Australian dollars. Mineral economics

chapter 4 – trade in minerals A nation (or company or individual) can obtain the foreign currencies needed to make payments for imports in two main ways6. These are: 1. by exporting goods and services to other nations, thereby earning the foreign currency needed to make the transactions 2. by attracting international investors to undertake new investment in a venture in the nation (or owned by the company or individual). Any nation’s total payments to other nations must be equal to, or balanced by, the total payments received from other nations. There are recorded in the balance of payments accounts. The exchange rates between one country’s currency and those of its trading partners typically generate a balance of payments. Where there are floating exchange rates as has been the case in Australia since December, 1983, international payments will always be equal. Exchange rates adjust up and down automatically to ensure that this takes place. With fixed exchange rates, the value of the local currency is set at a certain level in relation to other key currencies. In this situation, the nation’s Central Bank will use its reserves to buy and sell currency to ensure that this stable relationship continues. Foreign exchange markets reflect current levels of exchange rates. The values of these exchange rates are readily available in newspapers or on the web. Newsreaders report major exchange rates in television and radio news bulletins many times each day. As well as reflecting its value in terms other specific currencies, (eg $A1 = $US1.01 $A1 = ¥79, $A1 = €0.76, $A1 = ₤St0.65, or $A1 = $NZ1.30), another way to view the value of a country’s currency is in terms of the value of a trade-weighted index. The authors of the Reserve Bank of Australia (RBA) (2002) noted that: The TWI is a weighted average of a basket of currencies that reflects the importance of the sum of Australia’s exports and imports of goods by country. The TWI is often used as one indicator of Australia’s international competitiveness and is a useful gauge of the value of the Australian dollar when bilateral exchange rates exhibit diverging trends. The RBA has computed this measure on a daily basis for the Australian dollar since 1970, when its value was set at 100. The graph in Figure 4.8 shows movements in the index measured in December of each year between 1970 and 2011. The RBA revises these weights regularly to reflect changing trading patterns. Four phases stand out in this diagram: 1. a rising currency associated with the period of the resources boom in the early 1970s 2. a consistent decline in the value of the currency between 1973 and 1985 (the period in which 6

A third way that is also significant for some developing nations is from worker remittances by its citizens working abroad.

Mineral Economics








 


 


 


 


 


 











Fig 4.8 - Movements in Australia’s trade-weighted index since 1970

(source: Reserve Bank of Australia).

members of the Organisation of Petroleum Exporting Countries) exerted a major influence on the world economy 3. a period of relative stability at new lower levels between 1985 and 2003 4. a rising currency associated with the emergence of the Chinese economy from 2004 onwards, with a noted trough in the aftermath of the global financial crisis at the end of 2008. Two sets of currency weights – those for September, 2004, and those for December, 2011 – obtained from the RBA’s web page, appear in Table 4.6. Of particular note at both dates is the importance of Asian nations such as China and Japan in the basket. It is important to remember that the weights given to Japan would have been minimal in 1960 and China did not feature in the basket until the implementation of its ‘open door’ policy after 1978. Also in the seven-year period between 2004 and 2011, the weights for China doubled from 11.3 per cent to 22.58 per cent, while those of Japan, Europe and the United States fell notably. Australia’s recent increased dependence of the fortunes of the Chinese economy has been dramatic. There were increases also in the weights for other Asian nations such as India, Thailand, Singapore and South Korea. While movements in the trade-weighted index are important, it is more common to report movements of the Australian dollar (and other currencies as well) against the United States Dollar. This is a reflection of the continuing importance of the US economy to the rest of the world. In the case of minerals and energy, most prices are denominated in $US. The profitability of mines and oil wells in any nation will be affected significantly by the value of exchange rates. Local currency values matter because costs are incurred in local currency units, and so profit is determined by the difference in local currency price less local currency cost. The situation is, however, mitigated if exchange rates move up and down with mineral and energy prices. This has tended to happen 47

chapter 4 – trade in minerals Table 4.6 Currency weights in the trade-weighted index of the Australian dollar in December, 2011 and September, 2004 (source: Reserve Bank of Australia). Currency

Trade weight Trade weight Dec-11 Sep-04

Difference

moved back towards A$500/oz. With the surge in gold prices after 2008 the close link between the Australian exchange rate appears to have been broken. Movements in exchange rates have fortuitously worked as a ‘natural hedge’ against downward price movements in US dollars. From time to time economists reconsider the question of whether the Australian dollar is a ‘commodity currency’. Given how important mineral exports have been as a percentage of the Australia’s total exports in the past 40 years, the Australian dollar has tended to depreciate when mineral prices fall and appreciate when they rise. Yet over a longer time period mineral producers should not take these movements for granted.

Chinese renminbi

22.58

11.30

11.28

Japanese yen

13.50

16.06

-2.56

European euro

9.67

13.52

-3.85

United States dollar

9.54

13.16

-3.62

South Korean won

6.35

5.97

0.38

Singapore dollar

4.67

3.66

1.01

United Kingdom pound sterling

4.28

4.72

-0.44

New Zealand dollar

4.21

5.88

-1.67

Indian rupee

4.19

2.62

1.57

References

Thai baht

3.80

2.59

1.21

Malaysian ringgit

3.15

3.10

0.05

Indonesian rupiah

2.76

3.02

-0.26

New Taiwan dollar

2.69

3.18

-0.49

Hong Kong dollar

1.62

1.77

-0.15

Papua New Guinea kina

1.39

1.00

0.39

Vietnamese dong

1.22

1.13

0.09

United Arab Emirates dirham

1.06

0.86

0.20

Swiss franc

1.04

0.61

0.43

Canadian dollar

0.94

1.62

-0.68

South African rand

0.68

1.20

-0.52

Swedish krona

0.66

0.88

-0.22

Saudi Arabian riyal

0.00

1.23

-1.23

Philippine peso

0.00

0.76

-0.76

Australian Bureau of Statistics, 2011. International Trade in Goods and Services, Catalogue No 5368.0 (Australian Government: Canberra). Crowson, P, 1998. Inside Mining: The Economics of the Supply and Demand of Minerals and Metals (Mining Journal Books: London). Davis, G and Vásquez Cordano, A, 2011. International trade in mining products, Journal of Economic Surveys (Blackwell), DOI:10.1111/j.1467-6419.2011.00695.x. Grubel, H G, 1981. International Economics, revised edition (Irwin: Illinois). Hummels, D, 2007. Transportation costs and international trade in the second era of globalization, Journal of Economic Perspectives, 21(3):131-154. Krugman, P R, 1979. Increasing returns, monopolistic competitionnand international trade, Journal of International Economics, 9(4):469-479. Lundgren, N-G, 1996. Bulk trade and maritime transport costs: The evolution of global markets, Resources Policy, 22(1/2):5-32. Radetzki, M, 2008. A Handbook of Primary Commodities in the Global Economy (Cambridge University Press: Cambridge). Reserve Bank of Australia, 2002. Developments in the tradeweighted index, Reserve Bank of Australian Bulletin, October:1-6. Reserve Bank of Australia, 2011. Reserve Bank of Australia [online]. Available from: . Stewardson, R, 1992. Value adding in Australia, Australian Bureau of Agricultural and Resource Economics National Agricultural and Resources Outlook Conference, Canberra, 5 p. United States Geological Survey, 2011. The Mineral Industry of Australia by Tse, Pui-Kwan, 2010 Minerals Yearbook (Washington). World Trade Organization, 2010. World Trade Report 2010: Trade in Natural Resources (Geneva). World Trade Organization, 2011. International Trade Statistics 2011 (Geneva).

in Australia over time, though there are periods where the correspondence has not applied. The case of gold provides an interesting recent example. For some of the past 20 years, movements in the gold price were largely in unison with the Australian exchange rate. In the first part of that period, spot gold prices hovered around $A500. During 1997, however, there was a dramatic downward movement in the $US price of gold, due in part to the decisions of several Central Banks (including the RBA) to sell all or part of their gold holdings. As the market price sank below $US300/oz, the Australian dollar also declined, but not at the same rate. Soon spot gold prices stood close to $A 400/oz. Many gold producers were in trouble. Some switched to ‘high grading’ and most slashed exploration budgets to stay viable. Fortunately for local gold producers, the $A/US exchange rate continued to fall and the $A price of gold

48

Mineral Economics

Minerals – Consumption, Production and Markets

HOME

Chapter 5 Mineral Demand – The Theory in Practice Peter Howie Introduction The final product demand curve and the level of consumption Final product demand and its determinants Mineral resources and derived demand The mineral demand curve Shifts in the mineral demand curve Elasticity of mineral demand Own price elasticity of mineral demand in the short run Income elasticity of mineral demand in the short run Cross-price elasticity of mineral demand in the short run Elasticity of mineral demand in the long run Conclusions

INTRODUCTION Minerals are widely used in the modern economy. How these uses change as the result of changing economic, political and technological circumstances is the subject of mineral demand. Because the demand for minerals is multifaceted, it is also essential to have a good knowledge of the fundamentals that affect mineral demand so as to analyse and forecast output and price behaviour. The demands for minerals are commonly separated into three categories for ease of presentation: derived, created and historical. Industrial demand for minerals predominantly derives from their unique physical and chemical properties that enable their use in varied applications. Discussions of mineral demand particularly recognise this characteristic. There is a strong link between these uses and economic growth, and this relationship is likely to continue into the future. For many of the minerals sold as jewellery, demand has been created and requires constant promotion. The most famous example of created demand is the association of diamonds with love and commitment, developed by De Beers Consolidated Mines in association with NW Ayer and Son (Pequignot, 2010). Mineral Economics

In fact, the slogan ‘a diamond is forever’, is widely considered the most recognised and effective slogan of the 20th century (Otnes and Pleck, 2003). The growth in demand for jewellery is highly correlated with the demand for gold and other precious metals in the USA, Asia and the Middle East. Consumers in the developed markets of the west buy jewellery primarily for adornment and often for sentimental reasons; whereas, in the developing markets of Asia and the Middle East, they purchase it for investment as well as adornment. Investment demand is, for the most part, historical and relies on international currency movements and inflation. The monetary demand for gold and, to a lesser extent, other precious metals, has derived value from providing stability and security to overall investments. This chapter is organised to permit an orderly presentation of the basic topics of mineral demand, separated into four parts. The first presents the concept of final-product demand and introduces some of the economics required to understand subsequent sections. The second focuses on the derived demand for minerals and the characteristics of such demand. The third 51

chapter 5 – Mineral Demand – The Theory in Practice introduces the concept of elasticity and progresses, with an in-depth examination of the sensitivity of mineral demand to changes in prices and income. This section also examines the effect of time on mineral demand. The fourth section offers some concluding comments.

THE FINAL-PRODUCT DEMAND CURVE AND THE LEVEL OF CONSUMPTION This section presents some necessary economic tools as well as generating both individual consumer and market final-product demand curves. Economists define a final product as a product that is produced for its final user and not as a component of another good or service. For example, an Apple iPad, a pair of gold earrings and gold bullion used for investment are final products; however, copper wiring in the iPad and gold in the earrings are intermediate products or inputs. To help with the formal development of the final-product demand curve, let us introduce the hypothetical scenario of Ms Sangeeta Kumar, a Senior Manager at the Tata Group in India. Ms Kumar is interested in purchasing gold earrings for the upcoming year. Since most goods are scarce and Ms Kumar cannot have everything that she wants, she must make tough choices. The science of economics tells us that every time we make a choice, because resources are scarce, something else must be given up. That is, when Ms Kumar purchases one good she is giving up the opportunity to purchase another good or service with the money she spends. Furthermore, economics provides us with a set of tools that can help make the best decision available. This set of tools is based upon the philosophy of utilitarianism. The foundation of utilitarian philosophy is: … actions are right in proportion as they tend to promote happiness; wrong as they tend to produce the reverse of happiness. (Mill, 1863) In other words, utilitarian philosophy suggests that Ms Kumar makes decisions with the ultimate objective of maximising her happiness, both intellectual and sensual. Commonly people believe that choices they make are in the form of the following question: which and how many pairs of earrings should I purchase? The answer to this question is believed to be that the Ms Kumar decides to purchase the pairs of earrings that she likes the best so long as they are within her budget. Economists suggest that such questions should be answered by comparing all the costs, not only money costs but also the costs associated with an inability to do something else. Therefore, when Ms Kumar purchases earrings, economists suggest that she compares all costs and benefits. Often, however, it is difficult or impossible to list all the available purchase options within a person’s budget. Luckily, economics provides us with a simple way to approach this problem. It suggests that 52

we break the question: how many and which pairs of gold earrings should Ms Kumar purchase? into a series of questions. Before doing this, let us make two simplifying, but realistic, assumptions: 1. Ms Kumar budgets a certain amount of money to buy gold earrings and she spends all of this money either on gold earrings or on another product. 2. Benefits from the purchases are expressed in terms of money. This means that all benefits, both sensual as well as intellectual, from the purchase of gold jewellery are measured in terms of equivalent money value. Key questions to be asked are: •• How much is Ms Kumar willing to pay for the first pair of earrings? •• How much is Ms Kumar willing to pay for a second pair of gold earrings? •• How much is Ms Kumar willing to pay for each subsequent pair of gold earrings? This type of questioning examines the effects of changes in happiness with each additional purchase. It allows us to determine the number of dollars (or Rupees) that Ms Kumar regards as equivalent to each pair of earrings. It is a direct measurement of the benefits she receives from each pair of earrings. As Table 5.1 shows, Ms Kumar derives $300 worth of benefit from one pair of earrings, $550 worth of benefit from two pairs of earrings, and so on. So she receives $300 of benefit from the first pair of earrings, $250 from the second pair, and so on. The additional benefit that a consumer receives from consuming the next unit of a product is referred to as ‘marginal benefit.’ For Ms Kumar, marginal benefits are the amounts of money that she is willing to pay to enjoy the attributes of an additional pair of gold earrings. For example, the marginal benefit from the third pair of earrings is $204. Table 5.1 also shows that as Ms Kumar buys more and more pairs of earrings, the benefits that she derives from each additional pair will be less than that from the previous pair. Therefore, the graph of her marginal benefits from earrings is downward sloping (see Figure 5.1). Table 5.1 Marginal and total benefits. Pairs of earrings

Total benefits

Marginal benefits

0

0

-

1

300

300

2

550

250

3

754

204

4

918

164

5

1048

130

6

1148

100

Mineral Economics

chapter 5 – Mineral Demand – The Theory in Practice

300

Marginal benefits (dollars)

B’s Demand

A’s Demand

350

$/unit

$/unit

Market Demand $/unit

250 200

130

150

100

100 50

5 6

0 0

1

2

3

4

5

6

Q/t

6

8

Q/t

11

14

Q/t

Fig 5.2 - Individual and market demand curves.

Pairs of gold earrings per period

Fig 5.1 - Marginal benefit curve.

Ms Kumar’s marginal benefit curve from gold earrings (or any individual product or service) is identical to her individual demand curve for gold earrings (or any individual product or service). That is, the demand curve for gold earrings shows the marginal benefits received from consuming gold earrings during a certain period of time. It is also possible to derive the market demand curve for gold earrings. Table 5.2 provides a simplified example of the gold earrings market if there were only two consumers. At $130 per pair of earrings, consumer A demands five pairs per period and consumer B demands six pairs per period. Therefore, the market demand for gold earrings at $130 is 11 pairs of earrings. Similarly, at $100 per pair of earrings, consumer A demands six pairs and consumer B demands eight pairs; therefore, the market demand is 14 pairs. This procedure of generating the market demand is often described as ‘announcing a price and adding up the individual quantities demanded at that price.’ This procedure is the same whether there are only two consumers in a market or many millions.

or service to fall as its price increases. One is that many people will switch to a substitute good. If the price of gold jewellery was to rise, some consumers may switch to platinum jewellery, others to silver jewellery. The second reason is that consumers are unable to buy as much as before. Incomes usually do not fluctuate with the price of an individual product and when the price of a good goes up, it is not possible to buy as much as before unless the consumer purchases less of something else. Similar to the market demand curve, the market supply curve represents the behaviour of suppliers during a given period of time. The market supply curve shows the total number of units of a good or service that sellers are willing to deliver to the market at every possible price during a given period. Market supply curves generally slope upward, indicating that sellers are willing to supply a higher quantity as the price rises.

Consumer A's demand

Consumer B's demand

Market demand

160

4

4

8

130

5

6

11

100

6

8

14

When the price is such that the quantity that buyers want to buy is the same as the quantity that sellers want to sell the market is said to be in equilibrium. If consumers wish to consume more than producers wish to produce, there will be buying pressure and the quantity demanded will exceed the quantity supplied. As a result, price will rise. Conversely, if consumers wish to consume less than producers wish to produce, there will be selling pressure and the quantity supplied will exceed the quantity demanded. With this scenario price will fall. Such changes will continue until equilibrium is achieved – quantity demanded equals quantity supplied. The price that accomplishes this is termed the equilibrium price and the corresponding quantity the equilibrium quantity.

70

7

10

17

Final-product demand and its determinants

40

8

12

20

Recall that the demand curve shows that if there is an increase in the price of goods, consumers will purchase less of the goods, all other things equal. In other words, if price goes up, quantity demanded will go down; if price goes down, quantity demanded will go up. This is the concept that economists refer to as the law of demand. It indicates that if there is an increase in the price of a product, then there will be a leftward movement along its demand curve, and vice versa. Economists refer to movements along the demand curve as changes in the quantity demanded.

Table 5.2 Individual and market demand. Price ($/pair)

Figure 5.2 provides a graphical representation of the market demand for gold earrings outlined in Table 5.2. It is important to understand why the market demand curve is drawn as it is. Along the demand curve only price and quantity demanded are allowed to change, while income and the prices of related goods are held constant. Furthermore, there are two independent reasons for the market quantity demanded of a good Mineral Economics

53

chapter 5 – Mineral Demand – The Theory in Practice It is important to realise that the demand curve by itself isolates the impact of price on the quantity of a product demanded. Because the law of demand is one-dimensional (that is, it only examines the impact of quantity demanded caused by changes in the price of the good and vice versa) it leaves out elements that shift the demand curve. For example, the law of demand cannot fully explain the increase in the price of gold from around US$800/oz in November 2008 to more than US$1800/oz in August, 2011. That is because the quantities consumed and produced are not solely determined by price.

importance of the role of expectations by institutional investors is made clear by the actions of these after September 2008. On 17 September 2008, spot gold jumped by nearly $90 an ounce, a record one-day gain, as these investors sought safety amid turmoil in stock markets. Furthermore, during the week of 8 September 2009, purchases of long positions of gold futures contracts reached their greatest number for the 2000 - 2010 period as institutional investors worried about the weakness of the US dollar and concerns over the economic recovery (United States Commodity Futures Trading Commission, 2011).

One key to the higher gold price lays in changes of investors’ preferences for gold due to the concerns about the global economy and sovereign debt issues, particular those of the United States. After November 2008, investors became increasingly worried about the safety of their US dollar-denominated money and there was an increase in the preference to hold gold as an alternative.

Finally, the level of income and prices of related goods are also important to the demand for gold. China’s demand for gold jewellery increased from just over 500 000 oz in the late 1980s to over 12 Moz at the end of 2010, in spite of the price of gold going from $200 to $1500/oz. This rise in consumption coincided with a dramatic rise in China’s per capita income from $350 in 1991 to $3650 in 2009 (World Bank, 2011).

In addition to the growing investment demand for gold bullion, gold jewellery demand has seen recent increases due to changes in consumer preferences. Even with a 23 per cent increase in the price of gold during 2010, the World Gold Council estimated that the consumption of gold was up 22 per cent in tonnage terms (or 53 per cent in dollar terms) in 2010 (World Gold Council, 2011).

MINERAL RESOURCES AND DERIVED DEMAND

A change in preferences of consumers (ie consumers of gold jewellery) and investors who are consumers of gold bullion is only one of several non-price factors that change the quantity of a good that is consumed. These non-price factors shift the demand curve. Specifically, the demand curve: •• shifts to the right if a non-price factor causes the quantity consumed to increase •• shifts to the left if a non-price factor causes the quantity consumed to decrease. Other non-price factors that shift the demand curve include the level of income, the prices of related goods and expectations. The expectations of final consumers are very important to gold jewellery demand. A large proportion of the 17 per cent increase in gold jewellery demand by the world’s largest consumer of gold jewellery, India, during 2010 was due in part to a widespread expectation of higher gold prices (World Gold Council, 2011). China, the second largest consumer of gold jewellery, witnessed 13 per cent growth in jewellery consumption, especially in the pure gold (24 carat) segment, suggesting that expectations of higher gold prices were playing an increasing role in the demand for gold jewellery for the Chinese (World Gold Council, 2011). Institutional investors use gold as a hedge against inflation or a fall in the US dollar. Remember that gold transactions are denominated in US dollars. The 54

Up to now, we have discussed the consumer demand for final goods and services. However, most minerals are not final goods. Consumers do demand precious metals and gems as final goods, but these uses are a small fraction of total mineral demand. For the most part, minerals are used as inputs for final goods and services. Therefore, the demand for most minerals is derived from the demand for the final goods and services for which the mineral is an input. Demand of this type is known as derived demand. For example, the demand for copper in mobile telephones is derived from the demand for mobile telephones. Consumers of the final product, here mobile telephones, are not concerned about which inputs are used as long as the mobile telephone meets their specifications.

The mineral demand curve There is a clear relationship between final-product demand and the derived demand of a mineral to make these final products. Recall that determining finalproduct demand involves the ultimate objective of maximising a consumer’s happiness, determined by the prices of goods and by the income available for their purchasing. In contrast, for our mobile telephone manufacturer, who requires inputs for its production, mineral demand is a special case of demand in which the purchased goods are the inputs for production. As a result, the demand for minerals is linked closely with firms’ production processes. Our firm’s mobile telephone production process, and its demand for copper, expresses a relationship between its inputs and its outputs. Economists formally represent this production relationship by the production function.1 1

We have introduced the production function in Chapter 2. Mineral Economics

chapter 5 – Mineral Demand – The Theory in Practice The production function is a non-monetary relationship that correlates physical inputs to physical outputs. Prices and costs are not considered. A typical production function for a firm with only one variable input, say copper, and a set level of fixed inputs appears in Figure 5.3. In this example, the fixed inputs – those inputs whose quantities cannot be readily changed in an effort to alter the rate of output – include pieces of equipment and machinery, the factory space available for production, the know-how of managerial personnel and all labour. The vertical axis shows the total output of the final good (mobile telephones), and the horizontal axis shows the units of copper employed. Quantity of mobile telephones per time period

B

A Units of copper per time period X Y

APP

MPP Stage 1

Units of copper per time period

Stage 2

Fig 5.3 - The production function.

All points above the production function are unobtainable with current technology, all points below are technically feasible and all points on the function show the maximum quantity of output obtainable at the specified levels of inputs. From the origin, through points A and B, the production function is rising, indicating that as additional units of copper are used, the quantity of mobile telephones also increases. From the origin to point A, as the firm uses additional units of copper, the number of mobile telephones produced increases at an increasing rate. In economics, we call the increase in output generated by adding an additional unit of the variable input the marginal physical product (MPP). For the mobile telephone manufacturer, MPP is the increase in output of mobile telephones caused by increasing the amount of copper by one unit. As the number of mobile telephones is increasing from the origin to point A, then the firm’s marginal physical product is also increasing, as shown by the increasing marginal physical product of copper form the origin to point X. The average amount of Mineral Economics

telephones generated by each unit of copper employed – the average physical product (APP) – is rising along the production function between the origin and point A. Point A defines the starting point beyond which the number of mobile telephones produced increases at a decreasing rate when additional units of copper are employed. This corresponds to declining MPP of copper beyond point X. Point B is the starting point beyond which the average amount of telephones produced by each unit of copper employed starts to decrease. This trend is shown by the declining slope of the APP curve beyond point Y. To simplify the interpretation of a production function, it is common to divide its range into two stages. In Stage 1 (from the origin to point B) the average number of mobile telephones generated by both the variable input, here copper, and the fixed inputs is rising reaching a maximum at point B. Because the average number of mobile telephones generated by both the variable and fixed inputs is increasing throughout Stage 1, the firm will always try to operate beyond this stage. It turns out that in Stage 1, fixed inputs are underutilised. In Stage 2 (beyond point B), the output of mobile telephones increases at a decreasing rate. That is, both the additional amount of mobile telephones generated by each additional unit of copper used and the average amount of mobile telephones generated by each unit of copper used are decreasing. However, the average number of mobile telephones generated by the fixed inputs is still rising. It turns out that the optimum copper/mobile telephone combination will be in Stage 2. Therefore, a profit-maximising firm will always operate somewhere in Stage 2. As a result, from here on, our discussion of the marginal physical product curve refers to the downward sloping portion in Stage 2. The next step is to determine how many units of copper a profit-maximising firm will employ. The answer is straightforward: our firm will employ any unit of copper that produces greater revenue than the copper adds in cost. That is, the firm will use an additional unit of copper when the benefits from its use are greater than its additional costs. For simplicity let us assume that: •• the added cost equals the market price of the copper (which implies that the buyer of copper is a price taker) •• the price of mobile telephones is held constant. The value that copper contributes to the mobile telephone manufacturer depends on two things: how much the output of mobile telephones increases by adding an additional unit of copper and the extra revenue that each additional mobile telephone brings to the firm. In economics, we call the value that an extra unit of variable input contributes the marginal revenue product (MRP) as opposed to the MPP. The MPP of 55

chapter 5 – Mineral Demand – The Theory in Practice copper is simply the added revenue or benefit to the firm of employing an extra unit of copper. For our mobile telephone manufacturer, this benefit equals the marginal physical product of copper, multiplied by the market price of the mobile telephone. The cost of the copper, by the above assumption, is its market price. Therefore, the mobile telephone manufacturer will employ additional units of copper until the benefit that an extra unit of copper contributes (the MPP) equals the market price or cost of an extra unit of copper. A numerical example may help to clarify this idea. Nokia, a leading firm in the mobile telephone industry, has a mobile telephone assembly factory in Chennai, India. Suppose Nokia pays US$12/kg for copper wiring and it receives 540 rupees (equivalent to US$12) for each telephone. Adding another kilogram of copper will allow Nokia to make two more mobile telephones per hour. Is it worthwhile to add another kilogram of copper? Using the rule discussed above, one sees that the extra value to Nokia is 2 × US$12 or US$24. The extra cost to Nokia of another kilogram of copper is US$12. Therefore, it is profitable for Nokia to add the extra copper. After this kilogram of copper is added, Nokia may find that adding another kilogram of copper will add only one more mobile telephone. In this case Nokia is indifferent to adding an extra kilogram of copper because to generate an extra US$12 of income costs US$12. It is not in Nokia’s interests to employ any additional units of copper because the extra value that the additional unit of copper would generate is less revenue than the price of copper. An important characteristic of the marginal revenue product curve of a mineral is that it corresponds to a manufacturer’s demand curve for the mineral. Nokia’s mineral demand curve identifies the amount of copper it chooses to employ at different prices, holding everything else constant including the price of mobile telephones. Now let us examine the market demand curve for copper. If we assume that the price of mobile telephones and the price of copper remain constant, then market mineral demand curve for copper is the horizontal sum of individual firm copper demand curves. However, if the demand for copper increases the market price of copper, then the result is a change in the quantity, price, or both the price and quantity of mobile telephones. As a result, the market mineral demand curve, when mineral price changes, tends to have a steeper slope than the one obtained from the simple horizontal summation of individual firm copper demand curves (Campbell, 1985). We now have one half of our market for minerals – mineral demand and the market mineral demand curve. We now need to briefly look at the supply side of the minerals market2. We can once again use the Nokia 2

56

We will do this in more detail in Chapter 6.

example and attempt to put ourselves in the position of the mineral suppliers – the copper producers. If the price of copper increases, copper producers are willing to supply more copper to the market. As a result, the mineral supply curve is positively sloped. That is, at a higher price there will be a greater quantity of copper supplied. If we combine this supply information with our information on mineral demand we get a diagram such as Figure 5.4, which describes the achievement of equilibrium in the mineral market. $/unit

S

P* D Q*

Q/period

Fig 5.4 - Equilibrium in a mineral market.

This analysis is similar to the supply-demand analysis we explored earlier for gold earrings. The market will tend toward the equilibrium where mineral supply equals mineral demand. At any other price a shortage (price too low) or a surplus (price too high) will occur and there will be adjustments in the price to bring the market to the equilibrium.

Shifts in the mineral demand curve In the section ‘Final-product demand and its determinants,’ we discussed factors that shift the finalproduct demand curve. A parallel discussion for the mineral demand curve is necessary as some of the factors that cause it to shift are different from the factors that shift the final-product demand curve. These different factors reflect the derived nature of the input demand curve. In this discussion we discuss three factors that cause the mineral demand curve to shift. They are: 1. changes in demand for a final product 2. changes in technology 3. changes in the mix of inputs. First, let us consider changes in consumer demand for a final product. As you would expect, there is a direct positive relationship between final-product demand and mineral demand. That is, an increase in the demand for mobile telephones will increase the demand for copper. On a graph, this translates to a rightward shift of the mineral demand curve. A decrease in the demand for mobile telephones will reduce the demand for copper. On a graph, this equates to a leftward shift of the mineral demand curve. Second, let us think about changes in technology. Recall that the production function is constructed assuming: Mineral Economics

chapter 5 – Mineral Demand – The Theory in Practice •• constant technology in the minerals industry •• constant technology in the final product industry. Within the minerals industry, changes in technology have led to increased availability and utilisation of capital equipment and minimised non-productive work hours. More generally, they have brought more cost-effective mineral exploration, mine development and mineral processing. The result is a rightward shift in the mineral supply curve (discussed in Chapter 6). By contrast, technological changes in a manufacturing process for a downstream intermediate or final product that uses a mineral such as copper as an input will cause a shift in the copper demand curve. There are two types of technological changes in these manufacturing processes that may cause the copper demand curve to shift. They are: 1. the refinement and improvement of existing processes 2. the development of new products. The steel smelting industry provides a good example of refinement and improvement technological change. During the early 1960s, technological innovation in the injection of pulverised coal into blast furnaces reduced coking coal rates by 36 per cent per tonne of steel. By the beginning of the 1990s injection rates of coking coal had declined by an additional 15 per cent per tonne of steel (Mitchell, no date). When technological change permits the use of a smaller quantity of mineral inputs to obtain a given level of output, the final-product production function, here the production function for steel, shifts leftward, as shown in Figure 5.5, and the mineral demand curve will shift to the left. Quantity of steel output per time period Production function after technological change

Production function before technological change

Units of coal per time period

Fig 5.5 - Technological change shifting final-product production function.

Even though refinement and improvement technological changes directly reduce the demand for coal in the production of steel, it also indirectly increases the demand for coal in the production of steel. An important result of refinement and improvement technological change is its ability to lower the cost of delivering an extra unit of steel to market. This will increase the quantity of steel demanded, which will also increase the demand for coal. Hence, the coal demand curve will shift to the right. To conclude, the final result of refinement and improvement technological changes on a specific mineral’s demand curve is uncertain. Mineral Economics

Technological changes that develop new products can either increase or decrease the demand for a mineral. For example, optical fibre cables, which are now used widely in telecommunications, have replaced huge tonnages of copper wire. Comparisons indicate that an optical fibre can carry over a quarter million times more information than a similarly sized copper wire (Dulay, 2004). In contrast, renewable energy projects consume significant amounts of copper. On average, a one megawatt wind turbine contains 3.9 t of copper and a photovoltaic installation approximately 4 kg of copper per kilowatt of installed capacity (European Copper Institute, 2008). In 2008, this group estimated that the wind turbines installed in the European Union contained 190 000 t of copper and the photovoltaic installations nearly 19 000 t. The decision by Germany to close down its 17 nuclear power plants, which generate one-quarter of the country’s electricity (approximately 151 TWh), by 2022 and shift to renewable sources should greatly increase the installed amount of copper for energy production, and in turn copper demand, over the next ten years (Federal Statistical Office of Germany, 2011; Wiesmann, 2011). The third factor that causes the mineral demand curve to shift is a change in the price of other inputs, which causes a change in the mix of the inputs used. The effect of a change in the price of one mineral, say aluminium, on the demand for another mineral, say copper, may be uncertain. Aluminium and copper are often used together in coaxial cable, with copper as the centre conductor and aluminium as the shield. However, aluminium is a substitute for copper in electric motor rotors and many other electrical applications. When aluminium is a complement of copper, a decrease in the price of aluminium causes a rightward shift in the mineral demand curve for copper and an increase in the price causes a leftward shift. Price changes for a substitute mineral are more complicated. There is a direct effect as well as an indirect effect of the price change. A higher price of aluminium destined for the electric rotor industry may result in a direct increase in the use of copper because copper will be substituted for aluminium. However, the higher price of aluminium may cause copper use to decline indirectly because copper may not be able to completely replace all aluminium. The indirect effect of the increase in the price of aluminium is caused by the increase in the cost of producing the final product, which in turn leads to lower production and less demand for both aluminium and copper. The final result of a price change for a substitute mineral depends on which effect is larger, the direct or indirect, and varies from product to product.

ELASTICITY OF MINERAL DEMAND When there are price movements along the demand curve as well as shifts in demand, it is important to 57

chapter 5 – Mineral Demand – The Theory in Practice have an estimate of the magnitude of these changes. Economists use the concept of elasticity of demand to indicate the quantitative impact of the factors affecting demand. Even though it is a simple concept, elasticity is one of the most powerful devices used by economists. It is simple because it is no more than a form of measurement that tells how sensitive one variable is to another. It is powerful because of the way economists make use of how benefits and costs change by very small changes in specific variables such as prices and income. The concept of elasticity can be used to help answer questions such as: •• Will an increase in the price of a firm’s product make the firm more or less profitable? •• If the price of a particular good increases, will the amount of the good purchased change significantly or minimally? Economists have identified three main types of elasticity of mineral demand: 1. own-price elasticity of demand, which measures how the quantity demanded of a mineral changes if its price changes 2. income elasticity of demand, which measures how the quantity demanded of a mineral changes if income increases 3. cross-price elasticity of demand, which shows how the quantity demanded of one mineral changes if the price of another mineral changes. The discussion of elasticity is separated into two parts because elasticity is determined, in part, by the time period involved. Therefore, part one introduces us further to the concepts of elasticity of mineral demand and applies the concepts of elasticity to the short run. Part two then shows how the elasticities of mineral demand change over time and presents how economists use long-run elasticities. Economists commonly separate economic periods into the short run and the long run3. The short run is a period in which at least one factor or aspect of market conditions is fixed. Campbell (1985) argues that a firm’s lease, existing production capacity, agreed-upon labour contracts and several other operating conditions are fixed in the short run. When considering mineral demand, fixed factors in the short run would include the capital stock of companies using a specific mineral in the manufacture of a final product.

An important consideration between the short and long run is that the definitions do not include a definite time period. The definitions are based on the degree of flexibility to which firms have to change their inputs and consumers have to change their lifestyles. One of the consequences of the definitions is that the relevant time period that distinguishes the short run from the long run will vary from industry to industry.

Own-price elasticity of mineral demand in the short run The definition of own-price elasticity of demand is the percentage by which quantity demanded changes if its price increases by one per cent, all other things being equal. The simple formula is: Own price elasticity of demand =

Own-price elasticity of demand is negative because of the inverse relationship between price and quantity demanded, as indicated by the law of demand. If demand is elastic, the ratio of percentage change in quantity demanded resulting from a one per cent change in price will have an absolute value greater than one4. If demand is inelastic, the ratio will have an absolute value between zero and one. Generally, demand for luxury goods is price inelastic, as are the demands for essential products such as petrol and food since people generally buy them even if their price goes up. In contrast, the demands for many consumer goods such as gold jewellery and housewares are elastic, since people can easily find substitutes or do without them. Figure 5.6 illustrates two demand curves: one for gold jewellery and the other for petrol. From the diagram, when the price of gold jewellery rises from P1 to P2, the per cent change in the quantity demanded of gold jewellery – from Au1 to Au2 – is greater than the per cent change in price. Therefore, gold jewellery is own-price elastic at point Au1. Conversely, when the price of petrol rises from P1 to P2, the per cent change in the quantity demanded of petrol – from P1 to Pet1 to Pet2 – is less than the per cent change in price. Therefore, petrol is ownprice inelastic at point Pet1. Gold Jewellery: Elastic Demand

58

Petrol: Inelastic Demand

$/unit

By contrast, the long run has no such fixed costs and conditions; everything is free to change. Given more time, manufacturers can develop new strategies for adjusting production processes such as substituting copper for aluminium; or consumers can adjust personal lifestyles such as purchasing 18-carat white gold instead of platinum jewellery. 3 In Chapter 6, we use the related classification of the immediate run, the short run, the long run and the very long run.

% change in quantity demanded % change in price

$/unit

large percentage change in quantity demanded small percentage change in price P2

small percentage change in quantity demanded large percentage change in price P2 P1

P1 DAu Au2

Au1

QAu/period

DPetrol Pet2 Pet1

QPetrol/period

Fig 5.6 - Sensitivity of mineral demand to price changes. 4

Absolute value means ignoring the sign. The absolute value of -1 is 1. Mineral Economics

chapter 5 – Mineral Demand – The Theory in Practice Before discussing the determinants of own-price elasticity of mineral demand, it is important intuitively to understand own-price elasticity. Suppose Nokia spends a portion of its budget on copper wiring. If the price of copper wiring rises by five per cent, Nokia may buy less, but does the company buy six per cent less or just two per cent less? In the first case, demand would be own-price elastic, in the second, own-price inelastic. Clearly in the case of petrol, a rise of five per cent in the price would not cause a buyer to reduce his consumption of petrol by more than five per cent. That is, there is a small effect of a price change on rates of consumption. The argument would be similar for copper wiring. The demand curves for most minerals are own-price inelastic – that is, steeply sloped – if we are considering the short run because manufacturers and consumers that use minerals as inputs are constrained by their existing plants, equipment, and vehicles. In contrast, a higher gold price would cause a consumer to buy significantly less new gold earrings or other jewellery if her own-price elasticity of gold were elastic. That is, a rise of five per cent in the price of gold jewellery would cause the consumer to reduce her consumption of gold jewellery by more than five per cent. A good way to examine the factors affecting the ownprice elasticity of the mineral demand curve is to use concepts developed in the four Hicks-Marshall laws of derived demand. These four laws are named after the two distinguished British economists, John Hicks and Alfred Marshall, who are closely associated with their development. In his Principles of Economics, Marshall (1920) formulated four rules on the determinants of own-price elasticity of derived demand. Hicks (1966, pp 241-247) re-examined Marshall’s four rules in The Theory of Wages, describing own-price elasticity of derived demand for labour in terms of substitutability of inputs and own-price elasticity of final-product demand. While full statements of the four laws are quite complex, brief and simplified versions of them yield invaluable insights into the determinants of ownprice elasticity of mineral demand. The four Hicks-Marshall laws of derived demand conclude that the demand for a mineral will be own-price elastic when: 1. the demand for the final product, in which it is an input, is own-price elastic 2. it is relatively easy to substitute other inputs for the mineral 3. the supply of other production inputs is own-price elastic 4. the mineral accounts for a relatively large share of total costs of producing the final product. Let us examine each of these laws in turn. The first Hicks-Marshall law states that mineral demand will be own-price elastic when the demand for the final product is Mineral Economics

own-price elastic. Economists traditionally examine the response of mineral demand to a final-product price change by assuming that the proportions of inputs are fixed. When the demand for the final product is ownprice elastic, say -1.5, then the demand for the final product changes 50 per cent more proportionally than the price. However, when the demand for the final product is own-price inelastic, say -0.5, then quantity demanded of the final product changes only half as much proportionally as the price. Therefore, when the demand for a final-product is own-price elastic, there will be a greater reduction in the use of all inputs. A good example for the first Hicks-Marshall law is the use of silver in jewellery and dental filling alloys. The estimated demand for silver jewellery is strongly own-price elastic (Venkatesh, 2002; GFMS Limited, 2004) whereas the estimated demand for dental services is own-price inelastic (Eriksson, 2003; Grytten, 2005; Manning and Phelps, 1978)5. As the own-price elasticity of demand for silver jewellery is own-price elastic, an increase in the price of silver jewellery will result in a large reduction in the quantity demanded of silver jewellery. This will, in turn, cause a large reduction in the use of silver. Therefore, an increase in the price of silver jewellery will result in a large reduction in the quantity of silver demanded for silver jewellery. In contrast, the demand for dental services is own-price inelastic; therefore, an increase in the price of silver dental fillings will result in only a small reduction in the quantity of silver demanded for silver dental filling alloys. The second Hicks-Marshall law states that mineral demand is own-price elastic when it is relatively easy to substitute other inputs to replace the mineral under consideration. One measure of substitutability between inputs considers how much input proportions change when the price of one of the inputs, say copper, changes, holding output of the final product at a fixed level. When it is easy to substitute other inputs for copper then a small change in the price of copper will cause a large change in the proportion of the inputs used. On the other hand, when it is difficult to substitute other inputs for copper then a small change in the price of copper is probably not going to cause a firm to replace a unit of copper with a unit of another input. Decisions about the substitution between a specific mineral and other inputs depend on two general factors: technology and relative prices. Different combinations of inputs will produce different levels of output. The results of different combinations of a mineral such as copper and the remaining inputs to a final product reflect the technology that is available to the manufacturer. One example of the second Hicks-Marshall law is seen with naturally-occurring rutile being substituted 5

In their study of the USA, Manning and Phelps estimated that own-price elasticity for dental visits was -0.7.

59

chapter 5 – Mineral Demand – The Theory in Practice by synthetic rutile – which is produced from ilmenite – in the titanium dioxide white pigment, metal and welding-rod coatings markets (Ward, 1990). As it is relatively easy to substitute synthetic rutile for naturally-occurring rutile, a price increase in naturallyoccurring rutile will result in a large reduction in the quantity of naturally-occurring rutile demanded. The third Hicks-Marshall law states that mineral demand will be own-price elastic when the supply of other factors of production is relatively own-price elastic. It is worth digressing for a moment to discuss own-price elasticity of supply (also discussed in Chapter 6). The responsiveness of supply to changes in price of a good or service is its own-price elasticity of supply, as illustrated in Figure 5.7. The definition of ownprice elasticity of supply is the percentage by which a product’s quantity supplied would change if its price were to increase by one per cent, all other things being equal. The simple formula is: Own price elasticity of sup ply

$/unit

Elastic Supply

% change in quantity sup plied % change in price

$/unit

Inelastic Supply

S S

P2

P2 P1

P1

D D

D Q1

Q2

D

Q/period

Q1 Q 2

D D Q/period

Fig 5.7 - Own-price elasticities of supply.

When supply is inelastic, a change in demand affects the price more than the quantity supplied. The reverse is the case when supply is elastic – a change in demand is met with a small change in market price. The third Hicks-Marshall law examines the ease with which a mineral can be substituted by other inputs. From the discussion of the Hicks-Marshall second law it can be seen that substitution between a mineral and other inputs generally depends on technology and relative prices. However, substitution of one mineral input for another, say aluminium for copper, can be also affected by spare capacity in an input industry as well as the level of stocks or inventories of the other inputs. If there is plenty of spare capacity of aluminium or if its stocks are high, a manufacturer will find it more beneficial to substitute aluminium for copper, all other things being equal. Spare capacity and a high level of stocks correspond to elastic supply. Therefore, if the price of copper increases and the supply of aluminium is own-price elastic, the increase in demand for aluminium will have little effect on the price of aluminium and a manufacturer may significantly increase profits by increasing its use of aluminium and decreasing its use of copper. 60

However, if the supply of aluminium is inelastic, the increase in demand for aluminium will substantially increase its price and the additional quantity of aluminium supplied to the market will be small. In this case, a manufacturer would not increase its profits by increasing its use of aluminium and decreasing its use of copper. A good example of the third Hicks-Marshall law applied to manufacturing in the Former Soviet Union during the 1990s, ie in the early years of transition from socialism to capitalism. One of the impacts of inefficient Soviet central planning was that industry became heavily dependent on energy priced far below world levels (Platts, 2004; European Bank of Reconstruction and Development, 2002). During the 1990s, energy consumption fell principally as the result of the severe decline in output in the early 1990s. For example, Kazakhstan’s net energy consumption decreased by 45 per cent between 1992 and 1998 (United States Energy Information Administration, 2003). As a result, during the 1990s there was abundant excess capacity in electricity generation and the supply of electricity was quite elastic. A large increase in demand for electricity in the Former Soviet Union would result in a large increase in electricity use and a relatively small increase in its price. By contrast, when the supply of electricity is relatively inelastic – as has recently been in Chile6 – increases in demand drive up electricity prices by a relatively large amount, but the quantity of electricity used by industry increases only minimally. The increase in the price of electricity limits the amount of additional electricity that can be used as a substitute for another fuel mineral. The fourth Hicks-Marshall law states that mineral demand is own-price elastic when the mineral accounts for a relatively large share of total costs. In this situation, a price increase of the mineral will have a large effect on a manufacturer’s costs and, therefore, a large effect on the price of the final output. With this large increase in the price of the final product, the decrease in the quantity of the final product demanded will be large and, consequently, the reduction in the mineral’s use will also be large, all other things equal. The use of aluminium and palladium in motor vehicles explains the idea in the fourth Hicks-Marshall law. In 2008, a typical family automobile contained 248 kg of aluminium and between three and six grams of palladium (Ducker Worldwide, 2008 and Loferski, 2011). If palladium costs account for 0.25 per cent of total costs of an automobile, a doubling of its price will increase the total cost by 0.25 per cent. By contrast, if aluminium inputs account for two per cent of total costs of an automobile, a doubling of its price will increase total costs by two per cent. As a result, aluminium has a higher own-price elasticity of demand than palladium in the automobile industry. 6

Energy prices in Chile have nearly tripled in the last five years. This has caused copper mines to rely more heavily on diesel-powered generation (Haynes, 2011). Mineral Economics

chapter 5 – Mineral Demand – The Theory in Practice

Income elasticity of mineral demand in the short run Income elasticity of demand is a measure of the sensitivity of demand to changes in consumers’ income. It is the percentage by which demand will change if consumers’ incomes change by one per cent, all other things being equal. Its simple formula is: Income elasticity of demand

% change in quantity demanded % change in income

For many products, as income rises, demand increases. Goods and services with income elasticities above one are called income elastic. The demand for many minerals is income elastic. This is a direct result of the demand for final products being income elastic. These final products – things such as automobiles, houses and refrigerators – are items that consumers are more inclined to buy during economic upturns. Purchases of these durable goods (often also known as discretionary goods) usually increase when consumers feel wealthier. However, the demand for some minerals such as crude oil and industrial minerals are income inelastic7. Consider, for instance the demand for residential electricity as compared to gold jewellery8. Purchasing gold jewellery is more of a discretionary purchase than purchasing electricity for home use. Accordingly, we expect the demand for electricity to be income inelastic and the demand for gold jewellery to be income elastic (see Figure 5.8). Quantity demanded

Quantity demanded

Normal good: income inelastic

Normal good: income elastic

Income/period

Income/period

Fig 5.8 - Income elasticities of demand.

Resource economists commonly apply the concept of income elasticity of demand to analyse the effect of changes in national income levels – using measures such as Gross Domestic Product (GDP) – on the demand for minerals. For example, they may investigate how changes in national income influence iron ore demand. Year-to-year instability in a country’s mineral consumption is due, in part, to the strong link 7 8

The demand for a mineral is income inelastic if the ratio of the change in quantity demanded resulting from a one per cent change in income is between zero and one. Income elastic goods have a ratio greater than one. Data show that non-monetary demand for gold is income elastic and the demand for residential electricity is strongly income inelastic (Pulvermacher, 2005; Fell, Li and Paul, 2010).

Mineral Economics

between mineral demand and the state of its economy, particularly its investment spending. Large fluctuations in investment are often considered the driving force of business cycles – measured by fluctuations of GDP over time. Expansions and booms are generally characterised by high levels of investment, whereas troughs are generally characterised as low investment. During economic downturns mineral demand is commonly low as investment spending on buildings and structures, transportation equipment, heavy machinery and consumer durables is greatly reduced. Conversely, mineral demand is commonly very high during economic upturns as the consumption of capital goods and consumer durables swells. This pattern suggests that, at least in the short run, mineral demand in most developed countries is strongly income elastic. For major mineral exporting countries, such as Australia9, the implications of short-run mineral demand being income elastic are significant. Generally, short-run income-elastic mineral demand causes the mineral demand curve to shift sharply over the business cycle prompting mineral output, prices, revenues and profits to fluctuate greatly (Pei and Tilton, 1999). The resulting volatility can have significant impact on a country’s management of its macro-economy because of sudden swings in exchange rates and in tax revenues from the mining sector (Humphreys, 2000). In addition, because Australia is a commodity exporter and an importer of consumer durables and investment goods, its economy does not always conform to the general country-level models. Australia’s mineral sector is to a great extent linked with the manufacturing, construction and transportation sectors of other countries. The International Monetary Fund (2011) found that a one per cent change in emerging Asia’s GDP over the 2000 - 2010 period lead to a 0.33 per cent increase in Australian GDP10. As a result, the linkage between income levels and the demand for minerals in the case of Australia should be examined at a multicountry scale.

Cross-price elasticity of mineral demand in the short run It is also possible to use the concept of elasticity to indicate the effect of price changes in related products. The relevant concept here is the cross-price elasticity of demand. It relates the percentage change in quantity demanded for a mineral, say gold, with the percentage change in the price of another mineral, say platinum, all other things being equal. The simple formula is: 9 10

This argument applies also to countries such as Chile, as well as many oil exporting nations and several other mineral dependent developing nations. From 2000 to 2010, Australia benefited significantly from emerging Asia’s robust commodity demand. In particular, urbanisation and industrialisation in China and India boosted demand for commodities, especially iron ore and coal that account for one-third of Australia’s exports (International Monetary Fund, 2011).

61

chapter 5 – Mineral Demand – The Theory in Practice

Cross price elasticity of demand

% change in quantity demanded of good 'A' % change in price of good 'B'

The cross-price elasticity of demand can be positive or negative, depending on whether we observe a change in the price of a substitute or a complement. If the two minerals are substitutes, an increase in the price of one will increase the demand for the other, so the crossprice elasticity will be positive. For example, gold and platinum can be considered substitutes in the jewellery market in India (Johnson Matthey, 2009) where the sales of platinum jewellery are closely linked to the relative platinum/gold price (Watts, Clarke and Aitlan, 2010). The surge in platinum jewellery sales in 2008 was, in part, due to the large decrease in the relative platinum gold price when platinum lost around 25 per cent of its value (Johnson Matthey, 2009). Figure 5.9 illustrates a positive cross-price elasticity of demand for gold with respect to platinum. $/unit

Price of platinum, a substitute mineral, rises. Demand for gold increases. Positive cross-price elasticity of demand

Price of palladium, a complement mineral, rises. Demand for gold decreases. Negative cross-price elasticity of demand

D1

D0

D2

Quantity of gold/period

Fig 5.9 - Cross-price elasticity of demand.

By contrast, if two minerals are complements, an increase in the price of one will reduce the demand for the other; therefore, the cross-price elasticity will be negative. The demand of 18-carat white gold, which is an alloy made by mixing 75 per cent gold with 25 per cent other metals, such as silver and palladium, is sensitive to the prices of gold, silver and palladium (Gillett’s Jewellers, 2004). Therefore, if the price of palladium rises by 50 per cent, the demand for gold will decrease, as is illustrated in Figure 5.9.

demand. Du Pont argued that cellophane was not a separate market, since at prevailing prices its demand was cross-price elastic, with respect to aluminium foil, wax paper and polyethylene. This meant that what seemed to be a single seller or monopoly in the cellophane market looked like a much more modest share of ‘the wrappings market.’ The court found that Du Pont did not have monopoly power despite control of 100 per cent of the cellophane market because cellophane made up only 20 per cent of the ‘wrappings market’ (Cueller, 2000).

Elasticity of mineral demand in the long run Because minerals are inputs in durable and non-durable final products, from the construction of buildings to the manufacture of prescription drugs, it is important to discuss the effect of adjustment time on the elasticities of mineral demand. Commonly, economists examine only long-run own-price and income elasticities of demand. However, over the long run, minerals do exhibit some cross-price responsiveness because certain equipment choice decisions include the consideration of minerals, especially fuel minerals. An example is the decision to use natural gas instead of electric water heaters. Some equipment choices are based on more than just the price of a single mineral and these results in measurable long-run cross-price elasticities. Notwithstanding such cases, this discussion of longrun elasticities is restricted to own-price and income elasticities of mineral demand. A significant percentage of industrial minerals are used in nondurable final products. These include clays in animal feedstuffs and medicines, as well as limestone in paper. Generally, for nondurable final products, the longer the time that buyers have to adjust, the larger will be the response to a price change. Accordingly, the demand for such goods will be more own-price elastic in the long run than in the short run. Figure 5.10 illustrates the short- and long-run demand for a nondurable good. A nondurable final product worth highlighting is petrol. To the extent that petrol has no short-run substitutes, the short-run demand is own-price inelastic. $/unit

Cross-price elasticity of demand is a common analytical tool to identify markets in anti-trust inquiries. By examining the cross-price elasticity of demand it is possible to measure how much a firm can raise its prices without consumers defecting to some substitute and other firms altering their production processes and supplying similar products at lower prices. If there are close substitutes, then the price increase initiated by the firm will lead to a large reduction in its sales, and its profits will fall, as a consequence. The 1956 USA anti-trust case against Du Pont is a classic example of the use of cross-price elasticity of 62

long run demand

short run demand Q

Q/period

Fig 5.10 - Short- and long-run demand for a nondurable final product. Mineral Economics

chapter 5 – Mineral Demand – The Theory in Practice

Even though many minerals are used in the manufacturing of nondurable final products, the predominant use of minerals, especially metals, is as inputs in the manufacturing of durable final products, such as motor vehicles. The effect of adjustment time on the demand for many durable final products is different than for nondurable final products. Similar to the demand for nondurable final products, the demand for durable final products is more own-price elastic in the long run than in the short run as buyers need time to adjust to new prices. However, an opposing effect can lead final-product demand to be relatively more elastic in the short run. This opposing effect is especially strong for large changes in income. That is, the demand for some durable final products tends to be more income elastic in the short run than in the long run. As a consequence, the demand for minerals used in some durable final products is likely to be more income elastic in the short run than in the long run. A second example involving motor vehicles illustrates that the adjustment time for durable final products is somewhat different than nondurable final products. Commonly, people purchase new automobiles at intervals of several years. Now, suppose that there is a fall in income, referred to here as a decrease in a person’s purchasing power11. Some buyers will defer their plans to replace their cars, keeping their present models a little longer. Therefore, a decrease in income will cause purchases of new cars to fall, all other things being equal. In the long run, buyers eventually need to replace their cars and the effect of a decrease in income may be minimal. As a result, a decrease in income will cause demand for minerals used in motor cars to decrease more sharply in the short run than in the long run. Similarly, if incomes rise, people will replace their cars more frequently. Therefore, an increase in incomes will tend to cause demand for minerals used in automobiles to increase more sharply in the short run than in the long run. 11 A reduction in a person’s purchasing power can be caused by either a decrease in wage earnings, an increase in inflation without an equivalent increase in wages, or both. Mineral Economics

Consequently, the difference between short and long run elasticities of demand for minerals used in durable products depends on the interaction between the time needed to adjust to the new final-product prices and the replacement frequency for the final products. We have just seen how time can affect the elasticities of mineral demand. Now let us examine if the nature of income elasticity of mineral demand over the long term can help make long-range forecasts about the demand for minerals. It was concluded above that economic booms tend to increase the demand for minerals in the short run; however, prolonged economic growth – that is, continuing increases in the real GDP – can correspond with a decrease in the demand for minerals per person in the very long run. Economists commonly make mineral demand forecasts by examining a mineral’s intensity-of-use to a country’s per capita income. Intensity-of-use reflects the demand of a mineral (usually measured in physical units like tonnes) per unit of income discounted over time for inflation (usually measured in billion dollars of GDP). In general, a country’s intensity-of-use of a mineral follows an inverted U-shape when plotted against per capita GDP. Figure 5.11 shows a representative curve. tonnes/billion $US of GDP tonnes

The short-run effect of price changes on the quantity demanded will discourage people from purchasing an additional car or driving to work. Over time, however, people will purchase more fuel-efficient automobiles and find alternative means of transportation. Accordingly, the demand for petrol will be more ownprice elastic in the long run. The short-term own-price elasticity of petrol has been estimated to be between -0.034 to -0.077 (Hughes, Knittel and Sperling, 2008), and the long-term elasticity has been estimated at -0.46 (Brons et al, 2008). If we combine this information with the first Hicks-Marshall law – mineral demand will be own-price elastic when the demand for the final product is own-price elastic – the long-run demand for crude oil, which is used as an input in petrol, will be more ownprice elastic than the short-run demand for crude oil.

30 20 10 0 0

1000

2000

3000

4000

Per capita GDP ($US)

Fig 5.11 - Intensity-of-use curve.

Tilton (2003) identifies the two factors that cause this U-shape of intensity-of-use curves as changes in the product composition of income and changes in the mineral composition of products. Changes in the product composition of income occur because of changes in consumer preferences as per capita incomes rise. At low levels of development (low levels of per capita GDP), when subsistence agriculture predominates, mineral use tends to be minimal. Urbanisation and industrialisation propels an increase in mineral demand to build basic infrastructure such as roads, railways, bridges, factories, pipelines and power grids. As development continues (per capita GDP increases further), the need for basic infrastructure declines – the replacement frequency for basic infrastructure is very low – and consumer demand shifts increasingly towards services and nondurable final products, which are less mineral-intensive. The transition from a manufacturing-based economy to a service-based economy slows and eventually reverses the trend of consumption of minerals as a function of income. 63

chapter 5 – Mineral Demand – The Theory in Practice The mineral composition of products refers to the amount of minerals used to produce particular goods or services. The changes in the material composition of products are driven by material substitution and technological advancement. One major caveat of the relationship shown in Figure 5.11 is that per capita GDP is not a reasonable proxy for the underlying forces – technological progress – that determine the trend in changes in the material composition of products. This trend is more likely correlated with time than with income. As a result, the inverted U-shape is not stable, but rather typically shifts downward over time (Guzman, Nishiyama and Tilton, 2005). Therefore, there is no simple relationship between long-run mineral demand and income. The true relationship is complicated by a complex interaction between price differences between materials, technological change, material life-cycles, consumer tastes, changes in lifestyle and other such factors (Campbell, 1985). The Japanese economy provides a clear example of a change in the product composition of income. In 1984, for every inflation-adjusted billion yen of industrial production, Japan consumed only 60 per cent of the raw materials that were consumed for the same volume of industrial production in 1973 (Drucker, 1986). This trend corresponded to the switching away from heavily material-intensive products to more high-technology products. The change in the material composition of products is clearly visible with the trend towards more use of aluminium and plastics and less steel in automobiles. In 1960, an average US domestic automobile consisted of two per cent aluminium and one per cent plastics, while in 2008 these percentages had increased to six and one-half per cent for aluminium and eight per cent for plastics (Kandelaars and van Dam, 1998; Davis, Diegel and Boundy, 2010). The substitution of aluminium and plastics for steel in automobiles has caused a reduction in the use of steel per automobile produced. Today, economists are using the intensity-of-use approach to forecast mineral demand in China and India. For example, Wårrel and Olsson (2009) used this approach to determine where both India and China were on the intensity-of-use curve in 2008.

CONCLUSIONS As demonstrated in this chapter, most minerals are demanded as inputs for final products, such as automobiles, buildings, transportation infrastructure, mobile telephones and jewellery. As a result, there are characteristics of mineral demand that are different from usual final-product demand. In particular, mineral demand is strongly dependent on existing production technologies as well as on competing and complementary inputs of production. Furthermore, the demand for minerals depends on changes in demand for final products, changes in technology and changes in the mix of inputs. 64

The chapter also demonstrated that elasticity of mineral demand is important from the standpoint of understanding the magnitude of changes in mineral demand caused by changes in price, income and the prices of related products. The short-run demand for most minerals is own-price inelastic because manufacturers and consumers that use minerals as inputs are constrained by their existing plants, equipment and vehicles. Also, the short-run demand for most minerals is strongly income elastic as a result of high demand for final products being strongly income elastic. As the demand for most minerals is own-price inelastic and income elastic, many minerals having steeply sloped demand curves that experience significant shifts over the business cycle. Two important consequences of these features are severe fluctuations in the market prices of minerals and profits for mineral industry firms. To complete the discussion of elasticity of mineral demand it is important to examine the effects of time. Mineral demand tends to be more own-price elastic over the long run because buyers have more time to adjust their behaviour. Also, the demand for some minerals – the ones used as inputs in durable final products – are likely to be more income elastic in the short run than in the long run. Finally, this chapter has demonstrated that the demand for minerals is multifaceted. Understanding the demand side of the mineral markets is essential for both analysts and policymakers so that they can understand the economic implications of changes in mineral markets.

REFERENCES Brons, M R E, Nijkamp, P, Pels, E and Rietveld, P, 2006. A meta-analysis of the price elasticity of gasoline demand: A system of equations approach, Tinbergen Institute discussion paper TI 2006-106/3. Campbell, G A, 1985. Theory of mineral demand, in Economics of the Mineral Industries, fourth edition (ed: W A Vogely) (American Institute of Mining, Metallurgy, and Petroleum Engineers: New York). Cueller, S S, 2000. Is Microsoft a monopoly? Sonoma State University Working Paper. Davis, S C, Diegel, S W and Boundy, R G, 2010. Transportation Energy Data Book, Edition 29 [online]. Available from: [Accessed: 11 July 2011]. Drucker, P F, 1986. The changed world economy, Foreign Affairs, 63(4):768-791. Ducker Worldwide, 2008. Aluminium Association auto and light truck group 2009 update on North American light vehicle aluminium content compared to the other countries and regions of the world Phase II [online]. Available from: [Accessed: 4 July 2011]. Dulay, N, 2004. Fiber optic interconnections within computer systems [online]. Available from: [Accessed: 24 June 2011]. Mineral Economics

chapter 5 – Mineral Demand – The Theory in Practice Eriksson, R, 2003. The effects of deregulating prices for dental services, Swedish Institute for Social Research working paper. European Bank of Reconstruction and Development, 2002. Transition report 2001: Energy in transition, European Bank of Reconstruction and Development, London. European Copper Institute, 2008. The development of renewable energies is stimulating demand for copper in Europe [online]. Available from: [Accessed: 26 January 2012]. Federal Statistical Office of Germany, 2011. Share of renewable energy sources in gross consumption of electricity and primary energy from 1991 [online]. Available from: [Accessed: 2 June 2011]. Fell, H, Li, S and Paul, A, 2010. A new look at residential electricity demand using household expenditure data, Resources for the Future discussion paper, 10-57. GFMS Limited, 2004. Publication of platinum and palladium survey 2004 [online]. Available from: [Accessed: 3 August 2004]. Gillett’s Jewellers, 2004. White gold versus platinum: White gold and platinum information [online]. Available from: [Accessed: 11 July 2011]. Grytten, J, 2005. Models for financing dental care, Community Dental Health, 22:75-85. Guzman, J I, Nishiyama, T and Tilton, J E, 2005. Trends in the intensity of copper use in Japan since 1960, Resources Policy 30(1):21-27. Haynes, B, 2011. Costly Chile power may jolt renewable energy, Reuters, February 10. Hicks, J R, 1966. The Theory of Wages, second edition (St Martin’s Press: New York). Hughes, J E, Knittel, C R and Sperling, D, 2008. Evidence of a shift in the short-run price elasticity of gasoline demand, The Energy Journal, 29(1):113-134. Humphreys, D, 2000. Mining as a sustainable economic activity, paper presented at the OECD, Paris, 9 February 2000. International Monetary Fund, 2011. Regional economic outlook, Asia and Pacific, Washington. Johnson Matthey, 2009. Platinum jewellery demand surging in India [online]. Available from: [Accessed: 11 July 2011]. Kandelaars, P and van Dam, J D, 1998. An analysis of variables influencing the material composition of automobiles, research memorandum 1998-51S Amsterdam Free University. Loferski, P J, 2011. Personal communication, 7 June 2011. Manning, W G and Phelps, C E, 1978. Dental care demand: Point estimates and implications for national health insurance, Rand Corporation document No R-2157-HEW. Marshall, A, 1920. Principles of Economics, eighth edition [online] (Macmillan: London). Available from: <www.econlib.org/ library/Marshall/marP1.html> [Accessed: 4 July 2011].

Mineral Economics

Mill, J S, 1863. Ulitarianism [online]. Available from: [Accessed: 4 July 2011]. Mitchell, G D, no date. Coal utilization in the steel industry [online]. Available from: [Accessed: 24 June 2011]. Otnes, C C and Pleck, E H, 2003. Cinderella Dreams: The Allure of the Lavish Wedding (University of California Press: Berkeley). Pei, F and Tilton, J E, 1999. Consumer preferences, technological change, and the short-run income elasticity of metal demand, Resources Policy, 25:87-109. Pequignot, J L, 2010. Creating an engaging tradition: NW Ayer & Son and De Beers’ advertising campaigns in the United States from 1939 to 1952, Masters of Arts thesis, Miami University. Platts, 2004. Country profiles – Kazakhstan [online]. Available from: [Accessed: 5 August 2004]. Pulvermacher, K, 2005. What are commodities? [online]. Available from: [Accessed: 4 June 2011]. Tilton, J E, 2003. On Borrowed Time? Assessing the Threat of Mineral Depletion (Resources for the Future: Washington). United States Commodity Futures Trading Commission, 2011. Futures only reports [online]. Available from: [Accessed: 30 May 2011]. United States Energy Information Administration, 2003. Kazakhstan country analysis brief [online]. Available from: [Accessed: 5 August 2004]. Venkatesh, R, 2002. India’s consuming interest in silver, Alchemist, 28. Ward, C, 1990. The production of synthetic rutile and byproduct iron oxide pigments from ilmenite processing, PhD thesis (unpublished), Murdoch University, Perth, Western Australia. Wårrel, L and Olsson, A, 2009. Trends and developments in the intensity of steel use: An econometric analysis, presented at Securing the Future and 8th ICARD, Skellefteå, Sweden, 23 - 26 June. Watts, J C, Clarke, B and Aitlan, O, 2010. Jewellery shocks from China and India, paper presented to the Fourth International Platinum Conference, The Southern African Institute of Mining and Metallurgy, Sun City, South Africa, 11 - 13 October. Wiesmann, G, 2011. Germany to scrap nuclear power by 2022, Financial Times, 30 May. World Bank, 2011. China: GNI per capita, Atlas method (current US$) [online]. Available from: [Accessed: 1 June 2011]. World Gold Council, 2011. Gold demand trends: First quarter 2011.

65

HOME

Chapter 6 Mineral Supply – Exploration, Production, Processing and Recycling Philip Maxwell Some introductory remarks Short-run and long-run supply The mineral supply process Supply curves Resources and reserves Mineral supply – individual products, main products, co-products and by-products Key determinants of primary mineral supply Individual and main products By-products Co-products Secondary materials – the economics of recycling The supply of new scrap minerals Old scrap mineral supply Total mineral supply

SOME INTRODUCTORY REMARKS In Chapter 1, we quoted from MacKenzie (1987, p 6) who notes the importance of geological endowment in influencing the supply of minerals. Mineral deposits are: •• initially unknown (they must be discovered and there is a cost involved in doing this) •• fixed in size (they are a finite stock and, with depletion, are eventually exhaustible) •• variable in quality between and within deposits (this is determined by grade, depth of deposit, mineralogy and other factors) •• fixed in location (geological factors have often created these deposits in remote locations and they need to be moved to intermediate- and end-use markets). As we also noted in Chapter 1, following agencies such as the United States Geological Survey, it is common Mineral Economics

practice to classify mineral commodities in three categories – metals, non-metals and energy minerals. There are approximately 50 metals, 50 non-metals and seven or eight energy minerals in this taxonomy. We also noted that it is possible to recycle metals and some non-metallic minerals from old-scrap and new-scrap sources. This has the effect of postponing, and possibly even preventing, their eventual depletion. Despite consistently increasing consumption over the past century, the issue of adequate mineral supply has been a relatively infrequent source of concern. Where they have occurred, such discussions about mineral supply typically take place from both short-term and long-term perspectives.

Short-run and long-run supply Using a standard textbook approach, Tilton (1985, pp 395 - 399) defines the following periods: 67

chapter 6 – Mineral Supply – Exploration, Production, Processing and Recycling •• The immediate run is an interval so short that mining companies ‘do not have time to alter their rate of production’. •• The short run is a time when mining companies ‘have time to vary their output but not their capacity’. •• The long run is a period when ‘new mines can be developed and processing facilities built’ and ‘firms can also expand the capacity of existing operations’. •• The very long run is a period in which the: … constraint imposed by existing known … deposits no longer holds and firms have the time to conduct exploration and find new deposits. New technology induced by the exhaustion of known deposits and higher metal prices may also permit the exploitation of new types of deposits. A conceptual diagram showing the relations between these periods appears in Figure 6.1.

•• mining methods have become more efficient •• there have been continuing technical developments in mineral processing •• economic systems, such as the Soviet Union, have collapsed (with Russia exporting substantially greater amounts of specific metals such as aluminium)2. The issue of mineral supply in the very long run has attracted even less attention over the past two centuries. Some notable contributors include Jevons in his 1865 Essay on the Coal Question, and more recently commentators such as Meadows and ‘The Limits to Growth’ school in the early 1970s. Authors such as Tilton (2003) and Krautkraemer (1998) provide useful surveys of the associated discussion. Perhaps the most notable theoretical contribution has been by Hotelling (1931) in his paper ‘The economics of exhaustible resources’. Even with dramatic recent increases in mineral demand from China, with the state of current technology and expected advances in it, there is a general consensus that the world has enough minerals for the next 50 years. After that, the situation is less clear. In his analysis of this issue, Tilton (2003, pp 65 - 78) argues that four groups of factors will influence the situation – geology, the demand for primary mineral commodities, changes in technology and input costs.

Fig 6.1 - An interpretation of the relevance of different time periods

to mineral supply.

Limitations to mineral supply have often been an issue in wartime particularly during strikes and there was also a short period in the early 1970s when the Organization of the Petroleum Eporting Countries (OPEC) cartel constrained world oil supply. In 2011, there was major concern when Chinese producers threatened the supply of rare earths to other downstream users, particularly in Japan and the United States (US). Whenever oil and other mineral prices such as coal, iron ore, copper, nickel and rare earths rise to high levels, as has been the case on several occasions over the past 50 years, commentators also become concerned. Unsurprisingly, they seldom debate this issue in an active way when mineral prices have remained relatively stable or moved lower in real terms1. When this has happened, it has been in large part because:

While acknowledging this broad debate, the main focus of this chapter is more concerned with the short run and the long run, seeking to highlight the distinct features of mineral supply in these periods and, in conjunction with the preceding discourse on mineral demand by Peter Howie, building the foundations for the discussion of mineral market outcomes described by Phillip Crowson in the next chapter.

The mineral supply process A straightforward view of new mineral supply, following MacKenzie (1987), is a process involving exploration, project development, mining, processing and transportation to the market. The flow of minerals supplied in a given period generally involves the depletion of a finite mineral stock. One can view this in terms of the following equation shows the relationship between current mineral reserves, previous mineral reserves, recent mineral consumption, and additions to supply through recycling and new minerals which become available because of technological change or changes in mineral prices. Mineral Mineral reserves reserves this period = last period

•• geologists have utilised advancing technology to ensure that mineral reserves remain at manageable levels 1

68

For a discussion of these movements see, for example, Peter Howie’s estimates of Real Prices for Selected Mineral Commodities, 1870-1997 in Tilton (2003, pp 124-137).

New mineral - consumption last period

Amount of mineral + recycled last period New + mineral reserves

2 See Corts (1999) on this point. Mineral Economics

chapter 6 – Mineral Supply – Exploration, Production, Processing and Recycling While the world’s minerals are ultimately fixed in supply and are technically non-renewable, it is possible to recycle many of them. Significant percentages of current supplies of metals such as aluminium, copper, nickel, lead, zinc and gold come from the recycling of old and new scrap. If the demand for a mineral falls away, it is even conceivable that recycled materials could meet all new mineral demand and it would not be necessary to produce newly mined material.

(A) Price P2 P1 S

The world’s mineral stock is also affected by new discoveries; by technological advancements in mineral processing, which make previously uneconomic deposits profitable; and by variations in prices, which may add to or reduce the size of current mineral reserves.

Q1

(B)

RESOURCES AND RESERVES At any given time, the level of estimated resources and reserves provides a benchmark for the status of mineral supply. Our discussion begins from this base, before considering the nature of mineral supply using the above supply curve model.

S1

Price

S

P1

In addition to geological endowment, a variety of other factors also influence mineral supply. They include whether a mineral is an individual product or joint product, the price of the mineral, input costs, transport costs, government policy, institutional efficiency, technological change, the impact of strikes and other disruptions and market structure.

In this presentation, price is a variable and all of the other factors that affect the quantity supplied are held constant. If their values change, the supply curve will shift to the left or right as in Figure 6.2b.

Quantity per time period

Q2

S2

Supply curves

We utilise the familiar supply curve framework in explaining the relevance and importance of the above key determining factors. Students in economics principles classes learn about supply functions and curves in the early weeks of their course. The typical initial presentation of supply is as an upward sloping curve on a diagram, such as Figure 6.2, where price per unit is plotted on the vertical axis and quantity produced per period is on the horizontal axis. As prices rise, producers will be encouraged to produce more because it is profitable to do so. As price falls, they will produce less.

S

S

S1

Q1

S2 Q

Q2

Quantity per time period

Fig 6.2 - A typical supply curve: (A) price changes and quantity changes;

(B) changes in other factors and quantity changes.

Reasonably standard definitions of resources and reserves (following Tilton, 2003, p 19) are as follows: •• Reserves are those ‘quantities of a mineral commodity in subsurface deposits, that are known and profitable to exploit, given existing technology and prices’. •• Resources include reserves, together with deposits that are: •• economic, but not yet discovered •• expected to become economic as a result of new technology or other developments within the foreseeable future. The major mineral-producing nations use their own generally similar definitions of resources and reserves. The most popular early classification system is probably the McKelvey ‘Box’ of the United States Geological Survey, which became widely used after 19704.

Mining companies publish information about the mineral reserves and resources associated with their projects, while national agencies such as the United States Geological Survey, the British Geological Survey and Geoscience Australia3 generate parallel estimates for individual nations and the world as a whole.

The JORC Code is the standard mineral resource classification system in Australia and New Zealand. This is the product of an ongoing collaborative effort within the Joint Ore Reserves Committee of The Australasian Institute of Mining and Metallurgy, the Australian Institute of Geoscientists and the Minerals Council of Australia. The first edition of the JORC Code was published in 1989 and the most recent version, as this chapter was compiled, appeared in JORC (2012). Following a continuing period of international cooperation there is now widespread consistency in the

3

4

A relevant recent reference is to Geoscience Australia (2011).

Mineral Economics

This system has subsequently been updated and modified.

69

chapter 6 – Mineral Supply – Exploration, Production, Processing and Recycling mineral classification systems used in Australia, New Zealand, Canada, South Africa, United Kingdom and the US. The information in Figure 6.3 outlines: … the framework for classifying tonnage and grade estimates so as to reflect different levels of geological confidence and different degrees of technical and economic evaluation. Because the geological and modifying factors change on a continuing basis, statements of Reserves and Resources regularly change. It is interesting to consider further the relationship of a framework for Resources and Reserves such as the JORC Code, to a supply curve model for newly mined minerals. The diagrams in Figure 6.4 illustrate one attempt to do this. They are adapted from the work of Chavez-Martinez (1983), as reported in Harris (1985). Looking at Figure 6.4a, we see that in a given period, the market will clear at a price of P1, where q1 of the mineral, say copper or iron ore, is mined and produced. This corresponds in Figure 6.4b to the marked amounts of cumulative production and current reserves.

At current levels of technology and factor (input) prices, increments to new supply are possible with new capital investment, but only at higher prices. These are shown in Figure 6.4c. Technological advancement in exploration, mining methods, mineral processing and recycling, as well as changes to mineral demand, will affect the level of Reserves and potential future supply. In a JORC view of the world, only Proved Mineral Reserves appear in the ‘Reserves’ rectangle.

Mineral supply – individual products, main products, co-products and by-products Because of their geological occurrence, it is sometimes profitable only to recover one mineral commodity (an individual product) from the primary material mined or drilled. In Australia’s major mining regions, companies produce bauxite, coal, gold, iron ore and diamonds as individual products. Some of the lower value-to-weight minerals such as gypsum, limestone, sand, gravel, manganese, salt and talc also are extracted in this way. On other occasions, there is joint production. Here miners extract mineral commodities as main products,

Fig 6.3 - The general relationship between Exploration Results, Mineral Resources and Ore Reserves in the JORC Code (source: JORC, 2012). Price

Price

Price S”

S0

S’

S1

supply

P2 Potential

D1

Reserves

D0

production

P1

Cumulative

P3

q1 Quantity per unit time

(a)

Quantity of stock

(b)

Changes in supply

(c)

Fig 6.4 - One view of current new mineral supply, mineral reserves and potential mineral supply. 70

Mineral Economics

chapter 6 – Mineral Supply – Exploration, Production, Processing and Recycling co-products or by-products because this is more profitable. These may include combinations such as silver, lead and zinc; copper and gold; gold and silver; nickel and cobalt; copper and molybdenum; or tin, tantalum and lithium. It is important also to appreciate the meanings of each of these terms. Following Tilton (1985, p 393): •• a main product is so important to the economic viability of a mine that its price alone determines the mine’s output •• a by-product … is so unimportant, its price has no influence on mine output •• When prices of two or more (minerals) affect output, the (minerals) are co-products. We typically think of co-products and by-products being extracted from base metal mines in locations such as Mount Isa and Broken Hill. A topical example of a major Australian mine that produces co-products and by-products is Olympic Dam in South Australia. Some details for the 2010 - 2011 financial year appear in Table 6.1. Using average market prices, the total revenue from Olympic Dam exceeded A$2 B in this period. Copper production accounted for about 70 per cent of the total, while uranium was responsible for a little more than 20 per cent. Copper was clearly the main product, but uranium oxide, worth almost A$500 M, was also an important co-product. Even though the mine produced more than 100 000 oz of gold and nearly 1 Moz of silver, both of these metals made only small percentage contributions to mine revenue and profits. Both were by-products.

KEY DETERMINANTS OF PRIMARY MINERAL SUPPLY Individual and main products A standard way to consider the supply function of a newly mined mineral commodity such as coal, bauxite, iron ore, gold, nickel and copper, when it occurs as a main product, is in the following terms: f (own price input costs technological Mineral change supply = disruptive government market events activities structure)

This specification follows Tilton (1985, pp 393395) and includes most of the important influencing variables. It implicitly assumes that there are sufficient reserves of the mineral available for exploitation. Let us briefly reflect on the influence of these factors. According to the standard theory of the firm, a company will maximise its profits by producing at a point where the costs of the last (marginal) unit of output just offsets its own price. When the price of a mineral rises, a mining company will tend to increase its supply. When it falls, it will reduce supply. The industry will respond in the same way. Where the global price of a commodity is expressed in terms of another nation’s currency, eg US dollars, exchange rate variations have a similar effect to changes in price on an existing or potential mineral producer. Remember from Figure 6.1 how in the short run capacity constraints in existing mines will inhibit the ability of supply to increase as prices rise. A company can employ more workers and expand its operations within current mining tenements, but its ability to increase supply will be limited. With the need for regulatory approvals, and major capital investment for mines, mills and supporting infrastructure, such capacity constraints can apply for several years. Input costs, particularly wages and energy costs, are important factors affecting mineral commodity supply. When they rise, it becomes more difficult for producers to make profits. While wage levels of mining workers are high, their relatively small numbers often make the effects of rising wages less important than changes in energy prices. These are particularly important, for example, in transforming bauxite into aluminium. Producing aluminium requires so much electric power that it has sometimes jokingly been described as ‘frozen electricity’. During the past century, the positive impacts of technological change on mineral supply through more sophisticated mineral exploration, better mining methods and innovations in mineral processing have been substantial5. They have more than offset the depletion of higher-grade deposits and the subsequent 5

An interesting discussion of ‘revolutionary mining technologies developed since 1900’ appears in Bartos (2007).

Table 6.1 Mineral production at the Olympic Dam mine in South Australia – year ended June 2011 (source: BHP Billiton (http://www.bhpbilliton.com) for production details and Infomine (http://www.infomine.com) for prices). Product

Units

Amount

Estimated price per unit

Estimated value ($ mill)

Estimated per cent

Copper cathode

tonnes

194 100

$8250

1601

70.4

Uranium oxide

tonnes

4045

$30 000

485

21.3

Refined gold

ounces

111 368

$1400

156

6.9

Refined silver

‘000 ounces

982

$34 000

Estimated total sales

Mineral Economics

33

1.5

2276

100.0

71

chapter 6 – Mineral Supply – Exploration, Production, Processing and Recycling movement to lower grades. With positive impacts of open cut mining and the implementation of carbonin-pulp leaching and associated advances in mineral processing, it has become possible to produce gold from open cut deposits containing much less than 1 g/t. Profitable extraction was previously possible only at much higher grades. A major innovation in the copper industry has been in the solvent extraction electro-winning (SX-EW) process. Electro-winning contributed less than three per cent of the total copper production in 1980 in contrast to approximately 18 per cent of the world copper production in 2009 (International Copper Study Group, 2010). The SX-EW has allowed the recovery of copper from mine tailings, as well as a higher percentage of metal to be ultimately recovered from orebodies. The process cut the tonnes of waste per tonne of ore mined by over 35 per cent in 1995 in comparison to its level in 1970 (Olewiler, 2002). A variety of disruptive events such as strikes, accidents in major mines, major equipment failure in mineral processing plants, natural disasters such as bush fires, floods and cyclones (known elsewhere as hurricanes or typhoons), civil disturbances or even terrorist attacks can disrupt mineral supply. During 2004, for example, when the price of oil rose from around US$30/barrel to US$55/barrel, the disruptive impacts of events in Iraq were one source of concern about oil supply. Threatened supply disruption associated with strikes by oil workers in Venezuela and Nigeria during the year added to this impact. Another good example occurs in the cobalt industry, where the Democratic Republic of Congo (DRC) dominates new mine production. Internal disruptions (including civil war) in the DRC caused surges in cobalt prices during the mid-1990s. Together with Russia, Canada has been the major nickel producer for the past century. Strikes by workers in its key nickel-mining region around Sudbury have disrupted world supply on several occasions. Because such disruption drove up prices, Australian producers derived considerable benefit. Northern Australia has a cyclone season every year from about January to April. Even though they are in remote and often quite arid areas, large operating mines are sometimes badly affected by the aftermath of these major storms. This occurs unexpectedly in areas such as North West Queensland, the Northern Territory, the Pilbara, the Kimberley and even as far south as the Goldfields region of Western Australia. The activities of governments also have an impact on mineral supply. Assuming that a country has a significant mineral endowment, its mineral policy has a central effect on its ability to supply minerals. Hence the clear and stable regulatory framework in Australia has served the nation well as far as its mineral sector competitiveness is concerned. It has been assisted by strong government support of organisations, such as 72

state-based geological surveys that maintain significant databases and departments of mines that administer the operation of the minerals and energy sector. Federal and state authorities have financed these activities by using competitive taxation and royalty systems. Significant policy changes may, of course, affect this situation. For example, the introduction of more stringent environmental regulations can adversely affect mineral supply. If such regulations are less onerous in other mineral-rich nations, mining company executives will be tempted to invest in these regions. The Mabo judgment in the Australian High Court in 1992, and the subsequent passage of Native Title legislation in the Australian Parliament in 1993, are examples of how new policy may potentially influence mineral supply. The end of the colonial era in the 1960s and 1970s was associated with the emergence of state-owned mining industries in many of the newly independent nations. Political leaders wished to use the economic rent from the resources sector to build other parts of their emerging societies. Where foreign companies were allowed to operate in these countries, they began facing requirements: •• to purchase supplies from domestic producers •• to process ores or concentrates within the national boundaries •• to allow host governments to become part owners of the mines. Another common practice was, and continues to be, the requirement to engage citizens of the host nation in professional and managerial roles within resource companies. Working visa limitations for expatriates facilitate the impact of this. After the mid-1970s falling mineral prices, as well as a lack of investment and human capital, led to the decline of the mineral industry in many of these nations. Other favourable government policies that sometimes apply to encourage new mineral production include commitments to build infrastructure such as roads, ports and communications systems. Another policy is to offer low interest rate loans. Where mines or mineral processing plants are struggling, government may also provide operating subsidies. Many commentators agree that ‘flow-through shares’ in Canada have increased grass-roots mineral exploration, which accounts for 75 per cent of all exploration spending there. Market structure also has an important influence on the supply of individual and main products. This is a particular focus of attention in the next chapter. When there are few mineral producers, they exert greater influence on supply and price. While the influence of state-owned mining corporations has declined since the early 1980s, there was a significant trend towards greater concentration in many of the major minerals sectors from the mid-1990s. Mineral Economics

chapter 6 – Mineral Supply – Exploration, Production, Processing and Recycling The number of buyers is also an important influence on market structure and the competitive state of particular mineral markets. Few buyers tend also to exert large amounts of market power. Interestingly, the combination of few buyers and sellers can sometimes generate market outcomes similar to those where there are many buyers and sellers. The simple matrix in Table 6.2 provides a rudimentary view of how these influences tend to apply. Table 6.2 Market structure and competition – a rudimentary view. Number of buyers Small

•• mine capacity in the short run, and the size of reserves in the long run. In the very long run, new discoveries and technologies may drive down production cost, and, therefore, the prices that producers are willing to accept. A standard view of the position of competitive producers, following Tilton (1985) appears in Figure 6.5. By contrast, firms in producer markets set prices for given periods of time, often annually. If this is the case (again following Tilton, 1985) we might expect a set of horizontal costbased curves such as those that appear in Figure 6.6. Price

Immediate run

Short run

Long run

Large

Number of sellers

Very

Small

Market power on each side tends to offset one another, and outcomes may be competitive

Strong market power on selling side

Large

Strong market power on buying side

Competitive

It is instructive to reflect on how different mineral commodities have traditionally fitted into this matrix. It has been typical to consider the gold and copper sectors as relatively competitive, while there are few buyers (steel producers) and few sellers (major iron ore companies) of iron ore, as well as many of the minor minerals. Over time, as their size has grown, the markets of several minerals have become more competitive. As Phillip Crowson notes in the next chapter the major non-ferrous metals, as well as gold and silver, now trade in quite competitive terminal markets. His discussion extends the discussion of the importance of market structure for mineral supply across the resources sector. Where producers exert large amounts of market power, they tend to set prices – so-called producer prices or list prices. Such prices will typically guarantee producers a healthy profit. They may be based on some multiple of total costs of production, or alternatively on some other criterion that will return a greater than normal profit to the producer. At the other end of the scale lies a competitive outcome where firms are price takers and adjust their output to generate optimum profit. They will produce when they can make a surplus, but will cease operations if they cannot cover their average variable costs. An alternative view regarding this standard textbook result is that this is not necessarily true in the mining industry because of high closure costs due to environmental considerations and other factors. This has been one of the arguments about why the price of mineral commodities, such as zinc and lead, have remained so depressed over long periods, producing an inadequate rate of return to investors. As prices rise, higher cost producers will begin producing, though production constraints apply because of: •• current output and inventory levels in the very short run Mineral Economics

long run

Output constraint

Constraint of current reserves

Capacity constraint

Quantity (tonnes per period)

Fig 6.5 - Mineral supply curves during different time periods

in competitive markets.

Long run Very long run

Short run Immediate run

Output constraint

Capacity constraint

Constraint of current reserves

Quantity (tonnes per period)

Fig 6.6 - Mineral supply curves during different time periods

in producer markets.

These representations imply certain assumptions about the way in which the quantity that producers supply will respond to price changes. The usual way to assess such responsiveness is in terms of the elasticity of supply. This is a parallel concept to the elasticity of demand, discussed in the last chapter. Economists typically focus on own-price elasticity of supply. The simple formula for this for a particular mineral in a given period (say a year) is: Es =

% change in quantity supplied % change in own price

Supply is elastic when Es is greater than one, and it is inelastic when it is less than one. As production approaches capacity constraints, and the mineral supply curve becomes vertical, own-price elasticity of supply approaches zero. Where the mineral supply 73

chapter 6 – Mineral Supply – Exploration, Production, Processing and Recycling curve is horizontal, as is the case for producer pricing well before capacity constraints are approached, ownprice elasticity is effectively infinite. With the passage of time, the elasticity of supply tends to increase. Hence the own-price elasticity of supply will be greater in the long run than it is in the immediate run or short run.

By-products Because mineral by-products are so unimportant to a mine and their price has no influence on their output, their supply functions differ from those of individual or main products. Crowson (1998, p 81) has argued: That many metals and minerals are produced partly or solely as by-products introduce great rigidities to their supply. It means that their output will not always respond to changes in their own prices, but is often more influenced by the prices of the main products with which they are associated. This argument holds true in several parts of the Australian mining industry, as well as in mining in many other parts of the world. There are many good examples of by-products from main product mines. As well as the situation at Olympic Dam already mentioned, the Escondida mine in Chile produces copper as its main product and gold and silver as byproducts. Nearby Collahuasi produces copper as its main product and molybdenum as a by-product. At Antamina in Peru, copper and zinc are co-products, while silver and lead are by-products. In Canada, at the Voisey’s Bay operations, copper and cobalt are byproducts at the large nickel mine. Other examples of byproducts occur where exotic metals such as selenium and tellurium are produced with copper; indium and germanium with zinc; bismuth with lead; and gallium with bauxite. In many large gold mines, silver is a byproduct. Because of the relative unimportance of by-products, only the costs that are specific to their production affect their supply. Companies allocate the joint costs of producing main products and by-products only to the main products. This means that the average cost of byproduct production is typically very low. It may even approach zero, if in producing the main product, the company naturally separates out the by-product, which then requires no further processing.

may double the recovery rate of a previous by-product, increasing its contribution to revenue and profits and, thereby, changing its status to that of a co-product. Price movements can also have this effect. Consider, for example, the situation of the Murrin Murrin nickel mine in Western Australia. In promoting this new project in the mid-1990s, the Directors of Anaconda Nickel argued that nickel and cobalt would be co-products. At the time the price of cobalt stood at around A$60/kg, while nickel was selling for A$10/kg. Assuming the mine produced at full capacity (40 000 t of nickel metal and 2500 t of cobalt metal), the mine would have generated annual revenue of A$350 M in 1996 had it been operating at full capacity. About 57 per cent of revenue would have come from nickel and 43 per cent from cobalt. In such a scenario, most commentators would accept that these metals were co-products. By 2010, however, the average price of cobalt was A$45/kg, while nickel stood at A$21.50/kg. Of the annual mine revenue, over 88 per cent came from nickel and less than 12 per cent was from cobalt. Though its revenue stream was significant, cobalt was a by-product and indeed this has been the case for just about all of the years of the mine’s operation. Against this background it seems reasonable to argue that the mineral by-product supply function would take the following form: Mineral by-product supply

= f (byproduct price

74

specific by-product input costs

technological disruptive government change events activities

market structure)

If one draws by-product supply curves in the usual way (see Figure 6.7), with price on the vertical axis and quantity on the horizontal axis, immediate-run and short-run curves are initially elastic but then quite quickly inelastic as they come up against output and capacity constraints. There is greater initial own-price elasticity of supply in the long run and very long run, though again this changes when the by-product constraint is reached. Price

Immediate run

Short run

Yet the price of a by-product does influence its production in one notable way. If the price of the byproduct falls below the production costs specific to its production per se, the producer will have an incentive to discard the by-product as waste rather than process it to a saleable product. Technological change can, of course, change the status of a by-product to that of a co-product or even reverse the main product/by-product relationship. For example, the introduction of a new processing method

main product price

Long run and very long run

By-product constraint C1 O Output constraint

Capacity constraint

Quantity (tonnes per period)

Fig 6.7 - Supply curves for mineral by-products. Mineral Economics

chapter 6 – Mineral Supply – Exploration, Production, Processing and Recycling

Co-products We have noted above that when the prices of two or more minerals produced by a mine affect its output, they will be co-products. The price of the co-product must cover its specific production costs and an appropriate share of its joint production costs with other co-products. The range of factors that affect the supply of a co-product from a mine lies between those that influence main products and by-products.

The estimates for ten key minerals appear in Figure 6.8. Recycling rates for materials such as chromium (88 per cent), lead (mainly for batteries) at 80 per cent, iron and steel (77 per cent), magnesium (57 per cent), nickel (largely from stainless steel), aluminium (both at 46 per cent) and copper (35 per cent) are all significant. Recycling of metals such as gold and silver is also important.

Therefore, it seems reasonable to argue that the mineral co-product supply function would take the following form: Mineral co-product supply

=f (own price

technological disruptive change events

co-product prices

specific co-product input costs

government activities

market structure)

Co-product supply curves will have a similar look to the main product supply curves depicted in Figures 6.5 and 6.6, though the sharing of joint production costs may mean that they are a ‘pushed-down’ version of these curves until the various output, capacity and known deposit constraints are reached in the immediate run, short run and long run respectively.

SECONDARY MATERIALS – THE ECONOMICS OF RECYCLING Newly mined minerals, which deplete finite mineral resources, have traditionally made up the majority of mineral production; however, in recent times, recycling of minerals, particularly metals, has also become an important alternative source of supply6. This is particularly the case in developed nations where public policy makers are encouraging recycling more and more. While authoritative data about mineral recycling are not available on a world basis for all minerals, the US Geological Survey provides annual estimates of its importance for most key minerals in the US (see United States Geological Survey, 2011). Although these rates may not carry entirely across to Australia and other nations, they do provide some indicative ideas about the importance of the use of secondary materials in mineral supply, given that the US is a major mineral consumer7. 6 7

During the Cold War, another source of mineral supply for nations such as the US the United Kingdom was from strategic stockpiles. The US and British governments subsequently disposed of these stockpiles. Nations such as Japan, through the government agency, the Japan Oil, Gas and Metals National Corporation (JOGMEC), still maintain strategic stockpiles of important minerals. The US economy’s GDP has recently stood at around 25 per cent of world GDP, implying that the US is responsible for a significant amount of mineral consumption. Given the nature of the intensity of use of mineral commodities during the stages of economic development, it seems reasonable to argue, however, that consumers in the US are unlikely to be consuming equivalent percentages of mineral commodities.

Mineral Economics

Fig 6.8 - Estimated rate of recycling of key metals in the United States, 2009

(source: United States Geological Survey, 2011)8.

While many of the above percentages are high, it is important to realise that they are derived from two broad categories – so-called new scrap and old scrap. The authors of the United States Geological Survey (2011, p 61.1) advise that metal ‘new scrap’ comes from preconsumer sources, while ‘old scrap’ originates from post-consumer sources. Hence: ... when metals are converted into shapes – bars, plates, rods, sheets, etc new scrap is generated in the form of turnings, stampings, cuttings and offspecification materials. Because new scrap supply occurs before minerals are used by consumers of final products, it is secondary supply in an unexpected way. Old scrap, by contrast, is much easier to appreciate. It comes from products that have reached the end of their useful lives – from old cars, computers, household appliances, car batteries and many other products. The availability of ‘old scrap,’ as a percentage of total mineral use, will depend on the lives of products in which it has been an input, the cost of recycling and the rate of recovery of the mineral in question. Suppose that the supply (and consumption) of a mineral grows at an annual rate of three per cent per annum over a quarter of a century. After that period, the products in which it has been an input, becomes obsolete and can be recycled. Suppose further that it is profitable to recycle half of the metal in these worn out goods. It is a straightforward exercise to calculate that about 23  per cent of mineral supply at the end of this period can come from old scrap material. It is interesting to note in Figure 6.9 that, for the six metals whose secondary 8

Recycling rate for titanium is from 2007.

75

chapter 6 – Mineral Supply – Exploration, Production, Processing and Recycling

Old scrap mineral supply Consider the case of refrigerators. Over a given period, for example a year, there will be a flow of minerals to secondary supply, resulting in these units coming to the end of their service lives. Usually there is also a stock of old scrap material containing different minerals that has built up over time and has not yet been recycled. This may be because the price of newly mined minerals has been less than the cost of recycling from this old scrap.

Fig 6.9 - Estimated rates of recycling new and old scrap for six selected

minerals in the United States, 2009.

supply is separated into new scrap and old scrap, only lead (and then aluminium) stood out as having a highly significant rate of old scrap recycling.

The supply of new scrap minerals This supply will be relatively cheap to recycle and reasonably elastic until it comes up against a capacity constraint. As Tilton (1985, p 402) notes, with respect to metals, the factors affecting this constraint are: •• current overall metal consumption •• the distribution of this consumption by end uses •• the percentage of consumption resulting in new scrap for each end use. Some supply of new scrap takes place in reasonably competitive markets, though vertical integration strategies for other minerals may ensure that producer pricing continues to prevail in this area. A reproduction of Tilton’s view of the supply of new scrap in competitive markets appears in Figure 6.10.

Price

Although subject to less of a supply constraint because the stock of old scrap may be large, the cost of processing material is considerable for most minerals. This is because it needs to be collected and then processed. Where collection and processing are cheap, and consumption of a mineral has been growing slowly, the supply of a mineral from old scrap can be significant. This is the case for the recycling of lead from motor vehicle batteries, the main current use of the metal. With the removal of lead from paint and as a petrol additive contributing to slower percentage rates of growth in consumption than for other major metals, it is easy to appreciate why the percentage of lead recycled from old scrap has been so high. It is possible to construct indicative short-run and long-run supply curves for secondary materials from both the flow and stock of old scrap, and then add them to derive an old scrap supply curve – see Tilton (1985, pp 403 - 405). Such curves will be upward sloping in the usual way and relatively inelastic. One representation of a short-run supply curve – based on Tilton (1999) – appears in Figure 6.11.

Availability constraint

Short run Immediate run Long run and very long run

Quantity Fig 6.11 - A short-run supply curve for old scrap minerals.

Fig 6.10 - The supply of new scrap minerals in competitive markets.

What stands out in this representation is the similarity of the immediate run, short run, long run and very long run. One would assume that the recycling cost would be pushed down over time by small amounts. Although not shown in the diagram it is also possible to assume that the capacity constraint could be pushed out a bit by technological advance in the long run/very long run. However, the message of this diagram is one of elastic low cost supply that is subject to a capacity constraint. 76

TOTAL MINERAL SUPPLY The total mineral supply that becomes available in any period is the sum of new mineral supply and secondary supply9. The newly mined supply of a mineral may occur as: 9

This overlooks minerals held in stockpiles, though these could also be included. They are important, particularly for some precious metals, such as gold, but of limited relevance for most minerals. Mineral Economics

chapter 6 – Mineral Supply – Exploration, Production, Processing and Recycling •• an individual product •• a main product

(A)

Price

•• a by-product •• a co-product. Secondary supply can emerge from the flow of old scrap or the current stock of old scrap material available. The concept of new scrap is usually added to this. The usual way of visually representing a total mineral supply function is horizontally to sum supply curves from lowest cost to highest cost production for each of the components of new supply and secondary supply. Conducting this exercise for a metal that occurs significantly as a main product, a co-product, a by-product, or as new scrap and old scrap will be a complex exercise. Two good examples of such minerals are gold and silver. By contrast, for a mineral such as coal, which occurs only as an individual main product and is largely not recyclable, this exercise will be much more straightforward. As one moves from the immediate-run to the longerrun views, we have seen that the factors that affect each of the different forms of production are likely to change. Hence, the shapes of total mineral supply curves will differ depending on the time period specified – immediate run, short run, long run or very long run. They will also differ depending on whether the market is competitive or dominated by a few producers who exert strong market power. Consider, for example, the construction of a short-run total mineral supply curve for a mineral that occurs as a main product and a by-product and that it can be recycled from old scrap. A metal such as cobalt is one example of such a mineral. Even with the strong position of the Democratic Republic of Congo and Zambia there are enough producers and users elsewhere to suggest that a reasonably competitive market exists for this metal. Cobalt also began trading in the London Metal Exchange in 2010. The three components of shortrun supply are shown separately in Figure 6.12a and summed horizontally in Figure 6.12b. It is interesting to compare the shape of a mineral supply curve, such as that in Figure 6.12b, with that of the cost curves produced by a number of prominent industry consultants. These are based on cash costs. In discussing the behaviour of firms economists commonly distinguish between their fixed costs and variable costs. The latter vary with output, while the former are the same regardless of the level of output. Yet this distinction is often blurred in the mining process as Crowson (1998, p 125) notes. Operators of many mines seek to spread their costs over as great an output as possible. Also annual purchase contracts for fuel and supplies blur the distinction between mining and its associated first-stage processing. Mineral Economics

Old scrap

Byproduct Main product

P0 P3

Capacity constraints

P2 P1

Quantity

(B) Price

Total Supply curve

P0 P3 P2 P1

Quantity

Fig 6.12 - A long-run supply curve for a mineral produced as a by-product,

from old scrap and as a main product: (A) old scrap, by-product and main product supply curves; (B) total supply curve.

It has, therefore, become common practice to distinguish between cash costs and other costs within the mining industry. They refer to all fixed and variable costs sustained in cash rather than as ledger entries when operations are taking place. They include all site costs of mining such as stripping, processing and concentrating, but also incorporate sales and marketing. Industry analysts produce average short-run cashcost and total-cost data for different mines for various mineral sectors. They have not typically included data on recycling. As an example, an indicative shortrun operating cost curve for newly mined nickel might look like the curve in Figure 6.13. Such curves provide an approximation for a short-run supply curve for newly mined production10. They provide useful competitiveness benchmarks for new and existing producers. Yet because these data are usually commercially sensitive and collected by only a few organisations, they are not widely available in the public domain. Indeed they tend to be prohibitively expensive to observers who do not depend on them to generate significant income streams. In summary, the discussion in this chapter has sought to introduce the topic of mineral supply in a fashion that integrates with the preceding review of the elements of mineral demand. We trust that you find them, in combination, a useful foundation for Phillip Crowson’s discussion of Mineral Markets in Chapter 7. 10 It should be acknowledged that the sum of producer marginal cost curves, rather than average cost curves, are the components of an industry supply curve for producers in any competitive industry.

77

chapter 6 – Mineral Supply – Exploration, Production, Processing and Recycling .

Average Cost per tonne

$9,000 $8,000 $7,000 $6,000 $5,000 $4,000 $3,000 $2,000

Byproduct

$1,000 $0

0

Mine 3

M1 M2

100

200

300

Other mines

Mine 4

400

500

600

700

80

Fig 6.13 - A hypothetical total average cost (supply) curve for newly mined nickel in a recent time period. Quantity (kt)

REFERENCES Bartos, P J, 2007. Is mining a high-tech industry? Investigations into innovation and productivity advance, Resources Policy, 32(4):149-158. Chavez-Martinez, M L, 1983. A potential supply system for uranium based on a crustal abundance model, PhD dissertation, University of Arizona, Tucson. Corts, K, 1999. The aluminum industry in 1994, Harvard Business School Case Product# 799129-PDF-ENG. Crowson, P, 1998. Inside Mining: The Economics of the Supply and Demand of Minerals and Metals (Mining Journal Books: London). Geoscience Australia, 2011. Australia’s Identified Mineral Resources 2010 (Australian Government: Canberra). Harris, D P, 1985. Mineral resource information, supply and policy analysis, in Economics of the Mineral Industries, pp 181-224. Hotelling, H, 1931. The economics of exhaustible resources, Journal of Political Economy, 39(2):139-175. International Copper Study Group, 2010. The World Copper Factbook 2010 [online]. Available from: [Accessed: 1 June 2011].

78

JORC, 2012. Australasian Code for Reporting of Exploration Results, Mineral Resources and Ore Reserves (The JORC Code) [online]. Available from: (The Joint Ore Reserves Committee of The Australasian Institute of Mining and Metallurgy, Australian Institute of Geoscientists and Minerals Council of Australia). Krautkraemer, J A, 1998. Nonrenewable resource scarcity, Journal of Economic Literature, 36:2065-2107. MacKenzie, B, 1987. Mineral Economics: Decision-Making Methods in the Mineral Industry (Australian Mineral Foundation: Adelaide). Olewiler, N, 2002. Natural capital and technological change: Impacts on productivity growth and natural resource and environmental sustainability, Simon Fraser University working paper. Tilton, J, 1985. The metals, Economics of the Mineral Industries, 383-416. Tilton, J, 1999. The future of recycling, Resources Policy, 25:197-204. Tilton, J, 2003. On Borrowed Time? Assessing the Threat of Mineral Depletion (Resources for the Future: Washington). United States Geological Survey, 2011. Recycling – Metals, US Geological Survey Minerals Yearbook 2009, Washington.

Mineral Economics

HOME

Chapter 7 Mineral Markets, Prices and the Recent Performance of the Minerals and Energy Sector Phillip Crowson Market structure – competitive markets Market structure – imperfect markets Departing from the competitive model Alternative pricing arrangements The rise and fall of cartels Producer pricing Exchanges The London Metal Exchange Recent trends in mineral markets

The two preceding chapters examined first the diverse influences on demand for mineral products, and secondly the various forces acting on the supply side. In essence prices are determined by the interaction of these opposing forces in the market place. The geographical location of demand, the end uses and the nature and sources of supply differ for each product, and these differences in market structure dictate precisely how demand and supply interact to set the prices of individual products. The nature of the pricing mechanism is strongly influenced by the ease with which new suppliers can enter the market, in other words by the barriers to entry. In the short to medium term their level can be affected by political, economic and social conditions in mineral producing and consuming countries, but the main factors are geological and technical. Where ore deposits are readily discovered, and easily exploitable with existing technology at prevailing price levels, the barriers to entry are low. Conversely, a scarcity of exploitable deposits keeps the barriers high. Changes in exploration or extraction and processing technology can change the conditions of entry.

MARKET STRUCTURE – COMPETITIVE MARKETS Where the barriers to entry are low there is likely to be a relatively large number of suppliers. The more Mineral Economics

present and prospective suppliers there are, the more competitive with each other they are likely to be. Price in such competitive markets is determined by the free interplay of supply and demand, and it will fluctuate to the extent needed to clear the market. The demand curve facing each individual supplier is to all intents and purposes flat rather than downward sloping to the right like the industry’s demand curve. Producers are price takers, and have little or no influence over the prevailing price. They can, however, alter the amount they supply to the market, and each supplier will produce as much as possible as long as their cash costs are fully covered. Leaving aside the complications flowing from the existence of inventories, other than normal working stocks, prices will settle in the near term where demand and supply intersect. Other things being equal, a rise in demand or a fall in supply will prompt a rise in prices, and a fall in demand or a rise in supply results in a fall in prices until equilibrium is restored. In practice, prices will tend to fluctuate around the equilibrium level, because conditions are continuously changing. Prices will gravitate towards the industry’s marginal cost of production; the cost of production of the last, or most expensive, unit of supply from whatever source that is required to balance the market. 79

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector The nature of the supply curve in competitive markets, and of its interaction with demand and price, is illustrated in Figure 7.1. S D1 P1 D

Price P P2

D2

S

Quantity

Q2

Q

Q1 Capacity

Fig 7.1 - Short-run supply and demand in competitive markets.

When prices are very low there is no supply, as costs exceed prices. Higher prices allow producers to cover their costs and enter the market until the point is reached where supply is constrained by the available productive capacity. Then no additional supplies can be immediately forthcoming no matter how high prices rise. It takes time for new capacity to be developed, whether that comes from the expansion of existing operations or from new facilities. The price and the quantity supplied settle at the point where the supply and demand curves intersect (P and Q when the demand curve is D). If the demand curve rises to D1, higher cost producers will be able to supply and the price and quantity will rise to P1 and Q1. Conversely, when demand drops back to D2, perhaps because of economic recession or some technological change in end-use markets, higher cost producers will be unable to cover their costs, and both price and output will fall to P2 and Q2 respectively. This assumes that suppliers merely have regard to near-term demand and prices. In practice their reactions will be much more complex. If they believe that a price fall is temporary they may be prepared to stockpile rather than reduce their output, or to incur losses for a period. The costs of closure, including the repayment of debt, environmental remediation and redundancy payments, may exceed the costs of continued operation. Also, many suppliers may have more complex objectives than short-term profit maximisation, and be prepared to produce at a loss. Over the longer term, when the constraint of existing capacity is lifted, the supply curve will move to the right, with its level dictated by technological change, by investment and by shifts in the political and regulatory climate. The major non-ferrous metals – aluminium, copper, lead, nickel, tin and zinc – as well as gold and silver, 80

are the mineral products whose markets most closely approximate to the competitive model. They are typical commodities, in the sense that the products of different producers are reasonably homogeneous, and any individual supplier’s product can readily substitute for that of another. There are many customers and a variety of end uses, each with common standards and specifications. Producers can exert little, or no, influence over the markets for their products, which are usually regional or global and there is hardly any after-sales service, such as technical support, to give producers extra leverage over consumers. Prices are uniform for the standard grades, and the producers concentrate on controlling their relative costs. There are many suppliers spread throughout the world, and no single producer can influence the level of prices, except for very short periods. There are many ore deposits being exploited or under development, it appears relatively easy to discover new ones, secondary materials are readily available and transport costs are generally low relative to product prices. Information about recent and prospective trends in supply and demand is rapidly and widely diffused, and the markets are reasonably transparent. That prices and volumes will settle at the unique point where the demand and supply curves intersect does not describe the actual process of price discovery, except in an auction market where bids and offers are made in public until a price is derived which just clears the market. At that price all purchasers and suppliers are satisfied. The method is basically similar for gold, silver and the non-ferrous metals in that their prices are settled in terminal markets. The characteristics of such markets are explained in a later section of this chapter.

MARKET STRUCTURE – IMPERFECT MARKETS Departing from the competitive model The markets for most mineral products depart in varying degrees from the competitive model. The geological availability of many products is much more limited than for non-ferrous metals or the technology needed for their extraction and processing is far more complex. The accessibility of ore deposits for commercial mining may be restricted by a variety of political, environmental or economic factors. For example, many developing countries either totally prohibited or severely circumscribed mineral developments by privately-owned companies through much of the 1960 - 1990 period, especially where such companies were foreign-owned. Many countries prevent the mining of known ore deposits in national parks or wilderness areas. Unstable political conditions increase the risks of mineral exploration in many regions, but particularly in Africa and parts of Asia, to unacceptable levels. These various influences, either alone or in combination, raise the barriers to entry and limit the number of producers. Mineral Economics

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector As Table 7.1 illustrates, there are typically relatively few significant suppliers to the market for a wide range of minerals and their first stage products. It shows the shares of the largest firms in the global production of a range of mineral products, split between those that are traded in terminal markets, and those whose prices are fixed in other ways. Table 7.1 Concentration in mineral markets: percentage shares of largest firms in world production 2009 (source: Raw Materials Group, 2011). Leading firm

Top 3

Top 5

Top 10

Metals traded on terminal markets Aluminiuma

11

31

44

56

Cobalt

15

37

50

68

Copper

10

22

30

44

Gold

10

23

31

43

Molybdenum

11

30

42

58

Nickel

19

39

51

69

Platinum

33

67

83

93

Silver

7

18

25

39

Zinca

9

25

34

46

Negotiated, formula or list prices Alumina

12

35

51

68

Bauxite

14

36

47

64

Chromite

20

41

52

64

Copper mine

11

29

40

56

Diamond value

26

52

66

75

Iron oreb

14

32

37

45

6

18

23

32

Lithium

25

51

73

85

Manganese

7

17

27

42

Niobium

78

92

n.a

n.a.

Phosphate rock

15

29

37

46

Platinum

33

67

83

93

Potash

18

46

66

91

Titanium minerals

23

49

66

80

Uranium

16

45

67

84

10

22

31

44

19

40

49

57

Lead mine

Zinc mine

a

a

Zircon

a. Percentage shares of the leading firms are probably under-stated because the source does not cover most Chinese output, and China is a leading producer. b. The three leading firms have a substantially greater share of seaborne trade in iron ore.

Platinum is shown in both groups, as most production is sold direct by producers to users at list prices that lag terminal market prices. In recent years there has been a trend towards a greater use of market-based pricing, even in highly concentrated markets. The degree of industry concentration is a major influence on pricing, Mineral Economics

but not the only one. Often there are also relatively few major users. Where there are only a few major producers the suppliers do not have to take demand as given, and their actions can have some influence on prices. Rather than a demand curve that is flat, they face one sloping downwards to the right, just like the industry. As there are usually few suppliers the supply curve is likely to be stepped. Producers can exert some control, even if strictly limited, over the prices they receive by differentiating the characteristics of their products from those of their competitors. In many instances there is considerable competition in the non-price dimensions of the product, such as technical service, or delivery schedules. The chemical and physical characteristics of the product are varied not just for particular end uses, but often for individual users. There is a wide variation in grades and specifications, which is reflected in widely differing prices for apparently similar products. The costs of mining the raw ore are less important than its characteristics and the methods whereby it can be modified to serve the end uses that offer the highest prices. Even producers of commodity metals and minerals look for ways to upgrade and differentiate their products from those of their rivals in order to achieve a premium over the basic market prices. Their objective, which is sometimes attained, is to create a market for their own output that is distinct in some way from the market as a whole. Where prices settle will clearly still depend on how and where demand and supply intersect, no matter the precise structure of a product’s market. Since the costs of most suppliers are lowest at or near their maximum possible output they will tend to produce to capacity. Without the safety valve of terminal markets, however, the costs of stockpiling excess supplies usually force suppliers to reduce their offerings in periods of weak market conditions. The short-run market conditions facing a ‘representative’ producer are shown in Figure 7.2. The shapes of the demand and supply (marginal cost) curves have been deliberately exaggerated. Marginal Cost P

Average Cost

Above-normal profit

Price

Demand

Marginal Revenue Q

Quantity

Fig 7.2 - Short-run market equilibrium for a ‘representative’ producer. 81

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector As the producer faces a downward sloping demand curve for his output, the marginal revenue from additional sales will also decline with increasing output. Assuming that the producer aims to maximise profits, he will produce to the level of output (Q) where his marginal revenue equals his marginal cost of production. The price (P) is rather higher than would be set in a completely competitive market, and the producer would earn above-normal profits. That is not a stable position because such profits would induce a variety of competitive responses. Exploration and new mine development would be stimulated and technological research on lower-cost processes encouraged. On the demand side the use of substitutes would be encouraged. In consequence, the demand curve facing the ‘representative’ producer would be pushed downwards, lowering the level of output associated with a given level of prices. Subject to the ease or difficulty with which the barriers to entry could be surmounted, the excess profits would eventually be eliminated by competition, and the long-run equilibrium, shown in Figure 7.3, would be attained. The achievement of that equilibrium might take many years.

Marginal Cost

Average Cost

P1

Price

Demand

Marginal Revenue Q1

Quantity

Fig 7.3 - Long-run market equilibrium for a ‘representative’ producer.

The producer would still maximise profits at the point where marginal cost equalled marginal revenue, but with only a ‘normal’ rate of profit. Also the level of output would be rather lower than would be reached in a perfectly competitive market, were that to exist in the real world. As markets develop, and the number and range of producers expand, prices drop towards the marginal costs of production and any monopoly profits are gradually whittled away. The theoretically relevant marginal costs are those likely to pertain over the long run. In other words, they will incorporate the opportunity costs of capital of the facilities just needed to meet expanding demand over the long term. In practice prices tend to gravitate, at least in the competitive markets, towards the cash break-even costs of existing marginal producers. New entrants will aim to have much lower cash costs than these, and to cover their full costs at expected prices. 82

Markets with but a few suppliers are described as oligopolies, and those with only a few customers are given the less common description of oligopsonies. In many such markets there may be a penumbra of smaller suppliers or users around the few large firms. Small customers are liable to absorb an unduly large amount of time and effort from the suppliers’ sales staff, and they are often serviced through merchants, distributors, or agents. Although small producers are unlikely to produce a full range of products, their persistence in selling their own grades can undermine established price structures. Major suppliers of many non-metallic minerals and minor metals, therefore, have to take full account of their activities and potential actions. The power of the major producers to control their markets is accordingly circumscribed. In all cases each producer has to take account of the possible impact of his own decisions about pricing and production volume on his competitors, and of their likely policies. How those differ will partly depend on each producer’s relative costs and available capacity. In some instances the smaller producers may sell through merchants, who may also acquire supplies from other sources. These may include releases from redundant government stockpiles, scrap and secondary recovery, and in previous times imports from state trading countries that were on the fringes of the global market economy. Particularly when market conditions are weak, merchants have been able to re-purchase excess supplies from the customers of the major suppliers. Although the producers naturally discourage resale of their products, they cannot always prevent it. At the theoretical extreme of just one supplier, or pure monopoly, the demand curves of the supplier and the industry are the same. The monopolist can choose that combination of price and volume that best suits his objectives. Assuming that his objective is profit maximisation he will produce to the point where his marginal revenue equals his marginal cost. The shortrun position, shown in Figure 7.2, would hold for the monopolist over the long run. In practice there are no instances of natural total monopoly in the mineral industries on a global scale, although there have been cases of contrived monopoly through cartels and similar collusive actions in restraint of trade. The availability of secondary materials, and of substitutes of varying degrees of effectiveness for most mineral products, means that any individual supplier’s power to raise prices by holding back supplies is strictly limited. That substitutes exist, and there are usually competing suppliers to global markets, does not rule out the probability of more restricted monopolies. The key is the height of any barriers to entry. These can be artificially raised for domestic producers in a national market by protection against imports through tariffs or quotas. Over the post war years there was a steady trend in all major economies towards dismantling Mineral Economics

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector quotas and other quantitative restrictions and lowering tariff barriers on most products. That gradually eroded local monopolies, often against the strong resistance of the previously favoured suppliers. Some developing countries still have highly protective tariffs against imports, although there are continuing pressures for their reduction. The cost of transport provides a less penetrable barrier especially for bulk products with a low value to weight ratio. Thus the markets for sand and gravel remain largely local, even in the United States (USA) and Western Europe. For bulk products like coal and iron ore, however, sharply declining costs of ocean shipping during the decades following the Second World War opened up local and national markets to international competition. That had consequent repercussions on the market structure and pricing of such products. As demand for a product develops and expands from its initial niche markets, new entrants are attracted over the prevailing barriers to entry. The more suppliers there are, the more difficult it becomes for anyone to control, or even influence prices. In the initial stages of a product’s life cycle there may be only a limited number of uses, or perhaps only one. Users will be prepared to pay high prices to satisfy their needs. The owners of the more accessible deposits are able to generate monopoly profits, especially where they also control innovative processing technology. These profits naturally attract the envious attentions of other companies, stimulating both exploration and research into processes. Often both are successful, and the initially high barriers to entry are reduced. New entrants can piggy-back off the marketing activities of the initial pioneers. Capacity expands, probably at a faster rate than demand, which remains dependent on specialist uses. Sooner or later potential supply exceeds demand, and prices come under pressure. The initial producers will have probably recouped their investment several times over and be prepared to drop prices both to stimulate demand and to choke off new entrants. Conversely, the latter may be forced into price-cutting in order to gain market share. Often they may be able to withstand lowered prices because their deposits or processes are superior to those of the pioneers. Normally production starts at those deposits that are known or readily accessible, rather than at those with the potentially lowest costs. Followers building completely new facilities may be able to exploit process improvements more easily than the originators in their established plants. Military needs in wartime have often forced large increases in the capacity to produce many mineral products and metals, often irrespective of profitability. The physical need has been paramount. When military demand has dropped producers have been forced to develop new uses in order to keep their capacity running, often through price reductions. Changing Mineral Economics

technology has also been a driving force. In all cases rapidly expanding markets have allowed producers to exploit economies of scale.

Alternative pricing arrangements The ways in which market prices, other than those fixed in terminal markets, are actually determined varies widely between different mineral products. Prices for some are posted by producers, almost on a take-it-orleave-it basis. Such producer pricing, which is discussed later in this chapter, was once much more widespread. In effect the producer acts like a monopolist offering to sell at a given price, with an implicit assumption that output will be reduced to maintain that price when market conditions are weak, and that some customers may be unsatisfied when demand runs against the limits of capacity. Other producers may voluntarily decide to follow the lead set by the price-setting producer and accept satisfactory rather than maximised profits. In other instances producer pricing may be sustained through collusive behaviour, ranging from informal discussions to formal cartels. The recent history of cartels is also described later in this chapter. Where there are only a few major participants on each side of the pricing equation, which applies to many mineral products, prices are largely determined by negotiation. Each participant has to take account not only of the likely responses of the customer to his actions, but also of the possible reactions of his existing and potential competitors. Such intelligence is usually more important for the producers than the purchasers. Each mineral product effectively forms a small village where all the major participants know each other. This village-like nature of global mineral markets helps the rapid transmission of gossip and information, and the sense of prevailing market conditions, even where there is no explicit market place. How companies behave when negotiating prices largely depends on the point reached in the business cycle and on the strength of any barriers to entry. A tougher negotiating stance is more appropriate when markets are tightening than when they are in the recessionary phase of the cycle. Where there are few, if any, viable undeveloped ore deposits, where complex proprietary technology is required in the production process, where there is inadequate infrastructure for accessing undeveloped deposits, or where there are lengthy lead times and high capital costs involved in opening up such deposits, the existing producers’ bargaining power is strong. It weakens markedly where there is ample existing and prospective capacity and technology is readily available. Thus, the differing availability of ore deposits has historically favoured manganese producers over iron ore producers in their dealings with the steel mills. Neither had a very strong position, however, until their markets tightened from the mid-2000s. In contrast, the 83

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector existing producers of titanium dioxide feedstock during the 1980s and early 1990s benefited from high barriers to entry. There were a limited number of deposits of ilmenite suitable for upgrading at acceptable cost and the proprietary processing technology was complex. The producers’ market power was constrained by the comparative strengths of a few large purchasers. Mutual deterrence is as much a feature of some mineral markets as of international relations. Burgeoning demand for iron ore, relative to available capacity from the mid-2000s, enabled iron ore producers to force up prices dramatically, and then to insist on more flexible pricing regimes that took much greater account of spot prices that were leading contract prices. The bargaining power of steel mills was too weak to resist the leading iron ore producers’ demands in the short to medium term, but steel producers have recently been seeking alternative supplies, including backwards integration into ore production. Eventually a new equilibrium will be reached and the pricing power of the leading iron ore producers will be weakened. History suggests that price wars, once started, are difficult to stop, and that they normally benefit only the customers. Even that benefit may be strictly short-term if lower prices inhibit investment in additional capacity to meet growing demand. Much depends on whether the major producers concentrate their attention on maximising prices and profitability, or on volume. The pursuit of market share is a common corporate objective, on the assumption that it can enhance a company’s market power. It does not usually appear to have been accompanied by long-term profitability when it has been followed in the minerals industry. One possible argument in favour of maximising volume, even at the expense of weaker prices, is that it enables a producer to achieve the designed economies of scale from existing capacity. The structure of costs may be such that the burden of fixed costs per unit of output rises sharply when the mine and equipment are not fully utilised. The gains from increasing the volume of sales may more than outweigh any fall in prices. Trade-offs like those are typical of the minerals industry. Producers never look solely at one dimension of their sales contracts but look at them all simultaneously. Concessions on price may be set against increased volume, but these are not the only dimensions of sales. Quality, including such features as the grade, and the physical and chemical composition of the ore, is important, and is becoming increasingly so. Quality involves far more than the ore itself. The perceived reliability of a supplier, and its susceptibility to strikes and other disruptions, is another aspect of quality. The provision of technical service to customers is not really important for the producers of metallic ores, but it can be a valuable competitive tool for suppliers of non-metallic minerals. The terms on which credit is granted to purchasers, and the extent to which prices 84

may vary with the prices of the customer’s products are also relevant, especially in the markets for base metals concentrates. In iron ore and coal, as in many other products, pricing has evolved over the past 50 years. When many exporting mines were first established trade was mainly based on long-term contracts with prices fixed over long periods, or indexed to general indicators according to agreed formulae. Such contracts evolved into shorter-term contracts with volumes covering several years, but with periodic price negotiations. Those are still the norm for many products. The volumes can also vary within predetermined limits, depending on market conditions. Negotiations do not start from scratch every year, but from the prevailing prices, which roll over until a new agreement is reached. In some product markets, and especially in industrial minerals, prices are negotiated for the life of the contract, which may be for three to five years. Provision may be made for prices to move over the life of the contract in step with agreed indices, such as US wholesale prices. When the contracts expire the two parties will negotiate a new agreement taking into account changes in the balance between supply and demand, and the extent to which the expiring contract favoured one side or the other. Very often one party will be keen to offset any disadvantages it suffered during the previous contract term. Normally agreement is eventually reached because there is a mutual interest in a continued relationship, but discussions occasionally break up in acrimony, with the parties resorting to arbitration. The more frequent negotiation of prices tends to prevent such disruptions since contract prices then move more closely with market conditions. Sometimes prices are changed half yearly or even quarterly, as in sulfur and some fertiliser materials. Annual price negotiation remains the general rule in base metals concentrates and some coal markets, but with a tendency to more frequent price changes. Large producers of base metal concentrates may divide their contractual volumes, even with one customer, into blocks whose prices are negotiated at different times. That softens the impact of any large price movements resulting from any annual negotiating round. The outcome of the annual bargaining naturally depends on the relative strengths of the buyers and sellers, but also on the changing objectives of individual producers. The first major price settlement reached in any annual bargaining round usually sets the tone for the entire market, and other suppliers quickly follow. The same supplier and customer may lead the market for several years running, but the leadership often changes. Published prices are normally only one facet of a settlement, which also includes arrangements on tonnage. The producer that settles first in a weak market may have counterbalanced concessions on price by increased sales volumes, but the followers seldom derive Mineral Economics

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector those benefits. Participants in the market have to weigh up all the alternatives in their negotiating strategies. Obviously they will need to take account of the size of their own and their competitors’ inventories, and of the balance between the capacity and output of each producer. Eventually a global consensus about prices is reached, and prices in the main regional markets are closely linked. Sometimes such a consensus is reached quickly, whereas in other years the negotiations can drag on for months. Annually negotiated benchmark pricing for seaborne iron ore trade and for metallurgical coal broke down in the late 2000s with the strong growth in Chinese demand. Previously demand had been growing very slowly and there was over-capacity. The major shippers had faced well-organised users who could negotiate on equal terms. With demand pushing against capacity and the geographical diffusion of demand, the suppliers’ relative bargaining power rose. Spot prices increased sharply relative to annually negotiated benchmark prices. The producers sought to keep pace and pushed for more frequent price adjustments. The benchmarking system finally collapsed in 2010 and it has been superseded by quarterly or monthly prices, based on measures of spot prices, mainly in the Chinese market. This development has been accompanied by the linking of contract prices to published index numbers, over-the-counter (OTC) trading in iron ore swaps and derivatives and the creation of standardised iron ore and metallurgical coal contracts for futures trading.

THE RISE AND FALL OF CARTELS Even where prices are negotiated between major producers and users of a product there may be scope for collusive action between producers. Smith (1776) remarked on that inevitable tendency over two hundred years ago: People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. The same factor that facilitates producer pricing, namely a relatively limited number of producers, tends to encourage restrictive agreements to limit output or raise prices. The history of the minerals and metals industry is littered with attempts to fix prices through cooperative actions. These have met with varying degrees of success, but most have ultimately failed. Some have worked through producer pricing whilst others have operated through terminal markets. Many, but by no means all, were started in periods of oversupply as defensive reactions to self-defeating price cutting. Those were often introduced with the active support, or at least implicit connivance, of governments. Attitudes to cartels between producers are much affected by prevailing political philosophies. During the period between the First and Second World Wars, Mineral Economics

many governments accepted the need for concerted action to restrict output in conditions of acute excess capacity and weak demand in order to sustain prices. In the decades following the Second World War such attitudes persisted, and they were reinforced by the widespread acceptance of government intervention and regulation of economic activity. The Organisation of Petroleum Exporting Countries (OPEC) was one of many producer-based organisations established during this period. It was founded in 1960 by five countries – Iran, Iraq, Kuwait, Saudi Arabia and Venezuela – and a further eight oil producing countries had joined by 1973. For the first decade of its existence it achieved very little, but its members chipped away at the power of the international oil companies, which effectively controlled their production. Strongly rising international demand for crude oil, partly driven by the USA moving from a production surplus to a deficit, enabled the producers to achieve moderate price increases in 1971. The Arab-Israeli war of October 1973 and its aftermath encouraged OPEC to go much further in gaining control of pricing and production. The move was driven by political rather than economic considerations, as a means of putting pressure on industrial countries. The price of oil quadrupled, transforming the international oil market and prompting serious economic dislocation in the global economy. The Iranian revolution in 1979, coupled with political upsets elsewhere, led to a further round of sharp price rises from 1979 to 1980. The initial price increases held because the shortrun demand for oil was highly price-inelastic, but by the early 1980s alternative sources of oil were being developed, partly under the stimulus of the higher prices then ruling. Also there had been wholesale substitution away from oil to alternative fuels and energy saving measures of all types. By the late 1990s OPEC supplied about two fifths of the global production of crude oil compared with over three-quarters in the early 1970s (see Figure 7.4). Although OPEC introduced formal quotas on production in 1982 in order to sustain prices, there was widespread cheating and crude oil prices drifted downwards from the mid-1980s. The first Gulf War in 1991 had but a temporary impact on oil prices. By the late 1990s, global demand was again starting to outstrip the available capacity to produce and OPEC’s production quotas became more effective. The collapse of Iraqi production in 2003 helped OPEC to sustain crude oil prices. Most of the surviving members of OPEC (Ecuador left in 1992, but rejoined in November 2007, and Gabon left in 1995) are Islamic states with a similar political outlook, although the similarities between a theocratic Iran, a feudal monarchy like Saudi Arabia, and Nigeria or Indonesia should not be overstated. OPEC’s successes have sprung as much from the global market conditions it has faced as from its own policies 85

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector (A)

from exploiting any power they might have had. In any case, the basic economic conditions that allowed OPEC to boost oil prices do not exist in most commodities.

million barrels/day 90 OPEC

80

Non-OPEC

70

There are several preconditions for successful cartel action:

60 50 40 30 20 10 0

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

55

(B)

% share of world total

50 45

40 35 30 25 20

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

Fig 7.4 - (A) World crude oil production and OPEC’s share of world production (source: British Petroleum, 2012 – the data cover crude oil, shale oil, oil sands and natural gas liquids); (B) OPEC’s percentage share of world oil production.

and actions. That was especially true in the late 2000s when demand rose very strongly with rising global economic activity and above all with surging Chinese demand. Saudi Arabia, in particular, has been able to raise or lower its output in order to influence prices, whereas non-OPEC producers have generally lacked that flexibility. OPEC’s apparent success in raising crude oil prices in the early 1970s prompted the formation of similar international producer groups for a variety of mineral products, such as phosphates, bauxite, iron ore, mercury and tungsten. Less formal arrangements covered manganese, lead and zinc. Many groups, nominally at least, excluded any discussion of prices from their agenda. The articles of the World Phosphate Institute, for example, were framed in such a way as to leave the three US company members free of any anti-trust action. Australia only joined the bauxite and iron ore associations on the understanding that they would not attempt to increase prices unilaterally. Nonetheless, the smoothing of price fluctuations was always an important objective of most members of all these producer groups, and of the copper producers’ group, CIPEC, which was formed in 1967. Most were inter-governmental bodies, although the phosphate, mercury and tungsten organisations had individual company members. Most lacked the wider common interests, which created the strong cohesiveness of the Arab members of OPEC. Weak market conditions from 1974 onwards prevented most producer associations 86

•• members should share some common interests and objectives •• there should not be a wide range of grades or qualities of the product involved, but different producers’ output should be closely substitutable; the scope for cheating tends to vary inversely with the homogeneity of the product •• there should be a high level of concentration of production and reserves •• the cost structures of each producer should be broadly comparable. Where costs of production diverge widely there is little community of interest between the lower-cost and higher-cost producers. Similarly, a wide diversity of sources of production, and of undeveloped reserves, raises the prospect of new entrants undermining the cartel. In essence the barriers to entry need to be fairly high, and not just in the short run. There should be few viable substitutes in the product’s major uses, and the price-elasticity of demand should be very low. Even during their heyday in the late 1970s, producer associations, formed merely to increase or stabilise prices, were unlikely to succeed, because some or all of the necessary preconditions for success were lacking. Table 7.2 outlines the fate of several international producer groups that were formed, or gained prominence, during the 1970s. Bauxite was perhaps the nearest parallel to petroleum in the early 1970s, and producing countries such as Jamaica raised their returns from local bauxite production. That was a temporary success, however, because there were ample alternative resources and the barriers to entry were relatively low. The raising of prices provided leeway for potential producers in other countries, such as Brazil, to develop new mines. Jamaica’s share of global bauxite output fell from around 18 per cent in 1973 - 1974 to eight per cent by the mid-1980s. Morocco and the other members of the putative phosphate cartel were unsuccessful in sustaining their price increases because farmers effectively went on strike and delayed the application of phosphatic fertilisers. Many of the inter-governmental producer groups that were formed during the 1970s did not survive changes in market conditions and prevailing political philosophies. The International Bauxite Association, for example saw a gradual loss of members, before collapsing in 1995. In copper, CIPEC saw many members withdraw and it contracted, leaving its residual coordinating functions carried out in Chile. Mineral Economics

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector Table 7.2 International producer associations in the minerals industry.

Bauxite

International Bauxite Association (IBA) Formed March 1974, and by 1975 members controlled 85 per cent of non-socialist world output. Jamaica, Surinam, Dominican Republic and Guinea successfully raised bauxite mining taxes, but Australia did not. The countries that did lost market share, and the IBA became increasingly ineffective. Jamaica withdrew in mid-1994 and the IBA collapsed in 1995.

Copper

Conseil Intergouvernmental des Pays Exportateurs de Cuivre (CIPEC) Formed in June 1967 by Chile, Peru, Zaire and Zambia. Yugoslavia and Indonesia joined later, and Australia and Papua New Guinea became associates. In 1974-1976 CIPEC unsuccessfully tried to stabilise copper prices through production cuts, but its members controlled too small a share of the global market. CIPEC dwindled in importance with the collapse of Central African copper production, the withdrawal of several members and the establishment of an International Copper Study Group in 1993. Its residual coordinating functions moved to Chile’s Copper Commission.

Iron ore

Association of Iron Ore Exporting Countries (APEF) Developing country members pressed for attempts to set export prices in 1975, but Australia and Sweden refused. Neither Brazil nor Canada joined. APEF collected statistics on market trends until its suspension in 1989. Its statistics gathering role was taken over by an UNCTAD trust fund, which now subcontracts the work to the Raw Materials Group, a Stockholm-based consultancy.

Phosphate rock

World Phosphate Rock Institute Morocco, the leading producer outside the USA, joined with Algeria, Brazil, Jordan, Senegal, Syria, Togo and Tunisia in 1973. Morocco sharply raised export prices in 1974 and several other members followed suit. The United States’ export cartel, Phosrock, also raised its prices. The global market collapsed in 1975 when the effects of recession were exacerbated by farmers ceasing to apply phosphatic fertilisers.

Mercury

Mercury Producers’ Association (Assimer) Formed in 1975 by Algeria, Turkey, Mexico, Italy, Spain and Yugoslavia. Most production was state-owned. In late-1977, Assimer announced attempts to control the market, with sales restrictions followed by price increases. Its control was undermined in 1982 by falling consumption, increased secondary supplies and sales from US stockpiles, but was re-asserted for a brief period in the late 1980s. Growing concerns about the adverse impact of mercury on human health and the environment have led to tighter regulations on consumption. These have also boosted recycling and greatly reduced any pricing power of the primary producers.

Tungsten

UNCTAD Committee on Tungsten, Primary Tungsten Association and International Tungsten Industry Association An ad hoc committee on Tungsten, an inter-governmental body, was established under the auspices of the United Nations in 1963. One of its tasks was to examine ways of stabilising prices. In due course the committee and its various offshoots moved under the UNCTAD umbrella. Its main role was the collection of statistics, but it also attempted to reach agreement on means of stabilising the market, especially during the late 1970s. It was complemented by a producer organisation, the Primary Tungsten Association (PTA), established by major producing companies in 1976. With changing attitudes to market intervention the UNCTAD committee was replaced in October 1992 by the Intergovernmental Group of Experts on Tungsten, whose remit was solely statistical. The PTA was replaced by the International Tungsten Industry Association in early 1988. This brought together mining companies, processors, consumers and traders in a research organisation under Belgian law.

Even if the necessary preconditions for cartels had been in place, the marked change in global political conditions that gathered force during the 1980s would have made their lives difficult. The emphasis moved from collective to individual action and to the primacy of market forces, and government intervention became unfashionable. Prices should be allowed to find their own levels in response to competitive forces, which should be facilitated by effective competition policies. A major defect of producer cartels is that they do not explicitly take account of the interests of consumers. Governments of commodity-consuming countries are, therefore, wary of their creation, especially where companies rather than governments are involved. Both the USA and the European Union came out strongly against any effective cartels, whether these were organised by individual producing companies, privateor state-owned, or by governments. This opposition was less than total, however, as the USA has explicitly allowed cartels that enable US exporters to compete internationally. Thus, US exporters of phosphates and soda ash combine to sell in overseas markets. Similarly, Canadian producers of potash export collectively through Canpotex. Joint purchasing arrangements Mineral Economics

amongst consuming companies are also acceptable. Examples include the Japanese smelter pool, which arranges imports of copper concentrates, and joint purchasing by both the Japanese and the German steel mills. One company may take the lead in dealings with producers, with the ensuing agreement shared by all. Joint purchasing can tip the scales in the purchasers’ favour, even where they have an apparently weak initial bargaining position. Until the mid-1970s only the USA had strong antitrust legislation and non-US companies were prepared to collude to maintain prices. The important proviso was that such collusion did not affect USA’ commerce. Otherwise it would have brought those involved under the reach of the extra-territorial provisions of the USA’ anti-trust laws. It was reasonable to assume that producer pricing outside the USA was beyond reach as long as the USA was self-sufficient in the affected products. Imports into the USA of many minerals and metals began rising strongly in the early 1970s; however, for a variety of different, usually specific, reasons. That led the US Department of Justice to examine possible breaches of anti-trust laws by foreign companies. Simultaneously the European Union’s competition policy was being developed and enforced through case law. 87

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector International zinc producers were amongst the first to experience the changed climate. Companies who had established and maintained the well-publicised European Producer Price system for zinc from 1964 onwards, with the tacit approval of their host governments, were questioned by the US anti-trust authorities in 1976 and a case was brought against them by the European Competition Directorate. That eventually resulted in fines and the effective collapse of the system of zinc producer prices, which had been enforced through an agreement to stockpile, intervene on the London Metal Exchange (LME) and reduce output when necessary. The vestiges of the system lingered on for some years, but without its previous effectiveness. Even when it was fully operational those involved had been quite prepared to cheat their colleagues if they could. Also during the late 1970s the European Competition Directorate successfully prosecuted a group of companies that had collectively purchased all exports of aluminium from eastern countries in order to keep it off the LME and damage the prevailing producer price structure. These actions, and others in different industries, made suppliers of minerals and metals into North America and the European Union much more careful about the anti-trust rules. For example, the major aluminium producers took great pains to involve governments in ways of tackling the problems raised by the sudden and unexpected outflow of aluminium metal from the former Soviet Union in the late 1980s and early 1990s. The Memorandum of Understanding signed between Russia and certain major aluminium-producing countries in early 1994 was an intergovernmental agreement. It provided a fig leaf behind which the companies could shelter when they cut their output in order to restore market balance. Those cuts coincided with an influx of speculative funds into purchasing non-ferrous metals, especially aluminium. Prices rose sharply during 1994 by far more than anyone had forecast, and some aggrieved users of aluminium attempted to sue the US producers for anti-trust violations. The diamond market provides the longest running example of a price setting cartel that has been treated as unlawful in the USA. For many years De Beers operated an effective cartel amongst the mining countries and controlled market prices through its sales policies, and by stockpiling. The US anti-trust authorities were strongly antagonistic and would have prosecuted both the company and its officers had they ever been within US jurisdiction. That was not, however, a sufficient impediment, notwithstanding the considerable funds that had to be raised to finance stocks during periods of weak demand such as the early 1980s and early 1990s. The collapse of the Soviet Union in 1991 and the development of new mines outside De Beers’ control weakened its influence. Australian production, mainly 88

of industrial diamonds, began in the early 1980s, and the Australian producers became increasingly assertive towards de Beers’ Central Selling Organisation. Gradually its tight grip on global diamond marketing weakened, especially with the start-up of Canadian production in 2001. A considerable degree of market discipline remains, however, largely because of the nature of the market for diamond gems. Consumers, have an interest in maintaining high prices for a product that is purchased as a status object rather than for its intrinsic properties in use. If the global diamond market is cartelised, it is a cartel in which consumers are as guilty of conspiring as producers. That makes diamonds very much a special case. Even in diamonds, a form of producer pricing does not eliminate the need for careful analysis of market trends, for a willingness to stockpile, or for a need for production cut-backs in periods of weak demand. Notwithstanding strong anti-trust legislation in major minerals-consuming countries, collusive actions to restrict competition persist. In 2003, for example, the European Union fined European producers of copper tube for price fixing. It also began an investigation, with the relevant Canadian and US agencies, into the copper concentrate market. There were suggestions that meetings to discuss market conditions and industry statistics provided a front for price-fixing. The investigations were closed in 2005 without any adverse findings. More recently the European Union has taken action against European steel companies for price fixing. It has also shown concern about the market for seaborne iron ore in its investigations of actual or potential mergers between producing companies. The nature of the markets for minerals and their firststage products means that producers will always seek ways of restricting competition. The search inevitably intensifies during prolonged periods of weak market conditions. Most collusive agreements are likely to prove temporary because demand is not sufficiently price inelastic over the medium to long term, and because the barriers to entry are not high enough.

PRODUCER PRICING Collusive action of any type is not an essential prerequisite of producer pricing. Where there are only a few suppliers to a market, but many end-uses and customers, producers may quote list prices. Such producer prices may be set by a dominant producer, or price leader, and followed fairly closely by the other suppliers. They may have similar cost structures, and have learned from bitter experience that vigorous price competition brings only temporary gains in market share that are usually whittled away in the next round of price cuts, to the benefit of users rather than producers. Concentration on the other competitive dimensions, such as product quality, marketing, or technical service, may be more effective means of attracting and retaining Mineral Economics

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector customers. Such a concentration is common in the markets for many non-metallic minerals, regardless of the pricing methods used. Where producers set prices they tend to keep them fixed for long periods. They often set them not by reference to marginal costs, whether their own, or those of the industry, but to some form of average cost. Prices change in response to clear external stimuli, like movements in the costs of major raw materials such as crude oil. They are also responsive to their setter’s financial needs, and to changes in productive capacity, which often go together. Customers claim to like producer prices because of their apparent stability, and their air of predictability. Their infrequent changes enable consumers to plan ahead with confidence especially where their purchasing is subject to annual cash budgeting. That has been the typical pattern not just for state-owned companies and government departments, but also for major purchasers such as automobile producers. In the immediate post-war decades, most minerals and metals were priced by producers, and true market-related pricing was relatively rare. The stability of producer pricing was, and is, more apparent than real. It is impossible to maintain complete control over both prices and the volume purchased, except under total monopoly. No matter how clever the forecasters, there are always unexpected changes in the balance between supply and demand. Stable prices are only realised where suppliers are prepared to reduce their offerings when markets are over-supplied, and to expand their offerings rapidly in times of shortage. That, in turn, means a willingness to stockpile and even reduce production in weak markets, and to raise output rapidly in the boom. This implies that there will be a degree of over-capacity throughout most phases of the business cycle, which, in turn, means that really effective producer pricing is only achievable in those markets where there are only a few strong companies. High barriers to entry into the market and a perceived community of interest in price stability between the suppliers are usually preconditions for success. Producer pricing has been strongest and most tenacious in national or regional markets that are protected in some manner from major imports. The basic cost structures of producers within one country may differ, but they are subject to similar variations in costs and demand, and to a common regulatory framework. Often the producers of the primary materials may be integrated with downstream users of their products. That means that the actual price of the raw materials is not of great importance, but it merely indicates where profits are recorded for accounting purposes. The tax authorities will have some interest in ensuring that transfer prices between the various stages are not being used to evade taxes, but that need Mineral Economics

not impinge on market prices. The list prices for the raw materials may only be paid on the modest portion of sales, often to small users, made outside the integrated network. That was the case in the USA’ primary aluminium industry, and largely still is. The prices of semi-fabricated products are infinitely more important to the major US aluminium producers than the price of ingot. Progressive reductions in tariffs and other barriers to trade between major metal producing and consuming countries in the 1960s and 1970s lowered barriers to foreign competition and made the defence of domestic producer prices much harder. Prices could be more easily undercut by imports. Even where producers are able to tailor their production to fluctuating demand the fit will rarely be perfect. Individual producers may be unable to bear the burden of financing large inventories, even with accommodating financial institutions. When markets are weak for extended periods the patience of such institutions soon becomes strained and their willingness to grant additional credit distinctly limited. Hence recourse has to be made to production cut-backs. Those are seldom easy to engineer unless one supplier is prepared to shoulder the entire burden. Individual producers may believe that they have an inherent cost advantage that enables them to carry on producing at a profit when others make losses. They may expect an imminent improvement in market conditions, or they may be loath to countenance any drop in market share that might flow from their cut-backs. This all means that collusive action between the suppliers has often been necessary to ensure the appropriate cut-backs. This might be no more than following the example set by a dominant market leader, such as International Nickel (the former Inco, which is now Vale Inco) in nickel, or the former Amax in molybdenum. More than that invites a legal riposte. The USA has long had legislation prohibiting collusive action in restraint of trade, but the diligence with which it has been enforced has varied. The legal sanctions include possible imprisonment of those individuals found guilty and the threat of triple damages for any aggrieved parties. In cases where producers’ published list prices have been apparently stable for long periods, the prices at which business is actually transacted can diverge markedly. Large customers may enjoy volume discounts that rise when market conditions deteriorate, and other forms of incentive then creep in. When demand presses against the limits of capacity, and redundant plant has been brought into service, premiums may be imposed on groups of customers, or even on all. Moreover, rationing will sometimes be introduced, with longestablished customers favoured over casual trade. That naturally creates a constituency amongst the aggrieved parties in support of potential new entrants. It was Inco’s inability to supply nickel during a strike in 1969, and the ensuing acute shortages that triggered a massive 89

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector exploration boom and the subsequent development of new mines elsewhere. That, in turn, undermined Inco’s hold on the nickel market. Typically producers’ list prices have tended to rise over time, at least in money terms, with cost-justified, or market-driven, increases much more common than price cuts introduced when conditions are bad. The burden of those is taken more on volumes supplied. The benefits of productivity improvements of all types are not fully passed on to customers, except when new entrants threaten to undermine the established order. Indeed, effective producer pricing may discourage suppliers from pursuing productivity as aggressively as those who are forced continuously to lower their costs to survive in periods of falling market prices. The inherent discipline of market pricing is one reason why many producers nostalgically incline towards producer pricing. The ability of producers to set prices has been gradually weakened not just by trade liberalisation but also by the spread of demand away from its traditional locations, and by the development of new facilities to meet that rising demand. In the immediate post-war decade the USA was the dominant producer and user of minerals and metals, and prices were heavily influenced by the actions of USA’ companies. Gradually, first Western Europe, then Japan, and more recently China and other countries, emerged to challenge the USA’ hegemony, so that China is now by far the largest importer and consumer of most mineral products. Simultaneously, the nationalisation of foreign-owned mines and processing plants by many countries, particularly, but not exclusively, in the developing world, weakened the ability of US companies to control supply. The newly state-owned companies were often mainly concerned to maximise their throughput and revenues. Also new mines and plants were established in developing countries, often by state enterprises. These lacked any established marketing experience and they were initially content to sell through merchants, who could grant credit as well as obtain access to markets.

Another nail in the coffin of producer prices for products that are produced and sold in a range of countries was the collapse of the post-war system of fixed exchange rates that culminated in the devaluation of the US dollar in 1971. This ushered in a regime of floating exchange rates that was initially accompanied by rampant cost and price inflation. Although currencies could, and did, change their parities under the regime of fixed rates, such changes were infrequent. The prevailing assumption, broadly justified by experience, was of stability. Nearly all producer prices were denominated in US dollars, which had been regarded as a completely stable yardstick. Floating exchange rates soon undermined that faith, and contributed to diverging interests between producers with different currencies, let alone between them and consumers. What was a stable price in one currency was not necessarily stable in another. That meant that fixed dollar prices no longer provided unequivocal signals about the changing balance between supply and demand. Producers with appreciating currencies saw their receipts shrink in their own currencies, sometimes even when dollar prices rose. Conversely, those with devaluing currencies saw their domestic revenues rise even when markets were oversupplied and dollar prices eased. The stability of producer pricing, and hence one of its basic rationales, was undermined. Domestic prices still diverge even when global prices are marketdetermined and currencies fluctuate, but no one has ever claimed that market-driven prices are stable. A summary of the history of producer pricing in the non-ferrous metals appears in Table 7.3. Collusive action to fix prices has long been illegal in the USA, but overseas markets have not been subject to similar anti-trust legislation. That changed during the early 1970s, with the development of the European Union’s competition policy. As discussed in the previous section, anti-trust actions forced the demise of the European producer pricing system for zinc during the late 1970s. It was, however, already suffering from differences of interest between the different suppliers.

Table 7.3 The history of producer pricing in major non-ferrous metals. Aluminium

The US producer price (Alcoa) was dropped in 1986. Alcan’s World Price was the yardstick for pricing outside the United States to the end of 1988. It co-existed with various free-market quotations. The London Metal Exchange pricing began in 1979 and progressively superseded producer pricing.

Copper

Central African and Chilean producers set a producer price between 1961 and 1966, when it collapsed. Most sales outside the United States have subsequently been based on LME prices. Within the United States producer pricing continued until well into the 1980s.

Lead

Within the United States posted producer prices persist, but the vast majority of the lead industry has long used LME prices as their pricing basis.

Nickel

Inco posted its world producer price until December 1987. LME quotations began in late 1978. For much of the 1970s there was heavy discounting from posted producer prices, and free market prices were more reliable guides to transaction prices. LME quotations now dominate.

Tin

Prices in the London and Penang markets, which were the basis of most trade in tin, were effectively controlled by the operations of the International Tin Council (ITC) between 1956 and October 1985. With the collapse of the ITC prices became entirely market-determined, initially through reference to quotations in trade journals, but then through the LME, when it restored its tin trading in 1989.

Zinc

Most global business is now based on LME prices. Within the United States, prices were posted by producers until 1993. Elsewhere most producers nominally used the International Producer Price from its inception in July 1964 until its final demise in 1988. Its hold weakened from the mid-1970s, as described in the main text.

90

Mineral Economics

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector Some are fully integrated from mine to refinery, whereas others are not. Custom smelters face a fluctuating market for their raw materials as well as for their products. Costs of production, responsiveness to fluctuating exchange rates and ability to adjust output varied widely between producers. Given its fungible nature, there is nothing to distinguish between metal of a given quality from different producers so that users had little loyalty to particular suppliers. There was no long-term community of interest between the different producers that would persuade them to tailor their supply to demand for long periods, or to build up their own stocks rather than sell into the market, and cheating was rife. There was a tendency to set producer prices at a high enough level to placate the least efficient producer. That discouraged consumption, and provided scope for the more efficient to expand. It also eased the path for new entrants, who may have been outside the system. Excess capacity inevitably resulted. The aftershocks of the collapse of producer pricing reverberated around the zinc industry for years. There was always a tendency for all producer prices to be too inflexible in response to changing market conditions, and over the long term to be set too high. The world copper producer price of the late 1950s and early 1960s probably accentuated the over-supply of the early 1960s. The European zinc producer price and the stable nickel producer prices of the 1970s also tended to create excess capacity. Inevitably some countries or companies will not actively participate in producer price schemes but will exploit them to full advantage. These, rather than the active participants, gain the most. Over the longer term there is a tendency to cheat, and to discount in periods of weak demand. Aside from any tendency for over rigid producer prices to encourage excess capacity, there is a need to fund large stocks in periods of weak demand. If producer prices are to be credible compared with free market quotations, the latter must be supported, however thin the market. In a severe recession almost limitless funds and nerves of steel are needed to support a given price. Unless the support level is carefully chosen, the available funds will run out, market prices will then plunge and the participants will be faced with large book losses. That collusive action amongst suppliers to enforce list prices is illegal in the major industrial economies by no means rules out producer pricing. Some other countries lack effective anti-trust rules, or may accept that the resultant price stability is beneficial to their export earnings. The publication of list prices, even without collusive action, is still common in the minor metals, and some industrial minerals. It often co-exists with a dealer, or merchant, market in which prices are far more volatile. That is not just because the latter quickly reflects changes in the balance between the global supply and demand, but also because merchants Mineral Economics

will gain access to varying proportions of the total supply over the course of the business cycle. In good times producers will control a much greater share of the total supply than when conditions are depressed and their customers have more than they need and offload the excess onto merchants. When merchant prices diverge from list prices for extended periods, in either direction, the producers’ list prices become merely nominal, and of little practical relevance. In time they may be completely withdrawn, and all pricing then becomes based on the merchant market. Prices are usually indicated through regular compilations in the technical press of the averages or ranges of the quotations of individual merchants for specified grades and volumes. Prices of many minor metals, such as cobalt, have been compiled in such a fashion. No matter how assiduous and careful the compilers of such prices, there is no guarantee that much trade actually takes place at them. They are indicative at best. On occasion market participants have raised strong concerns about the validity of some published prices. For many market participants price transparency is a mixed blessing. There is often dispute about the relevance of published prices to particular trades. Those purchasers who have managed to obtain special deals, and their suppliers, often prefer secrecy rather than publicity. Prices are something agreed between consenting adults in private, rather than blazoned over the pages of the technical press, even if discreetly at the back amongst the small advertisements. Traders also thrive where they can exploit their unique knowledge of market conditions. Even so, the next logical step from a large merchant-based market, with opaque price formation, is the transfer of the process of price discovery to some form of terminal market. That not only enhances transparency, but offers opportunities for hedging price risk. During the 2000s, marketbased pricing became increasingly common, partly in response to the growth of Chinese demand, but also reflecting developments in communications and computer technology. Web-based pricing mechanisms and screen trading improved market transparency and lowered the cost of trading.

EXCHANGES The essence of trading and pricing systems using exchanges is that prices are set, on at least a daily basis, to balance that day’s marginal offerings and demand. Directly or indirectly, those prices govern all that day’s transactions, whether or not they are actually made through the exchanges. The offerings and demand may come not only from industrial companies, whether producers or users, but also from merchants and investors of all types. Thus supply and demand in these markets are much broader than production, whether of primary or secondary material, and industrial usage. 91

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector Exchanges may have four main interlocking functions, which they fulfil in varying degrees. These are: 1. the determination of daily reference prices for the products traded 2. the provision of facilities for hedging against price risk 3. acting as a market of last resort through a dedicated warehouse network 4. giving opportunities for investment in metals as assets. Each exchange has its different methods and traditions. Some do not provide for physical delivery, but are solely paper markets. Some trade against price index numbers, and much of their trade is in swaps or OTC contracts. Where exchanges do act as a physical market of last resort they are described as terminal markets. The leading terminal market for trading non-ferrous metals is the London Metal Exchange (LME), which accounts for over 90 per cent orof global exchange business for those metals it trades. These are aluminium, aluminium alloy or secondary aluminium, copper, lead, nickel, tin and zinc. Steel billet was first traded in 2008, with cobalt and molybdenum added in 2010. The CME Group trades copper and aluminium through its Comex Division of Nymex, the Tokyo Commodity Exchange started an aluminium contract in 1997, Kuala Lumpur trades tin and the Shanghai Futures Exchange deals in aluminium, copper, lead, zinc and gold. The Singapore Exchange started trading aluminium, copper and zinc in February 2011 mainly for investors, using LME prices. New York, Tokyo, Hong Kong, São Paulo and the London Bullion Market (LBMA) trade precious metals. Crude oil and natural gas are quoted by Nymex and the International Petroleum

Exchange in London. These markets trade in futures and price derivatives, which are not always backed by physical delivery. The China Beijing International Mining Exchange (CBMX) began trading a spot iron ore contract in May 2012.

The London Metal Exchange The LME was first established in 1877. It was extensively reorganised in 1987, following the default of the International Tin Council, and the passage of the United Kingdom’s (UK) Financial Services Act, and it became a limited company owned by its shareholders in 2001. Its activities are closely related to the physical metals trade, but it had to be fitted into the framework established under the Financial Services Act. It is a Recognised Investment Exchange regulated directly by the Financial Services Authority, which closely defines the conditions under which the Exchange operates, and above all requires that it maintains orderly markets in all its contracts. Where it carries out its activities in the USA, such as the listing of approved warehouses, the Exchange is governed by the relevant USA’ legislation, and by the Commodities and Futures Trade Commission (the CFTC). It is also subject to any relevant directives of the European Union. The Exchange is responsible for maintaining and policing its trading rules and regulations, but the commercial and ethical conduct of its members is regulated by a branch of the Financial Services Authority. Although the Exchange is based in London, most of its members are ultimately owned by foreign companies, and it is a truly global market. It opened a Singapore office in 2010. A historical summary of LME contracts appears in Table 7.4. The copper, lead and zinc contracts have a long history, as does tin. Trading in the latter, however,

Table 7.4 London Metal Exchange metals contracts. Copper: 1877 with specification periodically changed. First official LME contract 1883. Present Grade A contract June 1986. Tin: 1877, with specifications periodically changed. Contract suspended October 25th 1985, and re-introduced June 1989. First official LME contract 1883. Pig iron: 1877 until 1920s. Lead: 1920, but traded unofficially before then. The specifications have been periodically changed. Zinc: 1920, but traded unofficially before then. The specifications have been periodically changed. Present Special High Grade 99.995 per cent contract introduced June 1986. Aluminium: December 1978, with the contract changed to High Grade in August 1987. Nickel: April 1979, with specifications periodically changed. Silver: 1969 until mid-1989. New contract in May 1999 suspended in March 2002. Aluminium alloy: October 1992. North American Special Aluminium Alloy Contract (NAASC): March 2002. Steel billet: Mediterranean and Far East contracts introduced in May 2008, with cash trading from July 2008. The Far East contract was combined with the more active Mediterranean contract in July 2010 into a global Steel Billet contract. Cobalt: February 2010, with cash trading from May 2010. Molybdenum concentrates: February 2010, with cash trading from May 2010. Index: April 2000. Based on the six major non-ferrous metals, but not actively traded. 92

Mineral Economics

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector was halted after the collapse of the International Tin Council in October 1985 and only resumed in 1989. The zinc contract was given a new lease of life by the final demise of European producer pricing in the 1980s, and by the adoption of an LME pricing base by the USA in 1993. Trading in aluminium started in 1978 and nickel followed in 1979. Both contracts were initially shunned by their respective industries, and it was some years before they were fully accepted as being representative. The contract for aluminium alloy began trading in early 1992 and was also slow to gain acceptance. It was joined by a North American aluminium alloy contract (NASAAC) in March 2002. Pig iron was traded for a period until the 1920s, and trading in silver began in 1969, ceased in mid-1989, resumed on a new basis in May 1999 and was suspended once more in March 2002. Trading in steel billet began in 2008 with two regional contracts that were combined into one global contract in July 2010. Contracts were introduced for the minor metals, cobalt and molybdenum concentrate, in February 2010. The relative importance of each contract varies annually depending on the market conditions for each metal. In 2010, aluminium accounted for about 45 per cent of the total number of lots traded, copper accounted for almost 24 per cent and zinc for 15 per cent. Lead and nickel each provided around six per cent of the lots traded, and tin four per cent. The two aluminium alloy contracts accounted for just over one per cent, and the fledging steel and minor metal contracts for a negligible proportion. Only a very small percentage of the volume of nonferrous metal produced and traded is physically delivered into LME registered warehouses, but the bulk of the world’s non-ferrous metals are traded by reference to LME prices, and the LME captures by far the greater share of hedging business. Trading is by open outcry across a ring, in which the dealers sit and shout their bids or offers in designated short periods. This is backed up by a 24-hour telephone-based inter-dealer market outside ring trading sessions and by a screen trading system, LMEselect. This was first introduced in early 2001, and has been gradually refined. It allows accredited traders to execute trades electronically, and allows for straight-through processing in which LMEselect trades are automatically sent for matching and clearing. The system also enables LME members to connect their clients directly to the LMEselect trading system via third-party applications, a process known as ‘order-routing’. The share of total LME business transacted through the ring itself has gradually declined to roughly one-fifth. The basic contract for each metal is for three months forward, with each working day being good for delivery against the prompt, or delivery dates. Daily cash prices are also fixed, with additional prices for fifteen months ahead for tin, steel billet, cobalt and molybdenum concentrates, going to 27 months for Mineral Economics

aluminium alloys, 63 months for lead, nickel and zinc, and 123 months for aluminium and copper. The prompt dates were last extended in September 2008. The prices are strictly forward prices for future delivery on specified dates, rather than the futures prices traded in most other markets such as Nymex. This is one of the LME’s distinguishing features. All prices are fixed in US dollars, the prime currency of the non-ferrous metals industry, but with facilities for also clearing in sterling, Japanese yen and euros. The prices established by open outcry at the close of the second, or official, rings become the official settlement prices for each day’s trading. These rings concentrate bids and offers from the whole world into one brief trading session, which reaches its peak at the closing bell. The prices reflect the marginal tonnage offered and demanded that day, no matter the source or the destination. They inevitably fluctuate daily, but broadly reflect, under normal circumstances, the global markets’ balance of supply and demand. Trade is conducted in lots rather than tonnes, with each lot of aluminium, copper, lead and zinc amounting to 25 t. Nickel is traded in 6 t lots, tin in 5 t, aluminium alloys in 20 t, steel billet in 65 t, cobalt in 1 t lots and molybdenum concentrates in lots of 6 t of contained molybdenum in 10 t lots of roasted molybdenum concentrates. Prices are set for metal that meets the prevailing contract specifications, which are established with reference to the needs of the producing and using industries. Individual producers’ brands that meet the contract specifications can be registered and are good for delivery once they have been tested and accepted. The contract for each metal sets out the shapes, weights and methods of strapping. The contract specifications are for that quality and shape of each metal that is most widely traded and demanded. Specifications have tended to rise over the years. In the 1980s, for example, the aluminium specification was raised from a minimum of 99.5 per cent aluminium to 99.7 per cent, and the copper contract moved from wirebars to Grade A cathode. The quality of zinc has been progressively raised, initially from good ordinary brand (GOB) to high grade, and then the special high grade with minimum 99.995 per cent zinc that is traded today. The contracts specify minimum standards, which many producers easily exceed. The daily prices do not distinguish between the individual registered brands, but brokers and traders may pay premiums for particular brands that are especially in demand. Similarly, the price is for delivery into or out of any registered warehouse, no matter where it is located, and premiums may be established for specific locations. Whether they are concluded on or off the ring, all LME contracts are matched and cleared through LCHClearnet. In 2011, the LME announced that it was considering introducing its own clearing mechanism, but no decision has yet been reached. Before the 93

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector clearing arrangements were introduced in 1987 brokers acted as principals, which meant that the market’s users faced a risk of their broker defaulting. The clearing mechanism offers security to all users of the market that their contracts will be honoured, even if the initiating broker were to go bankrupt. The prime distinguishing feature of LME contracts is that they are not cash cleared. In other words, users of the market do not have to contribute additional cash when their contracts are making losses, nor can they take out profits ahead of the prompt date. Rather the contracts are cleared against bank guarantees, with brokers granting credit to their clients. Most trade users also do not insist that their business is segregated. These features make the Exchange particularly useful for trade users, who do not have to commit variable, and uncertain, amounts of working capital to use the market. Other exchanges that trade in metal futures, or in energy products, like the New York Mercantile Exchange, are cash cleared. It was the ability to take out paper profits when prices were rising that enabled the Hunt Brothers to drive up silver prices so dramatically in 1979 - 80, when they were attempting to corner the silver market. They could reinvest their paper profits in margins on yet more futures contracts. When the bubble burst and prices started falling, repeated calls for additional cash margin accelerated and accentuated the decline of genuine hedging as well as speculative business. In order to provide more convenient contracts for investors the LME introduced 5 t LMEminis for aluminium, copper and zinc in December 2006. These are cash-settled monthly futures contracts that can be traded on LMEselect or in the telephone market, or through a link with the Singapore Exchange. Prices are based on the settlement prices of the parent contracts. Credit clearing makes it easier for the metals industry to use the market to hedge against price risks. Hedging is the elimination of uncertainty at a known cost. Users of the market with future commitments for purchase or delivery of physical metal can buy or sell an equivalent, and offsetting, forward contract that matures at the same time. The prices are known today. When the time comes to deliver or buy, the user can close out the forward contract and take either a loss or a profit to set against the offsetting profit or loss on the physical contract. The liquidity of each contract tends to diminish rapidly the further forward they go beyond three months. In addition to conventional forward contracts, the LME also trades options. These give the purchaser or the seller the right, but not the obligation, to buy or sell at the strike price. The premium paid for this right varies inversely with the amount by which the strike price varies from prevailing price levels. It is like an insurance premium to protect against a known event. The LME’s traded options are mainly so-called European options, which refer to prices on specified 94

future dates, the third Wednesday of each month. Most users are much more interested in achieving average prices over a period, such as a month or a year. Until 1997, the substantial and fast growing business in Asian options of this type was conducted OTC in deals specifically tailored for individual users. The LME introduced traded average price options (TAPOs) in early 1997, initially for aluminium and copper, but now for all the metals, to provide the protection of the clearing mechanism to such widely used contracts, and to increase market transparency by bringing them into the open. Most OTC options deals are denominated in US cents per pound of metal, whereas LME contracts are expressed in US dollars per tonne. Its strike prices are, therefore, too far apart and inconvenient for the LME to attract as much business to its contracts as it initially expected. Metal brokers can provide an infinite variety of combinations of forward prices and options to cover virtually any eventuality. The underlying mathematics and the jargon of these various price derivatives can be complex, but their basic function is to enable producers and users of metals to eliminate the risk of unpredictably volatile prices at a known cost. The use of options overcomes one of the basic problems of forward contracts, which lock in specified prices. Use of those denies the seller the benefit of any upside if prices at the time of delivery greatly exceed the contract’s forward price, and the purchaser the benefit of any fall below the forward price. The latter is particularly important for fabricators who are actively competing for business, and operating on tight margins. One of their major concerns is that their competitors do not buy their raw materials on more favourable terms. No matter what combination of hedging mechanisms is used, it is always the responsibility of the user’s management to ensure that it is aware of exactly what is being done, and of the potential risks involved. The well-publicised incidents in which companies have lost heavily in metals trading have all been ultimately traceable back to lax management in the affected companies. The growth of options trading has been of especial value to investors in metals, otherwise known pejoratively as speculators. There must always be individuals or firms who are prepared to invest in metals in order to provide adequate liquidity to the market. Without such liquidity, the costs of hedging could become prohibitive. Moreover, prices could periodically swing uncontrollably in one direction or another, unless there were always people who were willing and able to take contrary views to the market as a whole. Trade use of the LME remains substantial, but investors of all types have become far more important during the last decade, at times accounting for the lion’s share of trades. Commodities have been increasingly regarded as a class of assets whose inclusion in a portfolio improves Mineral Economics

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector its risk profile. Very low interest rates since the banking collapses of late 2008, and the drop in metal prices immediately following the GFC, accentuated investment in commodities, including metals, as the prospective returns exceeded those obtainable on other assets. A widening range of financial institutions has invested in metal futures and options, although the financial sector’s holdings of physical metal remain very low. Much investment demand is cyclical in that it has tended to evaporate during periods of weak market conditions. It is greatly influenced by expectations about future price trends and by the returns available on more conventional classes of asset. Partly in response to investment demand, the LME’s turnover greatly exceeds the global production and use of each metal. In 2010, the multiples of LME turnover to global output varied from 21 for lead up to 42 for copper, with tin at 22, nickel at 30, aluminium at 31 and zinc at 37. The multiples were much lower (two to five) for the aluminium alloy contracts. These large multiples by no means reflect the amount of speculative activity and investment demand, as they have been at similar levels even when that has been weak. A proportion of LME turnover comes from brokers adjusting contract dates and volumes to meet the precise needs of their customers. It is seldom wise to attribute sharp and unexpected shifts in prices to the speculators. However good the statistics about consumption and production in the recent past, prices also reflect expected trends. We do not always have sufficient knowledge about the present and the future. Forecasts usually cluster together, and they are often wrong, perhaps because of random shocks. Sometimes market sentiment can change dramatically, almost overnight, and prices have to catch up. Sharp and apparently inexplicable price movements can often be explained retrospectively by fundamental forces.

Speculative investment tends to even out over time, and prices do broadly reflect relative shifts in supply and demand. At times, however, ‘investment’ in metals as such can become substantial and prices can then be driven up, or down, more than might seemingly be warranted by underlying trends in supply and demand. Much of the LME’s turnover arises from its use as a market of last resort. LME contracts provide for physical delivery, and in support there is a network of registered warehouses throughout the world. The Exchange itself does not own or operate the warehouses, and nor does it own the metal they contain. It approves warehouse locations, with the objective of having a widespread network throughout the world in all important areas of net consumption. Warehouse locations must have appropriate fiscal and regulatory systems, be served by a good transport network, have the facility to store goods without payment of duty and enjoy political and economic stability. These requirements rule out some apparently desirable locations. Once locations have been decided, warehouse companies may apply to open facilities. The contract between the Exchange and those companies that satisfy its criteria sets out the warehouse company’s rights and obligations, and it provides for a disciplinary procedure. Metal of approved brands may be delivered into a warehouse to satisfy delivery commitments, in exchange for LME warrants. These are bearer documents giving title to a specific parcel of metal in a specified warehouse. The terms on which metal is delivered and stored are agreed between the warehouse companies and the companies who deliver it. There are 36 approved warehouse locations, of which two in Turkey are only for steel billet, and over 600 registered warehouses or compounds (Figure 7.5). When markets are over-supplied, metal flows into warehouses, and it moves out again when markets tighten. Movements in the stocks held in LME registered

3 locations in the UK; all metals. 19th century to 1994 14 locations, 7 countries in Europe: all metals. 1962 to 2008, but the 2 in Turkey only steel 3 locations in Korea; not lead or zinc. 2001 to 2008 10 locations in USA; all metals. 1991-2008

Fig 7.5 - London Metal Exchange registered warehouse locations in 2011 (note: the number of locations increased during the 1990s to cope with an inflow

of metal associated with the collapse of the former Soviet Union and global recession, and several little-used locations were subsequently de-listed).

Mineral Economics

95

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector warehouses are thus useful indicators of market conditions. Over the years there has been a progressive move towards placing a greater proportion of surplus metal in LME warehouses. This partly reflects the growing use of the Exchange for hedging and as a price reference, and the extension of the warehouse network. Warehouses were originally confined to the UK, with locations first authorised in mainland Europe during the 1960s. Singapore and Japan followed in the late 1980s and the USA in 1991. Dubai and Korea were added in 2001, although Dubai was good for silver delivery from 1999 to 2002 and Malaysia was first registered in 2004. Turkey was approved as a location for storing steel billet in 2008. Some locations may not store particular metals, either because they are close to major producing areas such as Singapore was historically with tin (until the LME lifted this limitation in 2002), or because of local restrictions on trade. Thus Japanese warehouses only store aluminium, Dubai does not take aluminium and Korea may not accept zinc. LME copper trading only commenced in the USA in 1995. The growth of LME stocks relative to total reported inventories was also part of, and primarily mirrored, a global trend towards reducing the amount of working capital tied up. If metal is held in LME registered warehouses, there is much less need to hold stocks in producers’ or consumers’ yards, and no need for the metals industry itself to arrange their financing. LME warehouses became magnets for surplus metal during the recessions of the early 1990s. Excess western supplies were greatly augmented by outflows from eastern countries. Although much of the latter was not registered for LME delivery, it partly displaced metal that was, allowing the latter to be delivered into warehouses. Had the surplus metal not gone into LME warehouses most of it would have been absorbed elsewhere, and there would have been little, if any, cut-back in production beyond what actually occurred. From 1994 onwards the tonnage of metal held in warehouses contracted, but the withdrawals did not necessarily flow into final consumption. Much was taken out of LME registered facilities partly to reduce its visibility and influence prices. The expectation was that final demand would soon rise sufficiently to absorb excess stocks. In the event demand rose less than expected, and LME stocks levelled out. For most metals they fell to rock-bottom levels in 2004 - 2006 in response to booming demand, and then rose sharply after the banking collapse of late 2008 and the subsequent recession. During part of 2009 - 2010 the normal inverse relationship between LME prices and stocks was temporarily disrupted for some metals as a consequence of a surge in financial institutions’ demand for metals as assets. The spread of the LME’s warehouse network from its predominantly European focus changed LME prices from mainly reflecting European balances between supply and demand into global indicators. That, in 96

turn, altered the structure of premiums over and above LME prices for delivery in particular locations. The LME’s settlement prices will inevitably reflect the balance between deliveries of metal into warehouses and shipments out. There may be net inflows in some locations at the same time as metal is flowing out elsewhere. Not all locations and warehouses are equally accessible or convenient, and the charges for taking metal out vary. The warehouse companies in the less favoured locations have sometimes offered inducements to traders to place metal in their warehouses, and once it is there it tends to stick. Inevitably, the tendency to offer inducements in order to attract and retain stocks has spread to most warehouse companies. The wider the warehouse network, the easier it becomes to deliver metal onto warrant when markets are tight. When markets are well supplied they are usually in contango. In other words, prices for future delivery exceed cash prices by a margin that represents the costs of storage and insurance, and the rate of interest, or the time value of money. To the extent that warehouse companies offer any special deals on rents, the normal contango will be reduced. Other things being equal a rise in warehouse rents or interest rates would be accompanied by a widening of the contango. Often, however, such an adjustment would be swamped by other influences on prices. The further forward the quoted price, the greater the margin above cash prices, although a lack of liquidity for the far forward dates could influence the relationship. Without any extraneous shocks the relationship between prices for the different delivery dates is stable. When, for one reason or another, there is a shortage of metal for immediate delivery prices move into a backwardation. That means that cash prices for immediate delivery rise above the forward prices. There may be sound fundamental reasons for a backwardation, such as transport disruptions, or a strike at a major producer. A prolonged shortage of supply relative to buoyant demand can cause them to persist for long periods. The only cure is an influx of metal into LME warehouses, which is sufficient to restore balance. A backwardation often makes it worthwhile for those who have excess tonnage, however temporarily, to deliver into warehouses in order to earn a rate of return that may greatly exceed the cost of finance. The emergence of bubbles in the pattern of prices is, however, often a sign that someone is attempting to squeeze the market. In other words, they may have gained control of the greater part of the available LME inventory and also have large long positions that give them potential access to far more metal than they need to meet their future commitments. Those who are short will have to pay the backwardation, or borrow metal at a cost, in order to meet their commitments. Just occasionally the market may be squeezed inadvertently by a merchant, but often there will be deliberate manipulation. That Mineral Economics

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector offends against the preservation of orderly markets, which is one of the LME’s prime functions as a Recognised Investment Exchange. Backwardations raise the costs of hedging for physical users of the market, sometimes prohibitively. They can also distort the validity of LME quotations as reference prices for the global metals industry. The LME’s rules and regulations give it considerable powers to prevent manipulation and punish members who break those rules. In order to ensure orderly markets the Exchange operates a system of lending guidance whereby holders of dominant market positions are required to lend into the market on progressively more onerous terms depending on the size of their market positions. This guidance acts as a safety valve that limits potential gains from deliberately building dominant positions in order to squeeze the market. The Exchange has no jurisdiction over the parallel physical market, or over non-LME businesses. Squeezes may often be engineered in the OTC market rather than in LME contracts, although they spill over into the behaviour of LME prices. The best defence against market manipulation is the greatest possible transparency in all types of trade. Since mid-1996 the LME has greatly increased the amount of information that it publishes, but it always faces a difficult balancing act. An excessive insistence on transparency could lead to trade drying up or being driven offshore, or to OTC markets that are outside the scope of any regulation. That would not necessarily be in the users’ best long-term interests, as was demonstrated by the GFC of 2008 - 2009. This prompted a continuing move towards tighter regulation of OTC derivatives of all types, and a recognition of the benefits of clearing through organised markets. The LME’s main competitor, the New York Mercantile Exchange, has claimed that it has lost trade to the LME because the latter has been less tightly regulated. The methods of regulation in London and New York are certainly very different, but the LME is no less tightly controlled and policed than its US counterpart. The main reason that the LME captured most of the global business in non-ferrous metals is that its contracts and methods of trading have been more suited to the needs of trade users than those operating in New York. The LME’s main attractions include its system of prompt dates, its extensive warehouse network and credit rather than cash clearing. It also straddles the three main global time zones, picking up the close of business in Asian markets early in the day and overlapping with New York in the afternoon. Finally, the UK does not have a large domestic mining and smelting industry with vested interests, but it does have a long tradition of open markets and liberal trading. The Comex Division of the New York Mercantile Exchange has much lower liquidity, with trade concentrated on hedging by domestic US companies and on speculative investment business. A considerable amount of its trading is Mineral Economics

conducted on their own account by ‘locals’, rather than for trade clients. Arbitrage between the London and New York markets has ensured that their respective prices rarely step too far out of line with each other. The present systems will only survive, however, as long as the markets’ users are content that they give prices that are properly representative of market conditions. The prices set are far more chaotic and seemingly more haphazard than producer pricing systems, but more transparent and reflective of changing market conditions. Some criticise LME prices as being excessively volatile, under the influence of investment in metals by financial institutions of all types, often grouped under the general description of ‘speculators’. Certainly prices can move markedly even within the course of a day, let alone from one day to the next. The explosive growth of options-related business also appears to have introduced extra volatility. Much of that business, however, is conducted on behalf of producers and fabricators insuring against adverse future price trends. To the extent that a significant proportion of annual production is protected for months, or even years, ahead, that much will be less responsive than it might previously have been to weakening prices. The protected producers will have no immediate need to cut their output because they are incurring cash losses. That, in turn, means that the burden of any excess supplies in recessions is thrown more heavily than in the past on prices rather than volumes. That alone will give the appearance of increased price volatility, but it owes nothing to speculative activity. Evidence that prices of non-ferrous metals have become more volatile in recent years solely because of speculative activity is rather tenuous. Those who assert that prices have become more volatile have usually looked at trends over relatively short periods and have failed to allow fully for the many factors influencing prices.

RECENT TRENDS IN MINERAL MARKETS At the start of the new millennium most sectors of the minerals industry seemed set for a prosperous decade. The major international political tensions that had persisted since the Second World War were largely resolved, market capitalism had seemingly triumphed over more dirigiste systems and the global economy was becoming increasingly unified. It had quickly shrugged off the Asian crises of 1997 - 1998, and had resumed apparently healthy expansion, inflation had been tamed, currency markets were relatively stable and oil prices remained subdued. Subsequent events showed that any complacency was sadly misplaced and that turbulence was developing beneath an apparently smooth surface. Led by the USA the major industrial economies were on the brink of recession, and new political tensions and uncertainties were developing in the world at large. 97

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector Demand for mineral products is driven by economic activity, which faltered in 2001 after a strong start to the decade. Figure 7.6 shows the annual rates of change of output, both globally, in the major advanced economies (Canada, USA, Japan, France, Germany, Italy and the UK), and in China from 1998 onwards. Although the 2001 recession was relatively brief, the annual rate of economic growth of the advanced industrial countries did not regain its 1999 - 2000 rate, even in 2004. Fortunately for the minerals industry the newlyindustrialising and emerging economies took up the slack, growing strongly throughout the decade.

house-building in the van, but their capital spending contracted after 2008. Chinese and Indian capital spending rose as a share of total output in 2009 - 2010 from already high levels, as shown in Figure 7.7. The share of Chinese output devoted to investment explains why its demand for many mineral products has risen faster than its total output. The share has been unsustainably high and the International Monetary Fund predicts more moderate levels in coming years. 50 45

35

14 % of GDP

12

% per annum change

10 8

World

20

Major Advanced economies

5

2

0

0

1998

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

World

Major advanced economies

(source: International Monetary Fund 2012).

From 1999 onwards, global growth was much greater than that of the advanced economies, and in 2004 2007 exceeded four per cent per annum. The strength of global activity over the period owed much to the strength of Asian economies, and especially of China. The buoyant Chinese economy has been the main force driving demand for mineral products over the past decade. Its share of world output (measured on a purchasing power parity basis) rose from 6.3 per cent in 1997 to 13.6 per cent in 2010. This has been partly at the expense of growth elsewhere, with Chinese exporters benefiting from a low cost base and an undervalued currency, but it mainly reflects strongly growing internal demand, led by heavy investment in plant, equipment and infrastructure. The financial crises and banking collapses of 2008 2009 abruptly halted the global expansion in its tracks, and in 2009 the advanced economies experienced their deepest recession since the 1930s. Global output also contracted in 2009, but China continued to expand. The global recession, which was intensified by inventory adjustments, proved relatively brief in response to fiscal and monetary easing, and global output revived strongly in 2010. The stresses in many economies that led to the 2008 - 2009 crises had not been righted, however, and growth rates eased back in 2011. The demand for minerals is heavily biased towards the construction, capital goods and consumer durable sectors. Even advanced economies witnessed strong fixed capital expenditure in the 2003 - 2007 boom, with

2000 2001

2002

2003 2004

2005 2006

2007

2008 2009

2010

2011

The relationship between overall economic activity and the mineral and metals industry is brought out in Figure 7.8, which compares annual percentage changes in global Gross Domestic Product, the usage of primary aluminium and refined copper and the output of crude steel. Although demand for each mineral and metal product is driven by different end-use markets, all follow broadly similar trends. Many depend directly on the performance of the steel industry. Copper usage grew quite strongly in 1999 - 2000, when the US economy was booming, but it fell in 2001 and grew more slowly than global activity for most of the decade. By contrast, aluminium consumption and steel production were relatively weak in 1998 - 1999, but grew much more strongly than global GDP between 2001 and 2007, and 16 14 12 10 % change on previous yea

Fig 7.6 - The growth of economic activity (Gross Domestic Product), 1998 - 2011

1999

Fig 7.7 - The percentage share of fixed investment as a percentage of Gross Domestic Product, 1998 - 2011 (source: International Monetary Fund 2012).

China

-6

98

India

25

10

4

-4

30

15

6

-2

China

40

16

8 6 4 2 0 -2 -4 -6 -8 -10

World GDP

Refined copper usage

Crude steel output

Primary aluminium usage

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Fig 7.8 - Global Gross Domestic Product, aluminium and copper usage and steel output, per cent per annum changes 1998 - 2011 (sources: International Monetary Fund, 2012, International Copper Study Group, 2012, World Bureau of Metal Statistics, 2012 and World Steel Association, 2012). Mineral Economics

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector again in 2010. Both contracted in 2008 - 2009 by more than global GDP. The strong growth of metals production and consumption derives from China’s burgeoning economy. Chinese production of crude steel rose from 128 Mt in 2000 to 627 Mt in 2010, accounting for 88 per cent of growth in global output over the decade. It had an 81 per cent share of the decade’s rise in aluminium consumption, and 135 per cent of the increase in copper usage. In other words, the demand for copper contracted outside China. Inevitably China’s rapid growth has spilled over into strongly increased demand for raw materials from overseas, and in that regard these three metals have been typical of most minerals, including fuels. Figure 7.9 shows China’s growing dominance in the metals sector. It shows China’s shares in 2000 and 2010, and the annual average growth rates of world output or consumption during the decade. The slower growth of copper than of the other two metals reflects both supply constraints and the impact of substitution in response to high prices. China

China

Primary aluminium consumption 4.8% p.a.

Crude steel output 5.2% p.a.

2000

2000

2010

2010

Table 7.5 World oil demand (million barrels per day) (source: International Energy Agency 2012). OECD

China

Others

World

2000

48.0

4.6

24.5

77.1

2001

48.0

4.7

25.1

77.8

2002

48.0

5.0

25.5

78.5

2003

48.7

5.6

25.8

80.1

2004

49.5

6.5

27.2

83.2

2005

49.9

6.7

28.0

84.6

2006

49.5

7.2

28.9

85.6

2007

49.3

7.6

30.2

87.1

2008

47.6

7.7

31.2

86.5

2009

45.6

8.1

31.8

85.5

2010

46.2

9.1

33.0

88.3

2011

45.6

9.5

34.0

89.1

The effects of rising demand on prices were accentuated by continuing political tensions in the Middle East. Speculative pressures were further influences in driving crude oil prices up in early 2008 to their highest levels in real terms since the 1970s. In money terms prices had never been higher. Their behaviour from 1999 onwards, as expressed in the spot price of Brent crude on the International Petroleum Exchange in London, is illustrated in Figure 7.10. 160

China

140 Refined copper usage 2.4% p.a.

120

2010

Fig 7.9 - China’s shares of global output of crude steel and consumption of alu-

minium and copper, 2000 and 2010 (sources: International Copper Study Group, 2011, World Bureau of Metal Statistics, 2011 and World Steel Association, 2011). A strong global economy not only boosted demand for non-fuel minerals, but also for fuels, including petroleum. World demand for crude oil, shown in Table 7.5, rose by 3.4 per cent in 2004, the largest percentage increase for many years, forcing demand against the constraints of effective capacity. Iraq’s output had not recovered from the ravages of war, and some members of OPEC held back production. The Organisation for Economic Co-operation and Development (OECD) countries, led by the USA, raised their consumption in 2003 - 2005, but their offtake then eased back, with sharp falls in 2008 and 2009. The OECD countries’ combined share of the total fell from 62 per cent in 2000 to 51 per cent in 2011. The main growth was in the rest of the world, with Chinese demand more than doubling between 2000 and 2011, raising its share from six per cent to almost 11 per cent. Mineral Economics

US $/barrel

100 2000

80 60 40 20 0 1999 2000 2001 2002 2003

2004 2005 2006 2007

2008 2009 2010 2011 2012

Fig 7.10 - Monthly average prices of crude oil (US$/barrel for Brent crude)

(source: International Petroleum Exchange).

Prices had weakened in 2001 - 2002 in response to recession, with the attack on the World Trade Centre in September 2001 having no real impact. The Iraq war caused a minor blip in 2003, but prices really only started to rise strongly during 2004. They peaked temporarily in 2006, and fell back to early 2007, before the surge of 2007 - 2008. The levels reached from 2006 raised concerns about possible adverse effects on global inflation and levels of economic activity. Prices collapsed in 2008 with the drying up of speculative investment and the effects of the GFC on demand, but the fall was temporary. Subsequently, prices revived in response to resurgent demand and political uncertainties. The Arab uprisings 99

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector of early 2011 and Middle Eastern tensions added to the pressure, notwithstanding compensating increases in Saudi Arabian output. Not only do high oil prices have potentially adverse effects on demand for mineral products, but they also directly raise production costs. In part the rise in oil prices was initially justified by an accompanying weakening of the US dollar in currency markets. Some oil producing countries tailored their supply in order to raise prices sufficiently to offset the dollar’s decline, but such fine tuning is seldom possible. The performance of the US dollar has been a major influence on the prices of all internationally traded mineral commodities. Figure 7.11 plots two measures of the real effective exchange rate since January 1998. It strengthened by 21 per cent against a weighted average basket of major currencies (those of Australia, Canada, ‘Euroland’, Japan, Sweden, Switzerland and the UK) between October 1999 and February 2002. It followed a similar trend, but to a less marked extent, against the currencies of a much larger group of its trading partners, partly because some of those currencies are pegged to the dollar itself.

US $ million in real 2010 terms

Index numbers. January 1998=100

14000

Major currencies

115

12000 10000

110 105 100

18000 16000

125 120

peaked in 1997, and it subsequently plummeted, not just in response to weak markets, but also because of the off-putting effects of the Bre-X fraud (where a gold project in Indonesia had been hyped on the basis of non-existent ore reserves) and the competing lure for speculative investors of dot com projects. The trough in exploration spending was reached in 2002, with that on gold down from 1997’s US$2.6 B to under US$0.8 B. Exploration for other products dropped from US$2.5 B to US$1.1 B over the same period. The recovery in prices from their recessionary trough brought a corresponding revival of exploration, with spending on gold rising to US$4.9 B in 2008, and that on other products up to US$7.7 B (source: Metals Economics Group, Nova Scotia). Spending on exploration was inevitably badly hit by the global financial crisis (GFC) and its aftermath, with expenditure on gold exploration dropping to $3.5 B in 2009 and on other products even more steeply to $3.8 B. The declines were largely reversed in 2010, and exploration spending rose to a new peak in 2011, as shown in Figure 7.12.

US trading partners

95

8000 6000 4000

90

2000

85

0 1991

80 75 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Fig 7.11 - Effective monthly average real exchange rates of US$

(source: United States Federal Reserve Board, 2012).

Prices of most minerals and metals are denominated in US dollars, and its exchange rate is a strong influence on those prices. Ceteris paribus, a strengthening of the US dollar, leads to falling dollar prices and a weakening dollar to rising dollar prices. Many producers whose currencies strengthened against the dollar also saw rising costs and falling margins in 2000 - 2002 to the point where they were forced to suspend or curtail operations. The adverse impact of the currency squeeze was accentuated by the simultaneous weakening of demand because of recession. Capital spending of all types, but especially on exploration and grassroots projects, was pared back as the industry strove to minimise costs. These years witnessed a surge in mergers and consolidations in many sectors of the industry, with a pronounced peak in 2001. The gold industry was especially hard hit by weak prices in the late 1990s and early 2000s. Exploration spending of all types, heavily biased towards gold, had 100

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

Fig 7.12 - Corporate exploration spending in real 2010 terms (sources: Metals Economics Group, 2012 and United States Bureau of Economic Analysis, 2012).

A weakening of the US dollar contributed to the rise in metal prices between 2002 and 2008, to the weakening of prices in 2009 and to their subsequent revival. The dollar’s real exchange rate against major currencies fell by 33 per cent between early 2002 and early 2008, rose by 18 per cent in the ensuing year in response to the GFC and then dropped again by 16 per cent up to July 2011. Concerns about the euro area then caused a modest appreciation. The inverse relationship between real US dollar exchange rates and gold prices is illustrated in Figure 7.13. Gold prices had averaged below US$400/oz throughout the 1990s, and had fallen sharply from 1996. The recovery began in late 2001, after the attacks on the World Trade Center, and it was fostered not just by the weakening US dollar, but also by rising international tensions. Rising oil prices and fears of resurgent inflation gave an added fillip from late 2004. The rise in gold prices was temporarily reversed in 2008 with the onsetting GFC, but that was a temporary lull and prices then rose strongly. Concerns over rising international Mineral Economics

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector

125

600

Gold price index Jan.1998=100

550

115

Gold price

Real US $ exchange rate

500 450

110

400

105

350

100

300 250

95

200

90

150

85

100

Exchange rate index Jan. 1998=100

120

80

50 0

Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

75

Fig 7.13 - Index numbers of monthly average gold prices and real effective exchange rates of the US dollar against major currencies (sources: United States Federal Reserve Board 2012 and London Bullion Market Association 2012).

tensions, fears of strengthening inflationary pressures, worries about the stability of the euro and low rates of return on other assets all fanned the flames of gold’s rising prices. The monthly average London price peaked in September 2011 and subsequently eased slightly, but the gold market remained tense. Prices of non-ferrous metals lagged behind gold prices in 2002 - 2003. In some cases capacity had outstripped demand, notwithstanding mine and plant closures and cut-backs. There were also large inventory overhangs, particularly in the most visible form of exchange stocks. Their existence initially moderated the impact of improving supply/demand balances on price levels. Table 7.6 shows the end-year levels of LME warehouse inventories from 1999 onwards. LME warehouses are not the only sources of readily available metal, and stocks have moved substantially within each year. Nonetheless, Table 7.6 gives a broad indication of the changing pressures of demand for the various metals. They all danced to the beat of economic Table 7.6. Inventories in London Metal Exchange warehouses at year-end, 1999 - 2011 (thousand tonnes) (source: London Metal Exchange 2012). Aluminium

Copper

Lead

Nickel

Tin

Zinc

1999

774

790

176

47

9

279

2000

322

357

131

10

13

195

2001

821

799

98

19

31

433

2002

1241

856

184

22

26

651

2003

1423

460

109

24

14

740

2004

695

49

40

21

8

629

2005

644

92

44

36

17

394

2006

698

191

41

7

13

90

2007

929

199

45

48

12

88

2008

2338

341

45

79

8

253

2009

4624

502

147

158

27

489

2010

4275

378

209

137

16

701

2011

4979

372

352

91

12

820

Mineral Economics

activity, but with different timings and variations. Speculative activity by financial institutions of all types, including hedge funds, may have hastened, and even enhanced, some price rises, but the basic determinants were improving demand and a weakening US dollar. After the GFC of 2008 weakened, demand relative to supply forced prices down, but for many products the fall was temporary. Figure 7.14 shows the behaviour of a weighted average index of non-ferrous metal prices (LMEX) from the start of 1999. Prices rose during 1999, but levelled out in 2000, and fell back between September 2000 and late 2001. The recovery did not reach its stride until after May 2003. Prices then rose strongly until the early months of 2006 and then fluctuated around a high level over the next two years. The collapse from early 2008 to early 2009 was dramatic, taking prices back to their levels of early 2004. The setback was, however, relatively brief, and by early 2011 the index approached its early 2007 peak. Subsequently, prices drifted back, but remained high relative to their average of the previous decade. The different metals shared in the overall trend to differing extents and with different timings. 5000 4500 4000 Index January 4th 1999 = 1000

650

3500 3000 2500 2000 1500 1000 500 0

Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

Fig 7.14 - The London Metal Exchange index of non-ferrous metal prices 1999 -

2012 (source: London Metal Exchange 2011).

One contributor to the rise in the prices of gold and other precious metals, and of the metals traded on the LME since early 2009 was the low returns available on financial assets of all types. Given the continuing strong growth in Chinese demand the prices of early 2009 appeared unsustainably low. Figure 7.15 shows the monthly average US Federal Funds rate since January 1999. Allowing for inflation rates these were negative in 2003 - 2004 and again from early 2009 onwards. With prevailing levels of interest rates buying metal futures, or even physical metal, appeared an attractive option for a wide range of financial organisations. Yet the rise in prices of both the mid-2000s and 2009 - 2010 was based on far more than speculative investment. That rarely affects the level of prices for an extended period because of the possibilities of inter-temporal arbitrage, although it can affect the timing of price movements. 101

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector There is asymmetry between prices in recessions and boom times. When markets weaken, as in the 2001 - 2002 recession and again in 2008 - 2009, the marginal costs of existing producers set a flexible floor to prices. In boom times, such as 2004 - 2007 and 2010, when markets tighten and capacity is limited there is no ceiling to prices, which can rise sharply. The duration of such price spikes will depend on how rapidly additional capacity is created, on the ease of substitution, and on the behaviour of economic activity.

6 5.5 5

Per cent

4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 1999 2000 2001 2002

2003 2004 2005

2006 2007 2008 2009

2010 2011 2012

Fig 7.15 - United States’ Federal Funds rate, monthly averages, 1999 - 2012

(source: US Federal Reserve).

Figure 7.16 shows how year-on-year changes in the LME index of non-ferrous metal prices moved with changes in the industrial production of the advanced economies. Given that a rising share of demand is taken by other economies the close relationship between the two held up well throughout the decade. 25

100 80

LMEX (left-hand scale)

20

60

15

40

10

20

5

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 -20

0

-40

-10 Industrial production (right-hand scale)

-60 -80 -100

LMEX

Industrial production

-5

-15 -20 -25

Fig 7.16 - Percentage changes in the London Metal Exchange index of non-fer-

rous metal prices and advanced economies’ industrial production, 2000 - 2011 (sources: International Monetary Fund 2012 and London Metal Exchange 2012). The behaviour of the prices of products that are not traded in terminal markets, such as many minor metals, industrial minerals, and bulk minerals, including coal and iron ore, was similar to that of those that are. Speculative investment, although by no means absent, is far more difficult and costly, and much less common in these products. Prices of coal and iron ore greatly benefited from China’s burgeoning demand, but their prices during recent years should be judged against their lacklustre performance for much of the preceding decade. Whereas the non-ferrous metals are priced on terminal markets, which provide both opportunities for hedging price risk and a market of last resort, producers of bulk minerals have neither. Until recent years, demand grew relatively slowly and producers were fairly reluctant to invest in capacity in anticipation of future sales. In consequence the 2003 - 2004 spurt in demand created supply bottlenecks and suppliers seized their advantage by sharp price rises. 102

Supply bottlenecks were common throughout the minerals industry in the mid-2000s, but they affected different products to varying degrees. A trend of falling real prices into the early years of the decade had concentrated companies’ attention on cost cutting rather than investment in new capacity. Rising demand ran against capacity limits, not just at mines but in the accompanying infrastructure. Suppliers of capital equipment and services to the mining industry were just as affected. In some instances supply responded relatively rapidly to rising demand, but in others the necessary investment was slow to materialise. In many sectors after-tax profitability did not rise commensurately with prices because of steeply rising costs and increases in governmental shares of mine revenues through fiscal and other changes. The GFC of 2008 - 2009 brought many projects to a shuddering halt when sources of external funding dried up and there was great uncertainty about future demand. Although many projects were reinstated when prices and demand revived in late 2009 and 2010 they are slow to start production. Figure 7.17 compares yearly index numbers of prices of thermal coal, iron ore, gold and some metals. Copper and zinc made the running in 2006 - 2007, but their prices fell back in 2008 - 2009. Aluminium, whose capacity has more than kept pace with demand, remained largely immune to the decade’s price surges. Zinc markets remained subdued in 2010, but copper prices climbed to new peaks. The increases in coal prices outstripped those of copper, although demand was badly knocked 1500 1400

Thermal coal

1300

Index numbers 2000=100

7 6.5

1200

Iron ore spot China

1100

LME copper

1000

LME zinc

900 800

LME aluminium

700

London gold

600 500 400 300 200 100 0 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Fig 7.17 - Index numbers of prices of thermal coal, iron ore and non-ferrous metals, re-based on 2000 = 100 (sources: International Monetary Fund 2012 and London Metal Exchange 2012). Mineral Economics

chapter 7 – Mineral markets, prices and the recent performance of the minerals and energy sector and prices weakened in 2009. As noted earlier, prices of gold have risen almost uninterruptedly, but spot prices of iron ore have shown the greatest increases. Contract prices lagged but have largely caught up with the change to market-based pricing. Copper and iron ore have been the most affected by capacity constraints. Infrastructure improvements, mine expansions and new capacity are under construction that will improve the market balance within a few years. Some influential commentators suggest that prices may have peaked, not just because of rising supply, but also because of a slackening of China’s growth rate and a rebalancing of its economy towards consumption rather than investment. Meanwhile, the advanced economies face a prolonged period of readjustment and sluggish economic activity after the financial excesses of the past decade. Rising oil prices may have had a muted impact in the mid-2000s, but that does not mean that will always be the case. The profitability of the minerals industry depends on the ratio between prices and costs, and costs are likely to rise at least as fast as, and probably faster than prices over coming years. The one clear lesson of history is that even apparently wellentrenched trends do not continue indefinitely. The future remains uncertain.

REFERENCES British Petroleum, 2012. Statistical review of world energy, workbook [online]. Available from: . International Copper Study Group, 2011 - 2012. Press releases on ICSG 2010 and 2011 statistical yearbooks, 3 August 2010 and 7 September 2011, and on copper: Preliminary data for January 2012, 1 May 2012 [online]. Available from: .

Mineral Economics

International Energy Agency, 2011 - 2012. Oil Information, 2011 edition and oil market report, April 2012 [online]. Available from: [Accessed: 3 May 2012]. International Monetary Fund, 2012. World economic outlook and database, April [online]. Available from: . International Petroleum communication.

Exchange,

2011.

Personal

London Bullion Market Association, 2012. For gold (London morning and afternoon fix) [online]. Available from: [Accessed: 3 May 2012]. London Metal Exchange, 2012. For base metal prices and stocks. Personal communication, and online. Available from: [Accessed: 3 May 2012]. Metals Economics Group, 2012. Press releases on corporate exploration strategies Nova Scotia [online]. Available from: . Raw Materials Group, 2011. Raw Materials database, March, Stockholm, Sweden. Smith, A, 1776. The Wealth of Nations (Random House Inc). United States Bureau of Economic Analysis, 2012. US economic accounts, Table 1.1.9 [online]. Available from: [Accessed: 3 May 2012]. United States Federal Reserve Board, 2012. Statistical releases G5 and H15 [online]. Available from: [Accessed: 3 May 2012]. World Bureau of Metal Statistics, 2011 - 2012. World Metal Statistics Yearbook 2011, World Metal Statistics March 2012. World Steel Association, 2011 - 2012. Steel Statistical Yearbook 2011 and crude steel statistics [online]. Available from: [Accessed: 3 May 2012].

103

Mineral Finance and Investment

HOME

Chapter 8 An Introduction to Mineral Finance Pietro Guj and Allan Trench Financial objectives and financial management The role of financial managers Sources and application of funds General considerations Main sources of funds Sources of equity General considerations Off-market sources of initial equity On-market sources of equity Resource sector initial public offerings are generally small Criteria for inclusion in a stock market index Innovative investment vehicles for the resources industry Fiscal and policy incentives Joint venture farm-outs Specialty finance (royalty) companies The cost of equity – balancing risk and return Sources of debt Some general considerations Long-term debt Short-term debt Hybrids between equity and debt Project finance Some introductory considerations Risk underpinning The financial structure of mining companies Cost of debt, financial leverage and financial risk Financial structure of mining companies Conclusions

Mineral Economics

107

chapter 8 – An Introduction to Mineral Finance

FINANCIAL OBJECTIVES AND FINANCIAL MANAGEMENT Most analysts suppose that the financial objective of an exploration or mining enterprise is to maximise the value in the hands of its current ordinary shareholders. Whether decision makers in the enterprise achieve this objective depends, in the first order, on the quality of the orebody in terms of its size, grade, metallurgical and geotechnical characteristics. A sound mine plan to achieve such an outcome, however, can only become reality if mine managers and professionals are competent, labour is skilled, plant, equipment and materials are appropriate, and, above all, there is adequate investment and working capital. Second order effects beyond orebody management that influence shareholder returns include: •• the distinctive capabilities of the enterprise (Kay, 1993; Collins, 2001) •• the industry forces-at-work that shape (commodity) prices and competitiveness (Porter, 1980, 1985) •• the attractiveness (or otherwise) of the regulatory and external economic environment (Porter, 1990). Because of its capital-intensity and the requirement for large initial investments in mine developments, the mining industry has a voracious appetite for capital. Yet, some common sources of borrowing are not easily accessible to it because of its inherent risk and the variability of its cash flows. Compared to other sectors of the economy, mining companies generally must rely more on either equity, specialised financial arrangements such as project finance, or both together. The unique characteristics of the mining industry are also reflected in the specific style of financial management that characterises successful mining enterprises. The focus of this chapter is on four main areas: 1. the main principles of financial management and their relevance to the mining industry 2. the various sources of equity and debt funds used by the mining industry, their cost and availability 3. the more specific area of project finance 4. the financial structure of mining companies and the trade-off between financial leverage and financial risk. Discussion will consider the general financial context within which mines are successfully developed and operated, setting the scene for the following two chapters, which deal with specific aspects of mine finance in more detail. Financial managers of mining companies are particularly concerned with two distinct types of decisions. These are: 1. the investment decision 2. the funding decision. 108

Another important decision concerns the proportion of profits that are to be devoted to dividend payments to shareholders. Traditionally, the capital-hungry mining industry has tended to be parsimonious in terms of dividends. Many exploration and small mining companies never pay dividends. Their shareholders must derive their return entirely from capital gains when selling their shares. The investment decision is concerned with determining which asset base is most appropriate to achieve the financial return based objectives of an enterprise. A company’s Board of Directors sets these objectives at a level that is sufficiently high to attract and retain adequate investment capital from the owners, or shareholders, given the degree of risk that they face. To build, diversify and maintain an optimal portfolio of exploration, development and mining projects, and other assets entails occasional asset acquisitions and disposals. The effect of having a diversified portfolio, as will be discussed in a later section, means that the combination of assets: •• adds greater value for the shareholders than the sum of the returns on the individual projects •• results in lower combined risk exposure or •• both of the above. The process of selecting capital investments is sometimes referred to as capital budgeting. Investment (and disinvestment) decisions are the main determinant of the assets, which appear in the statement of financial position (balance sheet), of a mining company and indeed of any enterprise. The time focus of investments is also a major consideration in financial management. While the mining industry is capital-intensive and its assets long-lived (ie fixed or non-current), it is also critical to manage cash, other short-term (current) assets and liabilities to maintain adequate liquidity. The inability to satisfy any debt as it becomes payable is often a reason for enterprises to be placed under administration/liquidation. Liquidity problems, rather than a lack of net asset worth (solvency), push companies into liquidation. This is because most of their noncurrent assets are illiquid, ie not capable of being sold on a short-time scale. Liquidity is crucial in the case of mining because of the high variability of cash flows, which is due to the general volatility of commodity prices and revenue. The funding or financing decision, by contrast, is concerned with how to fund the above assets, whether through: •• equity (ie owners’ or shareholders’) funds or •• debt (bank loans or other financiers’ and creditors’ funds) in its various forms. These funding sources appear as liabilities, both short and long term, and as shareholders’ equity in the balance sheet. As the name implies, the balance sheet must balance. As a consequence, total liabilities Mineral Economics

chapter 8 – An Introduction to Mineral Finance plus shareholders’ equity must equate to the value of the corresponding assets. In effect shareholders’ equity represents the balancing item. Thus the shareholders have control of but bear the ultimate risk of the enterprise, although their risk is limited to their investment in it and does not flow through to their other assets, personal or otherwise. Of course, the value of the assets must equal or exceed that of the liabilities. When this is not the case the enterprise is insolvent. Directors who continue trading in the knowledge that their company is insolvent commit a punishable crime. Shareholders’ equity = assets - liabilities is the fundamental financial accounting equation. Every financial transaction is either an asset, a liability or an equity account entry in the chart of accounts (financial system) of the firm. The funding decision also encompasses determining which financial structure, ie which proportion of equity and debt, is most appropriate for any specific company or project. To the extent that interest is a tax-deductible expense, using debt reduces the amount of tax payable and as a consequence improves a project or company’s cash flows. This is the financial leverage effect. As discussed later in more detail, the use of excessive debt introduces an additional element of risk, which is known as financial risk. It differs from the technical and marketing risk inherent in any mining project. Project finance is sometimes provided on a limited recourse basis in which case, as discussed below, some of the shareholders’ risk is transferred to the lenders. As we will see below, the search for an optimal financial structure is a complex and somewhat ambiguous field of academic research on which opinions are divided.

The role of financial managers Financial managers play a significant corporate role in securing the necessary funds and ensuring that they are used effectively and efficiently in achieving the financial objectives set by their Board of Directors. Peirson et al (2004, p 7) provide an exhaustive list of their duties and services. They include: •• Group accounting, including developing and implementing financial policy, and maintaining accounting systems supporting both consolidated, financial accounting reports on an accrual basis, and operational management accounting reports compiled on a cash basis. •• Treasury operations, including both management of current assets and liabilities (ie cash management) to ensure an appropriate level of continued liquidity, and obtaining and servicing long-term finance through borrowing (including project finance), leasing, retention of earnings after payment of dividends, and issuing of shares and other securities. This function also includes managing relationships with corporate bankers. Mineral Economics

•• Tax services, including tax advice, compliance and optimisation. •• Corporate finance services, including the financial analysis and evaluation of exploration, development, mining projects and other investment opportunities, contribution to the financial components of prefeasibility and feasibility studies, implementation of selected projects, advice on related strategic financing issues, and advice on possible mergers and acquisitions. •• Risk assessment and management, relating to both project and market risk. This involves identifying and assessing sources of risk through internal audits to determine their potential impact and likelihood of occurrence, and helps in formulating the company’s risk-management policy to secure an appropriate level of insurance, commodity prices and exchange rates hedging to shelter them from those risks that the company is less capable to, or does not wish to bear. •• Investor relations with shareholders, investment analysts and the public as well as satisfying all disclosure and other requirements of the Australian Stock Exchange (ASX). •• Financial planning, including forecast and construction of corporate and project specific financial models capable of generating short, medium and long-term forecasts of the company’s finance under different development scenarios and various economic and other assumptions. To the extent that this monograph focuses on economic and financial analysis rather than financial accounting, we make further reference to this discipline only when it is relevant to the first two topics. Most exploration and mining professionals probably require a relatively superficial knowledge of the principles and practice of financial accounting, as well as the intricacies of reporting on an accrual basis. A reasonable understanding of management accounting on a cash basis generally satisfies their immediate financial management needs. By contrast, to be effective strategic managers, a relatively deep understanding of corporate finance, financial planning and project modelling and evaluation is required. Our focus is therefore on these latter topics in the rest of this and in the following chapters.

SOURCES AND APPLICATION OF FUNDS The reporting of the sources and application of funds by companies is communicated to stakeholders through the company’s financial reporting process and embedded financial statements. Specifically, movements in funds are outlined within the company’s financial statement of the same name, being the sources and application of funds (or cash flow) statement. 109

chapter 8 – An Introduction to Mineral Finance

General considerations The sources and application of funds (or cash flow) statement is structured into three types of activity that generate or consume funds (cash). They are: 1. operations – hopefully generating more cash through reported revenue than the operations consume in the corresponding recurrent expenses and tax payments 2. investment activities – increasing tangible and intangible assets consumes cash; while asset sales and risk-spreading activities like joint venture farmouts may increase cash 3. financing activities – either issuing new shares or drawing down loans (ie increasing liabilities), or both activities, generates cash, while repaying loan principal or returning capital to the shareholders by means of such activities as share buy-backs (while reducing liabilities) consume cash. The first two activities can be sources of internal funding, while the last will generate external funds. As can be seen in Figure 8.1, each year the directors appropriate cash (funds) from the company’s operations equivalent to its profit, after covering recurring operating cash flows, less dividends (ie retained earnings for the year), plus depreciation, plus the difference between the opening and closing balance of all the recurrent items accrued in the balance sheet.

ongoing mine production, have the capacity to generate benefits over future periods during their useful lives. A fundamental principle of financial accounting is to match revenue with the corresponding expenses incurred to generate it in each period. This includes the cost of ‘consuming’ or ‘wearing down’ fixed assets acquired through lumpy investments in the past. This item of expense, which is called depreciation is not a cash cost, but merely an accounting convention attempting to match revenue and expenditure in each reporting period. In the case of the mining industry, given its capitalintensity and the presence of accelerated depreciation, the amount of cash appropriated each year, in the form of tax savings, against depreciation can be considerable. In some cases, particularly during its early years, the bulk of the cash generated by a mining project is attributable to depreciation and a company may have significant cash flow even if it makes an accounting financial loss. Investment activities are central to the mining industry given its capital intensity and generally long project lives. The investment characteristics at the exploration stages, however, are very different, as we will see in coming chapters, from those at the development and operational stages.

Main sources of funds A company’s main sources of financing fall into two broad classes: 1. Equity (E), or owners’ or shareholders’ funds: shareholders have control over the affairs of the company, but in return for this control, they also must bear the ultimate risk for the firm/project. Equity is typically secured through an initial public offering (IPO) process when a company first lists on a stock exchange, then from follow-on, subsequent or secondary equity raisings post the IPO. 2. Debt (D), or banks’ or financiers’ funds, which are generally secured by: •• a senior floating claim on the firm’s assets

Fig 8.1 - Schematic representation of the sources and application of funds.

They make further adjustments to account for the cash flow relating to investment and financing activities, which collectively will capture all changes in assets and liabilities generating or consuming cash. For example, a reduction in non-cash assets, say the sale of a property or equipment, or an increase in liabilities, say the drawing down of a new loan, will generate cash. By contrast an increase in fixed assets, say a new mine development, or a reduction in liabilities, say repayment of principal on a loan, will consume cash. The cash outflows relating to the acquisition of significant depreciable capital items occur in discrete ‘lumpy’ amounts, even though these assets, as inputs to 110

•• specific collateral •• the project to be funded or •• are unsecured. There is also a third (albeit quantitatively less significant) hybrid category of funds, which includes financial instruments displaying both the characteristics of equity and debt, such as preference shares and convertible notes. Major integrated mining houses with strong, diversified balance sheets and large annual cash flows have little difficulty in raising debt funds either on: •• their balance sheet (eg conventional loans, bonds, notes and debentures) or •• from project-specific loans. Mineral Economics

chapter 8 – An Introduction to Mineral Finance The type of funding must be appropriate to the specific stage of the project in the mineral cycle and its related risk. Companies finance high-risk exploration primarily with equity. They use a mixture of debt and equity for medium-risk development projects, with high levels of debt early in the project life decreasing as the project cash flows improve. Operators of lowerrisk, established mining operations, seek an optimal and steady balance between equity and debt that optimises taxes and leverages shareholders’ returns at an acceptable level of financial risk. Table 8.1 indicates the overall importance of loan financing to the minerals sector, with loan and bond financings being the predominant sources of capital for the major minerals companies. Without the backing of a profitable operation, small to medium-size exploration companies typically rely more on equity as their main source of funds, even though equity raisings can become complex and, as it will be seen, expensive. Table 8.1 Capital raisings in the global metals and mining sector 2007 - 2011 (source: Ernst & Young, 2012). Proceeds ($ M)

2007

2008

2009

2010

2011

IPOs

21 400

12 406

2987

17 948

17 449

Follow ons

66 802

48 751

73 806

49 705

49 745

Convertibles

12 865

12 238

14 1431

5477

2365

Bonds

36 358

38 146

61 016

72 502

83 804

Loans

110 787

171 691

62 420

183 875

187 059

Total

248 212

283 232

214 660

329 507

340 422

SOURCES OF EQUITY General considerations The prevailing ‘outsider’ system of corporate ownership strongly influences corporate financing in Australia (Trench, 2002). A similar situation applies in the United States, the United Kingdom and Canada. The Australian system is characterised by rapid ownership dispersion, stock market floats and relatively weak, contractfocused relationships between companies and financing institutions. By contrast, in Germany, France, Japan and Chile, where an ‘insider’ system operates, company ownership is typically concentrated, with fewer share floats and stronger relationships of companies with banks and financiers and also with governments. Traditionally the exploration and mining sector has relied largely on equity to fund its operations, in combination with retained earnings. This is because mining operations become established, with average debt for this sector historically seldom exceeding 40 or 50 per cent of the total funds employed. While equity markets in Australia are well developed and satisfy the significant demand arising from the mining industry, companies also obtain significant funds off-market. Mineral Economics

Off-market sources of initial equity Apart from internally generated funds, which probably represent the lowest-cost source of capital, new offmarket equity funds include: •• privately sourced seed and venture capital from ‘business angels’ and other ‘venture capitalists’ •• other lower-risk and generally more significant off-market placements •• farm-outs/joint ventures •• royalty-based finance arrangements. ‘Business angels’ are generally astute technical or financial specialists investing up to a few hundreds of thousands of dollars for five to ten years to help detect and address missing critical success factors and develop high-risk high-return opportunities to the point where they can seek formal external funding or be profitably sold. The main advantage of venture capital is that it is often the only source of capital available to start up a mining project. Based on a persuasive business plan, venture capitalists will invest amounts in the order of $0.5 M to $10 M for between, say, three and seven years. They aim to achieve high capital gains by disposing of their investment at a favourable time, rather than maintaining their investment in the company and waiting for eventual dividends. Venture capital has, however, some drawbacks. For instance, the original project promoters are likely to only be able to retain a minority position in their project. They also experience the added pressures of working with an active board that has a contractual attitude towards management, and a tendency to go well beyond the provision of general direction and governance into the sphere of day-to-day technical and managerial decisions. From a company’s point of view, equity funding provided by venture capitalists has a number of significant advantages. These include: •• it may be the only way of funding higher-risk projects •• unlike the obligation to pay interest on debt, there is no obligation to pay a dividend on ordinary shares, even though this would be desirable at some stage in the project life; similarly, there is no provision for repayment of initial shareholders’ capital contributions as contrasted to principal repayment at the maturity date of a loan •• the shareholders’ liability is also limited to their investment in the company; this means that their liability does not extend to other personal assets if, in case of liquidation, the total assets of the company are insufficient to satisfy all creditors’ claims. There are, however, some disadvantages as well: •• there is the dilution effect of additional equity issues; by contrast, debt finance does not cause dilution of ownership 111

chapter 8 – An Introduction to Mineral Finance •• equity issues are complex and entail high transaction costs relating to the preparation of a prospectus and related underwriting •• funds may not be available when needed as their availability is a function of economic and commodity price cycles.

from full disclosure and documentation requirements when targeted solely at sophisticated and professional investors for example.

On-market sources of equity

•• prevailing equity market conditions

There are a number of ways to raise equity ‘on-market.’ These include initial public offerings (IPOs) and through follow-on, subsequent, or secondary equity raisings. For new mining companies, IPOs typically occur on the Australian Stock Exchange (ASX), but also on overseas stock exchanges such as on the Toronto Stock Exchange (TSX) in Canada or on the London Alternative Investment Market (AIM). The share issues in these IPOs can include: •• ordinary fully paid shares, which generally represent the bulk of equity funds sought, and largely determine the financial structure of the company •• contributory or partly paid shares, which, while popular, are quantitatively subordinate and are used to provide a reliable source of equity funds through calls on shareholders when funds are actually needed •• preference shares conferring the payment of dividends, which are often fixed to their holders ahead of ordinary shareholders. Preference shares are issued to attract funds from interested but more risk-averse potential investors •• options that are used as a sweetener for equity issues or as a reward to executives and other employees designed to encourage them to work in ways that enhance the company value. Subsequent equity raisings include: •• right issues (where entitlements are proportional to the size of each shareholder’s equity stake) •• placements •• dividend re-investment •• shareholder share purchase plans (where entitlements are equal for all shareholders, large or small) •• employees’ share schemes. Bonus issues and share splits, by contrast, do not raise new equity, and even though they were once popular, they are now uncommon. In Australia capital raisings are generally highly regulated and costly. The Corporation Act 2001 and Australian Stock Exchange rules require significant disclosure documentation generally in the form of a prospectus. A Profile Statement or an Offer Information Statement may be required for a smaller raising of less than $5 M. However, some offers are exempt 112

The choice of the process, type and timing of subsequent equity raisings by companies depends upon a number of factors. These include: •• the urgency for additional funds required by the company (with most but not all significant equity raisings requiring shareholder approval) •• the level of concentration of ownership across the share register of the company (which can influence the choice between rights issue and a shareholder purchase plan) •• the placement capacity of the company at the time (for example, whether shareholder approval is required to fully accommodate a proposed private placement). According to Peirson et al (2004) the major costs in an IPO include: •• Compiling and printing a prospectus, (inclusive of independent experts’ reports such as those detailing geological documentation and prevailing commodity market conditions and forecasts) at $300 000 to $500 000. •• Stockbroker management and/or underwriting of the IPOs or of subsequent share issues. Broker fees and underwriting costs typically vary between over one per cent and seven per cent of the size of the float or the underwritten proportion thereof. This percentage also depends on the standing of the company and whether the IPO price has been set at a realistic level. The total cost for a large float ranges between perhaps two and six per cent of the funds raised, while small ones absorb a much larger proportion of the funds raised (perhaps even more than 20 per cent). There were 78 metals and mining IPOs listed in 2011 (Trench, 2012), compared to 66 similarly focused IPOs in 2010 (Trench, 2011); both years witnessing a significant number of new listings. This compared with IPO numbers of less than five per year in the late 1990s and around 15 per year in 2001/02 and 2002/03, when commodity prices were still weak. This figure then rose to 60 IPOs per year in 2005/06 as commodity (and equity) markets strengthened - see Kreuzer, Etheridge and Guj (2007). The general investor perception is that subscribing to an Initial Public Offering is a strategy for easy money. In practice however, shareholder returns from IPOs are highly variable. Mining and metals-focused IPOs listing on the Australian Stock Exchange in calendar years 2010 and 2011 illustrate the volatility of shareholder returns. The investment performance of the metals and mining IPOs of 2011 in their first calendar year was in stark contrast to their 2010 predecessors. While the 2010 Mineral Economics

chapter 8 – An Introduction to Mineral Finance IPO group rose on average by 61 per cent by calendar year-end, the corresponding 2011 IPOs fell by 17 per cent from listing par values. During commodity booms, most resource company stocks open at a listing premium relative to their issue price. This may be because the listing price has been set too low under the risk-averse influence of the underwriting stockbrokers. Underwriters have a propensity for curbing the project proponents’ excessive optimism and most sacrifice the potential rewards of a higher-priced IPO so that they are not exposed to a potentially costly under-subscribed float. Less riskaverse investors are willing to pay listing premiums when general market sentiment is buoyant and there is a strong appetite for cyclical stocks. As we shall see in Chapter 10, the difference between the fundamental value of exploration and mining assets and their market value (ie the market premium) may represent the so-called real option value (ROV) of the assets.

the typical company intended to spend approximately two-thirds on exploration, with the remainder covering corporate overheads and the costs of the IPO. Trench (2012) made similar findings in analysing the 78 IPOs listed on the ASX in 2011, where the average raising was $A7.79 M, and the median (‘typical’) capital raising was $A4.3 M. Figure 8.2 shows the combined market capitalisation of the largest 150 mineral resources companies listed on the ASX in January, 2012. At this time, the size of the two diversified global mining houses, BHP Billiton (BHP) and Rio Tinto (RIO), at approximately $A329 B, was larger than the combined value of the next 148 companies, as well as all of the other resources companies. Two other companies – Newcrest Mining (NCM) and Fortescue Metals Group (FMG), had market capitalisation exceeding $A10 B. Only 30 of the 850 listed mining and exploration companies exceeded A$1 B in capitalisation at that date.

During periods of resources boom and strong general equity market performance such as in 2010, there is generally a strong investor appetite for cyclical stocks such as mining company shares. Furthermore, the heightened risk appetite extends beyond mining companies to include support for mineral exploration companies. When market support pushes share prices higher, there is a trend for companies to respond by financing their mergers and acquisitions with shares rather than cash, particularly late in an economic cycle. Depending on how the offers are written (Rappaport and Sirower, 1999), this type of deal is difficult to evaluate. This is because of the ambiguous signals that the management of the acquiring company sends to the capital market. Logic dictates that if they truly believed that their shares were poised for a great leap forward, they would be better placed to use cash instead of scrip – thus benefiting from the impending increase in share value. A possible interpretation is that companies who favour scrip bids may have considered that their shares were overvalued.

Resource sector initial public offerings are generally small In a recent study, Kreuzer, Etheridge and Guj (2007) analysed the floats of the 179 junior exploration companies listed on the Australian Stock Exchange in the period between July 2001 and June 2006. They found that the ‘typical’ junior explorer raised just $A4 M at initial public offering (IPO) to finance a two year, mainly greenfields, exploration program. The capital raised at IPO entitled its investors to approximately half of the company, with the balance in the hands of the promoters, vendors, seed capital investors or a combination of these groups. Of the $A4 M raised at IPO, Mineral Economics

Market Values to End January 2012

Fig 8.2 - Market valuation of the Australian metals and mining sector in

$A B – end of January 2012 (largest 150 companies by capitalisation) (source: Gresham Partners 2012).

The size threshold for inclusion in the largest 100 companies at the end of January 2012 was $A 178 M. This figure has remained in the same order of magnitude for some time, being A$116 M in 2006 (Trench, Pridmore and Lau, 2006), rising to $A228 M in 2007 prior to the global financial crisis (Trench, Thompson and Lau, 2007), then falling back to $A173 M in 2008 (Trench, Thompson and Lau, 2008) as the impact of the GFC lowered values, before rising again to around $A300 M in January 2011 (Trench, 2011). The size distribution of mining companies in Australia is highly positively skewed. Most of the 850-strong ASX-listed minerals companies, which continue to rise in number, are not large enough to become part of the Standard and Poors or ASX index.

Criteria for inclusion in a stock market index Relatively few mining companies are included in any of the main stock market indices in Australia. To be included a company share must display: 113

chapter 8 – An Introduction to Mineral Finance 1. liquidity 2. free float 3. high capitalisation. These three investable weight factors (IWF) determine which of the companies listed on the Australian Stock Exchange are captured by its various indices. In February 2012, there were 2226 companies listed on this exchange. Of these, only the six largest mining companies (BHP Billiton, Rio Tinto, Newcrest Mining, Fortescue Metals, Iluka Resources and Alumina Limited) were included in the S&P/ASX 50, thus gaining broader international exposure. A further 39 companies (ie to a total of 45) were included in the S&P/ASX 200 index, which is used by many domestic passive fund managers. So the majority of exploration companies are therefore not on the ‘radar screen’ of large, index using institutional investors. In aggregate, 80 out of the total of about 850 listed mining companies (ie 35 more than in the S&P/ASX 200) appear in the S&P/ASX 300. They are typically small to medium-size mining and mining project development companies. The remaining 770 or so small exploration companies do not appear as index constituents at all. Most equity funds come from investment institutions including: •• •• •• ••

superannuation funds life insurance companies unit trusts investment companies. Some fund managers actively manage their funds with the objective of maximising returns, albeit under some risk exposure. But many funds are passively managed or index-bound. That is, their managers seek to achieve returns equivalent to movement in a relevant index. Furthermore, many institutional fund managers are often constrained to invest in certain main S&P/ASX index shares by risk-management policy, regulation, or by rate-of-growth objectives in combination with the sheer magnitude of the funds to be invested. As a result, institutional investors do not represent a good source of equity funds for small to medium-size exploration and mining companies. Even general public investors, who leverage their portfolios using margin loans, are constrained by the banks to select shares from the benchmark S&P/ASX 300 index. It is clear that small to medium-size enterprises (SMEs) are at a disadvantage. This is because their low capitalisation falls well below that necessary to create portfolio critical mass, even though during resource booms they can display very high levels of growth and rates of return.

Innovative investment vehicles for the resources industry It is possible to achieve critical capitalisation for inclusion in an appropriate index by aggregating the 114

value of a number of the shares of small and medium size companies using innovative investment vehicles, such as Specialised Listed Investment Companies (LICs). Such a strategy can make them meaningful investment targets for large institutions. The basic concept of LICs raising equity funds for investment in diversified portfolios of shares, debt securities, property and other assets is not new. Yet Australian LICs have traditionally been small compared with those in the United Kingdom and the United States. There has recently been significant growth both overseas and in Australia in LICs of various sizes specialising in resources stocks.

Fiscal and policy incentives There has been significant political debate in many resources-rich countries, including Australia, about the fiscal treatment of small and medium size companies. From time to time this results in government policy makers introducing specific fiscal and policy incentives for this sector. Notable examples are: •• the Canadian ‘flow-through’ shares •• the Australian pooled development funds (PDFs) •• the award of specific government grants for exploration activity. A flow-through share scheme has been in place in Canada since 1983. It has allowed deduction of 100 per cent (enhanced to 115 per cent in 2000 through the Investment Tax Credit for Exploration legislation) of eligible exploration expenses from the taxable income of private investors. This has assisted Canada to become the world’s largest mineral explorer for much of this period. In 2011, for example, annual mineral exploration and deposit appraisal expenditure in Canada amounted to almost $C4 B. Even though there has been considerable political lobbying, the Australian government has not pursued such a scheme in the past three decades. This is presumably because a similar scheme operating in the boom of the late 1960s and early 1970s was open to abuse. The Australian government has, however, allowed the establishment of pooled development funds (PDFs) to provide equity capital for eligible activities of Australian small to medium-size enterprises (SMEs), under stringent compliance rules. The Pooled Developed Funds Act 1992 requires that a PDF must invest 65 per cent of the capital it raises within five years. Also, there must be a minimum of ten per cent equity in new Australian companies with total assets of less than $50 M. This initiative is designed to establish an eligible business or substantially expand existing capacity or markets. The Australian Government taxes PDFs at a concessionary rate. Their taxable income has the following components: Mineral Economics

chapter 8 – An Introduction to Mineral Finance •• SME income is taxed at 15 per cent (instead of 30 per cent) •• unregulated (ie non-SME) income is taxed at 25 per cent as an incentive for PDFs to invest uncommitted funds in SMEs instead of in interest-bearing securities. In addition, capital gains on disposal of PDF shares and PDF dividends are tax-exempt. Lion Selection Group, for example, utilised the PDF legislation to focus upon resources sector investments, especially during the downturn in the minerals sector in the late 1990s and early 2000s – but it has since shifted its business model towards that of a standard fund manager, albeit one focused on the mineral resources sector. Etheridge and Uttley (2003) proposed the dedicated drill fund concept as a specialised form of pooled development fund. They argued that Australian junior company exploration programs have been unnecessarily long and protracted because of their struggle to secure drilling funds. Yet, the first mineralised drilling intersection is usually when most value is added to an exploration/mining project as reflected in rapidly rising share prices. A good example of rapid value appreciation occurred with the dramatic rise in the share price of Sandfire Resources (ASX Code SFR) following their discovery of the DeGrussa copper sulfides in Western Australia in 2009. In their subsequent argument, Etheridge and Uttley (2003) advocate the establishment of dedicated ‘drill funds’ spending in excess of 80 per cent of the funds raised on drill-testing robust targets. The concept envisages a major company partnering the fund with an option to acquire between 50 and 60 per cent of high-value discoveries. While such ‘drill funds’ remain at the proposal stage, the concept may deserve serious consideration from government. The drill fund concept has not been widely applied in the sector, with companies preferring to raise funds through traditional pathways when markets improved from 2003 levels and risk appetite returned to the sector. It will be interesting to see whether PDFs, drill funds, or other supportive financing mechanisms, become more popular when markets weaken in the future. To promote economic multipliers from mineral exploration success and subsequent mine development, the Australian states and the Northern Territory have also initiated specific activities and related grants to support mineral exploration. Prominent among these are completion of new, high-resolution geophysical surveys and, in some cases, provision of direct funds (under competitive bid process) for the drill-testing by listed companies of high-risk, high-reward exploration targets. Examples include South Australia’s PACE programs (Plan for Accelerating Exploration), the ‘Bringing Forward Discovery’ initiative in the Northern Territory, the Collaborative Drilling Initiative (CDI) Mineral Economics

in Queensland, the ‘New Frontiers’ initiative in New South Wales, the Victorian Initiative for Minerals and Petroleum (VIMP), and Western Australia’s Exploration Incentive Scheme (EIS).

Joint venture farm-outs A joint venture (JV) is a contractual arrangement where two or more parties cooperate to enhance the potential performance of a project that neither of them would develop entirely at their own cost and risk. Joint ventures include two stages: 1. A farm-in/farm-out stage, where the ‘farming in’ party progressively acquires a predetermined percentage of the equity in a project from the diluting, ‘farming out’, party for a specific consideration, which frequently includes a commitment to fund exploration or development work in the minerals sector. As a source of funds, the farm-out stage of a joint venture is similar to a partial asset sale. 2. A joint venture proper stage, which commences after the joint venture participants reach the desired level of equity ownership. During this stage participants contribute to the joint venture’s expenses and share its produce (not profit) generally in proportion to their equity. As a consequence, the joint venture ceases to be a source of funds for the diluting company, unless the agreement is ‘geared’ or includes progressive payments unrelated to dilution of equity.

Specialty finance (royalty) companies Specialty finance (royalty) companies provide funds for acquisition, development or expansion, mainly of operating gold mines or advanced projects, in exchange for an appropriate metal royalty on production. This source of funding differs from gold loans (discussed below in the debt sources of funds section) in that the financiers share in the risk of the project. As examples, New York and Toronto-listed Franco Nevada has developed a global royalty portfolio as a specialist finance provider to the minerals sector, including a number of royalties over Australian mines. On a lesser scale, London-based Anglo Pacific Group is active as a provider of royalty-related finance. ASX-listed Royalco Resources has also entered the market to provide royalty finance to companies but is presently of smaller scale to its international counterparts.

THE COST OF EQUITY – BALANCING RISK AND RETURN Utility theory suggests that ‘economically rational’ investors will select, from the various opportunities open to them, the course of action that maximises their utility (Hirshleifer, 1980). To the extent that the magnitude of an individual’s utility is a function of their risk tolerance, investors tend to maximise their 115

chapter 8 – An Introduction to Mineral Finance wealth, while minimising their risk exposure. But, depending on their degree of risk-aversion, they will be willing (within limits) to trade risk for higher returns1. So a rational investor will not shift money from riskless Government Bonds (returning the risk-free rate of return (RF) to a risky project unless he or she receives a suitable risk premium for bearing the additional risk. The risk of any individual investment is characterised by two components: 1. idiosyncratic risk, which is unsystematic and unique, and depends on the characteristics of the specific investment; this risk can be diversified away (see Figure 8.3) by constructing a portfolio of a reasonable number of investments (15 to 20) where the individual returns are ideally poorly correlated 2. systematic or market risk, which depends on broader movements in the economy at large and which cannot be diversified away by portfolio effects (also shown in Figure 8.3).

Fig 8.3 - Diversified portfolio effect.

Trench (2002) points out how, for example, the performance of a nickel-producing company is correlated with demand derived from the steel industry, which in turn is one of the best indicators of aggregate economic activity. Its risk is therefore mainly systematic. By contrast, the success of a nickel exploration company and a possible new nickel mine development project is dependent on whether the relevant drill holes are mineralised or barren, and on the local ground conditions. The major part of its risk is unique and independent of economic conditions. An investor in a diversified market portfolio (ie in a portfolio including all securities weighted by their respective market capitalisation, say the All Ordinaries Index) would legitimately expect to receive a return on the market portfolio (RM) adequate to compensate for bearing the market or systematic risk, but not any unique risk. Naturally, RM should be greater than the 1

We develop this issue further in Chapter 10.

116

risk-free return (ie RF), ie it should incorporate a market risk premium (RM - RF).

The market portfolio premium has varied over time, with a tendency towards a gradual decrease. For instance, according to Officer (quoted in the Independent Pricing and Regulatory Tribunal of New South Wales, 2002) the market risk premium from 1882 up until 1987 averaged around 7.9 per cent on an arithmetic mean, or more correctly 6.6 per cent on a geometric mean. If the average is extended to 1997, these values drop to 7.1 per cent and 5.7 per cent respectively. In postWorld War II times (until 1991) the arithmetic mean fell to 6.6 per cent according to Hathaway (also quoted in Independent Pricing and Regulatory Tribunal of New South Wales, 2002). A number of recent surveys display a high level of annual variability, with recent annual or shorter arithmetic means in the range of three per cent to 7.1 per cent. An average of six per cent is generally used as a general approximation, even though it may be naïve to assume that future market performance will necessarily follow a linear extension of the past. Six per cent as a best estimate concurs with a study by Adams (2009) that concluded the generic equity premium based upon various time-windows of US equity returns sits in the range 5.5 - 6 per cent. To the extent that idiosyncratic risk is diversifiable, financial markets neglect it in determining the return that equity investors should expect to justify investing or maintaining their funds in specific securities or projects. This is also known as the cost of equity (RE). Different investments within the market portfolio, however, respond differently to overall economic influences. In some cases they are sensitive to and amplify general market movements, while in others they react less than average to them. Investors must be compensated for this range of variations in the behaviours of different investments by providing a higher risk premium for those that are more volatile than the market portfolio and conversely. The adjustment is achieved through the use of a beta (ß) index, reflecting how the return on the project is sensitive to and would amplify or abate general market movements. Thus, the applicable risk premium becomes ß × (RM - RF), where a ß > 1 denotes sensitivity to the market. The capital asset pricing model (CAPM) captures this relationship between risk and the related cost of equity funds as follows: RE = RF + ß× (RM - RF) where: RE

= return on equity

RM

= return on the diversified market portfolio

RF

= return on government bonds

ß (Beta) = index of the sensitivity of a security returns to market Mineral Economics

chapter 8 – An Introduction to Mineral Finance So if the risk-free rate of interest (RF) is five per cent, the market premium is six per cent, and the beta (β) index of a specific exploration company is 1.35, ie reasonably sensitive to the market, the cost of equity would be: Cost of equity (RE) = 5% + 1.35 × 6% = 13.1%

SOURCES OF DEBT Some general considerations In raising debt funds either for their operations or for new developments, or both, companies essentially have access to two types of lending: 1. corporate finance, where a bank lends to the company and has recourse to secure its debt on the company’s total assets and on the company’s cash flows to service its debt 2. project finance, where the capital investment involved will be repaid and serviced only by the cash flows generated by the project with no (or limited) recourse on all the other company’s assets. Irrespective of its type, debt can be characterised by its: •• term, either short-term, ie with maturity of less than 12 months or long-term, ie with maturity of more than 12 months; the terms of loans should ideally match the life of the investments they are funding •• degree of security, whereby loans can either be secured, senior or un-subordinated, ie guaranteed by specific assets or by a floating claim against the borrowing firm’s assets or unsecured or subordinated •• marketability, ie whether the relevant debt instruments can be traded on secondary capital markets, where, by contrast with primary markets, no new funds are raised •• type of interest rate, whether fixed or variable. Nowadays swaps are commonly used to convert variable-rate to fixed rate loans. From a company’s point of view, debt finance has a number of advantages. First, funds are available flexibly and when they are actually needed. Second, the transaction costs of establishing a loan are lower than those of equity and, because of the taxdeductibility of interest expenses, debt leverages returns on shareholders’ equity. Finally, contrary to the providers of equity, lenders do not acquire ownership of and control over the firm, so there is no dilution of ownership. There are, however, a number of disadvantages. For example, because interest expenses are unrelated to fluctuating profit levels, higher levels of debt bring about additional ‘financial risk.’ Also, floating security over company’s assets extends financial risk to projects Mineral Economics

other than those being funded with debt. Even in project finance, restrictive covenants may limit the capacity to use other company assets as security to raise funds for new projects. While senior lenders have no formal control over the company as long as it regularly services its debt, they can acquire a critical influence on its affairs if there are liquidity problems. To make use of debt, a company must either have currently positive net cash flows, or expect to become cash-flow-positive in a sustainable way in the foreseeable future. Small to medium-size exploration companies, without the backing of a profitable operation are not cash-flow-positive and consequently cannot service debt. They must rely entirely on equity to fund their operations, even though it is complex and expensive to raise. This is the case until they make a discovery and can secure project finance by convincingly establishing project feasibility. Major integrated mining houses, by contrast, with strong, diversified balance sheets and large annual cash flows have little difficulty in raising debt funds both on their balance sheet (eg conventional loans, bonds, notes and debentures) or project-backed. But even exploration subsidiaries of major integrated mining houses display the highest level of investment in exploration at times of boom when new equity is easy to raise in the capital markets.

Long-term debt Companies use long-term debt for mine construction and development, and for ongoing corporate funding needs. In most cases, lenders ensure that it is secured by a senior claim on the firm’s assets. Long-term debt can be either marketable or nonmarketable. It includes: •• Long-term commercial bank loans, mostly at a variable-rate, with fully drawn advances having terms of one to ten years. Variable interest rates are based on the government bond rate plus a margin between 1.5 per cent and four per cent depending on the lender’s level of perceived risk. Fixedrate bank loans, by contrast, tend to have shorter terms of one to five years. In both cases interest is generally calculated on a daily basis and charged monthly in arrears. Loans are mostly on an interestonly basis with balloon principal repayments. On rare occasions a schedule of progressive principal repayments (credit terms typical of the mortgage loans frequently used by property developers) applies. Although banks are reluctant to grant long-term debt at a fixed rate of interest, it is possible to utilise a swap agreement to achieve the same result as if the loan had been issued on a fixed rate. While no principal changes hands, if in any period the variable rate rises above the agreed swap rate, then the merchant bank providing the swap will remit the difference 117

chapter 8 – An Introduction to Mineral Finance to the borrower. Swaps are desirable because they make a company’s liabilities more predictable, thus reducing the perception of financial risk in the eyes of institutional investors. •• Specific project finance, secured mainly by the fortune of the project, is becoming an important source of funds to the resources industry for mine development. •• Marketable long-term debt papers that are issued directly to lenders and traded on secondary markets. •• Debentures, which are long-term (one to five years), fixed-interest instruments mostly written by finance companies, secured by specific assets or floating charge over the company’s assets. Debentures require the issuing of a prospectus and Australian Stock Exchange listing and are therefore expensive. Furthermore, the trust deed imposes restrictions on further senior debt and on the company’s level of total liabilities. To obviate these difficulties, companies often combine a bank loan with a swap, to achieve long-term fixed interest. As a consequence debentures are becoming a less popular mean of raising funds. •• Corporate bonds, issued by large companies, with a credit rating of AA+ or better. They are generally placed with private or institutional investors. Hence, there is no need for a prospectus making this source of funds cheaper than debentures. They are generally issued at a fixed interest rate and are unsecured. Australian dollar denominated Eurobonds are sometimes issued on medium to long terms outside Australia. While their interest rates may be comparatively low, it is advisable to hedge against exposure to currency risk when using these vehicles. •• Unsecured notes are similar to debentures but, as the name implies, are unsecured. The trust deed is less restrictive and hence they are more risky to the debt provider. Consequently lenders are justified in demanding a higher rate of interest. •• Financial leases, which are normally used to fund the use plant and equipment. The mining company (the lessee) obtains the right to use the plant and equipment, which remains the property of the lessor, by paying rental with no immediate requirement for significant capital outflows. There may or may not be an opportunity to purchase the equipment at expiry of the lease. In the past it was possible to structure the lease agreement in a manner that did not generate a liability in the lessee’s balance sheet. This arrangement is referred to as an operating lease. Nowadays, most lease agreements generate a definite liability for the lessee, which must be recognised in their balance sheet. While there are a number of desirable aspects to sourcing funding through leasing, the implicit interest rate may be 118

higher than that of an equivalent loan. An effect similar to leasing is achieved by contracting out aspects of mine development or operations to a contractor, which supplies the use of the necessary plant and equipment. •• Commodity (gold)/derivative loans and advance sales contracts: companies have used gold loans for construction and development of gold mines during periods of very high gold price contango and low gold leasing rates. Under these circumstances a gold loan may be competitive relative to conventional borrowing even though leasing rates are not taxdeductible in spite of being a form of interest. The bank buys gold and lends it to the company. The company then sells this gold to finance the development of the project, pledging to deliver gold to the bank at a future date from its production. Commodity/derivatives linked facilities have become less frequent due to lower contangos and progressively higher leasing rates. More recently, as it will be seen, merchant banks have made it a requirement of project finance packages for the development of nickel and base metal mines for the proponents to sell forward a significant proportion of their production while the loan is outstanding. In some cases, customers (off-take parties) have contributed funds towards the development cost of projects to secure supplies for their smelters. Two examples are Inco (subsequently acquired by Brazilian mining company Vale) financing the Emily Ann nickel project in the Southern Goldfields region of Western Australia (Rothschild & Sons (Australia) Limited, 2000), and Chinese miningsmelting-refining company Jinchuan financing the Savannah nickel project in the Kimberley region. In some cases, to support desirable developments, customers have actually bought and paid for future production in advance. This practice is known as customer finance.

Short-term debt Short-term borrowing, that is debt instruments with maturity of less than twelve months, is the main tool for day-to-day liquidity and operational cash management. This is because the operational cash flows of many mining operations are neither smoothly distributed over time on accurately predictable, and the consequences of lack of liquidity at times of peak demand on the company’s cash is potentially dire. There are a number of facilities to secure short-term debt. Aside from trade credit, the cheapest forms of short-term borrowing include: •• overdraft accounts •• loans secured by inventories or by accounts receivable (factoring) and similar very short-term instruments •• bridging finance Mineral Economics

chapter 8 – An Introduction to Mineral Finance •• marketable debt papers including promissory notes, bills of exchange, bank bills (often as revolving facilities) and non-bank bills, all of which are sold at a discount to their face value.

HYBRIDS BETWEEN EQUITY AND DEBT There are a number of hybrid financial securities that display the characteristics of both equity and debt. These include preference shares, which are legally equity but which financially display more of the characteristics of debt. They have preference over ordinary shares in terms of receiving dividends and capital repayments. Dividends are often fixed and in many ways resemble interest payments. Generally, they can be converted into ordinary shares at any time or at the end of a specified term. In some cases, the contributed capital can be redeemed. This is not dissimilar from the repayment of a loan principal, making this type of share very similar to a fixedinterest loan. The main difference is that preference shares are less secure, ranking after other creditors in the case of liquidation, the quasi-interest dividends are not deductible for the purpose of assessing income tax and, in some cases, they have a right to participate with ordinary shares in profit distributions. Hybrids also include unsecured convertible notes that can be converted into ordinary shares or redeemed at maturity. From a legal point of view, these are initially treated as debt but, ultimately, after conversion into shares, they become equity. As convertible notes generally have definite terms and fixed rates of interest, they are effectively equivalent to a fixed-term loan plus an option. The value of this option makes it possible for companies to issue convertible notes at a lower level of interest than would have applied to a corresponding conventional fixed-interest term loan.

PROJECT FINANCE The very future of the mining sector is dependent upon the successful delivery of new mines, replacing currently operating mines as reserves gradually deplete. In this respect, the successful financing of new mine projects is one of the critical elements underpinning the industry’s future.

Some introductory considerations A standard definition of project finance is: Financing of project development based on a financial structure with no, or more often limited, recourse on the corporate assets of the sponsoring company, where project debt and equity used to finance the project are secured only by the project assets and serviced and repaid from the project cash flows. Project finance packages are project specific, highly structured and take into account tax implications. They are generally syndicated packages of different loan Mineral Economics

facilities provided by different lenders and coordinated by a lead merchant bank. Packages offer flexibility to match the varying funding needs of different stages of the project development, commissioning and initial operations over time. As a result, they are typically a mix of short and long-term, floating or fixed rate loans with different principal repayment profiles, currency denominations and related details. Banks tailor the terms and repayment schedules to fit prospective, but conservatively estimated, cash flows from the project. Naturally, the project must have the capacity to provide an expected rate of return that is sufficient to both ensure that the borrowing is adequately secure and serviced, as well as providing reasonable returns on equity funds. Thus, determination of an appropriate discount rate to be used in the evaluation may be a challenge. In packages requiring a substantial proportion of forward sales the discount rate to be used must be reduced accordingly to recognise the fact that the major source of risk, ie commodity price volatility, has been hedged. Most current project finance (PF) arrangements are negotiated by companies to share risks and to underpin financial structures that shift some, but not all, of the risk from the corporation to the lender. Lenders may receive some reassurance from a requirement for borrowers to provide project completion guarantees backed by equity (hurt money) and to maintain specific financial ratios while the loans are outstanding. Much of the initial project financing focused on large projects and companies, but more recently, small- to medium-size enterprise (SME) promoters have become more sophisticated and persuasive in their approaches to merchant banks. Project finance arrangements often come into play when venture capitalists realise their gains by vending into either an Initial Public Offering or to other equity investors. Merchant banks have also become more effective in identifying and valuing potential assets and growth opportunities, irrespective of the influence of their corporate owners. In this context, they have gone upstream and taken a project facilitation role by: •• locating initial sources of venture capital •• identifying and introducing potential joint venture participants •• protecting juniors from potential takeovers. There have even been instances where merchant banks have provided minor participation funds prior to the finalisation of feasibility studies, subject to riskreward considerations and repayment at the earliest opportunity. The rewards for successful relationship banking with project sponsors may even go beyond the project finance fees by securing additional business, such as, supporting a possible listing, hedging arrangements, margins, and foreign exchange transactions. 119

chapter 8 – An Introduction to Mineral Finance As with equity, the availability of project finance is somewhat cyclical, depending on market sentiment and commodity booms. Whether funds are available depends on the strength of the project and on a detailed and robust (bankable) feasibility study. Lead advisor banks generally have specialised mining analysis departments that, prior to project finance negotiations, will carry out thorough technical and Discounted Cash Flow modelling and evaluation of the project, as well as risk analysis on a one hundred per cent equity basis. Banks generally require free access to and time to digest additional information about a project, particularly in regards to: •• the grade and size of the resources and reserves, related models, and on the prospectivity of the surrounding tenements •• the technical feasibility of the proposed mine design and the realism of the related capital and operating cost estimates •• the potential position of the proposed operation on the supply (cost) curve for its commodity •• the marketability of mine outputs, in particular for those mines set to produce an intermediate metal product •• the reputation, experience and track record of the company management and its consultants in managing similar developments and operations •• how sensitive the financial performance of the project would be to variations in the value of its main inputs and to changes in the adopted mine design •• the realism of various production schedules under different scenarios, which must display a sufficiently long tail of ore beyond the life of the PF loans. In carrying out due diligence, banks review source data and construct their own models and project cash flows focusing mainly on the ‘downside’ of the project. They tend to disregard sponsor tendencies to focus primarily on the ‘upside.’ If a project’s proponents are to be successful in obtaining project finance, the project must satisfy a number of financial ratio tests, the most critical of which (Amos, 1995, p 15) are: •• the project life ratio, calculated as the net present value (NPV) of the operating surplus for the life of the project at the end of the period divided by the loan principal outstanding at the beginning of the period •• the loan life ratio, which is the NPV of the operating surplus for the life of the loan at the end of the period divided by the loan principal outstanding at the beginning of the period. Acceptable values for these ratios depend on the commodity, location, sovereign risk, the size of the project and the individual bank’s strategic objectives (Amos, 1995). A final ratio of importance is the debt service ratio, of which there are a number of formulations. In general, 120

banks require a minimum cash debt cover ratio of 1.5, calculated as follows: (Annual cash flow + interest expenses + principal repayments)/(interest expenses + principal repayments) This measure differs from the corresponding and frequently quoted interest cover ratio based on accrualbased financial accounting rather than cash figures, calculated as follows: (Earnings before interest and tax)/interest expenses From a lender’s risk-minimisation point of view, payout periods and repayment profiles must be as short as possible without hindering the success of the project. This may mean that debt has to be serviced preferentially to equity. Sponsors often push for as much debt as possible, while merchant banks usually insist on as much equity (‘hurt money’) as possible to underpin some of the risks.

Risk underpinning Few, if any, current project finance deals are truly no-recourse as the relevant arrangements may include significant restrictive covenants that further encumber the company’s assets without the consent of the project lenders. This may entail limits being placed on further borrowings, on the issuing of shares and on the amount of dividends to be paid. In the majority of recent project finance loans, banks have retained some recourse on the sponsor’s balance sheet, at least until physical completion of the project. After this point, their interests are secured mainly by the fortune of the project. Banks insist on stringent specifications regarding physical completion and acceptable, predefined, operational performance. They insist that the sponsor should bear the risk of achieving the relevant milestones on time and on budget. On the other hand, junior sponsors must be able to raise adequate equity capital to cover feasibility costs and possible project cost overruns if they are to qualify for project finance. As a result, sponsors may react by transferring some of this risk to contractors through turn-key contracts, but this may add significantly to project costs. Even after successful completion tests, banks may still insist on stringent riskmanagement measures being in place before lessening or relinquishing recourse to sponsors. When the project has passed the physical completion and operational performance tests, the banks become partially or fully exposed to a variety of major risks, including those relating to whether: •• the operations proceed according to plan, with projected production schedules being achieved and ore reserves and grade estimates being reconciled with the metal produced Mineral Economics

chapter 8 – An Introduction to Mineral Finance •• producers sell the mine’s output at the estimated prices, keeping in mind the issue of commodity price volatility and that the lead time to production may have been up to four years (banks may make it a condition that some of this marketing risk be mitigated by an appropriate level of hedging while the loans are in place) •• management is competent and operates the project successfully •• there is compliance with the necessary legal conditions to secure and maintain a valid title and other statutory and environmental requirements; there may also be exposure to some sovereign risk, which in its mildest form may express itself as bearable changes in the regulatory and fiscal regime affecting returns over time, while at the limit may culminate in expropriation of the project. Rather than being a true non-recourse source of funding, project finance may be more of a risk-sharing mechanism. For it to be successful and result in a lower cost of funds, the relevant arrangements should shift various sources of risk to those parties better equipped to bear it. The matrix suggested by Deer (1987) illustrates the process of risk attribution well. A version of it appears in Table 8.2 and illustrates where key stakeholders are well placed to share key risks – such as a customer or customers being most closely aligned to market risks for example. If a project is large and reasonably secure, the lead bank may decide to either unbundle or accept (securitise) the project credit risk, or both, so that syndicate investors can raise money by selling secured bonds domestically or source funds from low-interest Euromarkets and other global capital markets. Table 8.2 Project-finance risk-sharing (source: Deer, 1987). Type of Risk

Banks

Reserves

Borne by borrower

Other

X or

X (eg contractors)

X (subject to audit)

Completion Operating

X (following completion test) and/or

X (depending on conditions)

Marketing

X (limited)

X or

Management

X

Legal

X

Force majeure

X

X (eg customers)

X (limited)

THE FINANCIAL STRUCTURE OF MINING COMPANIES Cost of debt, financial leverage and financial risk A prudent amount of secured borrowing by creditworthy companies is inherently significantly cheaper than the cost of equity. The cost of debt (RD) is further Mineral Economics

reduced after tax as the relevant interest expenses before tax (I) are deductible in determining the company’s assessable income. The result is that the rate of return on equity (RoE) generated by a project funded with a portion of debt is higher than that from a project funded entirely with equity. This effect is known as financial leverage. On a financial accounting accrual basis, gearing (borrowing) will leverage the return on equity on a period-by-period basis by a factor of: PBIT/(PBIT - I) where the profit before interest and tax (PBIT) must be greater than the interest expenses after tax (I × (1 - t)), where t is the tax rate. On a cash basis, the overall internal rate of return (IRR) of a project will also significantly increase with gearing, subject to the condition that in any period the PBIT plus depreciation plus the difference between the opening and closing balance of all other balance sheet items over the period must be greater than the corresponding after-tax interest expenses (I × (1 - t)) for the period. Hence, in theory at least, it would be in the shareholders’ interest to make use of as much debt as possible and prudent. As a result, one might expect to find relatively high levels of debt in the balance sheet of most mining companies. However, this does not appear to be the case in practice because borrowing introduces a new dimension of financial risk, particularly if PBIT is close to I × (1 - t).

Financial structure of mining companies The average amount of debt on total assets [D/(D + E)] differs widely from industry to industry. However, the risk that is inherent in the resources sector, when compared with the additional financial risk brought about by increasing the level of borrowing, seems to act as a disincentive to borrow. Because of their high level of risk, exploration companies have generally low, or zero, levels of debt, while mining companies, on average, have only moderate debt levels. In a survey of gearing across the major mining companies globally, and to a lesser extent the mid-tiers, Ernst & Young (2012) found the relative use of debt to be at an all time low. Leverage has been reduced in 2011 from previous levels, and balance sheets are far stronger than they were going into the global financial crisis in 2008. The average gearing levels across a sample of majors had decreased to just 12 per cent at June 2011, compared with 69 per cent at December 2008. This does not mean that individual mining projects may not display significantly higher, as well as lower, levels of debt. Indeed the level of debt used is not constant over time, and is generally high at the start of project developments. As already noted, project finance packages for individual developments in Australia can 121

chapter 8 – An Introduction to Mineral Finance cover up to 70 per cent of total funds, but are subject to repayment in the early stages of production. Overall, ongoing levels of the corporate debt for mining companies in Australia seldom exceed half of total funds, even in aggressively geared growth companies. This behaviour is consistent with the ‘traditional’ view that the proportion of debt in the financial structure of a company can increase with beneficial leverage effects until both shareholders and lenders become anxious about the increasing financial risk, and therefore expect rapidly increasing returns to compensate for it. Even secured lenders become anxious because they know that the realisable value of a mining company’s assets in the case of a liquidation fire sale may be much lower than its book value. As Figure 8.4 shows, the Weighted Average Cost of Capital (WACC or RC) after-tax will fall as the percentage of debt employed increases from zero, then plateau and start rising rapidly again when suboptimal levels of debt are reached.

After-tax weighted average cost of capita (WACC) = = 6.5% × 0.4 × (1- 0.3) + 13.1% × 0.6 = 9.68% Note how the after-tax weighted average cost of capital at 9.68 per cent is considerably lower than the corresponding cost of equity at 13.1 per cent. In Chapter 9 it will be argued that the before-tax weighted average cost of capital (WACC) is a suitable discount rate if project risk is similar to that of the firm as a whole, and the project is going to be funded with a mixture of debt and equity. The before-tax WACC should be used as the discount rate instead of the after-tax WACC, because the DCF model will deduct the interest expenses before calculating the taxable income and related tax, hence the tax shield due to the deductibility of interest expenses is incorporated in the model output. In the early stages of project evaluation, however, it is customary to assess the financial robustness of a project by assuming 100 per cent equity funding and using the cost of equity (RE) as the discount rate, particularly if the project is to be funded primarily with share issues and /or from retained earnings.

CONCLUSIONS •• Financial objectives and the management of exploration and mining companies differs from that of other sectors of the economy only in so far as their resources and reserves are depleting, they are capital-intensive, and that, particularly exploration, is very dependent on the availability and cost of raising equity funds. Fig 8.4 - Optimising the after-tax weighted average corporate

cost of capital traditional view.

By contrast, Modigliani and Miller (1963) maintained that theoretically, in frictionless capital markets, the risk-adjusted return expected by both shareholders and lenders would gradually adjust upwards as the level of debt increases and that, for this reason, in the final analysis the actual level of debt used to fund a project/ company should not matter. The WACC is calculated as: WACC = (D/D+E) × RD × (1-t) + (E/D+E) × RE As can be seen from the following example, it is a relatively simple matter to calculate the after-tax WACC using the following assumptions: •• cost of equity (RE) = 13.1 per cent •• cost of debt (RD) = 6.5 per cent •• tax rate (t) = 30 per cent •• debt (D) as a percentage of total funds = D/(D + E) = 40 per cent 122

•• In spite of a high number of IPOs in times of boom, the mining sector is most prominent amongst the smaller companies listed on the Australian Stock Exchange by capitalisation because the amounts raised (ie typically $2.5 M to $6 M and on average only $4 M) and capitalisation of exploration and mining companies is relatively low. •• As a consequence, only a few resource companies qualify for inclusion in the main S&P/ASX 300 index. Large, index-using institutional investors tend not to be interested in the majority of explorers and miners too small to qualify for an index. •• Mergers, takeovers, listed investment companies (LICs) and PDFs are effective strategies to overcome this handicap and tap into institutional funds. •• Different financial structures are appropriate to different project stages: •• on account of its risk, exploration up to feasibility is funded primarily by equity •• development and construction makes use of significant levels of debt mainly in the form of project finance, but banks will require early repayments and risk mitigation by way of some Mineral Economics

chapter 8 – An Introduction to Mineral Finance equity to guarantee project completion and possible cost over-runs •• ongoing operations are funded with a lower (generally less than 50 per cent), appropriate and stable proportion of debt. •• Use of an appropriate but prudent level of debt in the financial structure of a project will increase/ leverage the return on the equity invested in the project (RoE or IRR) because of the tax deductibility of interest expenses. •• Increased debt will, however, increase financial risk and consequently the after-tax weighted average cost of capital (WACC) of the firm.

Independent Pricing and Regulatory Tribunal of New South Wales, 2002. Weighted average cost of capital, discussion paper DP 56 [online]. Available from: [Accessed: 8 May 2006]. Kay, J, 1993. Foundations of Corporate Success (Oxford University Press: Oxford). Kreuzer, O P, Etheridge, M A and Guj, P, 2007. Australian junior exploration floats, 2001-2006, and their implications for IPOs, Resources Policy, 32:159-182. Modigliani, F and Miller, M H, 1963. Corporate income taxes and the cost of capital: A correction, American Economic Review, 53(3):433-443. Peirson, G, Brown, R, Easton, S and Howard, P, 2004. Business Finance, eighth edition (McGraw-Hill Irwin: Sydney).

•• No-recourse or limited recourse project finance is becoming the prevalent way of funding new mine developments, with lead merchant banks putting together flexible, generally syndicated, packages of loans to best match the timing and nature of the project funding needs, as well as attribute risk to the parties best equipped to manage it efficiently and effectively.

Porter, M E, 1980. Competitive Strategy – Techniques for Analysing Industries and Competitors (The Free Press: Cambridge).

REFERENCES

Rappaport, A and Sirower, M L, 1999. Stock or cash? The tradeoffs for buyers and sellers in mergers and acquisitions, Harvard Business Review, 77(6):147-160.

Adams, R, 2009. The cost of capital in the mining industry – An update [online]. Available from: . Amos, Q G, 1995. Debt finance: The technical factors, in Proceedings PACRIM ’95 (The Australasian Institute of Mining and Metallurgy: Melbourne). Collins, J C, 2001. Good to Great – Why Some Companies Make the Leap – And Others Don’t (HarperCollins: New York). Deer, P W, 1987. Project financing of Australian resources, in Proceedings PACIFIC RIM CONGRSS ’87, pp 689-695 (The Australasian Institute of Mining and Metallurgy: Melbourne). Ernst & Young, 2012. Mergers, acquisitions and capital raising in mining and metals: 2011 trends, 2012 outlook [online]. Available from: . Etheridge, M and Uttley, P, 2003. Uncertainty, decisionmaking and value measurement – The fundamentals of the business of exploration, in Proceedings AIG Conference (The Australian Institute of Geoscientists: Perth). Hirshleifer, J, 1980. Price Theory and Applications (PrenticeHall: London).

Mineral Economics

Porter, M E, 1985. Competitive Advantage – Creating and Sustaining Superior Performance (The Free Press: Cambridge). Porter, M E, 1990. The Competitive Advantage of Nations (MacMillan Business: London). PriceWaterhouseCoopers, 2010. Review of global trends in the mining industry [online]. Available from: .

Rothschild & Sons (Australia) Limited, 2000. Getting financed, presentation. Trench, A, 2002. Mine finance and accounting 282, course notes, Curtin University of Technology’s Western Australian School of Mines. Trench, A, 2011. A Sharebuyer’s Guide to Investing in the Australian Mining Boom (Major Street Press: Melbourne). Trench, A, 2012. Class of 2011: A continued focus on Australian gold for IPOs, quarterly newsletter Issue 19 (March 2012), pp 12-17 (University of Western Australia). Trench, A, Pridmore, D and Lau, L, 2006. Top Resource Stocks 2007 (Wrightbooks-Wiley: Milton). Trench, A, Thompson, M and Lau, L, 2007. Top Resource Stocks 2008 (Wrightbooks-Wiley: Milton). Trench, A Thompson, M and Lau, L, 2008. Top Resource Stocks 2009 (Wrightbooks-Wiley: Milton).

123

HOME

Chapter 9 Mineral Project Evaluation – Financial Modelling and Discounted Cash Flow Analysis Pietro Guj What is it worth? Types and uses of financial valuations General issues Market and cost-based evaluations Fundamental or technical evaluation Income-based valuations and discounted cash flow models The basic discounted cash flow model characteristics and structure Constructing a simple discounted cash flow model of a mine in nominal dollars Project valuations are at a point in time – discounting cash flows Reconciling cash and financial accounting accrual figures in a discounted cash flow model Modelling debt and financial leverage Converting a discounted cash flow model from nominal to real dollars Modelling the preproduction period Comparison of mutually exclusive projects with different lives Inherent weaknesses and common traps in discounted cash flow analysis Conclusions

WHAT IS IT WORTH? – TYPES AND USES OF FINANCIAL VALUATIONS General issues The VALMIN Code (VALMIN Committee, 2005, p 8) states that the type of financial valuation methodology best suited for a specific mineral/mining project depends on the nature of the valuation, the stage of development at which the project is in the mining cycle and the extent and reliability of available information. The Code defines five distinct project development stages: exploration, advanced exploration, predevelopment, development and operating mines. The level of geological, geotechnical, metallurgical and financial information and the knowledge on which an evaluation can be based increases from the exploration to the mining stage depending upon the degree of confidence Mineral Economics

that a valuer can attribute to the related information. Valuing an early or advanced exploration project presents very different challenges from a project at the conceptual, prefeasibility or feasibility study phase of development, or from the evaluation of an established operating mine. The most suitable methodology will also depend on the intended use of the valuation. While an investor would value a project on the basis of its potential financial performance and expected returns over its entire life relative to other investment opportunities, banks may only be concerned with the capacity of the net cash flows (NCFs) generated by a project to service 125

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis interest and repay loan principal over the early years of the project life, while the loan is outstanding. Banks are essentially unconcerned if, after the loan has been repaid, the project becomes unviable. Government, on the other hand, is concerned with the economic performance of a project. This encompasses both monetary values and socioeconomic measures of benefits and costs, many of which are non-monetary. Estimating economic costs and benefits (a process which may involve econometric models, cost-benefit analysis (CBA) and input-output and impact matrices) may also be of critical importance to a company seeking the government’s approval and the community’s acceptance of a project by proving its potential contribution to the broader or regional economy. Setting aside the complex subject of how to determine the broader economic value of a project, financial evaluations fall essentially into three distinct categories. Lawrence (2001, p 115) describes these as: 1. market-based 2. cost-based 3. income-based. The first two approaches are more frequently applied at the exploration stages. The third is applied after mineral resources have been inferred or better indicated and some initial technical concept of how they could be developed and mined formulated and costed, at least in a preliminary way. There has been major development and standardisation in the field of project evaluation since 1990. The adoption of the Australasian Code for Reporting of Identified Mineral Resources and Ore Reserves (JORC Code, 2004) in 1993, and the Code and Guidelines for Assessment and Valuation of Mineral Assets and Mineral Securities for Independent Expert Reports (VALMIN Committee, 2005) in 1995, were major milestones. Both the JORC and VALMIN codes have been the subject of subsequent reviews with the latter currently under review. There have been similar developments in other major mining countries such as the USA, Canada (CIMVAL Standard) and South Africa (SAMVAL) that have promoted greater reasonableness, materiality and transparency in project evaluation. This has been accompanied by a more disciplined approach and greater accountability on the side of corporate governance and valuers. Bourassa (2001, p 78) provides a useful review of the international legal requirements and standards for mineral valuations. In Australia, while not specifically mandating the use of the VALMIN code, the Corporations Act 2001 and the Australian Securities and Investment Commission (ASIC) Act 2001, make reference to experts’ reports and valuations and there is evidence that this code is a benchmark for best practice in the compilation of prospectuses, takeovers documentation and related documents. In addition, in 2010, The Australasian Institute of Mining 126

and Metallurgy (The AusIMM) issued draft guidelines for Technical Economic Evaluation of Mineral Industry Projects. In its listing rules, the Australian Stock Exchange (ASX) mandates that all reports dealing with resources and reserves must be drafted in compliance with the JORC Code under the supervision of a ‘competent person’. While not mandating compliance with the VALMIN Code, the ASX supports its general principles. The VALMIN definition of market value in Australasia is: … the estimated amount of money (or the cash equivalent of some other consideration) for which the mineral asset should change hands on the valuation date. It must be between a willing buyer and a willing seller in an arm’s length transaction in which each party has acted knowledgeably, prudently and without compulsion. Lawrence (2001) argues that the ‘fair market value’ of infrequently traded mining projects does not necessarily equate to their ‘price’, which may be realised under specific industry or corporate circumstances. It is fair to say that internationally there is still some confusion about the meaning of such terms as ‘fair market value’, ‘price’, ‘value in exchange’ and ‘value in use’ based on the highest and best use concept.

Market- and cost-based evaluations Market- and cost-based valuations circumvent the difficulty inherent in embarking on income-based valuations when a project is still at the exploration stage. At the early stages of a project there is considerable scarcity of critical information and uncertainty about the input factors essential to reliably model its future potential cash flows. Given the local influence of real estate valuers, marketbased methods are generally favoured in the United States to value and compare essentially very different mineral projects. Lawrence (2001, p 123) observes that there is a continuing debate about the appropriateness of this approach. He subsequently discusses the benefit and considerable drawbacks of various market-based approaches, including the benchmark/comparable sales, joint venture (JV) terms, yardsticks and transactional rules-of-thumb methods. The comparable sales and JV terms methods have certain conceptual similarities in that they establish a fair market value by comparison with: •• consideration that changed hands in recent sale transactions for similar projects •• the level of firm expenditure commitments and other considerations involved in farming into a given level of equity in a similar project grossed up to the implicit value for 100 per cent of the project. The problem with these methods is that truly comparable transactions are infrequent, their precise Mineral Economics

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis terms generally confidential and they are influenced by market sentiment at the time of the transaction. Apart from the fact that no two mining projects are alike, evolving bull or bear market influences make comparison of values derived at different times unreliable. In addition, yardsticks and transactional rules-ofthumb, often relating to the price per unit of resources in the ground (eg dollar per ounce of gold), also suffer from lack of comparability. A variety of differences inevitably arise between the gross and net values of different transactions given their different potential profitability due to differences in grades, recoveries, unit mining and processing costs, logistics and other factors. Roscoe (2001) discusses the cost-based look-back approach, and in particular the Canadian appraised value and the Australian multiple of exploration expenditure (MEE) methods in a comprehensive way. He observes that both methods attempt to determine a fair market value of exploration properties in which no potential commercially viable mineral deposit has yet been discovered. The first utilises the amount of past exploration expenditure and of justifiable further investment in exploration to test the residual mineral potential of a project as the basis for its value. In the case of the MEE method, these figures are then adjusted by a prospectivity enhancement multiple (PEM) to arrive at the final value. Roscoe also reviews the Canadian appraised value method, which assumes that the amount of future exploration expenditure that is justified on a property is a function of its value. This approach is supported by the fact that in farmin agreements equity is often acquired in proportion to commitments to fund future exploration. Values, therefore, are determined with reference to comparable exploration property transactions. As for the market-based approach, the validity of these methods ultimately relies largely on the judgement of ‘expert’, ideally registered, valuers. In addition, all the above methods (ie market and cost-based) lay a heavy reliance on past events and information, whereas the value of a mining project is derived from its potential in terms of the capacity of future operations.

Fundamental or technical evaluation Irrespective of the approach used, the value of a mineral project originates from: •• its capacity to generate future net income •• the magnitude and timing of such income •• the probability of its realisation. Income-based valuations are often referred to as technical or fundamental valuations. This is because they form the foundation to which a market premium (or discount) is added to achieve a fair market value. The market premium is generally positive in a bull market and, besides sentiment, accounts for any strategic, specific corporate or real option value, if the project Mineral Economics

is leveraged to the volatility of demand, commodity prices, exchange rates or other influencing factors. The geological risk method is the most basic income-based valuation. The costs associated with completing various stages of exploration weighted by the probability of progressing to each subsequent stage are deducted from the estimated gross value of a target resource to assess the value of the project. The validity of this method, as for the geosciences-factor (also known as the Kilburn) method, is heavily contingent on the subjective judgement of expert geoscientists. Fundamental valuations are generally based on discounted cash flow (DCF) financial models of projects over their entire lives. While more objective, they may still be biased by their deterministic, static character and by the weakness inherent in the estimation and use of a single time- and risk-adjusted discount rate for comparing the values of projects with often significantly different risk profiles. We explore these issues in some detail in the following chapter, which deals with risk analysis and advanced project evaluation methodologies. In practice, many of the above valuation methods are not mutually exclusive and valuers should attempt more than one approach if they have relevant information at hand to support them. The introduction of the JORC and VALMIN codes was accompanied by the publication of a large number of relevant papers and guidelines, collated in a number of key AusIMM publications. Prominent among them are the proceedings of the VALMIN 1994 and 2001 conferences. Many of the methodologies discussed in these papers are now in common use in the mining industry. Torries (1998) provides a useful summary and description of these methods. As already mentioned, recently a committee of The Australasian Institute of Mining and Metallurgy (AusIMM, 2010) has issued draft guidelines for Technical Economic Evaluation of Mineral Industry Projects for comments by members. These guidelines, if endorsed, will not be mandatory, but will represent recommended best practise for valuers. The content of this chapter is broadly in line with the above guidelines. The remainder of this chapter assumes that the reader has a minimum degree of familiarity with basic valuation methodologies and focuses primarily on how to avoid common pitfalls in constructing and interpreting DCF models of mining projects as an aid in their fundamental valuation.

INCOME-BASED VALUATIONS AND DISCOUNTED CASH FLOW MODELS The basic discounted cash flow model characteristics and structure Investment is the commitment of funds in the present in the expectation of receiving returns in the future, 127

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis sufficient not only to repay the original capital investment, but also to generate an acceptable surplus after covering all recurrent operating costs. If the rate of return is greater than the cost of the capital used (both equity and debt) to fund the project, than the project adds value. Hence, to value a project at the time of investment, its NCFs need to be discounted to their present value using an appropriate cost of capital/ discount rate, which compensates investors for both the timing and risk of its future cash flows. The overriding corporate objective for the management of a mining project is to maximise the value-added to its current owners (shareholders). Adding value to the enterprise satisfies its corporate growth objectives. As a consequence, as will be discussed later, the paramount measure of the value of a project is its net present value (NPV), which is a measure of the degree of value added by investing in a project. To assess the returns, and in particular the value added by a project, one must construct a technofinancial model simulating financial performance of the project over its whole life, from the next dollar to be invested (past investments are sunk) to the closure and final rehabilitation of the operation. The model will contain a range of input variables, the value of which must be estimated or forecast, together with a series of interactive algorithms, which manipulate the inputs and generate a range of model outputs or results. Financial models have three components: 1. technical – dealing with the selection of the most suitable mining method and design, and its physical characteristics 2. financial – converting the physical project specifications into financial parameters and determining the optimal annual combination of ore and waste throughput which maximises the value added for the owners 3. risk analysis and management – to identify and quantify •• market risk created by the volatility of commodity prices, exchange rates and demand •• private/project risk relating to the uncertainty of geological, geotechnical, metallurgical and engineering characteristics of the mineral deposit and its preferred mode of development •• financial risk arising from the amount of debt as a proportion of total funds (gearing) used in funding the project •• country risk arising from the degree of political, social and economic stability of the country hosting the project. Risk analysis enables decision-makers to identify and quantify the risks to which their project will be exposed. It does not, however, address what the firm should be doing about it. This is determined in the corporate risk128

management policy, ie determining which elements of risk should be hedged or insured, contracted out to third parties better suited to bear them, or borne by the firm. Financial models underpin categories of decisions:

three

fundamental

1. the investment decision – determining the worth of the project assuming 100 per cent equity funding 2. the financing decision – determining the optimal level of gearing to leverage the return to equity holders, consistent with their willingness to bear the additional financial risk 3. the portfolio decision – determining the desirability of the project in light of possible synergies with other existing corporate assets, ie its capacity to •• increase the combined expected returns •• decrease the combined risk •• use a combination of both. It is possible to construct financial models in two ways: 1. Under assumed certainty using single-point, expected (mean) estimates of input variables, which in models with essentially linear algorithms generate single-point, expected values for model outputs. Single-point models can then be used compatibly with their capacity to adjust to changes in inputs without affecting the realism of their outputs, to determine •• the inputs to which the project performance is most sensitive, deserving more in-depth investigation (sensitivity analysis) •• the performance of the project under various scenarios, ie under combinations of likely input values, both optimistic and pessimistic, to test the robustness of the project performance under a range conditions. 2. Under probabilistic conditions using probability distributions (not single-point mean estimates) of input values, and carrying out Monte Carlo simulations. During a Monte Carlo simulation, input variables are sampled randomly and simultaneously from their assumed distributions according to their respective probability of occurrence for a large number of model iterations. Each successive iteration constitutes one of a large number of possible scenarios that define the distributions of all possible values for each of the model outputs, their respective means and other statistical parameters. For a model to be used for risk analysis it is critical that it should be capable of being interrogated. This means that it should be constructed internally interactive. A safe approach, if the model is built using a computer spreadsheet, is not to type any number in any of the model algorithms, but to refer to them in a table of assumptions and to test some of the model columns before and after some change in inputs using a pocket calculator. Mineral Economics

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis A model constructed under assumptions of certainty using single-point expected input values is often referred to as the project base case. The structure of a financial DCF model consists of cash flows from three types of transactions: 1. operations 2. investment activities 3. financing activities. The sum of these cash flows for a specific project represents its NCF. Cash flows are typically calculated on a period-by-period basis. There is a close relationship between the NCF of a project in a specific period and the sources and applications of funds (cash flow) statement in the financial accounts of the project for the same period. Irrespective of whether preliminary or detailed production schedules have been estimated, the NCFs from operations in each period depend, aside from flows of a capital nature, on the interplay of: •• the recurrent revenue function, which is the quantity of the mineral product sold × its realised price •• the recurrent cost function, which includes fixed costs (FC) plus total variable costs (VC) for the period; the latter is the product of the quantity of ore produced and processed × relevant variable unit costs. The performance of most projects is very sensitive to factors affecting revenue (eg market-related factors such as commodity prices and exchange rates and project-related factors such as ore tonnages, grades, metallurgical recovery, etc) and to a lesser extent to capital and recurrent operational costs. While DCF models must cover the whole life of the project, an important decision is to determine an appropriate period to break up the cash flows. Given the long life of most mining projects, yearly periods are generally selected for early stage evaluations (ie scoping, prefeasibility and feasibility studies). Once a time period is selected, however, the timing of individual cash flows within each period loses any significance. It is generally assumed that cash flows take place at the stroke of midnight on the last day of each period, ie in arrears. Some analysts would argue that an endof-period approach may distort the analysis if there are significant time lags between revenue and expenditure cash flows within a period and recommend use of a mid-point in the year. The author contends that such an approach, while not representing a major improvement, has the potential to create unnecessary complexity and possible errors and that, if the timing of cash flows is a concern, selection of an appropriate shorter time period in arrear is a preferable approach. In addition, using the end-of-period represents a conservative approach to valuing the cash flows, which is prescribed by The AusIMM project evaluation guidelines. Mineral Economics

A yearly period may not be suitable if it is necessary to persuade a bank that a project can generate free cash flows sufficient to service monthly interest and frequent periodic loan principal repayments. In such a case, analysts can select quarterly, monthly or even more frequent intervals. An investment is said to be instantaneous if it involves the disbursement of an initial lump sum followed by immediate receipt of the net operating cash flows from the project. An example would be the purchase of an operating project or a piece of equipment ready for use. Within an evaluation model, an instantaneous investment occurs in the so-called year 0, which by convention has no duration. Project optimisation is an iterative process to determine the optimal mining method and design, and therefore the optimal annual mine throughput, or mine life. The objective is to provide maximum value for the owners of the project compatible with the level of risk they are prepared to bear. An initial assessment of ore reserves, their geometry and geomechanical characteristics leads to a range of technically feasible mine methods, mine sizes and related costs. These, in turn, determine the related cut-off grades on the basis of which the initial ore reserves are refined. The intent is for the outcome to be a mining method and rate of production that realises economies of scale without creating excessive operating leverage. The final mine life will be heavily influenced by the need to optimise capital recovery under the prevailing tax regime. This task is facilitated by powerful mine modelling and optimisation software which, given a body of mineralisation, accurately determines the size and shape of possible mines at different realisable prices and operating costs. While there are no real short cuts to determine an optimal mine life, it is possible to obtain a coarse initial approximation by analogy to existing similar operations, or by using Taylor’s empirical formula (Taylor, 1978): Mine life in years = 6.5 × (diluted mining reserves in millions of tonnes)0.25 Although the validity of Taylor’s formula has been severely criticised, the author has found that 75 per cent of the life suggested by the formula provides an acceptable first-pass approximation for the life of base and precious metals mines, and 65 per cent of the suggested life for large-scale bulk commodities operations. As DCF models are constructed using whole years in many instances, the integer or whole year rounded value of the mine life figure obtained using the Taylor’s formula must be used. In analysing a project, it is possible to build a model in either: •• nominal money terms (also known as historical dollars or dollars of the day) using figures that incorporate forecasted general inflation 129

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis •• real money terms (also called constant dollars), which do not incorporate the effect of general inflation. Prices, however, may rise in real terms in each period by more or less than the general rate of inflation. As a result, real escalation factors need to be incorporated in DCF models constructed in real dollars even though no general inflator will apply. The relationship between real and nominal dollar figures is: Real dollars (including real escalation if applicable) = nominal dollars/(1 + inflation rate expressed as a decimal)time There are both advantages and disadvantages in the use of either nominal or real money terms. For instance, building a model in real dollars makes estimating the cost of input variables using today’s dollars more meaningful to planning and cost engineers, and easier to communicate to company decision-makers. Both groups relate more easily to current prices than to future prices that need to incorporate compounding inflation over future years. Using nominal dollars, by contrast, makes it easier to reconcile DCF models with forecast financial accounting figures, related financial ratios and measures of return. For this reason, banks often require nominal dollar models to assess loan applications. The use of nominal dollars also helps circumvent difficulties that arise in correctly calculating depreciation and amortisation charges for use in real dollar DCF models. Depreciation and amortisation charges are not cash outflows in a period as they relate to capital investments, for which the outflow has occurred in previous periods. However, because of their deductibility from taxable income, they influence the cash outflows relating to the tax paid in each period. Irrespective of whether one uses real or nominal money values, the result of any DCF analysis, if correctly conducted, will be the same. In practice, evaluation errors often arise because analysts inadvertently mix real and nominal dollar values in the same model. Finally, the future rate of general inflation can either be estimated on average or occasionally using a cyclical forecast. The latter approach generates different inflation rate forecasts at various stages in the economic cycle and consequently creates complexities when discounting cash flows to their present value, as individual nominal discount rates have to be used for each period.

Constructing a simple discounted cash flow model of a mine in nominal dollars Consider a company wishing to acquire an operating open cut gold mine with residual diluted mining 130

reserves of 2 Mt, at an average grade of approximately 4 g/t of gold (3.9 g/t Au). Necessary capital upgrades costing $41 M, will, in the initial simple model, be handled as an instantaneous investment in year 0, and will be depreciated on a straight line over the life of the mine. In a later section, the realism of the model will be improved by recognising that these capital works will be completed over a twoyear preproduction period, as well as distinguishing different asset categories for the capital outlay and applying to them different depreciation methodologies. It is expected that the net salvage value of the assets after the mine closes and is rehabilitated will be $12 M estimated in nominal dollars of the day. As the initial revenue generated by the project will lag behind operating costs, and is therefore inadequate to cover them, an initial injection of working capital of $2 M is required. The real value of this initial working capital will eventually be recovered after the mine closes, as mining and processing costs will no longer be incurred, but the lagging revenue will continue to be received. Taylor’s formula suggests a mine life of five years if using the integer, or six years if rounding is used, eg: Life (years) = Int ((6.5 × (2 Mt) ^ 0.25) × 0.75) = 5 Life (years) = Round ((6.5 × (2 Mt) ^ 0.25) × 0.75), 0) = 6 A life of five years translates to an annual ore throughput of 0.4 Mt/a. Assuming a waste to ore ratio of four to one, removal of waste will average 1.6 Mt/a. A simple nominal dollar model of this investment appears in Table 9.1. This assumes a gold price of US$1024/oz, an exchange rate of A$1 = US$0.855 and gold recovery of 92 per cent from the mill. A study by Guj and Nakamura (2011) suggests that most feasibility studies of gold and copper/gold projects use as their price input the average gold price over the previous three years. Accordingly, the average price for the three years ending 31 December 2010 will be used in the present model, and it will be assumed that prices escalate by one per cent per annum in real terms, ie over an expected average annual rate of general inflation of three per cent per annum, over the life of the mine. An ad valorem mineral royalty of 2.5 per cent and corporate income tax rate of 30 per cent apply. The operation will produce the following: •• annual quantity of gold of 46 143 Troy ounces, ie (0.4 Mt or ore × 3.9 g/t Au × 92 per cent recovery)/ 31.10345 (the grams contained in a Troy ounce) •• nominal gross sales revenue of $57.52 M in year 1, ie 46 143 oz at A$1210/oz (ie US$1023.94/oz/0.8545 exchange rate) × 1.01 real price escalator × 1.03 general inflator); the corresponding real dollar figures can be obtained by omitting the general inflator from the above calculation. Mineral Economics

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis

Table 9.1 A simple nominal dollar model of an operating gold mine. Year

0

Gold produced (oz M) Gross sales revenue ($M)

1

2

3

4

5

0.046143

0.046143

0.046143

0.046143

0.046143

57.52

59.84

62.25

64.76

67.37

Other revenue (salvage)

6

12.00

Less: Royalty at 2.5%

-1.44

-1.50

-1.56

-1.62

-1.68

Opererating exp ($M)

-16.18

-16.92

-17.69

-18.49

-19.33

Depreciation

-8.2

-8.2

-8.2

-8.2

-8.2

Interest expenses

0.00

0.00

0.00

0.00

0.00

0.00

Taxable income

31.70

33.22

34.81

36.45

38.15

12.00

Tax at 30%

-9.51

-9.97

-10.44

-10.93

-11.45

-3.60

Production profit after tax ($M)

22.19

23.26

24.36

25.51

26.71

8.40

Depreciation

8.20

8.20

8.20

8.20

8.20

0.00

Losses carried forward

0.00

0.00

0.00

0.00

0.00

0.00

Less:

Addback:

Working capital CAPEX Debt: principal drawdowns and repayments $M

-2

2.39

-41.00 0

0

0

0

-43 1

30.38938532

31.4566

32.56417

0.882612533

0.779005

0.687559

Present value of net cash flow ($M)

-43.00

26.82

24.50

22.39

Cumulative DCF ($M)

-43.00

-16.18

8.33

30.72

NPV at 13.3%

74.97

IRR

68.8%

1.061

1.093

Net cash flow ($M) Discount factor

Periods to break even General inflator

0

1

1.000

1.030

0

0

0

33.7136

34.90646

10.788105

0.606849

0.535612

0.472738

20.46

18.70

5.10

51.18

69.87

74.97

1.126

1.159

1.194

Real price escalator

1.000

1.010

1.020

1.030

1.041

1.051

1.062

Real cost escalator

1.000

1.015

1.030

1.046

1.061

1.077

1.093

If we assume fixed costs at real (year 0) values of $4 M/a, variable mining costs of $2.50 and $3.00 for each tonne of waste and ore moved respectively, a grade control cost of $1.20, milling cost of $12.00 and administration cost of $2.50/t of ore treated, and a real cost escalation of 1.5 per cent per annum, then the: •• nominal annual operating and maintenance cost in year 1 will be $16.18 M, ie (fixed cost $4 M + ((0.4 Mt of ore × (mining cost $3.00/t + grade control $1.20/t + milling cost $12.00/t + administration cost $2.50/t) + (1.6 Mt of waste × mining cost $2.50/t)) × 1.015 real cost escalation × 1.03 general inflation; once again the corresponding real figure can be obtained by omitting the general inflator. Many mines produce and sell concentrate (eg copper or lead-zinc concentrate) to a custom smelter rather than metal to a terminal market such as the London Metal Exchange. Estimating their revenue, ie their net smelting return (NSR) or value of concentrate free on board (FOB – after deducting smelting and refining Mineral Economics

charges levied by the custom smelters and the relevant transport costs), becomes more complex as the terms of custom smelting contracts are different for various types of concentrates. For copper concentrates, for instance, they include: •• a unit deduction of between one and two and a half per cent •• a fixed smelting charge per tonne of concentrate •• a variable refining charge as a function of the contained copper •• a price participation factor if the LME copper price falls beyond a neutral price range •• credits and penalties for associated metals (eg gold). More often than not, in preliminary evaluations an approximate percentage smelter return (eg 75 per cent of the value of the payable copper contained in the concentrate less transport cost) is used to simplify calculations. 131

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis Detailed revenue and cost engineering estimates are beyond the scope of this paper.

Project valuations are at a point in time – discounting cash flows A modern way of looking at cash flows is to consider them like commodities, the value of which is determined by two criteria: timing and risk. Even if there was no risk attached to future cash flows, a rational investor would prefer early rather than later cash flows of equal magnitude, because he or she could in the interim invest the relevant amounts in a bank and generate risk-free interest income. Thus, the risk-free rate of interest compensates the investor for the timing, but not for the risk of future cash flows. In reality, by receiving the cash flows later the investor would forego the return he or she would have expected from the ‘next best opportunity’ available, which may involve a degree of risk to be compensated for by an adequate risk premium, and therefore, a higher riskadjusted ‘opportunity cost’. To compensate for the opportunity cost, future cash flows must be discounted to their present value at an appropriate time and risk adjusted discount rate (RADR).

rate of discount without adding any additional value. Projects with negative NPVs will consume value and should not attract investment. In the example described in Table 9.1, the operating mine adds $74.97 M after paying 13.3 per cent interest on the $41 M investment, compound over the five-year life of the mine. Under the assumptions made, the mine is clearly a good investment. The discount rate at which the NPV becomes zero (ie 68.8 per cent) is known as the internal rate of return (IRR) and is a measure of the project return on equity. Figure 9.1 shows how, at discount rates in excess of the IRR, the NPV of the project becomes negative. As a consequence, if the rate of return required by the investor is higher than the IRR, the project should be rejected. Thus, whether a project is acceptable or not is a function, among other things, of the discount rate that has been applied to it.

IRR = 68.8%

Rates of discount can be expressed as either decimals or percentages. In the example described in Table 9.1, there was a nominal discount rate of 0.133 or 13.3 per cent. A compounding factor is the sum of one plus a rate of interest or discount (eg 1 + 0.133 = 1.133 is the compounding factor at 13.3 per cent for one period, 1.1332 for two periods and 1.133t for t periods). The reciprocal of a compounding factor (eg 1/1.133 = 0.8826 for one year) is the discounting factor for the same number of periods (eg 1/1.133t for t periods). Most readers will be familiar with the process of discounting, which entails determining the present value (PV) of cash flows to be received or disbursed at various periods (t) in the future by multiplying them by an appropriate discount factor for the relevant period (ie 1/(1 + discount rate)t ). To the extent that the corporate objective of an enterprise is to maximise shareholders’ wealth, the paramount criterion of value must be the NPV or value-added. NPV is the sum of all the net project cash flows discounted to their present value: NPV = Σ0t (CFt/(1 + discount rate)t ) If the NPV is positive the investment is acceptable because it adds value after having recouped all capital investments with compound interest equal to the discount rate. A NPV of zero means that the investment repays the capital investment, but only returns the compound 132

Fig 9.1 - Graphical determination of internal rate of return as the

discount rate at which the net present value becomes zero.

Although popular, the IRR has considerable theoretical and computational difficulties (particularly when the project generates alternations of positive and negative cumulative cash flows). Analysts should use it, at best, as a supplementary criterion of value. In addition, the IRR is a measure of return per dollar invested. As such, it is of limited use in comparing projects of significantly different scope. An exhaustive discussion about the pros and cons of using IRR is beyond the scope of this paper, but can be found in Torries (1998, pp 41-47). Other supplementary criteria of value are the: •• capital efficiency index (KE = NPV/PV of CAPEX), which measures the value added per dollar invested; in the above example, KE was $0.32 per dollar invested •• pay-back period, which represents the time that a project takes to repay the initial investment. The payback period can be calculated both on an undiscounted (PBP) and discounted (DPBP) basis. On a discounted basis in the above example, the project breaks even sometime during year 2. Establishing an appropriate discount rate is a complex and ambiguous process both from a theoretical and practical point of view, with a serious danger of Mineral Economics

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis introducing bias in the evaluations. We deal with this issue in greater depth later while dealing with risk. For the time being it is sufficient to recognise that firms face different costs for their equity and debt capital. A common tool for determining the cost of equity (RE) is the capital asset pricing model (CAPM). This model implies that a rational investor, who maximises wealth and minimises risk, but trades risk for return, would only shift funds from government bonds paying a risk-free rate of return (RF) to a risky project if offered an adequate risk-premium over and above the RF to compensate for the additional risk. This risk-premium is the product of the premium on a balanced market portfolio (RM - RF) and a β index reflecting the sensitivity of the returns on the specific asset to movements in the market portfolio. One can think of the market portfolio as containing all securities weighted by their market capitalisation. For example such a portfolio might mimic the ASX’s All Ordinaries Index. Hence, the CAPM formula is: RE = RF + β * (RM - RF) As RE is a measure of the cost of equity only, ie not including any debt, it is an appropriate discount rate if the DCF model, as in the example of Table 9.1, has been constructed under 100 per cent equity assumptions. The after-tax cost of debt (RD × (1 - t) where t is the tax rate) is generally lower than that of equity, because loans are in most instances secured, and the related interest expenses are tax-deductible. This leads to financial leverage, ie to enhanced returns to equity holders, as long as the level of debt in the funding structure of the firm (ie its debt to equity ratio) does not rise to a point where it engenders excessive financial risk and concerns on the side of both the equity and debt providers, who would be seeking increased compensation on account of the increased risk they would bear. Analysts frequently use the weighted average cost of capital (WACC) as the basic discount rate in evaluations involving the use of debt in the funding structure of a project. Its after-tax formula is WACC = D/(D + E) × RD × (1 - t) + E/(D + E) × RE where: D

refers to debt

E

to equity

t

is the effective tax rate

Its before-tax equivalent (ie D/(D + E) × RD + E/(D + E) × RE) is frequently used as the minimum discount rate for models that incorporate the use of debt in the funding structure. This is because the model will automatically compute the interest tax shield, and further reducing the cost of debt by (1 - t) would amount to double counting the tax benefit of borrowing. Mineral Economics

Reconciling cash and financial accounting accrual figures in a discounted cash flow model As their name implies, DCF models deal exclusively with cash and not with commonly encountered financial accounting figures that are typically compiled on an accrual (not cash) basis. Accrual accounting conventions aim at matching revenues with the related expenses in each period. Erroneous mixtures of cash and non-cash figures are commonly the source of potentially significant errors in project evaluations. Occasionally, because of the need to satisfy financial accounting and DCF performance criteria, sophisticated models are constructed in a way that broadly reconciles these two views. This implies modelling the time lags between recognising (ie accruing) a transaction in the financial accounts and the time when the relevant cash actually changes hands. As financial accounts are written in historical or nominal dollars, it is generally more practical to build this type of model in nominal dollars. If the project is operating steadily, and the differences between the related opening and closing balances in the balance sheet (statement of financial position) for certain accrual items may not be significant in terms of the accuracy of the model. Under these circumstances differences in accrued items such as accounts receivable, accounts payable, inventories, work in progress, annual leave and other employees’ provisions, etc are broadly the same from year to year, they can be ignored in the DCF analysis. These items are sometimes referred to as rolling accruals. Royalties and taxes accrued in the first quarter of operations after the mine opens become payable 28 days after the end of the quarter, hence, one quarter of payments are deferred until the time when the mine closes. The fact that in the first year of operation royalties and taxes are only paid for three quarters is generally also neglected in DCF models unless there is a strong desire to slightly improve the value of the project. For some other items, however, the lags between the timing of accrual and cash transactions, and the relevant amount, may be significant enough that if neglected would severely affect the valuation. Given the capital-intensive nature of mining, by far the most significant lags occur between lumpy outflows for initial and sustaining capital investments and their recovery over the useful life of the related assets by way of annual depreciation and amortisation charges against revenue in the profit and loss account. As an investment incentive, the fiscal rates of depreciation for mining assets to determine taxable income are generally faster than the corresponding financial accounting rates on which the annual profit is computed and reported. While the former allows for an accelerated recuperation of the capital invested, the 133

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis latter better reflects the longer effective utilisation of assets in the actual operations, and the combination of these two rates has the effect of deferring significant tax liabilities until late in the mine life. Asset depreciation and amortisation relate to the original, historical acquisition cost of an asset as recorded in the firm’s balance sheet. Over time the asset register will contain a mixture of historical values of different years. Furthermore, selected assets may be periodically re-valued while others are kept at their historical value until fully written off. While depreciation and amortisation are not cash costs (as the cash outflow to establish the assets occurred in a previous period) they do, however, on account of their deductibility from taxable income, influence the income tax payable and eventually paid, and therefore the project cash flows. There is a strong case, if one wishes to avoid the chance of making depreciation-related mistakes, for constructing DCF models in historical or nominal dollars, as there is less danger of underestimating income tax. Significant inflows of a capital nature may also occur if or when assets are salvaged. Significant lags can also occur when provisions are progressively brought to the profit and loss account as legitimate expenses to account for major future capital outflows such as site rehabilitation after mine closure. Other major nonrecurrent cash flows occur if the company draws down or repays loan principal, and in the case of major changes in inventory. These cash flows must be recognised and modelled accurately as they can potentially have a dramatic effect on the value of the project. If a company discovers and develops a mine, its value is generally recorded in the company’s balance sheet at the historical cost of its exploration and development, ie no value is attributable to the mineral resources in the discoverer’s balance sheet. Yet if a company acquires a mine, its acquisition cost incorporates both the tangible value of previous capital investments in the project plus the value of the relevant mineral resources and reserves. The difference between the acquisition cost and the value of the tangible assets (eg of exploration and development) represents an intangible asset in the acquirer’s balance sheet called mining rights, which is subject to amortisation on a unit of production basis. While exploration expenditure is immediately deductible for tax purposes in the year incurred, further differences between the financial and tax accounts are created by the degree of discretion of directors as to whether and when exploration expenditure should be capitalised or expensed in terms of computing the firm’s profit and loss statement. Needless to say, these aspects cause difficulties in properly comparing many conventional financial accounting measures of value, relying as they do on components such as profit, which is a function of 134

accrual conventions like, among others, depreciation and amortisation, rather than on cash flows. A comparison of the annual profits that would be reported by two different owners of the same mine with a life of five years, gross annual revenue of $100 M and recurrent expenses of $60 M before depreciation, tax and amortisation is shown in Table 9.2. Table 9.2 Comparing reported profits and cash flows for a ‘discover-owned and developed’ and an ‘acquired’ mine. Discoverer $M

Acquirer $M

Mine life (years)

5

5

Tangible assets: exploration and development

30

30

Project acquisition price

0

140

Intangible assets: mining rights = price premium paid by acquirer

0

110

Gross revenue

100

100

Recurrent expenditure

-60

-60

Depreciation

-6

-6

Amortisation of mining rights

0

-22

Net operating income before tax

34

12

-10.2

-3.6

Less tax at 30% Net profit after tax

23.8

8.4

Net cash flow after tax

29.8

36.4

The first column relates to the mine being operated by the discoverer after a capital investment of $30 M in exploration and development. The second relates to a company that acquires the mine at start of production for $140 M. It is interesting to note how, on the basis of a year-by-year comparison, the discoverer would post a much higher profit than the acquirer (ie $23.8 versus $8.4 M), even though their annual cash flow is lower because of the absence of cash appropriation against amortisation charges. Clearly just comparing annual profits in isolation will not give a potential investor a proper appreciation of the worth of this project. The acquirer’s lower annual profit, but higher cash flow reflects his need to recover the full $140 M initial acquisition cost, not just $30 M in tangible assets.

Modelling debt and financial leverage Returning to our previous example, let us now assume that the company borrows 50 per cent of the total capital cost of $41 M, ie $20.5 M, using a 7.5 per cent per annum, fixed interest rate, balloon loan repayable after the closure of the mine. The model of Table 9.1 has been modified into that of Table 9.3 to accommodate the borrowing by: •• introducing an inflow of $20.5 M in year 0 to recognise the loan principal draw down, and an outflow of $20.5 M in Year 6 to show its repayment Mineral Economics

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis Table 9.3 Nominal dollars base case discounted cash flow model including borrowing. Nominal bank interest rate %

7.50%

% borrowed

50.00%

Debt: principal drawdowns and repayments $M

20.50

Debt: principal outstanding $M

20.50

Nominal (WACC) discount rate % Year

-20.50 20.50

20.50

20.50

20.50

20.50

0.00

1

2

3

4

5

6

0.04614

0.04614

0.04614

0.04614

0.04614

57.52

59.84

62.25

64.76

67.37

10.40% 0

Gold produced (oz M) Gross sales revenue ($M) Other revenue (salvage)

12.00

Less: Royalty at 2.5%

-1.44

-1.50

-1.56

-1.62

-1.68

Opererating exp ($M)

-16.18

-16.92

-17.69

-18.49

-19.33

Depreciation

-8.2

-8.2

-8.2

-8.2

-8.2

Interest expenses

-1.54

-1.54

-1.54

-1.54

-1.54

0.00

Taxable income

30.16

31.69

33.27

34.91

36.61

12.00

Tax at 30%

-9.05

-9.51

-9.98

-10.47

-10.98

-3.60

Production profit after tax ($M)

21.11

22.18

23.29

24.44

25.63

8.40

Depreciation

8.20

8.20

8.20

8.20

8.20

0.00

Losses carried forward

0.00

0.00

0.00

0.00

0.00

0.00

Less:

Addback:

Working capital CAPEX Debt: principal drawdowns and repayments $M

-2

2.39

-41.00 20.5

0

0

0

0

0

-20.5

Net cash flow ($M)

-22.50

29.31

30.38

31.49

32.64

33.83

-9.71

Discount factor

1.0000

0.9058

0.8205

0.7432

0.6732

0.6098

0.5523

Present value of NCF ($M)

-22.50

26.55

24.93

23.40

21.97

20.63

-5.36

Cumulative DCF ($M)

-22.50

4.05

28.98

52.38

74.35

94.98

89.61

NPV at 10.4%

89.61

IRR

131.21%

1.061

1.093

1.126

1.159

1.194

Periods to break even General inflator

0 1.000

1.030

Real price escalator

1.000

1.010

1.020

1.030

1.041

1.051

1.062

Real cost escalator

1.000

1.015

1.030

1.046

1.061

1.077

1.093

•• inserting a line showing the amount of loan principal outstanding in each year •• inserting a line to show the amount of annual interest expense, ie $20.5 M × 7.5% = $1.54 M/a •• using the before-tax weighted average cost of capital of 10.4 per cent (ie WACC = 50% × 7.5% (fixed interest) + 50% × 13.3% (cost of equity)) as a discount rate. To the extent that the above figures are those that will appear in the financial accounting statements, which by definition are written in historical dollars of the day, they can be used directly in a model built using nominal dollars. It will be noted that only $22.5 M of equity (ie 50 per cent of capital costs and $2 M in initial working Mineral Economics

capital) will now be needed to develop the project. As a consequence, to the degree that the increased financial risk is acceptable to investors, the return on equity is strongly leveraged as shown in Table 9.4. In the previous example, for instance, 50 per cent debt as a proportion of total funds invested (gearing) generates the leverage described in Table 9.4, compared to the same project modelled on a 100 per cent equity funding assumption. Such a direct comparison, however, can be naïve because increases in debt beyond generally accepted, relatively low, industry levels are accompanied by additional financial risk. It is, therefore, inappropriate to compare highly geared and ungeared projects with 135

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis Table 9.4 Leverage effects of gearing. Gearing (%)

Net present value $M

Internal rate of return (%) (nominal)

Discounted Capital payback period efficiency index – years – $NPV/Capex

0

74.97

68.76

2

1.83

20

81.62

74.7

2

2.49

50

89.61

131.21

1

4.37

significantly different risk characteristics using the same time- and risk-adjusted discount rate. Empirical evidence suggests that initially, as the level of debt increases, both providers of equity and debt are not unduly concerned about the marginally higher financial risk. After all, shareholders benefit handsomely from leverage effects and bank loans are generally secured. However, as gearing increases shareholders, who bear the ultimate risk of the firm, become more concerned. Their expectations, in terms of return on equity, will rise steeply to compensate for the additional risk. Also, as gearing continues to rise, even the providers of secured debt become nervous and expect higher interest rates. They fear not being able to fully realise the value of the rather illiquid mining assets provided as collateral in the case of a fire sale. These expectations for higher returns will eventually erode and overcome the tax benefits from the lower after-tax cost of debt vis a vis that of equity. We expand on these issues later when introducing the concept of ‘price of risk’.

Converting a discounted cash flow model from nominal to real dollars It is important to note that in Table 9.5 the NPV of the project at $74.97 M is the same irrespective of whether the model is constructed in nominal or real dollars, provided the nominal dollar cash flows are discounted by the nominal discount rate of 13.3 per cent, and the real dollar cash flows are discounted by its real equivalent of ten per cent (ie real discount rate = (1 + 0.133 nominal discount)/(1 + 0.03 inflation) - 1 = 10%). The IRR found using the real model will differ from the corresponding one found using the nominal model by the inflation factor for one year, ie: Real IRR = (1 + 68.8% Nominal IRR)/ (1 + 3% inflation rate) - 1 = 63.8% The discounted pay-back in year 2 and capital efficiency index of $1.83 are also the same in the nominal and real dollar models. Obtaining the same results, irrespective of the money terms used, provides confidence that the model computations are internally consistent, and it is a good form of quality control. If the straight-line depreciation method has been adopted, the financial statement accounts in successive 136

years will be as in the nominal dollar model of Table 9.3. The amount of annual depreciation expense in the financial accounting statements and in this model is the same in each of the five years because it was computed by dividing the historical cost of the asset by its fiveyear useful life. As, by definition, financial accounts use historical or nominal dollars, these depreciation figures are correctly used in the nominal dollar model, but cannot be used in the real dollar one. To obtain the same NPV in a real dollar model, a range of inputs of the nominal model, such as depreciation, salvage value, fixed interest expenses and loan principal repayment, must be deflated, as in Table 9.5, to reflect their progressively diminishing power of acquisition. Had this not been the case, the NPV of the real dollar model would have been different and incorrect. The error of using nominal depreciation or salvage in real dollar models occurs frequently. It leads to underestimation of the tax liability and overvaluation of projects. Similar mistakes in the handling of fixed interest expenses and loan principal repayments, by contrast, severely punish the value of the project. The handling of the return of working capital at the end of operations is another area likely to bias the result of a model. Assuming that both revenue and expenditures inflated over the life of the mine, so would the value of the initial working capital, which would, therefore, be recouped roughly at its original real value.

Modelling the preproduction period In the previous simplified DCF models of Tables 9.1, 9.3 and 9.5, the $41 M in capital upgrades were handled as an instantaneous investment in year 0, and a simple straight-line depreciation (ie $41 M/five years = $8.2 M depreciation per annum) was applied to all the relevant assets, as shown in Figure 9.2. Let us assume that it would take a two-year preproduction period to procure and construct the relevant assets and that they include a number of different asset categories subject to different depreciation methods. In particular, let us assume that $15 M out of the total of $41 M of real dollar capital investments are spent in the first year, with the remaining $26 M in the second. Let us further assume that assets fall into the following three generic categories in the proportion displayed in Table 9.6: 1. immediately expendable assets, including exploration, environmental and overburden stripping expenditure 2. normal depreciable assets, which mining uses in common with any other sector of the economy 3. project pooled assets, which are specialised and project-specific and which include Mineral Economics

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis Table 9.5 Real dollar model equivalent of the nominal mine model of Table 9.1. Real (WACC) discount rate %

10.00%

Year

(1 + 13.3% nominal discount rate)/(1 + 3% inflation) - 1

0

Gold produced (oz M) Gross sales revenue ($M)

Real price escalation, but no inflation

Other revenue (salvage)

Deflated

1

2

3

4

5

0.046

0.046

0.046

0.046

0.046

55.85

56.40

56.97

57.54

58.11

6

10.05

Less: Royalty at 2.5% Operating exp ($M)

-1.40

-1.41

-1.42

-1.44

-1.45

Real cost escalation, but no inflation

-15.71

-15.95

-16.19

-16.43

-16.68

Deflated

-7.96

-7.73

-7.50

-7.29

-7.07

Real value of depreciation Interest expenses

0.00

0.00

0.00

0.00

0.00

0.00

Profit before tax ($M)

30.78

31.32

31.85

32.38

32.91

10.05

Losses carried forward

0.00

0.00

0.00

0.00

0.00

0.00

Less: Tax at 30%

-9.23

-9.39

-9.56

-9.72

-9.87

-3.01

Production profit after tax ($M)

21.54

21.92

22.30

22.67

23.04

7.03

7.96

7.73

7.50

7.29

7.07

0.00

Addback: Depreciation Working capital

-2

2.00

Sustaining capital CAPEX

0.00

0.00

0.00

0.00

0.00

0

0

0

0

0

0

0

-43.00

29.50

29.65

29.80

29.95

30.11

9.03

-41.00

Debt: principal drawdowns and repayments $M Net cash flow ($M) Discount factor

1.0000

0.9091

0.8264

0.7513

0.6830

0.6209

0.5645

Present value of NCF ($M)

-43.00

26.82

24.50

22.39

20.46

18.70

5.10

Cumulative DCF ($M)

-43.00

-16.18

8.33

30.72

51.18

69.87

74.97

Periods to break even

0

1

NPV at 10%

74.97

Real IRR

63.8%

General inflator

1.000

1.030

1.061

1.093

1.126

1.159

1.194

Real price escalator

1.000

1.010

1.020

1.030

1.041

1.051

1.062

Real cost escalator

1.000

1.015

1.030

1.046

1.061

1.077

1.093

68.8%

•• mining capital expenditure (MCE)

Straight line depreciation

Written down value $'000

Nominal IRR =1 + real IRR * 1.03 =

•• transportation capital expenditure (TCE)

45000 40000 35000 30000 25000 20000 15000 10000 5000 0

•• project infrastructure •• sustaining capital expenditure (SCE). It will be noted that the original aggregated estimate of $41 M in real dollars corresponds to a nominal as constructed cost of $44.1 M spread over the two preproduction years. The latter is the figure on which depreciation will be based. 0

1

2

3

4

5

Year Wrritten down value $'000

Fig 9.2 - Straight-line depreciation used in the discounted cash flow models

of Tables 9.1, 9.3 and 9.5.

Mineral Economics

6

Sometimes money is borrowed to fund capital works during preproduction while the project is entirely cash flow negative. Then the relevant interest has to be capitalised, ie added to the cost of the project. It is, therefore, critical that when valuing a project the analyst be clear as to whether the capital expenditure estimates 137

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis studies up to the point where a decision to develop a project is taken.

Table 9.6 Capital expenditure breakup in real and nominal dollar values. Year

0

1

2

1.00

1.50

3

Year 0 (real) dollar CAPEX estimates $M Immediately expedaible items Exploration Environmental

1.00

Feasibility study

0.50

Overburden stripping

1.50 2.00

Normal depreciable assets

4.50

6.67

Pooled project assets

9.00

13.33

Sustaining capital Annual real dollar capital expenditure

15.00

26.00

Total real 41.00

Average annual inflation rate % Inflator

1.000

1.030

1.061

Real cost escalator

1.000

1.015

1.030

Exploration

1.05

1.64

Environmental

0.00

1.09

Feasibility study

0.52

1.64

Nominal dollar CAPEX estimates $M Immediately expendable items

Overburden stripping

2.19

Normal depreciable assets

4.71

7.29

Pooled project assets

9.41

14.57

15.68

28.42

Sustaining capital Annual nominal dollar capital expenditure

Total as constructed 44.10

are in real or nominal dollars and whether they include capitalised interest. As the nominal as constructed asset values are higher than the corresponding real dollar estimates, so will be the related depreciation charges and the degree to which the project will be shielded from taxes. As already indicated, the first category of capital assets is immediately expendable for the purpose of assessing taxable income. The same assets, however, may be capitalised and depreciated over their useful lives for reporting purposes in the profit and loss account of the financial accounting statements, which attempt to match the revenue received in each period with the degree to which assets were utilised to achieve it. Writing off the exploration, environmental and stripping expenditures in the year in which they are incurred (ie years 1 and 2) will generate an equivalent loss in those years. It is worth pointing out that in Australia at least, the definition of exploration in the taxation legislation is rather generous, as it includes all expenditures incurred, both capital and recurrent, from reconnaissance exploration through full feasibility 138

The losses incurred during the preproduction period can be carried forward until the project generates adequate taxable income against which they can be defrayed. This function must be incorporated in the DCF model of the project. The taxation office provides a schedule of recommended useful lives for normal depreciable assets. These may vary from a few years, as for instance for computers, to very long, up to many tens of years for long-lived assets such as tailings dams. If one has detailed knowledge of the nature and value of different asset categories, then the depreciation charge can be computed for each of them. However, in preliminary evaluations, normal depreciable assets values are cumulated and depreciated using an estimated weighted average useful life. In our example, as shown in Table 9.7, this will be assumed to be nine years. In the case of project pooled assets, the preferred method of depreciation is the declining-balance or diminishing value. This approach to depreciation results in the value of assets decreasing faster in the earlier years of use, and is, therefore, sometimes referred to as accelerated depreciation. To create a further incentive for investment in new assets, government sometimes further accelerates the rate of depreciation by allowing the depreciable asset base to be increased by an investment premium (Figure 9.3). This is currently set in Australia at 200 per cent of the written down values. A comparison to the corresponding straight line method is shown in Table 9.8. Table 9.7 is connected to the DCF model of Table 9.9 and its last line provides the annual depreciation charges applicable in each year of the model. It must be noted that in the example, for the sake of simplicity, depreciation of normal and project pooled assets is set to commence at the start of production in year 3. In reality, some assets used during mine development and construction would have started depreciating during the preproduction stage, thus contributing to the losses to be carried forward. Particular care needs to be paid to make sure that the losses carried forward are progressively deducted from taxable income as this is adequate to cover them. It must also be remembered that the losses are cash outflows when incurred, in our case during preproduction, but that they are not a cash outflows when they are carried forward and deducted from future taxable income. For this reason they need to be added back to the net profit after tax to calculate the net after-tax cash flow for the year in which they were deducted. From a practical point of view, the easiest way to build a DCF model including preproduction is to first build a simple model, as in Table 9.1, taking care that all algorithms are fully interactive, and then insert Mineral Economics

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis

Table 9.7 Depreciation. YEAR

0

1

2

1.05

1.64

Feasibility study

0.52

1.64

Overburden stripping

0.00

2.19

3

4

5

6

7

8

Nominal dollar CAPEX estimates $M Immediately expensible items Exploration Environmental

1.09

Normal depreciable assets

4.71

7.29

Pooled project assets

9.41

14.57

15.68

28.42

1.57

6.56

Sustaining capital Annual nominal dollars CAPEX

Written down value

Annual write-offs and depreciation $M Immediately expensible items Normal depreciable assets

1.33

1.33

1.33

1.33

1.33

5.33

23.98

14.39

8.63

5.18

3.11

Depreciable base

47.96

28.78

17.27

10.36

6.22

Depreciation pooled project assets

9.59

5.76

3.45

2.07

1.24

1.86

Total write-offs and depreciation 1.57 6.56 Diminishing value depreciation (200% premium)

10.93

7.09

4.79

3.40

2.58

7.19

9

Average effective life (years) Pooled project assets Project life (years)

5

Premium

200%

Opening written down value

Written down value $'000

Sustaining capital

Table 9.8 Comparison between diminishing-value and corresponding straight-line depreciation amounts.

45000 40000 35000 30000 25000

Acquisition cost $'000: 41 000

20000 15000 10000

Year

Straight-line Written down Value

5000 0 0

1

2

3

4

5

6

Year Written down value $'000

Fig 9.3 - Graphical example of diminishing-value depreciation with

200 per cent asset base premium.

the additional columns necessary to accommodate the preproduction period. If the model is internally interactive, most cells will adjust automatically to the deferral of the operating cash flows by two years, and most of the effort would be concentrated in making sure that the relevant capital investments, depreciation charges and losses carried forward are calculated, and their effect on the final net after-tax cash flows is correct. From Table 9.9 it can be seen that the introduction of the predevelopment period had a number of impacts. Mineral Economics

Depreciation $’000

Asset life (years): 5 Diminishing value Written down Value

Depreciation 200% premium

0

41000.00

1

32800.00

8200.00

41000.00 24600.00

16400.00

2

24600.00

8200.00

14760.00

9840.00

3

16400.00

8200.00

8856.00

5904.00

4

8200.00

8200.00

5313.60

3542.40

5

0.00

8200.00

3188.16

2125.44

First, the increased depreciation charges and the losses carried forward had the effect of shielding taxes and increasing net after-tax cash flows. However, this was more than compensated for by the effect of deferring both revenue and expenditure cash flows by two years given that the former exceeds the latter in each year. The net result is that the NPV of the project fell from $74.97 M for the simple model of Table 9.1 to $61.73 M for the model including the preproduction period. 139

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis Table 9.9 Discount cash flow model including a two-year preproduction period. Year

0

1

2

Gold produced (oz M)

3

4

5

6

7

0.046143

0.046143

0.046143

0.046143

0.046143

62.25

64.76

67.37

70.08

72.91

Gross sales revenue ($M)

8

Other revenue (salvage)

12.73

Less: Royalty at 2.5%

-1.56

-1.62

-1.68

-1.75

-1.82

Opererating exp ($M)

-17.69

-18.49

-19.33

-20.21

-21.13

Depreciation Interest expenses

-1.568175

-6.5577942

-10.92507

-7.087974

-4.785715

-3.404359

-2.575546

-7.1941334

0.00

0.00

0.00

0.00

0.00

0.00

0.00

0.00

Profit before tax ($M)

-1.57

-6.56

32.08

37.56

41.57

44.72

47.38

5.54

Losses carried forward

-1.57

-8.13

0.00

0.00

0.00

0.00

0.00

0.00

Taxable income

0.00

0.00

23.95

37.56

41.57

44.72

47.38

5.54

0

0

-7.186474

-11.26801

-12.46991

-13.41484

-14.21404

-1.661

0.00

0.00

16.77

26.29

29.10

31.30

33.17

3.88

10.93

7.09

4.79

3.40

2.58

7.19

8.13

0.00

0.00

0.00

0.00

0.00

0.00

0.00

0.00

0.00

0.00

Less: TAX at 30% Production profit after tax ($M) Addback: Depreciation Losses carried forward

0.00

Working capital

0.00 -2.1218

2.53

Sustaining capital CAPEX

-15.68374

-28.415032

Debt: principal drawdowns and repayments $M

0

0

0

0

0

0

0

0

0

Net cash flow ($M)

0

-15.68374

-30.536832

35.81948

33.37999

33.88217

34.70566

35.74164

13.60334

Discount factor

1

0.882613

0.77900488

0.687559

0.606849

0.535612

0.472738

0.417245

0.3682652

Present value of NCF ($M)

0.00

-13.84

-23.79

24.63

20.26

18.15

16.41

14.91

5.01

Cumulative DCF ($M)

0.00

-13.84

-37.63

-13.00

7.25

25.40

41.81

56.72

61.73

1

2

3

Periods to break even

NPV

General inflator

1

1.03

1.0609

1.092727

1.125509

1.159274

1.194052

1.229874

1.2667701

Real price escalator

1

1.01

1.0201

1.030301

1.040604

1.05101

1.06152

1.072135

1.0828567

Real cost escalator

1

1.015

1.030225

1.045678

1.061364

1.077284

1.093443

1.109845

1.1264926

COMPARISON OF MUTUALLY EXCLUSIVE PROJECTS WITH DIFFERENT LIVES Project evaluation has to do with choices. Even when one values a single project using DCF analysis, its acceptability as an investment depends on the return on the project exceeding the return from investing the money in the next best alternative, or at the limit leaving the money in the bank. Engineers often have to make a choice between two alternative pieces of plant or equipment with different capital and operating costs and expected useful lives. As an example, consider a decision whether to purchase one of two pumps, A or B, with four and six years expected lives and prices of $15 000 and $20 000 respectively. In the first instance, let us assume that their operating cost is the same. 140

It is not possible to make a correct choice consistent with one’s required discount rate without first making the capital cost of the two pumps comparable on a perunit-of-time basis. This can be done by converting the acquisition costs of the two pumps into their annual equivalent values (AEV) and selecting the lower of the two. The AEV is obtained by dividing the capital expenditure of each pump by the annuity factor for the number of years equal to its expected life at the required discount rate. The annuity factor in arrears at an interest rate of i for n years is: Ain years = [1 - (1 + i)-n]/I which is the same as the sum of the individual discount factors for interest i for year 1, 2, 3… n. Mineral Economics

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis

The choice would change if pump A cost $1500 annually to operate and pump B $2000 annually, because their respective total annual equivalent costs would become $6232 for pump A and $6592 for pump B. An alternative approach to compare the value of assets with different lives is to assume a number of assets replacements such that their combined lives become the same. For instance, repeating the investment in pump A three times and in pump B twice makes costs over a combined period of 12 years comparable. This approach is illustrated in the DCF model of Table 9.10, which confirms that pump A has the lowest combined capital and operating cost. As can be seen in Figure 9.4, the choice of pump is a function of the discount rate selected. At a discount below approximately eight per cent, pump B would become preferable.

INHERENT WEAKNESSES AND COMMON TRAPS IN DISCOUNTED CASH FLOW ANALYSIS Aside from the common error of mixing nominal and real dollar term items in the same model, particularly when dealing with depreciation and fixed-interest loans, there are other fundamental inherent weaknesses in DCF analysis. This is because a DCF/NPV approach values and compares projects with inherently different risk characteristics using the same risk- and time-adjusted discount rate. This leads to a view that larger, faster production rates will, in the majority of cases, generate economies of scale and, therefore, are the best alternative. If ‘the larger, the sooner, the better’ belief is pushed to the limit, in the presence of large ore reserves and disregarding possible market saturation effects on the price of the commodity mined, the value of a mine will

-30000 -35000

Total PV cost $

If the required discount is ten per cent, pump A, with an annual equivalent value of $4732 (ie $15 000/3.1699), is more expensive than B with an AEV of $4592 (ie $20 000/4.3552). If the operating cost of the two pumps is the same, the investor would select pump B.

-40000 -45000

Pump A Pump B

-50000 -55000 -60000 -65000

0%

5%

10% 15% Discount rate %

20%

Fig 9.4 - Comparing assets with different lives.

be optimised by expanding capacity indefinitely. This, however, does not happen in practice. There is evidence that, as the initial capital investment becomes substantial, management becomes uncomfortable and intuitively starts doubting the realism of its basic optimisation beliefs. Their behaviour is easy to justify. This is because the variability of cash flows, sensitive to volatile levels of demand for the metal produced, increases with the capital-intensity of alternative project designs, as the following simplified example illustrates. Table 9.11 displays two alternative ways of developing a project producing 30 000 t/a of a metal currently priced at $3000/t. The first (A) is a capital-intensive design resulting in $30 M annual fixed costs with a low variable unit cost of $1000/t of metal produced. The second (B) is a labour-intensive design with a relatively low annual fixed cost at $10 M, but a high variable unit cost of $1667/t. At the current level of demand both projects generate the same gross annual cash flow of $30 M. However, the cash flows of the capital-intensive project are more sensitive to changes in demand than those of the labour-intensive project. If demand for the metal falls or rises by 25 per cent, the cash flow of project A falls to $15 M, or rises to $45 M respectively.

Table 9.10 Comparison of the total cost of assets with different lives. Year

0

1

2

3

4

5

6

7

8

9

10

11

12

Pump A lasting four years Acquisition capital cost

-15 000

Annual operating cost Total cost

-15 000

Present value of pump A cost

-42 463

-15 000

-15 000

-1500

-1500

-1500

-1500

-1500

-1500

-1500

-1500

-1500

-1500

-1500

-1500

-1500

-1500

-1500

-16 500

-1500

-1500

-1500

-16 500

-1500

-1500

-1500

-1500

-1700

-1700

-1700

-1700

-1700

-1700

-1700

-1700

-1700

-1700

-1700

-1700

-1700

-1700

-1700

-1700

-1700

-21700

-1700

-1700

-1700

-1700

-1700

-1700

Pump B lasting six years Acquisition capital cost

-20 000

Annual operating cost Total cost

-20 000

Present value of pump A cost

-42 873

Mineral Economics

-20 000

141

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis Table 9.11 Comparing the risk of projects with different capital intensity. Company Price $/t Production t × '000

A capital intensive

B labour intensive Demand volatility % pa

3000 30

A capital intensive

B labour intensive

25.00%

30 Sensitivity of gross CFs to changes in demand

Revenue $'000

90 000

90 000

Variable cost of production $/t

1000

1666.667

Annual fixed cost $'000

30 000

10 000

22.5

15 000

22.5

20 000

Total annual cost of production $'000

60 000

60 000

30

30 000

30

30 000

Gross annual cash flow $'000

30 000

30 000

37.5

45 000

37.5

40 000

The volatility of its cash flows at 40.82 per cent is much higher than that of project B at 27.22 per cent. Table 9.12 depicts the case where the same gross annual cash flow of $30 M is achieved by two different projects, the unit production costs of which are fully variable but different. In the example the unit cost of production of project A at $2000/t is lower than that of project B at $2500/t. For project B to generate the same gross cash flow as project A, it must produce twice the sales volume, ie 60 000 t/a instead of 30 000 t. A single discount rate attributes the same value to the annual cash flow of both these projects. However, the high-cost project B is more sensitive to variations in commodity prices than is project A. A commodity price volatility of 25 per cent leverages the cash flow variability of project B to 122.47 per cent, much more than that of project A at 61.24 per cent. It would not be objective to compare the values of projects A and B in the two scenarios portrayed using a single discount rate. To be more objective and still use conventional DCF analysis we would have to apply

30 000

30 000

Standard deviation of CFs $'000

12 247

8165

Standard deviation of CFs %

40.82%

27.22%

progressively higher and higher, risk-loaded discount rates to compensate for the increasing risk created by high operating leverages. One could price the variability or risk of the cash flows of a project by determining a specific discount rate for each percentage level of cash flow volatility. Table 9.12 shows that if, for instance, one were to price the risk at the rate of 0.10 per cent for each one per cent of cash flow volatility, then the risk discount appropriate to project A would be 6.12 per cent and for project B 12.25 per cent. Salahor (1998) has demonstrated how this measure of price of risk can be derived and how it is in fact consistent with the risk-adjusted rate of discount derived using the popular CAPM logic. The derivation of prices of risk is beyond the scope of this discussion. The consequence of making choices using the same discount rate is that riskier projects may be overvalued vis a vis less risky ones. Additional bias may also arise in DCF analysis by using a single discount rate for both the riskier revenue and less risky cost function of an individual financial model. The variability of the price of some commodities can be as high as plus or minus

Table 9.12 Comparing the risk of projects with different unit operating costs. Company

A

B

A

B

Low

High

Low

High

Price $/t

3000

Cost of production $/t

2000

2500

Sensitivity of gross CFs to price changes

30

60

30 000

30 000

Annual production t × '000

Price volatility % pa

25.00%

Annual Revenue $'000

90 000

180 000

2250

7500

-15 000

Annual operating cost $'000

60 000

150 000

3000

30 000

30 000

Annual gross cash flow $'000

30 000

30 000

3750

52 500

75 000

18371

36742

Standard deviation of CF $'000 Volatility of CF % Price of risk = % discount per 1.00% of CF volatility =

142

0.10%

61.24%

122.47%

6.12%

12.25%

Mineral Economics

chapter 9 – Mineral project evaluation – Financial modelling and discounted cash flow analysis 100 per cent in a single year. This plays havoc with the realism of revenue estimates. It is for this reason that commentators describe mining projects as price-risked. By contrast, much of the capital investment occurs in the present and is relatively easier to estimate correctly. One would also have to be a very poor project planner and manager if one was to incur recurrent operation and maintenance cost over-runs of over ten per cent. In addition, management can generally devise and implement strategies to keep costs on average on budget. Depending on the relative timing of revenue inflows and cost outflows, choices may be biased against investing now to save costs later, and/or favouring future and more risky patterns of revenue inflows. This source of bias can be eliminated, as will be seen in Chapter 10, by discounting the less risky operating costs of a project at a lower rate than that of its riskier revenue.

CONCLUSIONS In summary, it can be concluded that: •• The use of cost- and/or market-based valuation methodologies is generally confined to projects at the exploration to prefeasibility stages of development, when an initial development concept and related costing have not yet been formulated. •• From the conceptual design to the feasibility and development stages the main criteria of value are derived from the financial DCF model of a project. •• The most important criterion of value is the NPV – a measure of the value added by the project after returning the initial and sustaining capital investments with interest equal to the discount rate. This is a measure of the compensation expected by investors for the timing and risk of future project cash flows. •• A DCF model can be constructed in either nominal (ie including inflation) or real (ie excluding inflation) money terms. If care is taken to ensure that all inputs of a model are consistently cash and not financial accounting accrual items, and all nominal or real, then the resulting NPVs will be identical. •• Initial models are generally constructed under the assumption of certainty and 100 per cent equity funding, using single-point expected or mean values of inputs and generating single-point expected or mean outputs. •• Models must be constructed in a fully interactive way by not typing any numerical input in their algorithms, but rather by referring to them in a

Mineral Economics

separate table of inputs and by testing some of the results manually using a pocket calculator. Only models that are fully interactive can then be used for risk analysis, ie sensitivity and scenario analyses and Monte Carlo simulation. •• Modelling of a preproduction period requires care in determining the correct values on which assets depreciation will be based, in determining the amount of losses to be carried forward, and their effect on the cash flows of the future years in which they are deducted. •• While DCF analysis remains the most important valuation methodology, it has some inherent weaknesses, mostly stemming from the use of a single time- and risk-adjusted discount rate to compare the value of projects, which may have very different risk characteristics.

REFERENCES Bourassa, M J, 2001. International legal requirements and standards for mineral valuation, in Proceedings Valmin 2001 Conference (The Australasian Institute of Mining and Metallurgy: Melbourne). Guj, P and Nakamura, R, 2011. Are project evaluation assumptions realistic? CET Quarterly News, issue 15, March 2011. JORC, 2004. Australasian Code for Reporting of Exploration Results, Mineral Resources and Ore Reserves (The JORC Code) [online]. Available from: (The Joint Ore Reserves Committee of The Australasian Institute of Mining and Metallurgy, Australian Institute of Geoscientists and Minerals Council of Australia). Lawrence, M J, 2001. An outline of market-based approaches for mineral asset valuation best practice, in Proceedings Valmin 2001 Conference (The Australasian Institute of Mining and Metallurgy: Melbourne). Roscoe, W E, 2001. Outline of the cost approach to valuation of mineral exploration properties, in Proceedings Valmin 2001 Conference (The Australasian Institute of Mining and Metallurgy: Melbourne). Salahor, G, 1998. Implications of output price risk and operating leverage for the evaluation of petroleum development projects, The Energy Journal, 19(1):13-46. Taylor, H K, 1978. Mine valuations and feasibility studies, Mineral Industry Costs (Northwest Mining Association: Spokane). Torries, T F, 1998. Evaluating Mineral Projects: Applications and Misconceptions (Society for Mining, Metallurgy and Exploration: Littleton). VALMIN Committee, 2005. Code for the Technical Assessment and Valuation of Mineral and Petroleum Assets and Securities for Independent Expert Reports – The VALMIN Code, 2005 edition [online]. Available from: .

143

HOME

Chapter 10 Mineral Project Evaluation – Dealing with Uncertainty and Risk Pietro Guj Introduction – beyond discounted cash flow/net present value analysis Risk analysis – identifying and quantifying financial risk: expected value, sensitivity and scenario analyses Probabilistic financial models and Monte Carlo simulations Attitudes to risk – from expected value to expected preference value (certainty equivalents) and pricing of risky projects Understanding the nature of risk and risk-neutral expected returns From risk-neutral to risk-averse investment decisions Risk preferences and the price of risky investment opportunities Risk spreading through joint ventures Bayesian (decision trees) and progressive risk and value analysis Size distribution of mineral deposits and the Zipf law From static discounted cash flow/net present value to dynamic real option valuations A different logic Types of real options in mining projects The market has been effective at setting real option values Using the Black and Scholes formula to estimate the real option value of the Sally Malay project Modern asset pricing using commodity forward prices Fundamental real option principles – value consistency, no-arbitrage and replicating portfolios Commodity-forward prices as certainty equivalents Using binomial lattices to value real options in practice Valuing an expansion option with the binomial lattice and binomial tree methods using the ‘riskneutral’ probability

Binomial lattice method

Binomial tree method Valuing tonnage-grade trade-offs Valuing a farm-in/out sequential/compound option

Mineral Economics

145

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk

Differences between real option value using binomial trees and ‘hybrid’ real option value decision trees Strategic real option value considerations Conclusions

INTRODUCTION – BEYOND DISCOUNTED CASH FLOW/NET PRESENT VALUE ANALYSIS Much of Chapter 9 dealt with evaluations under assumptions of certainty. However, the only thing one can be certain about is that virtually all of the single-point estimates of the inputs and outputs of a discounted cash flow (DCF) model are in fact uncertain. Uncertainty is the variability of the distribution of all possible values around their estimated, expected or mean value. Uncertainty has both an up and a down side, and for the purpose of this chapter: •• risk is the potentially negative effect of uncertainty relative to one’s objectives, eg the chance of the actual outcomes being below expectations or even a loss, while •• opportunity is the other side of the distribution leading to potentially higher than expected gains. Risk analysis seeks to identify and quantify the impact that varying degrees of uncertainty surrounding various model parameters will have on the performance of an investment, but it does not determine how an investor should handle the related risk. Typical tools for risk analysis, such as sensitivity analysis, scenario analysis and Monte Carlo simulation will be discussed early in this chapter. The performance of a project may be very sensitive and deeply affected by the volatility of some critical inputs. Yet a project may still be quite attractive as an investment notwithstanding the presence of a number of uncertain inputs, provided: •• the investor is in a position to bear the consequences of possible unfavourable project conditions if they eventuate, or •• the project is designed in a flexible manner with the capacity to anticipate and ideally take advantage of likely eventualities. The performance of most projects is not as static as the deterministic nature of standard DCF analysis would imply. A decision to invest in a project based exclusively on a conventional DCF/NPV without a riskmanagement strategy would imply that the investor is inflexibly committed to the project plan, irrespective of unfolding future events. In fact, very few projects evolve and are managed strictly according to plans. Managers can generally react to events, whether anticipated or not, and modify their actions in such a manner as to minimise the potential impact of 146

uncertainty. The science of anticipating and planning strategies to alleviate or even neutralise the potentially negative impacts of uncertain events is known as risk management. The extent to which investors seek and manage risky investments is a function of their individual or corporate risk tolerance and related attitude to risk, which is typically strongly influenced by their level of wealth. Our discussion in this chapter will explore how static DCF valuations, which back risk-neutral investment decisions based on expected monetary value (EMV), can be analysed and modified to account for individual risk-aversion, generating risk-adjusted, or certainty equivalent (Cx) based, measures of value. We will further address how financial option valuation methodologies can be adapted to assess the real option value (ROV) naturally inherent or created by the design or contractual characteristics of many tangible, but risky, resources projects. This is an area of rapid and exciting development in the field of project evaluation. It will be discussed how valuation concepts and methodologies in common use in the valuation of financial derivatives can be gainfully adapted for use in RO valuations of resources projects, with emphasis on binomial lattices and binomial trees as the most practical tools for the relevant calculations.

RISK ANALYSIS – IDENTIFYING AND QUANTIFYING FINANCIAL RISK: EXPECTED VALUE, SENSITIVITY AND SCENARIO ANALYSES A financial model constructed under an assumption of certainty and based on single-point expected or mean input estimates generates single-point expected output results1. As already noted, this type of model is often referred to as the base case. Most inputs are, however, uncertain and the actual values, which will eventuate in nature according to their probability distribution of occurrence, may be significantly different from those used in the base case model. 1 The output of such models will be close to the expected value obtained by simulation as long as the single point estimates are the actual means of the probability distributions of inputs used in the simulation. This is sometimes not the case leading to erroneous differences. Mineral Economics

Chapter 10 – MIneral projeCt eValUatIon – DealIng wIth UnCertaInty anD rISk Provided the base case model has been constructed in a fully interactive manner, one can determine the sensitivity of the project results to: changes in the value of individual inputs (sensitivity analysis), or • likely or extreme combinations of input values (scenario analysis). As already discussed in Chapter 9 there are some useful rules to ensure a model is fully internally interactive, including: •

never typing numbers in a model algorithm, rather refer to them in a separate table of assumptions • always checking the results of a spreadsheet column before and after changes in major inputs using a pocket calculator making sure that they are identical • constructing the model in both nominal (including inflation) and real (excluding inflation) money terms and ensure the two NPVs are identical. Sensitivity and scenario analyses have been greatly facilitated by the capacity to construct interactive models on computer spreadsheets and by specialised risk analysis software. The degree to which models can accommodate changes in input variables is, however, limited to ‘relevant ranges’ beyond which results become nonsensical. For instance, one cannot test the sensitivity of a project to an excessively wide range of commodity prices, as significant variations would affect the optimal cut-off grade, the size of the reserves, the optimal ore throughputs, and as a consequence the size and capital cost of mining and milling equipment and related unit operating costs. At the limit, the very design of the mine may switch from underground to open cut and vice versa. In other words, project outcomes are only a continuous function within limited ranges of key input values, beyond which they may display discontinuous, steps reflecting different optimal mine designs. •

However, within acceptable ranges, sensitivity analysis provides significant insights into the risk of a project, by determining which input variables the project is most sensitive to. The ‘spider diagram’ of Figure 10.1 shows how the NPV of the mine project of Table 9.1 (in the preceding Chapter 9) is highly sensitive to variation in factors affecting its revenue, both exogenous (eg market risk associated to gold prices and exchange rates) and endogenous (eg private or project risk associated with gold grades, reserve tonnages and recoveries), which is typical behaviour for mining resources projects. A left-sloping curve (eg prices and grades) denotes a positive correlation between the NPV and the related input, a slope to the right (eg exchange rates) a negative one. The steepness of the slope indicates the degree of correlation. Overlapping curves (eg prices, grades and recoveries) denote perfect correlation between the related variables. If one can estimate realistic ranges of possible input values, a ‘tornado diagram’, such as that of Figure 10.2, can be helpful to assess and rank their respective impact and better focus efforts on which additional information would create the most value. For instance one could reduce the uncertainty of grades and tonnages with some additional, critically located, in-fill drilling, and thus a more refined resources model. Alternatively, a value study could be undertaken to trim the capital investment estimates. There is a limit as to how much money is justifiable in collecting additional information to progressively dispel uncertainty before its marginal cost exceeds its marginal value in terms of reducing the cost of error. Mining is typically carried out on the basis of relatively imperfect information. Unfortunately, no amount of further research will resolve the uncertainty surrounding the exogenous inputs (eg prices and exchange rates) that are subject

Fig 10.1 - A spider web diagram. Mineral economics

147

Chapter 10 – MIneral projeCt eValUatIon – DealIng wIth UnCertaInty anD rISk

Fig 10.2 - A Tornado diagram.

to the vagaries of markets on which the investor cannot in most cases exert any influence. If the potential consequences of their downside, multiplied by their respective probabilities of occurrence, are too severe, the only course of action is to manage the related risk by hedging or by rejecting the investment. A useful form of scenario analysis is the revenue/ cost scenario matrix, as exemplified in Figure 10.3. The matrix displays the values that the NPV of the DCF model of Table 9.9 (Chapter 9) may assume under various combinations of real price (y axis) and cost (x axis) escalation. This type of matrix is easy to construct and contour using the standard table function provided in Excel. It is also easy to interpret, as for instance in Figure 10.3, which clearly shows that the project is financially robust. Contouring shows that it would take the combined and compound effect of severe (7.5 per cent) annual increases in real costs and falls (-9.5 per cent) in commodity prices for the NPV of the project to turn negative. This figure also shows a range of realistic combinations which would result in the NPV exceeding its expected base case value of $61.73 M.

PROBABILISTIC FINANCIAL MODELS AND MONTE CARLO SIMULATIONS In both the spider and tornado diagrams, and the revenue-cost scenario matrix, we used increments and ranges of possible input values without any reference

Real price escalation

61.73 -9.0% -7.0% -5.0% -3.0% -1.0% 1.0% 3.0% 5.0% 7.0% 9.0% 11.0%

9.5% -6.79 1.33 10.13 19.72 30.17 41.55 53.92 67.36 81.96 97.79 114.95

7.5% -1.14 6.92 15.71 25.30 35.75 47.13 59.50 72.95 87.54 103.37 120.53

5.5% 4.07 12.13 20.92 30.51 40.96 52.34 64.71 78.16 92.75 108.58 125.74

to the probability of occurrence of any specific value within the range. Analysts are never completely ignorant, and can do better than attributing the same probability of occurrence (Laplace criterion) to all of the possible values for an input between a minimum and a maximum value within the range, ie in a uniform or rectangular distribution. For the majority of inputs they have some knowledge of how their values are likely to distribute, ie of the probability with which various input values may occur. At worst, they can guess their most likely (modal), minimum and maximum possible values in order to use them in a triangular distribution. Depending on the nature of an input, its probability distribution may be: discrete or continuous symmetrical (eg rectangular, triangular, normal); or asymmetrical/skewed (eg triangular, log-normal, binomial, exponential) Many natural phenomena (eg ore grades, size of mineral and petroleum accumulations, prices in general) are characterised by positively skewed lognormal distributions, in which the logarithm of possible values distribute normally. Handling lognormal distributions correctly requires some practice and care. As an alternative, analysts often use an asymmetrical triangular distribution as a surrogate, • • •

Real cost escalation 3.5% 1.5% -0.5% 8.93 13.46 17.69 16.99 21.52 25.75 25.78 30.31 34.54 35.37 39.90 44.13 45.82 50.35 54.58 57.20 65.96 61.73 69.57 74.10 78.33 83.02 87.55 91.78 97.61 102.14 106.37 113.44 117.97 122.20 130.60 135.13 139.36

-2.5% 21.63 29.69 38.48 48.07 58.53 69.90 82.27 95.72 110.31 126.15 143.30

-4.5% 25.31 33.37 42.16 51.75 62.20 73.58 85.95 99.40 113.99 129.83 146.98

-6.5% 28.75 36.80 45.59 55.19 65.64 77.01 89.39 102.83 117.43 133.26 150.41

-8.5% 31.95 40.00 48.80 58.39 68.84 80.22 92.59 106.03 120.63 136.46 153.62

Fig 10.3 - Contoured revenue-cost scenario matrix displaying possible net present value corresponding to

various combinations of real revenue and cost escalations in the discounted cash flow model of Table 9.9.

148

Mineral economics

Chapter 10 – MIneral projeCt eValUatIon – DealIng wIth UnCertaInty anD rISk as shown in Figure 10.4. When doing this, however, it must be remembered that the triangular distribution is based on three parameters: the minimum value, the most likely value (or mode) and the maximum value. If the distribution is asymmetric, the value of its mean and mode will be different and their relationship will be:

surrounding distribution of all possible outcomes and a range of relevant statistics.

Mean = (Minimum + Mode + Maximum)/3

gold prices (lognormal, mean US$1024/oz and standard deviation US$196/oz) • exchange rates US$:A$ (normal truncated, mean 0.854, standard deviation 0.1, minimum 0.75 and maximum 1.05) • grades (triangular, minimum 3.4 g/t, most likely 3.8 g/t and maximum 4.5 g/t) • recoveries (normal truncated, mean 0.92, standard deviation 0.08, minimum 0.89 and maximum 0.95) • capital investment (triangular, minimum $37 M, most likely $39 M and maximum $47 M) • waste mining (lognormal, mean $2.5/t, standard deviation $0.4/t) • ore mining (lognormal, mean $3.0/t, standard deviation $0.5/t) • milling costs (lognormal, mean $12.0/t, standard deviation $1.0/t). After 30 000 iterations the simulation generated an expected NPV for the project of $76.18 M (close to the base case NPV of $74.97 M), within a positively skewed distribution of possible values having a standard deviation of $31.70 M. The histogram of Figure 10.5 shows that minimum and maximum NPVs of -$5.86 M and $283.42 M are possible, albeit with infinitesimal probabilities of occurrence. The cumulative probability distribution of Figure 10.6 shows that:

Fig 10.4 - Relationship between the continuous lognormal distribution of gold

prices and its triangular distribution proxy. Use of the latter to substitute to highly skewed distributions will introduce a bias in simulations.

This must be taken into account if, for instance, a triangular distribution is to be used as an input in the Monte Carlo simulation. An issue also arises in determining which values should be used as the minimum and maximum. Extremely low and high values would provide little information, and would generate both positive and negative biases if the probability distribution for which the triangular distribution is a substitute has long asymptotic tails. Depending on the nature of the distribution, the first and 99th, or even higher, percentiles may be an appropriate choice. Sometimes a continuous distribution fits a model parameter well, but its asymptotic tails may generate combinations of unrealistically high or low values, albeit at very low probability of occurrence, but sufficient to distort the results. To rectify this problem, the extreme and unrealistic tails of the offending distributions can be truncated, preventing sampling below or above realistic minimum and maximum values.

Consider, for example, the result of a simulation carried out on the mine model of Table 9.1 in Chapter 9, where the following probability distributions have been used as inputs: •

•

there is a 45.6 per cent probability that the NPV will exceed the expected $76.18 M

•

the project is almost certain to add value, although there is a minimal probability (0.1 per cent) that its NPV will be negative, ie that its rate of return may be under the selected discount rate (13.3 per cent); given the very low minimum there is virtually no chance, under the input distributions assumed, that the project will not make a cumulative profit over its life.

If the base case model has been built interactively, it is a relatively straightforward exercise to substitute distributions of occurrence for selected inputs in order to replace the original single-point estimates. This enables the model to be used for financial Monte Carlo simulation using sophisticated risk analysis software. Risk analysis software samples each input randomly, according to its probability distribution of occurrence, over a very large number (thousands) of iterations of the model. This process generates not only the expected, or mean, value for the various model outputs, but also the Mineral economics

Fig 10.5 - Histogram of possible net present values for the project. 149

Chapter 10 – MIneral projeCt eValUatIon – DealIng wIth UnCertaInty anD rISk Mean = ∑n i=0(xi × pi) •

Risk: as measured by the standard deviation around this mean (ie $31.4 M), which defines the probability distribution of all possible net present values under the probabilistic input assumptions used in the Monte Carlo simulation; the relevant formula is: Standard deviation = [∑n I = 0 (xi - mean)2 × pi]0.5

Fig 10.6 - Cumulative frequency distribution of possible net present values

for the project.

Conducting the Monte Carlo simulation has confirmed that not only is the project attractive on a deterministic DCF basis, but also on the basis of sensitivity and scenario analysis, and is not very risky, re-enforcing the decision to invest. To ensure more accurate results, it is important to identify model inputs that are highly correlated. For example, commodity prices in US dollars and the exchange rate between the Australian and US dollar, given the ‘commodity currency’ nature of the former, have a high degree of correlation. There may also be high correlation between grades and recoveries, grades and metal content of concentrates, and related net smelter returns. These correlations can be entered into modern risk analysis software to refine sampling during successive iterations of a Monte Carlo simulation. Ideally, the expected value derived from a Monte Carlo simulation should, as in the example, be of the same order of magnitude as that of the base case. A significant difference most probably indicates a degree of inconsistency between the single-point, ‘mean’, values of inputs used in the base case and the mean of the corresponding probability distributions used for the same inputs in the Monte Carlo simulation. Care must be taken to ensure that maximum consistency between these two sets of inputs is maintained.

ATTITUDES TO RISK – FROM EXPECTED VALUE TO EXPECTED PREFERENCE VALUE (CERTAINTY EQUIVALENTS) AND PRICING OF RISKY PROJECTS Understanding the nature of risk and risk-neutral expected returns Earlier, we used sensitivity and scenario analyses to identify and quantify the input variables to which the performance of the DCF mine model of Table 9.1 is most sensitive. We then applied a Monte Carlo simulation to produce its: •

EMV (ie NPV = $72.4 M): this represents the mean of the distribution or the sum of all possible NPV values weighted by their respective probability of occurrence, ie:

150

For example applying the above formulation of the mean to a game of tossing a fair coin, where the bank pays $2 if a head (H) comes up and where the gambler pays $1 if a tail (T) comes up, the expected value from the point of view of the gambler would be: EMV = 50% × $2 + 50% × (-$1) = $0.50 or an expected return = $0.5/$1 = 50% In this case, we know the discrete classical or objective probability of these two events (p(H) = p(T) = 50 per cent), which are mutually exclusive and collectively exhaustive. No other event can happen, and therefore their cumulative probability of occurrence must be one. While there is an expectation that in the long run one would win an average of $0.5 per toss, there is nonetheless an even (50 per cent) chance of losing $1 in any trial. In finance, risk is defined with reference to expectations. It has both an upside and a downside, which includes, but is not limited to, risk in its colloquially accepted meaning as the chance of making a monetary loss. On the basis of the expected return on each dollar invested, the game represents a good investment opportunity. No one would have any hesitation in investing in it. This, at least, would be the case provided there were no alternative opportunities with the same odds but offering a higher EMV (say one that paid $4 instead of $2 for the same $1 bet; ie with an EMV of $1.50). However, it is common to have to choose between mutually exclusive projects, such as the following exploration opportunities: •

•

Project A, which has a potential gross value of $105 M with a ten per cent probability of discovery, and an exploration cost of $5 M Project B, which has a potential gross value of $70 M with an 80 per cent probability of discovery, and an exploration cost of $40 M. Their respective EMVs are: EMV(A) = 0.1 × ($105M - $5M) + 0.9 × (-$5M) = $5.5 M EMV(B) = 0.8 × ($70M - $40M) + 0.2 × (-$40M) = $16 M

Rational investors are wealth maximisers. Using a strictly risk-neutral criterion (ie if they attribute the same value to a dollar won as to one lost) they will Mineral economics

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk select the project with the highest EMV – that is Project B. In other words, risk-neutral investors maximise expected value. But let us now assume that the exploration performed on project A leads to an improvement in its chance of discovery from ten per cent to 20 per cent. The EMV of project A now becomes: EMV(A) = 0.2 × ($105 M - $5 M) + 0.8 × (-$5 M) = $16 M Risk-neutral investors would now be indifferent between projects A and B because they have the same EMV of $16 M, irrespective of their different risk characteristics. Project A has a lower chance of a higher return, but a higher chance of a lower loss than B, and vice versa. In theory, risk-neutral investors would not differentiate between investing in a larger number of type-A projects or in a lower number of type-B ones, as long as they have the same expectation of an EMV of $16 M. In reality, in spite of risk neutrality, the less risky project would have a higher value in a market which would include risk-averse investors. It is to be expected that, if the distribution of possible returns is symmetrical, risk-neutral investors would choose the less uncertain project. On the other hand, if the distribution of possible returns is asymmetric, they would choose the project with the highest opportunity to risk ratio. This is one of the ‘mean-semi-variance’ criteria of choice clearly explained by Kim and Wallace (1998).

From risk-neutral to risk-averse investment decisions In reality, the choice becomes more complex because investors generally do not attribute the same value to wins and losses. This behaviour, known as riskaversion, is discussed in some detail in the following section. Returning to the coin-tossing game, its expected return would still be 50 per cent if the wagers were to be progressively increased to say: •• •• •• ••

$200 and -$100 $2000 and -$1000 $20 000 and -$10 000 $20 M and -$10 M, and so on. However, as the wagers rise relative to an investor’s wealth, his or her attitude will soon swing from riskneutral to risk-averse. This happens because, as the capital at risk increases as a proportion of their wealth, they become increasingly sensitive to exposure to the risk of Gambler’s Ruin. Consider an exploration company with a budget of $1 M embarking in a series of projects costing $0.2 M each and with an individual chance of success (Ps) of ten per cent. The company is in a position of withstanding Mineral Economics

five successive failures, after which it will go out of business. Their chance of Gambler’s ruin, that’s to say one minus the cumulative binomial probability of at least one discovery, can be calculated using the discrete binomial distribution where the chance of exactly 1, 2, ... n discovery in n trials is: Pxn=(Cxn)×Px×(1-P)n-x (Cxn) = n!/[x! × (n - x)!], where n! = 1 × 2 …× n and 0! = 1 In the example the probability of at least one success in 5 trials (P15) = [5!/(1! × 4!)] × 0.1 × 0.94 + [5!/(2! × 3!)] × 0.12 × 0.93 + …. …+ [5!/(4! × 1!)] × 0.14 × 0.9 = 0.4099 or 40.99% and that of Gambler’s ruin is 1 - 0.4099 or 59.01 per cent. Clearly the company would have food for thought and ask themselves whether they are in the right game. An alternative approach in estimating the risk of Gambler’s ruin is to use an exponential function which, as will be seen later, is the continuous equivalent of the discrete binomial distribution: Probability of Gambler’s ruin = Pf = e –nPs = 60.7% This estimate of the probability of failure is conservative, because it is based on the inherent assumption that the probability of discovery in each trial does not decrease with successive discoveries, ie exploration in a terrain with a very large pool of undiscovered orebodies or ‘sampling with replacement’. A better approximation could be obtained by using a hyper geometric distribution, provided one could estimate the rate at which the initial probability of discovery in each trial decreases with each successive discovery as the area matures, ie ‘sampling without replacement’. The magnitude of the potential adverse consequences of a downside outcome multiplied by its probability of occurrence represents the severity of the impact of the risk to which one would be exposed when embarking into an uncertain venture. A company should seriously assess the corporate consequences of such an impact when establishing a sound risk-management policy to determine their future strategies that are in line with the level of risk exposure acceptable to their shareholders. If the project is a currently held asset, they can: •• sell it to a party better equipped to handle its risk; or •• spread the risk by farming out some equity through a joint venture. If, on the other hand, the project represents a new investment opportunity the investor has a range of options open to him including to: •• bear the risk •• hedge or insure against individual risk components, if possible •• shift some of the risk to another party through contractual arrangements 151

Chapter 10 – MIneral projeCt eValUatIon – DealIng wIth UnCertaInty anD rISk •

spread the risk by farming in at a level of equity lower than 100 per cent by means of a joint venture; or

•

reject the project.

Risk preferences and the price of risky investment opportunities The level of risk-aversion varies from investor to investor as a function of: their individual wealth/risk capital other individual or corporate traits, which are a function of the culture of the organisation, its management and past risk-exposure experiences. It is possible to overcome the shortfalls of using the expected value criterion (ie assuming risk-neutrality) in risky investment decisions by using a ‘utility’ function (Newendorp and Schluyer, 2000). This function, unique to each investor, captures the way he or she assesses the inherent risk characteristics of a project, ie their riskaversion, by describing how an investment opportunity makes them feel. • •

Most utility functions in modern decision analysis are exponential and, if the pay-off is desirable, ie to be maximised, take the form: u(x) = 1 - e-x/RT where: RT

is the risk tolerance coefficient

x

is the monetary pay-off2 variable

e

= 2.7182818 is the exponential constant

It is normal practice to scale risk profile curves in such a manner that the utility value on the y-axis, as in Figure 10.7, ranges between -1 and 1.

function is highly concave to the pay-off, or x axis. It could be said that a win does not feel as good as the loss of an equivalent amount feels bad. This is particularly so, after a series of consecutive losses, as one approaches one’s venture capital limit and the likelihood and fear of gambler’s ruin increases. In the example of Figure 10.7, a loss of -5 has a utility value of around -0.95; roughly double that of a win of a similar magnitude of +5. The individual risk tolerance coefficient (RT) is the main determinant of the selling price at which the holder of a risky project would be prepared to divest in exchange for secure cash in hand. This secure cash price represents the ‘certainty equivalent (Cx)’ of the otherwise uncertain expected value of the project. This can be stated as: Cx = -RT ln {Σni=1 pi e-xi/RT} where: pi

is the probability of outcome i

n

is the total number of possible outcomes

xi

is the value of outcome i

Returning to projects A and B, if for instance the firm had a risk tolerance coefficient (RT) of $100 M, it would select project B because its Cx value at $11.54 M is higher than that of A at $8.93 M (Figure 10.8), even though their expected values at $16 M are the same. At a RT of $100 M the company would be indifferent between selling project B for any price in excess of $11.54 M and attempting to achieve its EMV of $16 M by bearing its risk. They would view the potential net success value of $30 M as desirable even though it comes with a smaller, but still significant, chance of losing $40 M. It is worth noting from Figure 10.9 that investors with risk tolerances (RTs) lower than about $40 M would still value both projects for sale at a minimum of around $3.5 M, even though they would not be in a position to invest in project B. At RTs lower than $40 M, project A becomes more valuable, until at a RT of around $33 M the Cx of project B becomes negative followed by project A at a RT of around $22 M. The fact that investors with different levels of riskaversion will value the same project differently creates a potentially significant range of acceptable negotiating prices. These range between a floor set by more riskaverse, generally smaller companies, and a cap reflecting the less risk-averse character of major companies. For this reason deals are often perceived as win-win.

Fig 10.7 - A typical risk profile curve for an investor or firm.

Risk-neutrality, ie a straight line, is only approximated for relatively small potential losses and gains beyond which risk-aversion rapidly sets in. Indeed, the utility 2

If the pay-off is undesirable, ie must be minimised, then the utility function takes the form: u(x) = 1 - ex/RT.

152

Aside from risk, project size is another major strategic consideration in the determination of the price that major companies would place on a project. This is because major companies find it hard to maintain a competitive growth rate acceptable to their shareholders and are prepared to pay for projects that may result in major increments in their future cash Mineral economics

Chapter 10 – MIneral projeCt eValUatIon – DealIng wIth UnCertaInty anD rISk

Fig 10.8 - Risk-averse comparison of certainty equivalent values of projects A and B.

a structured interview process of decision-makers. The results so obtained could then be compared with previous actual risky investments. Initial research by the author seems to indicate that, in the case of pure exploration as opposed to producing companies, RT may represent a much higher proportion or even the totality of their net assets value. This may reflect their role as a medium to satisfy demand for high-risk, high-return investments.

RISK SPREADING THROUGH JOINT VENTURES

Fig 10.9 - The sensitivity of certainty equivalents (Cx) to risk tolerance

coefficients (RT).

flows. As a result of these considerations, and a host of other strategic objectives, projects of different sizes and having different levels of underlying risk (irrespective of their potential up-side value) tend to get in the hands of companies of appropriate size to handle them. We may call these the ‘natural project owners’. This dichotomy is in some ways inconsistent with the notion of a single fair market value as espoused by the VALMIN code, as the fairness of the price relates to individual risk profiles. Thus, the risk-averse expected preference value rule for any value of RT is to select the investment with the highest certainty equivalent (Cx).

An empirical approximation of the risk tolerance coefficient (RT) is twice the maximum bet that an individual or a corporation would be prepared to place on a game generating benefits twice as large as the corresponding costs with a probability of 50 per cent - 50 per cent, ie with an expected return of 50 per cent (Howart, 1978 in Newendorp and Schluyer, 2000). This maximum bet can generally be established through Mineral economics

Different companies may wish to embark in joint ventures for a variety of reasons. Besides budgetary and risk spreading considerations, these may include tax minimisation and strategic commodity, geographical and/or technological diversification. Greenwaldt’s formula (1981, p 2190) provides a simple approach to estimate the effectiveness of joint venturing as a means of spreading risk. One can, for instance, determine the number of trials (N) necessary to achieve a desired level of confidence (S) that gambler’s ruin would be avoided: N = ln (1 - degree of confidence (S))/ln (1 - probability of success in 1 trial (Ps)) If for example one wished to be 90 per cent confident of avoiding ruin (S = 0.9) and the probability of success in each trial is ten per cent (Ps = 0.1), then one would have to secure enough risk capital to carry out 22 (N) trials. Alternatively, if $5 M of risk capital (M) were available and the before-tax cost of each exploration trial (C) were $0.3 M (ie $5 M/$0.3 M = 16.7 possible trials), the percentage joint venture participation to achieve the above level of confidence of avoiding gambler’s ruin (ie P(Gambler’s ruin) of 1 - S = 0.1) would be: 153

Chapter 10 – MIneral projeCt eValUatIon – DealIng wIth UnCertaInty anD rISk F = (M × ln (1 - Ps))/(C × ln (1 - S)) × 100 = 76.26% If one were to farm out 50 per cent of a risky project in consideration of a commitment by the farmingin participant to contribute 50 per cent of future expenditure, this would allow exploration of two similar projects per unit of money invested instead of only one. However, it does not follow that such a strategy would double the company’s cumulative chance of discovery, and therefore its survival. This is because the cumulative probability of discovery (Pn) adheres to a binomial distribution, which is not a linear function of either the number of trials (n) or the probability of success in a single trial (Ps). The non-linear nature of the change in the ratio between the cumulative probability of discovery for 100 per cent equity exploration and that for double the number of trials under a 50 per cent joint venture as a function of changing Ps is emphasised if plotted on log-normal graph paper as in Figure 10.10 (modified after Burn, 1984, p 60).

an EMV (of 50 per cent joint venture exploration) = 0.6513 × $25M + 0.3487 × (-$0.5 M) = $16.11 M These are the minimum EMVs, because 40.99 per cent and 65.13 per cent are the probabilities of at least one (not exactly one) discovery in five and ten trials respectively. For a more correct figure one would have to weigh the probability of exactly one discovery, exactly two discoveries and so on up to five or ten trials respectively. Thus, under the assumptions, in order to reduce the chance of Gambler’s ruin from 59.01 per cent to 34.87 per cent, one would have to forego a minimum of $3.79 M (ie $19.90 M - $16.11 M) in expected value. As for all forms of insurance or hedging there is a cost to spreading risk through joint ventures. It is obvious that, if the contributions to joint venture costs are to match a participant’s equity, the minimum loss of expected return occurs on the more risky side of the spectrum. Thus, under these conditions, there is a rationale for farming out risky projects, and for farming into as much equity as possible in those with a higher probability of success. In effect, farming into low-risk projects justifies an adequate premium. Projects that are of a suitable potential size and have lower risk of failure are likely to absorb most of the exploration investment capital available in the market at any time. Those firms that are less subject to ‘capital rationing’ or that have ready access to equity are most likely to undertake these expenditures.

Fig 10.10 - Joint venture risk trade-off.

The figure shows three companies, with exploration budgets of $1 M, $2 M and $10 M. Assuming that the average cost of an exploration trial is $0.2 M, the companies could undertake five, ten and 50 exploration projects respectively on a 100 per cent equity basis, or ten, 20 and 100 projects on a 50 per cent joint venture basis. It can be observed how the relevant ratios, eg P(5/10), P(10/20) and P(50/100), are close to two only at relatively low levels of Ps. As Ps increases, the number of times by which joint venturing increases the cumulative probability of making a discovery falls rapidly. For instance, at a probability of success (Ps) of ten per cent, the cumulative probability of at least one discovery in ten trials is 0.6513. This is only 1.59 times as high as that on five trials, ie 0.4099. For a Ps of ten per cent, the minimum expected value per dollar invested for a target worth $50 M will be: an EMV (of 100 per cent exploration) = 0.4099 × $50 M + 0.5901 × (-$1 M) = $19.90 M; versus 154

A good application of certainty equivalents, in the context of risk spreading, is in determining the equity participation appropriate to companies with specific individual levels of risk tolerance. This can be illustrated by an example where a company with a RT of $100 M is offered an exploration project with 50 per cent probability of discovering an orebody worth $100 M net of the exploration costs, and a 50 per cent probability of losing $40 M in exploration. Although the EMV of this project is $25 M, the corresponding certainty equivalent (Cx) can be obtained using the relevant formula previously introduced as: Cx = - $100 M × ln (0.5 × e-$100 M/$100 M + 0.5 × e-(-$40 M)/$100 M) = -$8.29 M As a consequence, acquisition of 100 per cent of the project is out of the question for this company. However, from Figure 10.11, which shows how the Cx varies as a function of the acquisition of progressively lower percentage equity in the project, it can be observed that the Cx becomes positive once the equity participation falls below 70 per cent, and peaks in value at about $5 M for equity levels of around 35 per cent. Mineral economics

Chapter 10 – MIneral projeCt eValUatIon – DealIng wIth UnCertaInty anD rISk will increase from one per thousand to 1.86 per cent; a significant but not extraordinary amount. This happens because P(M|A) is Bayesian, ie: P(M|A) = P(M) × [P(A|M)/P(A)] This level of improvement can be demonstrated using the case of a geophysical survey covering 10 000 grid locations. In the area covered by the survey there will be 0.001 × 10 000 = 10 mineralised occurrences of which the survey picks up 95 per cent or 9.5 true positives. There will also be anomalies on five per cent of 10 000 – 10 = 9990 grid locations, ie 499.5 false positives hence: Fig 10.11 - Certainty equivalence as function of percentage joint venture equity.

With this information, the company is now in a better position to determine whether and to what level of equity they should farm into this project. Many companies have reasonably stringent policies as to the minimum equity they are prepared to acquire in projects. Large companies generally prefer in excess of 50 per cent, with management of the joint venture and resident status. In the present example, while positive, the value of acquiring a majority equity position is suboptimal compared to a 35 per cent equity position.

BAYESIAN (DECISION TREES) AND PROGRESSIVE RISK AND VALUE ANALYSIS In exploration and mining projects, successive probability events and related decisions are generally dependent on one another or Bayesian in nature. Bayesian, or dependent, probabilities systems, as opposed to independent ones, can often lead to counterintuitive results. Hayward (2003) considers the case of a new airborne geophysical technique that, when flown over potential targets, generates an anomaly over 95 per cent of concealed deposits, with only five per cent of the anomalies generated being ‘false positives’, ie obtained over barren terrain. Thus, the probability of getting a true anomaly given mineralisation is present (ie P(A|M)) is 0.95, and that of a false anomaly over barren terrain (ie P(A|No M)) is only 0.05, where the symbol | denoted dependency. Because systematic pattern drilling in the region is expected on average to intersect mineralisation every thousand grid positions drilled, the probability of discovery without the use of the new geophysical technique is P(M) = 0.001. The question is by how much does the probability of discovery increase if a geophysical survey is run on the project grid to generate drilling targets, ie what is the probability of discovery given an anomaly P(M|A)? Most geologists will intuitively tend to overestimate the posterior probability of discovery given an anomaly P(M|A) , with many guessing improvement of 20 per cent or more. In reality, the probability of discovery after the geophysical survey has generated an anomaly Mineral economics

P(A) = P(A | M) + P(A | No M) = (9.5 + 499.5)/10 000 = 0.051 and P(M | A) = 0.001 × (0.95I0.051) = 0.0186 or 1.86% The first impulse, which is to rush to drill the anomalies, would not be the best strategy. It may be better to run the geophysical survey with a coarser detection threshold, which could reduce the number of false anomalies. Hayward (2003) concludes that the ‘best targeting parameter is not the one that captures the most deposits’. One should also devise some alternative means of reducing the number of false anomalies through the use of different and unrelated exploration techniques and selection criteria. Decision trees are useful tools to structure, display, and analyse project risk and returns in chronological sequential order. A decision-tree consists of a sequence of: •

decision nodes (squares) or possible alternative actions at various points in time, which are under the control of and at the discretion of management

•

probability or event nodes (circles), which are subject to chance (state of nature) and on which management has no influence

•

terminal nodes (triangles).

Contrary to DCF/NPV, which entails a single static decision of the invest/reject type at the point of evaluation, decision trees are dynamic in that they consider the possible future decisions open to management following each relevant chance event. Thus a decision tree model values the effect of combinations of probabilistic events. Let us assume that it costs $250 000 for a geophysical survey, which has a 50 per cent probability of outlining an exploration target. Assume also that an adequate delineation drilling program and feasibility study, costing $2.5 M, in turn, has a five per cent probability of leading to the discovery of an orebody with an expected value of $191.6 M. The owners of the project must also consider whether to attract a joint venture participant to earn 50 per cent equity by fully funding the drilling program. 155

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk basis, the owners would prefer to farm out 50 per cent equity in the project in exchange for the necessary drilling funds, as the option of funding 100 per cent of the drilling expenditure in-house would be negative, and that the project is now worth a Cx of $0.96 M. Now consider (Figure 10.14) the point of view of a party with an RT of $100 M that is potentially interested in farming into the project. The initial geological reconnaissance and geophysical survey would have resolved some risk. Both the expected value of $2.4 M (ie 0.5 × ($191.5 M/2) + 0.5 × (-$2.5 M/2)) and its corresponding certainty equivalent (Cx) of $0.63 M make entering into a joint venture attractive.

By working out and rolling back the EMV of individual outcomes at each stage in the decision tree of Figure 10.12, the owners can determine that, in their current scenario, and on a risk-neutral basis, the optimal decision is to carry out the geophysical survey and drilling program in-house, thus retaining 100 per cent equity in the project having an EMV of $3.29 M. This decision would tip over to carrying out the reconnaissance in-house, and then potentially farming out the prospect if the chance of success were to be perceived as lower and/or the estimated cost of drilling as higher. If the firm had a limited exploration budget and was risk-averse (eg had a risk tolerance coefficient RT of $60 M), certainty equivalent values could be substituted as shown in Figure 10.13. Notice that, on a risk-averse Assumptions Cost of geophysics Probability of anomaly Cost of drilling Probability of discovery Expected value of discovery Percentage JV equity retained

-0.25 0.5 -2.5 0.05 191.5 0.5

If required, it is also possible to estimate the duration of various activities, and place them in the correct intervals of time to facilitate the process of discounting 0.05 Discovery Drill

191.50 -2.50

6.83

0.5 Anomaly 0

1

Geophysics Proj. EV

0

95.75 4.54

3.29

95.50

188.75

-2.75

95.50

0.95 Barren 0

EV

-2.75

0.05 Discovery Joint venture

-0.25

0.95 Barren 0

6.825

188.75

-0.25

-0.25

0.5 3.29

1

No anomaly 0

-0.25

-0.25

Relinquish 0

0

0

Fig 10.12 - Example of exploration decision tree computed on a risk-neutral expected monetary value basis to determine whether to drill or farm out the project. $M or % Assumptions Cost of geophysics -0.25 Probability of anomaly 50% Cost of drilling -2.5 Probability of discovery 5% Expected value of discovery 191.5 Percentage JV equity retaine 50% Risk tolerance coeff. (RT) 60

0.05 Discovery Drill

191.50 -2.50

0.5 Anomaly 0

0.20 0.00

0.95 Barren 0

2.19 0.04

2

-2.75

95.75

95.50

95.5

0.80 0

0.96

2.19 0.04

0.02

0.95 Barren 0

0.5 0.96 0.02

188.75

-0.05

Geophysic Proj. Cx

1

-2.75

0.05 Discovery Joint venture

-0.25

188.75 0.96

-0.25 0.00

-0.25

No anomaly 0

-0.25 0.00

Relinquish 0

0

-0.25

0

Fig 10.13 - Certainty equivalents corresponding to the expected value tree of Figure 10.12. 156

Mineral Economics

Chapter 10 – MIneral projeCt eValUatIon – DealIng wIth UnCertaInty anD rISk

Farminee's RT 50% of target value

100 95.75

0.05 Discovery

Enter into 50% JV -2.50

95.75

0.63 0.006272

0.95 Barren

93.25 0.606431

Cx

93.25

-2.50 1

0

0.63

0.006272

Reject project 0

0

-2.5 -0.02532

0

Fig 10.14 - The certainty equivalent point of view of the farming-in party.

the related values to their present values. However, it must be kept in mind that certainty equivalent values by definition have already been ‘discounted’ by the risk factor inherent in the utility function of the firm. As a consequence, the relevant ‘risk-adjusted’ cash flows need only be discounted to present value to account for the ‘time-value of money’, not for risk. In this light, the appropriate discount rate is below the firm’s corporate weighted average cost of capital. In most cases, the risk-free rate of interest would be an adequate rate of discount.

Fig 10.15 - Frequency distribution of possible project EV derived

from tree simulation.

Constructing a decision tree is not difficult. The main challenge rests with estimating the probability distributions of various events. Frequently, an order of magnitude of relevant, relatively objective probabilities can be based on frequency distributions derived either from statistically significant experimental trials, pilot studies, or more often, from statistical analysis of historical time series. Sometimes estimates are based on subjective expert advice. Continuous probability distributions of both costs (eg drilling) and pay-offs (eg target value) can be used as input to decision trees and the output of the tree (EV or Cx) can then be simulated, generating not just their expected or mean values, but also a distribution of all possible values. Figure 10.15 displays the simulated distribution of possible EVs from the previous tree in which the drilling cost was entered as a triangular distribution (min. = $2.2 M, most likely = $2.5 M and max. = $2.8 M), and the target value as a lognormal distribution with µ = $191.5 M and σ = $291.6 M. Figure 10.15 shows that the distribution of possible project values is highly positively skewed, nonetheless the simulated EV of the project at $3.79 M is close to that derived from the original decision tree at $3.29 M. As it is usually the case, mineral deposit sizes and related values are fitted well by a positively skewed lognormal distribution. In the example, the values of 25 known deposits from a mineralised reference terrane, with a mean of $191.5 M and a standard deviation of $291.6 M, were used to set the target for the decision tree. Their cumulative probability distribution was generated by sorting the deposit values in ascending order and generating their cumulative probability distribution or probability density function (PDF) using the Excel percentile formula as shown in Figure 10.16. Mineral economics

Fig 10.16 - Cumulative distribution of target values displaying the bracket median used in the discretisation of their original lognormal distribution for use in the decision tree.

The PDF shows how the target value has only a one per cent chance of exceeding $1167 M and of being smaller than about $8.4 M. It is worth noting that the Excel percentile formula, which attributes a probability of zero per cent to the value of the variable being equal or lower than the lowest value in the sample or higher than the highest value in the sample, while easy to use, is a poor approximation if the sample number is low. A more conventional approach would be to attribute a 1/(2 × 25) probability to the lowest value in the sample and of 1/25 to all the others and then get round percentile values by interpolation. In practice, reasonably good fitting continuous probability distributions may not be available for all variables. Even if they are available, they may need to be discretised into probability or event nodes with a limited number (3 - 5) of branches to prevent the tree from growing into an unmanageable number of branches, or imposing an excessive computational load on the computer. There are a number of discretisation methods (Clemen and Reilly, 2001, p 308) that can be used: 157

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk •• Pearson-Tuckey three-branch method, which attributes a 0.185 probability to the fifth and 95th percentiles and 0.63 to the median •• bracket median five-branch method, which attributes a 0.2 probability to the median of five equally probable intervals, eg to the tenth, 30th and so on up to the 90th percentile •• for log normally distributed values, the Swanson mean (Rose, 2003), shown in Figure 10.17, which attributes 0.3 probability to the tenth and 90th percentiles and 0.4 to the median. Swanson Mean

0.3 P10 20.91

Mean

0.4 P50

173.06

104.41

104.41

0.3 P90 416.73

416.73

Exploration category Greenfield

Probability of discovery % Irrespective of size

0.9%

Major

0.3%

World-class

0.07%

Brownfield

5%

Minesite

20%

relatively mature gold exploration district of Laverton in the Eastern Goldfield, and by Guj and Fallon (2009) for the Plutonic-Marymia inlier in the mid-east region of Western Australia. The results of these studies, summarised in Table 10.2, provide good examples of:

20.91

20.91

Table 10.1 Average historical rates of probability of exploration success (source: Bartrop and Guj, 2009).

104.41

416.73

Fig 10.17 - Distribution of target values discretised using the Swanson mean.

Some sophisticated decision tree software packages offer more mathematically complex but more accurate ‘moments matching’ facilities. The example shows how discretisation may introduce a degree of bias, which, if significant, would need to be compensated for. Where the need to estimate probabilities of discovery for inclusion in a decision tree arises, it may be useful to cross-check the order of magnitude of the historical average probability of exploration discovery as derived from empirical studies are provided in Table 10.1 (Bartrop and Guj, 2009). The figures for Brownfields and Near Mine exploration are heavily influenced by studies by Lord, Etheridge and Uttley (2003) on Placer Dome’s exploration in the

•• Brownfields exploration where by spending $54.6 M in the Laverton District over 13 years, Placer generated 290 prospects, 26 of which were systematically drilled leading to the discovery of over ten M ounces of gold and the establishment of 12 mines •• near mine exploration by Barrick and its predecessors investing $277 M around the Plutonic mine to generate 208 prospects, of which 109 were drilled leading to the discovery and establishment of 38 mine sites. The Plutonic belt analysis is close to the Laverton study in terms of the probability of a prospect advancing to resources delineation (ie 50 per cent versus 58 per cent), the rate of progress to feasibility (85 per cent versus 87 per cent), and the progression to mining (83 per cent versus 90 per cent) respectively. The main difference between the overall probabilities of discovery for the Laverton and Plutonic areas (ie 4.14 per cent versus 18.17 per cent) can be traced to the upstream stages of exploration. In particular, to the definition of at what stage an ‘area of interest’ becomes a ‘prospect’. Another reason is that in 1987 the Laverton

Table 10.2 Comparison of the Laverton District after Lord et al (2001) and the Plutonic-Marymia Belt – historical exploration activity by exploration stage. Laverton District 1987 to 1999 Stage

Prospects A$ M

Expenditure prospect

Avg cost A$ M/prospect

Plutonic Marymia Gold Belt – 1987 to 2007 Probability to advance

Prospects prospect

Expenditure prospect

Avg cost A$ M/ prospect

208

77.85

0.37

Probability to advance

A’

Acquisitions from 3rd parties

A

Generative

290

2.70

0.01

208

4.19

0.02

B

Reconnaissance

156

11.40

0.07

0.54

172

18.89

0.11

0.83

C

Systematic drill testing

26

6.00

0.23

0.17

109

54.19

0.49

0.63

D

Resource delineation

15

6.90

0.46

0.58

54

98.51

1.82

0.5

E

Feasibility

13

27.60

2.10

0.87

46

23.59

0.51

0.85

F

Mine

12

0.9

38

Total

158

54.60

2.87

0.04

0.83 277.23

3.34

0.18

Mineral Economics

Chapter 10 – MIneral projeCt eValUatIon – DealIng wIth UnCertaInty anD rISk District was already a maturing terrane that had been explored and mined for nearly 100 years. It is likely that most of the near-surface deposits, including many small enriched ones, had been found and mined by the time Placer-Dome initiated its exploration campaign. The Plutonic belt, by contrast, was still a virgin gold belt having escaped the attention of the early prospectors, thus offering the full distribution of potential deposit sizes. While the number of projects that resulted in discoveries in the Plutonic Belt is higher than in Laverton, their average size, at around 0.26 Moz, is smaller than that of Laverton at 0.83 Moz. In part, this may be due to the lower exploration maturity of the Plutonic area, but it may also reflect differences in the minimum target criteria of the two companies, with Barrick being in a position to gainfully develop many small satellite deposits within easy reach of the Plutonic mill, even though some of these deposits would have not warranted delineation drilling and development on a stand-alone basis.

Fig 10.18 - Log-log plot of the Zipf-generated size distribution of nickel sulfide deposits relative to that of known deposits in the Norseman to Wiluna greenstone belt of Western Australia.

Size distribution of mineral deposits and the Zipf law Recent research (Guj et al, 2011 and Mamuse and Guj, 2011) supports the hypothesis that the size of mineral deposits of the same genetic origin in various geological terranes abide by the Zipf power law and distribute according to an exponential distribution of the type: Y = C × R-k where: Y

is the size of a deposit of size-rank R

C

is the size of the rank 1 deposit

k

is an exponent that in stable geological terranes approximates one

The largest and top ranking deposits are generally discovered early in the exploration history of a terrane because of their most obvious foot prints. As a consequence, given the size of the rank one deposit, it is possible to generate a distribution describing the size of all deposits present in a terrane, both already known and as yet undiscovered. This is what is known as the natural mineral endowment of the terrane. The difference between the original natural endowment and the known deposits is the residual yet to be discovered endowment. Figures 10.18 and 10.19 compare the Zipf-generated size distribution to that of 94 known nickel sulfide deposits hosted in komatiitic dunites and peridotites in the Norseman to Wiluna greenstone belt of the Archaen Yilgarn Craton of Western Australia, expressed in terms of their individual nickel metal content. Figure 10.18 uses a logarithmic scale. The gap between the two curves represents the nickel metal still to be discovered, amounting to approximately ten million tonnes of Mineral economics

Fig 10.19 - Natural scale plotting of the Zipf-generated size distribution of nickel sulfide deposits in the Norseman to Wiluna greenstone belt of Western Australia showing the size and rank of as yet undiscovered deposits.

nickel metal out of an original natural endowment of 21 Mt. The large deposits roughly coincide, but smaller known deposits sitting below the Zipf curve are either in the right rank but not fully delineated or, if fully delineated, should be at a lower rank, thus creating gaps to be filled by new discoveries. Figure 10.19 shows the Zipf curve plotted on a natural scale with known deposits matched to the theoretical ones wherever possible. This representation is useful in that it clearly shows the gaps in terms of their potential tonnages to be filled either by new discoveries, or by lower ranking deposits climbing up in rank in response to increased resources being delineated by future exploration. The size distribution of as yet undiscovered deposits, ie of the residual endowment, is plotted as a cumulative density function. It is then also possible to estimate the Bayesian probability that, given a discovery is made, its size may be below any specific value. Unfortunately, the Zipf curve, while providing an indication of the number and size of deposits yet to be discovered, does not give any information as to where in the greenstone belt they are likely to be located. 159

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk However, analysis conducted at the level of individual camps within the belt may disclose areas of above average exploration maturity where significant future discoveries have become unlikely.

value the flexibility management has to keep their future options open to progressively learn and adjust their actions as a project unfolds, depending on emerging circumstances and information dispelling uncertainty.

FROM STATIC DISCOUNTED CASH FLOW / NET PRESENT VALUE TO DYNAMIC REAL OPTION VALUATIONS

Consider the following example of this fallacious logic, adapted from Copeland and Keenan (1998). Assume an opportunity to invest in a project costing $100 M that has:

A different logic DCF analysis will continue to provide the dominant investment decision-making criteria, for resources projects: •• with healthy NPVs, low volatility in their cash flows

•• a 50 per cent chance of success, realising a present value of $150 M in future net after-tax operating cash flows •• a 50 per cent chance of failing, such that only $10 M of the $100 M capital investment would be salvaged. As the EMV is negative:

•• where management has limited flexibility, ie the opportunity to change their course of action during operations in light of emerging circumstances.

EMV = 50% × ($150 M - $100 M) + 50% × ($10 M - $100 M) = -$20 M

Interestingly, lack of managerial flexibility in the presence of high volatility is indeed what differentiates a bet (ie put your money down and wait for the outcome) (Copeland and Keenan, 1998) from an investment in a project capable of offering a range of strategic options. However, many projects may feature low or even negative net present values (NPV) because analysts have discounted them at excessively high rates to compensate for high volatility in their cash flows. Much of this CF volatility typically comes from high volatility in the price of the commodities they produce, in exchange rates (market risk) and other uncertain inputs.

Discounted cash flow logic would lead to rejecting this project.

Such projects can be very valuable if their inherent characteristics or design provides sufficient management flexibility to take advantage of favourable emerging circumstances and to avoid or minimise the effects of unfavourable ones. If for a period of time the decision-makers have the right, but not the obligation, to proceed with the initial or successive investment phases in a project only if conditions are favourable, the project is said to offer ROV, where the project cash flows volatility can be the source of significant value. As the words imply, real options (RO) have to do with real assets, such as exploration and mining projects, rather than financial assets, which underpin traded derivatives. Mineral and petroleum exploration, research and development, and pilot studies, for instance, have the characteristics of real options, as they create opportunities, but no obligation to invest. Yet, many of these projects continue to be under-funded and often unwisely rejected. Even worse, projects involving new, untested technology may sometimes be commissioned without adequate piloting in the hope of shortening their lead times and lowering their overall capital cost. This frequently leads to disastrous results. This type of error occurs because investors do not fully recognise and 160

Now assume that the company can build a pilot plant for $10 M and carry out an adequate level of testing thus resolving the project uncertainty. As a result, the EMV of the project becomes positive: EMV = 50% × ($150M - $110 M) + 50% × ($0 - $10 M) = $15 M Real-option logic would lead to the decision of investing in the pilot plant. If it is successful, then the company should invest in the project. If not, it can abandon the investment at a relatively low-cost and with no regret of having missed out on a potentially lucrative investment opportunity. Conventional DCF analysis is deterministic and static. It assumes that an investment is irreversible and compares investing ‘now or never’ (Dixit and Pindyck, 1995). In DCF models there are no inherent or planned contingencies to delay development and learn, to expand or contract production rates, to minimise the cost of recurrently opening and shutting down a project in response to market conditions, or finally abandoning it altogether. In reality, and irrespective of whether the decision to invest was taken on the basis of conventional DCF criteria, projects evolve according to unfolding circumstances that often require unexpected and costly changes. This is the case unless possible future eventualities were already anticipated and incorporated in the project plan to soften the effect of uncontrollable chance events.

Types of real options in mining projects Most real options in the context of the mining industry entail the managerial flexibility to undertake actions such as: Mineral Economics

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk 1. delay mine development and learn 2. embark on a pilot project and learn 3. commence development and production on a staged basis, learning from emerging events 4. alter the rate of production by exploiting gradetonnage trade-offs a. expand to include lower-grade resources into reserves b. contract by high-grading the reserves 5. suspend or re-commence production temporarily 6. abandon a project altogether. The first four, up to 4a, are call options; while 4b and 6 by contrast are more akin to put options. The former confer the right, but not the obligation, to ‘buy’, within a predetermined time (T), all future net aftertax operating cash flows generated by the project (a proxy for the spot price S) for a predetermined implementation cost (a proxy for the exercise price X), which includes any acquisition cost plus the present value of all initial and sustaining capital investments. The latter are designed to generate savings, or avoid future potential losses (S), for a predetermined cost (X) (eg care and maintenance, abandonment, severance and rehabilitation) at or before a predetermined time (T). The fifth option, also known as a switching option, is a combination of calls if re-commencing production and puts if suspending it. Depending on the nature of the project it is possible to distinguish between: •• single options, when there is only one possible decision or the alternative is to delay investment at each node •• multiple and chooser options (Mun, 2002), when at any node there is more than one possible, mutually exclusive decision, as opposed to delaying the investment •• sequential/compound options, when there is a series of decision nodes in chronological order (eg exploration project stages), where each successive decision may or may not be conditional or compound on a previous one. It is therefore possible to view most projects as a series of real options to defer and learn, commence, expand, contract or suspend production, or finally abandon the project, the value of which is not captured by the NPV obtained using conventional DCF evaluation techniques. Projects can be modelled as a tree-like structure of sequential possible future scenarios having probability nodes representing ‘states of nature’, which are not under management control. The branches that emanate from each node, in turn, lead to distinct groups of possible future scenarios. Each branch represents a possible action, which managers may decide to take to optimise the returns from the Mineral Economics

project ‘with the wisdom of hindsight’, having learned from emerging circumstances and the arrival of new information resolving uncertainty.

The market has been effective at setting real option values Considering the case of Sally Malay If we could assume that new information is quickly disseminated in the market place and incorporated in prices (ie if opportunities for arbitrage were few and short-lived), an objectively assessed NPV of a project should also closely match its fair market value (Lawrence, 2001). Yet, examination of actual mining project transactions often shows significant differences (generally a premium) between their stock market and their fundamental (DCF/NPV) valuations. Lawrence (2001) attributes this difference to the widespread international use of reporting guidelines that encourage valuations primarily based on proven and probable reserves (as categorised in the Australasian Joint Ore Reserves Committee’s (JORC) Code). This approach, he argues, disregards the potential contribution to revenue from more uncertain and lower-grade resource categories, and tends to underestimate the potential project value in fundamental DCF calculations. Irrespective of the categories of resources used, if one follows strict JORC logic to the limit, any company holding tenements over a marginal deposit with a negative NPV at current commodity prices would be justified in relinquishing them. As a consequence, the value of the company shares should fall to zero in the absence of other significant assets in its portfolio. However, the stock market has traditionally placed a value on option creation, particularly by non-dividendpaying mineral and petroleum exploration companies. Until recently, quantitative methodologies to measure this value have been lacking. A recent prominent example concerns the valuation of Sally Malay Mining Ltd, which in 2001 was a prospective nickel mining company holding subeconomic nickel resources in the Kimberley region of Western Australia. Soon after its initial public offering (IPO) in September 2001, when the price of nickel was US$5000/t, the company had a market capitalisation of around A$12.2 M. This value arose: •• in part because the project was based on a commodity with high price volatility (London Metal Exchange price data showed that at the time the volatility of the nickel price was between 20 and 25 per cent) •• there was still a reasonable length of time to the expiry of the company’s mining titles. During this period the company was in a position to delay mine development at the relatively low cost of simply keeping the mining tenements in valid legal 161

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk standing. Interested investors also hoped that during this time of potentially rising nickel prices, further drilling might lead to extensions to the existing reserves and conversion of previously uneconomic indicated resources into additional ore reserves. At September 2001 prices (ie US$5000/t), most investors would have assessed the deterministic net present value of a nickel deposit, containing 3.4 Mt of diluted mining reserves at a grade of 2.32 per cent nickel equivalent, to be very low or even negative. Depending on the assumptions made about other variables such as capital costs (eg A$52 M including A$6 M in working capital), cash operating and concentrate transport costs (eg A$3.15/lb), recoveries and smelter returns, exchange rates, etc its net present value was negative at around -A$8.87 M. This was a rigid, irreversible view of the project’s future and its value, equivalent to being committed to start and operate the project for five years through possible good and bad times, irrespective of what happened to the price of nickel. It implied no value in waiting before taking the decision to develop, and no capacity, once the decision to develop was taken, to avoid, or at least mitigate, the likely adverse impact of potential price falls. However, there was a widespread perception that an economic recovery was just around the corner. The price of nickel was at historically low levels and it was likely that it would rise strongly. When these expectations were incorporated into DCF models, they produced healthier net present values, justifying the decision by investors to purchase Sally Malay Mining Ltd’s shares, and thus its market capitalisation of A$12.2 M. The idea of relinquishing the tenements would have been preposterous even at the end of 1999, when nickel prices stood at a mere US$3600/t and a 40 per cent equity in the project was acquired for a cash consideration of $2 M. The static DCF based NPV completely disregarded the fact that the company had the flexibility to delay development until the nickel price conditions indicated that the project would add rather than consume value. There are in theory no negative NPV scenarios when one has the option to delay investment because, at worst, the value of the project is zero (or close to it, if there are costs in keeping the option open, as for instance in retention lease fees). This is a dynamic view of the project future and the basis to value its inherent managerial flexibility to only develop if high nickel prices eventuate. As will become clear, this value, which is not captured by a conventional DCF/NPV, can be very significant. Prior to the dramatic increases in nickel prices in late 2003, the situation at Sally Malay had all the characteristics of an out-of-the-money American call option, conferring the right, but not the obligation, at 162

the discretion of its owners to defer or proceed with development of the project at any time on or before the expiry date of the mining leases in 11 years, which is analogous to the term (T) of the option. The parameters to calculate this ROV can be obtained using the Copeland and Antikarov’s (2003) market asset disclaimer (MAD) method, whereby a proxy for the: •• spot price (S) of the underlying asset would be the present value of all future net after-tax operating cash flows, discounted at an appropriate risk and time adjusted discount rate and amounting to A$43.13 M •• exercise price (X), or the implementation cost, would be the present value of all initial and sustaining capital investments amounting to A$52 M •• volatility (σ) would be the standard deviation of the logarithmic returns on holding the asset, as discussed in more detail later. Obviously, development can proceed only if S-X is positive; otherwise it is preferable to defer it. This means that the option value of the project can only be positive (ie the maximum between S-X and zero). As the price of nickel increased to around US$7000/t by the end of 2002 on its climb to US$16 000/t by the end of 2003, the option moved well ‘in the money’ and it became warranted to be exercised. That is, it became profitable to develop the Sally Malay mine. The NPV of the project had improved from marginal at 2001 prices to between A$51 and A$58 M by the middle of 2003 using realistic nickel prices of $US6500 and US$7000/t, and a nominal discount rate of 7.5 per cent. The company’s market capitalisation, of around A$115 M in March 2004, reflected: •• the project’s sensitivity to continued increases in nickel prices late in 2003 •• the positive market sentiment about the exploration potential in the areas surrounding the mine at these price levels •• that it was tempered by the hedging effect of forward sales. It also reflected the realisation that nickel prices had stabilised and there was an expectation that they would start to progressively fall, reverting to their long-term mean, as indicated by the London Metal Exchange forward contracts and futures quotes at the time.

Using the Black and Scholes formula to estimate the real option value of the Sally Malay project The only way to capture investors’ expectations at the time of Sally Malay’s initial public offering in 2001, which justified a $12.2 M capitalisation for this company, well in excess of its deterministic DCF-based NPV of -$8.87 M, would have been by estimating its Mineral Economics

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk ROV. Determination of this ROV is easy because of the call nature of the real option inherent in this project, which lent itself to be handled effectively using a closeform equation, namely the Black and Scholes (B-S) formula (Peirson et al, 2002, p 633):

Table 10.3 Calculation of the real option value of Sally Malay using the Black and Scholes formula. C = value of real option A$ M

21.03

d1

0.98512

Price of call = C = SN(d1) - X e-rT N(d2)

d2

0.15596

= (ln(S/X) + (r - δ + s2/2) T)/(sT 0.5) = d - (sT 0.5)

X = exercise price = PV of capital investments $A M

52

t = time to expiry (years)

11

= spot price

σ = cash flow volatility

0.25

X

= exercise price

δ = convenience yield

0

σ

= standard deviation of the logarithm of stock return percentages expressed as decimals

Risk-free interest %

0.06 12.16

T

= time to exercise in years

Expanded net present value = Enhanced NPV = NPV + real option value $A M

where: d1 d2

S

1

r = Annual risk-free rate of interest expressed as decimal N(d) = cumulative standard normal distribution density function with upper integral limit d δ

= convenience yield (dividend) as a percentage per annum expressed as a decimal

In addition to the assumptions already discussed, the volatility of the cash flows of this project was estimated to be 25 per cent, of which about 20 per cent was represented by the volatility of nickel prices and the rest by a variety of other uncertain project inputs. Another necessary input was the risk-free rate of interest (RF), which was estimated at six per cent, ie at a premium of 1.25 per cent above the 4.75 per cent RBA cash rate prevailing at the time. On this basis, given that the mining leases did not need being renewed for another 11 years (T), the ROV of the project was assessed at $21.03 M, as shown in Table 10.3. As a consequence the net present asset value (NPAV), or expanded net present value (ENPV) (Mun, 2002, p 168), of the project/company, assuming no other significant assets in its portfolio at that time, is then the sum of its NPV and ROV, ie: ENPV = NPV + ROV = -$8.87 M + $21.03 M = $12.16 M

S = spot price = Present value of net after-tax operating cash flows $A M

43.13

in mining projects; the volatility of returns cannot, as is the case with financial securities, be simply generated from ASX statistics, and may require complex forecasts and Monte Carlo simulations; and the list goes on. In the case of the Sally Malay example, the structure of the delaying option could be simplified to an extent that a closed-form equation (ie the Black and Scholes formula) fitted the problem well. However, the somewhat restrictive underlying assumptions, which are valid in the case of financial derivatives, can be less realistic in the case of mining projects. Infrequent trading patterns, potential negative values, and generally more complex sequential and compound real option structures make determination of ROVs using the Black and Scholes formula less reliable and in many cases infeasible. However, when the project model can be simplified to fit, the B-S formula can provide a reasonable order of magnitude ROV. If on the other hand, the project model cannot be reconciled with some of these limitations and constraints, then more complex and more versatile methods, such as the binomial lattice or the binomial tree, need to be used. These will be discussed in a later section.

This figure is remarkably close to the company’s market capitalisation at the time, ie around A$12.2 M.

MODERN ASSET PRICING USING COMMODITY FORWARD PRICES

The B-S formula was devised to value financial derivatives and is based on a range of assumptions, some of which may be too restrictive and unrealistic in the context of real options. For instance, the lack of continuous direct frictionless trading and market valuations of mining projects underlying real options, fall a lot shorter than their financial securities counterparts, where a lot of the necessary metrics can be easily derived from market records; real options often involve the flexibility of early exercise and possible dividends while not exercised; the fact that option values are always positive presupposes no abandonment costs

Fundamental real option principles – value consistency, no-arbitrage and replicating portfolios

Mineral Economics

A fundamental assumption underlying option valuations is that financial markets are frictionless and display relatively high levels of efficiency, ie relevant information is rapidly disseminated and incorporated in the price of assets. Under these circumstances (Salahor, 1998), assets with similar risk characteristics and producing the same cash flows at the same times in the future should have the same price. 163

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk If this value consistency principle did not apply, then arbitrageurs would have an opportunity to make a risk-free profit by buying undervalued assets and selling overvalued ones. Arbitrage opportunities are infrequent and short-lived. This is known as the no-arbitrage or one-price principle. Furthermore, according to the value additivity principle, the components of a cash flow model (eg revenue and costs) can be separately evaluated, appropriately discounted and re-combined. Thus, cash flows can be viewed as commodities (Bradley, 1998), with timing and risk as criteria of value. In this light, as discussed below, the present value of holding a claim on a future cash flow, irrespective of the assets from which it is derived, can be simulated by a replicating portfolio of different investments, as long as they provide the same present value. Under no-arbitrage conditions Samis (2002) visualises a mining project producing a highly price-volatile commodity as a set of contingent claims on future cash flows providing the same value as a replicating portfolio3 composed of: •• A series of forward contracts, with quantities and delivery dates matching the mineral production schedule of the mine. After all, the present value of a unit of production at various times in the future is exactly replicated by the corresponding forward prices, which incorporate discounting for risk. •• Issuing a series of bonds with interest and principal repayments of a magnitude and maturity matching the estimated annual cash outflows related to the emerging operating and capital costs of the project. This approximation is broadly warranted because operating and capital costs can be estimated with a higher degree of confidence and can, to some degree, be kept on budget by sound technical and financial management. A portfolio made up of the risky project, the forwards and the bonds would in fact be fully hedged and riskfree.

Commodities forward prices as certainty equivalents Commodities forward contracts are a form of ‘certainty equivalent’ because the negotiated prices will be received in cash and with certainty at the time of delivery. Forward prices take into account and compensate for the potentially high volatility of the 3

In theory, the holder of proven mineral reserves in the ground, supported by a strong bankable feasibility study, would not need to develop a physical mine to achieve the same cash flow results. For commodities such as gold, the prices of which are dominated by contango (ie with futures prices higher than the corresponding spot prices) a ‘virtual mine’, made up of a series of rolling forward sales matching the production schedule of the mining plan in the feasibility study, would have the same cash flow effect. The main reason why ‘virtual mines’ do not exist is due to the fiscal regime, while tolerating rolling over of forward sales as legitimate hedging in tune with future physical production, acts as a disincentive to pure speculation.

164

spot commodity price in the future and are adjusted for convenience yields (ie any possible leasing/dividend cash inflow net of related storage, insurance and financing costs of holding the physical commodity). On the basis of the fundamental ROV principles, one can build models of mining projects that separate the revenue function from the cost function and determine the revenue cash flows using forward prices as the relevant price input. As the use of secure forward contract sales removes the main component of risk (ie the price risk) from the estimate, it would then be inappropriate to use a risk-and-time-adjusted discount rate to obtain the present value of future revenue cash flows and as a consequence, the only discount to be applied is the risk-free rate to compensate for the time-value of future cash flows. This modelling methodology, which is a form of real option valuation known as modern asset pricing (MAP) (Salahor, 1998, p 15; Laughton, 1998; Guj and Garzon, 2007), gives good, generally conservative, estimate of the value of a project under the assumption that the bulk of its risk is linked to the volatility of the price of the commodity produced. As it will be discussed later, there are other forms of real option valuations that will allow to ‘neutralise’ the volatility of the cash flows of a project encompassing all other sources of risk besides price risk. For some commodities forward prices are readily available for deliveries up to three years in the future. This makes evaluation of short-lived mining operations very accurate and convenient. For operations with longer mine lives, analysts must forecast forward commodity prices beyond the longest available delivery quotation using stochastic (probabilistic) models of their market behaviour. Under normal market conditions, prices generally distribute log-normally and follow a Geometric Brownian Motion (GBM) around a mean trend or drift. GBM means that in any interval of time, prices can either go up or down randomly as a function of their volatility. Furthermore, following any unusual price-shock, the prices of most mineral commodities (see the nickel example in Figure 10.20) gradually revert to their mean trend or drift because market forces react by bringing new supplies into production in the case of significant price increases, or reducing supplies for falls in price. Figure 10.20 was constructed using the standard GBM for continuous spot price changes (dS) including reversion to the mean and error factors, ie: dS = [a* + 0.5 σ2 – γln (S/S*)] S dt + σ S dz where: α*

= short-term growth rate of the price median

S

= current spot price

S*

= current long-term price median

σ

= short-term price volatility Mineral Economics



chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk financial securities rather than that of other mineral commodities, represents a notable exception, which can be explained by the quasi-monetary role played by gold in the financial system.

$25,000.00

Ni Price ($US/t)

$20,000.00

$15,000.00

More details about this price forecast model can be found in articles by Baker, Mayfield and Parsons (1998), Salahor (1998), and Samis (2002), who deal with its various mathematical components and derivation.

$10,000.00

$5,000.00

$0.00

0

1

2

3

4

Time (years)

5

6

7

Expected spot price ($/unit)

Forward price ($/unit)

Lower 10% confidence

Upper 10% confidence

8

Average LME Forward Quote Calibration

Fig 10.20 - Projected spot and forward nickel price curves as of January 2004.

γ z

= ln(2)/half-life = reversion factor = a standard random variable

Let us assume that in January 2004 (Table 10.4), when the price of nickel was US$14 810/t, you had been offered for sale an operating mine with five years of remaining production at the rate of 5000 t/a of nickel metal. Let’s further assume that reliable mine records showed that the unit operating cost at the time was US$7000/t and likely to rise in line with inflation at a rate of 3.0 per cent per annum. What would be a fair purchase price for this operation if your company has a beta (β) of 1.25 and a risk-free rate of interest of six per cent is used? One could approach this problem in two ways by:

If a very large half-life value is input in the γ formula, then the value of γ tends to zero, and the GBM algorithm can be used to forecast the behaviour of the price of non-reverting commodities such as gold. The gold price non-reverting behaviour, which is more akin to that of

1. Forecasting the likely spot prices for nickel over the next five years, as in Figure 10.20, and building a cash flow model to assess the relevant fundamental value for the project, ie its DCF/NPV after discounting by the risk-and-time-adjusted discount rate.

Table 10.4 Comparison between the discounted cash flow/net present value and modern asset pricing/net present value of an operating nickel mine. Comparison between discounted cash flow and modern asset pricing Annual nickel production (t)

5000

5000

5000

5000

5000

Expected nickel spot price ($US/t)

14 810

14 479

13 787

12 972

12 174

11 448

Forecast nickel forward price ($US/t)

14 810

13 190

11 634

10 282

9164

8261

0

1

2

3

4

5

Real unit cash production cost ($US/t)

7000

Risk-free interest (%)

6.00%

Beta index of company

1.25

Market porfolio premium (%)

6.00%

Average annual inflation (%)

3.00%

Year Discounted cash flow (DCF) analysis Revenue ($US M)

72.4

68.93

64.86

60.87

57.24

Cash production cost ($US M)

36.05

37.13

38.25

39.39

40.57

Net cash flow ($US M)

36.35

31.8

26.62

21.48

16.66

0.8811

0.7763

0.6839

0.6026

0.5309

32.03

24.69

18.21

12.94

8.84

Risk and time adjusted discount factor @

0.135

1.0000

DCF ($US M) DCF/net present value ($US M)

96.71

Modern asset pricing (MAP) analysis Revenue ($US M)

65.95

58.17

51.41

45.82

41.31

Cash production cost ($US M)

36.05

37.13

38.25

39.39

40.57

Net cash flow ($US M)

29.9

21.04

13.16

6.43

0.74

0.9434

0.8900

0.8396

0.7921

0.7473

28.21

18.73

11.05

5.09

0.55

MAP risk-free discount factor @

0.06

1.0000

MAP discounted CF ($US M) MAP/NPV ($US million)

Mineral Economics

63.63

165

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk 2. Inputting the then current nickel forward price quotes from the LME for the first three years and forecasting those for the remaining two years, as in Figure 10.20, and then discounting the resulting cash flows by the risk-free rate of interest to obtain the relevant MAP/NPV.

confidence. Methods to estimate volatility, as described in Copeland et al (2003, pp 244-269) and Mun (2002, pp 197-202), can be problematic at times and probably represent the greatest challenges in carrying out real option valuations.

Table 10.4, which provides a comparison of these two approaches, clearly indicates that the MAP method produces a much more conservative valuation (ie US$63.63 M) than the corresponding DCF analysis (ie US$96.71 M). This results primarily from the fact that the higher rate of discount applied to the operating costs in the DCF model makes their impact particularly in the later years of the project life insignificant by comparison to the less discounted operating cost counterparts in the MAP model.

1. logarithmic return

A MAP valuation would thus, in contrast with DCF analysis, encourage up-front investments designed to reduce future annual operating costs, and may place a higher value on projects with revenue or operating efficiency increasing over time relative to DCF valuations.

Using binomial lattices in valuing real options in practice While price volatility is the predominant source of volatility in the cash flows of many mining projects, it is often not the only source. A significant degree of uncertainty may be attributable to other revenue input components, to which the performance of the project is highly sensitive. These include uncertainty surrounding the estimates of: •• grade and tonnages of ore reserves •• metallurgical recovery (taking into account its correlation with grades) •• exchange rates between the Australian and United States dollars (making allowance for a degree of correlation between US$-denominated prices and the Australian dollar given its so-called ‘commodities currency’ characteristics, and so on. While it is mathematically possible through complex stochastic calculus and partial differential equations to build specific project models that take into account the volatility of the various project inputs, as their number increases, the construction of a realistic mathematical model for application in MAP, or to generate a closedform equation, becomes very hard to handle in practice. A more friendly way to construct a real option model of a project is by using the volatility of its future net aftertax cash flows, rather than the individual volatilities of various inputs. After all, the volatility of the project cash flows is a complexly ‘weighted’ function of the volatility of all the project inputs. Such an approach provides more accurate results, as long as one is able to estimate the cash flow volatility with some degree of 166

Two methods are of practical application, the: 2. market proxy approach. For financial assets which are continuously traded in the market, such as shares, σ can easily be calculated from the time series of their daily price variations. In the case of infrequently traded assets underlying real options, their aggregated volatility (σ) is represented by the standard deviation of the logarithmic returns on holding the project (Benninga, 2001, p 513). This is calculated by performing a Monte Carlo simulation on the ‘logarithmic returns’ factor γ derived from the project DCF model (Copeland and Antikarov, 2003, pp 244 - 246): γ = ln(PVt = 1∑CFt = 1 to n /PVt = 0∑CFt = 0 to n) In the above formula, the numerator represents the present value of the net after-tax operating cash flows of the project from year 1 onwards discounted to time t = 1, while the denominator represents the present value of the operating cash flows from year 0 onwards, discounted to time t = 0. The Monte Carlo simulation is performed on the numerator only, while keeping the denominator of factor γ constant. The market proxy method entails calculating the standard deviation of the logarithmic returns due to daily changes in price (ln(P t + 1/P t)) of the share of a listed company holding a project similar to that being evaluated. The daily volatility must be annualised, eg for 250 trading days Δt = 1 y/250 = 0.004, hence, annual σ = daily σ/Δt ^ 0.5. If debt is present the volatility must be brought back to a 100 per cent equity basis. Once the cash flow volatility of a project has been estimated, it can be used not only with established closed-form equations (eg the B-S formula) but also with the more versatile and friendly binomial lattice and binomial tree methods, and as one of the inputs when calculating ROV with ‘hybrid’ decision trees (Guj and Chandra, 2012) where sources of market risk and private risk are handled separately, the first in aggregate and the second individually. Ito’s Lemma states that a dependent variable, such as the revenue cash flows of a project, which is a function of a stochastic process (eg commodity prices), is itself a stochastic process. As a consequence, the NPV of a project can also either go up or down over an interval of time along a path determined by the volatility of its cash flows, which in turn is a function of the combined volatility of the price of the commodity produced and of other significant uncertain variables. Mineral Economics

Chapter 10 – MIneral projeCt eValUatIon – DealIng wIth UnCertaInty anD rISk Binary systems with two possible, mutually exclusive outcomes of the type success or failure (or up or down) generally adhere to the discrete binomial probability distribution, which explains its importance in option analysis. In discrete binomial systems: success means the price will rise in any unit of time by a factor (1 + σ), where σ is the measure of volatility per unit of time (T in years) • failure means that the price will fall by a factor of (1 - σ). If we select a smaller (at the limit infinitesimal) time interval (Δt = T/n, where n is the number of time subdivisions within one year), the discrete binomial distribution lattice tends to become finer-grained, continuous and exponential with: •

Up factor up = exp(σ × Δt0.5) and down factor down = exp(-σ × Δt0.5). Mun (2002) shows that these exponential formulae provide a reasonable approximation of the corresponding discrete binomial distribution even when the time intervals used are reasonably coarse. For this reason, the author recommends the use of continuous binomial lattices or of related binomial trees as the most practical way of modelling real options. There will be cases, however, where these methods may not be practical in modelling complex real options, and the use of hybrid decision trees may be more applicable. Risk can be neutralised using one of three related methods: 1. the relatively unfriendly ‘replicating portfolio’ method 2. the related more friendly ‘state prices’ 3. the ‘risk-neutral probability’ method. Each of these methods seeks to ‘neutralise’ risk by analysing and mathematically manipulating the individual risk characteristics of each project/ investment opportunity. As for MAP, this obviates the need for risk discounting. In other words, instead of using a single time- and risk-adjusted discount rate, real options evaluations entail (see Figure 10.21) a twostep process of:

Fig 10.21 - Differences between discounting in discounted cash flow

analysis and in real options valuations (after Dias, 2002).

amount an investor would be prepared to pay today for a state asset. It is in effect the risk- and time-discounted value of $1 to be received if the relevant state of nature eventuates, with no alternative loss. The ‘risk-neutral probability’ p is the undiscounted equivalent of the state price for the up state. As each method is derived from the preceding one and delivers identical ROVs, the choice as to which to use is a matter of individual preference and ease of use. In this respect the author agrees with Mun who recommends the continuous ‘risk-free probability (p)’ approach as the most practical and versatile. Its formula is: p = [exp(( r -b) × Δt) - down]/(up - down) where: r

is the risk-free rate of interest

b

represents any continuous dividend payout, if applicable, expressed as decimals

Proof of the risk-neutralisation capacity of these techniques is beyond the scope of this chapter. Benninga (2001) provides a simple introduction to the concept of replicating portfolios and state prices, while Copeland and Antikarov (2003) deal with ‘risk-neutral’ probabilities in more depth. Mun (2002) identifies a number of distinct steps in the process of determining the ROV of a project. These are essentially:

1. determining certainty equivalents of the undiscounted cash flows through risk neutralisation

•

2. discounting them for their timing using the risk-free rate of interest.

•

Benninga (2001, pp 253 - 273) describes how the ‘state price’ method is derived from the ‘replicating portfolio’ method and its relationship with the Black and Scholes formula, in understandable terms. A ‘state asset’ is a claim that pays a future cash flow of $1 if a particular state of nature occurs, with no loss if the desired state of nature does not eventuate. A ‘state price’ is the Mineral economics

• • •

constructing a static DCF base case model of the project carrying out a Monte Carlo simulation of its outputs (eg its expected NPV and volatility of net, after-tax operating cash flows) to be used as inputs in the real option valuation identifying and modelling the real option(s) applying an appropriate real options valuation method and optimising choices/decisions reporting and communicating the results effectively. 167

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk

VALUING AN EXPANSION OPTION WITH THE BINOMIAL LATTICE AND BINOMIAL TREE METHODS USING THE ‘RISK-NEUTRAL’ PROBABILITY

two downs, because 1.6 times the relevant value of the underlying asset at $60 M less the implementation cost of $40 M is greater than the value of not expanding, ie:

Binomial lattice method

Similarly, for 234.33 versus 171.46, and for 96.23 versus 85.14 the same choice would be made. For the scenarios from two up and three down to five down, the value of expanding is lower than continuing with the single mill, and the expansion option is consequently let to expire.

The binomial lattice with ‘risk-neutral probabilities’ is the simplest and most versatile step in overcoming complexity and achieving greater realism. This will be illustrated by valuing an expansion option. Consider a gold custom mill with an annual capacity of 1 Mt of ore and a static DCF-based NPV of $60 M. The volatility of the logarithmic returns on its future cash flows is estimated using a Monte Carlo simulation to be 35 per cent. The owners of the mill have been successful in attracting ore to their facility and they envisage that within the next few years it may be possible to secure double the current volumes. As a consequence, they are seriously considering expanding their capacity. They have now become aware that a mine in the region is approaching exhaustion and that its owners would be agreeable to sell their mill with a 0.6 Mt annual capacity at any time during the next five years for $40 M, and if necessary, letting the acquirer treat their remaining ore on a custom basis. This represents a potential 60 per cent expansion, which would increase the DCF/NPV by a factor of 1.6 minus the acquisition (exercise) price of $40 M. The option is at present not ‘in the money’ because, if exercised, the value of the expanded enterprise would be 1.6 × $60 M - $40 M ($56 M), which is less than the NPV of not expanding the mill currently worth $60 M. Given the high volatility and long time to its expiry, this does not mean that the option is worthless. On the contrary, both the buyer and the writer of the option need to determine how much the option may be worth as a basis for negotiations. This classical expansion option lends itself to being solved by applying the continuous ‘risk-free probability’ method to the relevant binomial lattice of the asset. First, one must calculate the: •• up factor, up = exp(σ × Δt0.5) = 1.419 •• down factor, down = exp(-σ × Δt0.5) = 0.705 •• risk-neutral probability, p = [exp((r - b) × Δt) - down]/ (up - down) = 0.515. Then, one must construct, as in the top part of Figure 10.18, the binomial lattice displaying the effect of various combinations of ups and downs on the NPV of the underlying asset. An option valuation lattice is then constructed as shown in the bottom part of Figure 10.18 by first determining, in column 5, under which combinations of ups and downs it would be optimal to expand. For instance, expansion is warranted in the case of five ups, four ups and one down, and three ups and 168

1.6 × 345.28 - 40 = 512.44 > 345.28

The next step is to roll back the values in the option valuation lattice from right to left starting from the step 5 column. For instance, 352.00 in step 4 is obtained by applying the ‘risk-neutral’ probability (p) to 512.44 and 234.33 as follows: (512.44 × 0.515 + 234.33 × (1 - 0.515)) × exp (- 0.07 × 1) = 352.00 where: exp (- 0.07 × 1) is the time discount factor for Δt = 1 year on a continuous basis As each pair of figures in each column is rolled back to the left in a similar manner, the combined value (or expanded net present value (ENPV)) of $74.33 M is obtained. These lattices can be done relatively simply using a personal computer spreadsheet as shown in Figure 10.22, but more complex options may require specialised software which also allows the construction of more accurate, multi-step lattices with greater granularity (Mun, 2002, p 154). The difference between the ENPV at $74.33 M and the basic NPV of the project prior to expansion (ie $60 M) is the ROV from the point of view of the buyer, ie $14.33 M.

Binomial tree method Exactly the same ROV of $14.33 M as for the previous expansion problem can be obtained by inputting the same continuous up and down factors and risk-neutral probability in a decision tree as shown in Figure 10.23. In the case of this simple example, the choice between the two methods boils down to a matter of individual preference and available software. The binomial lattice with only six terminal branches, most of which represent a number of different combinations of up and down states or scenarios leading to the same value, has the benefit of being more compact, and therefore, more visible on a computer screen. Its disadvantage is that the optimal decision path under different scenarios is not immediately visible or intuitive, but can relatively easily be calculated. The binomial tree, by contrast, would over the five years develop into 26 = 64 terminal branches of which Mineral Economics

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk BINOMIAL LATTICE USING THE CONTINUOUS RISK-NEUTRAL PROBABILY METHOD NPV of underlying asset $M Expansion cost $M Maturity (Years) Risk-free rate (%) Capacity augmentation factor Dividend (%) Volatility (%) Lattice Steps

60 40 5 7.00% 1.60 0.00% 35.00% 1

Time 0

Stepping-time (t) Up-step size (up) = exp(*t 0.5)= Down-step size (down)= exp(-*t 0.5)= Risk-neutral probability (p) =(exp(rf*t)-down)/(up-down)=

Time 1

Time 2

Time 3

Time 4

Time 5

1up 1down

2up 1up1down 2down

3up 2up1down 1up2down 3down

4up 3up1down 1up3down 1up3down 4down

5up 4up1down 3up2down 2up4down 1up4down 5down

1 1.419 0.705 0.515

Possible outcomes Certain

Underlying asset value lattice

= 60 * 1.419 60.00

85.14 42.28

120.83 60.00 29.80

= 60 * 0.705

Option valuation lattice and decisions ENPV 74.33

Real option value = ENPV - NPV = ROV

Open 109.75 47.84 14.33

171.46 85.14 42.28 21.00

243.31 120.83 60.00 29.80 14.80

345.28 171.46 85.14 42.28 21.00 10.43

=(512.44*0.515+234.33*(1-0.515))*exp(0.07*1^0.5) Open Open 239.56 352.00 512.44 Expand 104.45 156.02 234.33 Expand 44.84 65.32 96.23 Expand 21.00 29.80 42.28 End 14.80 21.00 End 10.43 End Max(1.6 * 345.28 - 40 and 345.28)

Open 162.25 70.42 31.02

Fig 10.22 - Binomial lattice using the risk-neutral probability method.

Fig 10.23 - Binomial tree providing a real option value identical to that obtained with the binomial lattice of Figure 10.22. Mineral Economics

169

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk only a few are displayed in Figure 10.23 as the bottom section of the tree has been truncated to fit the page. This means that even the current simple example would be beyond the capacity of some basic decision tree software requiring manual data entry on screen at each branch, and would require more sophisticated, programmable decision tree software, ideally with dynamic programming capacity (ie DPL7), as that utilised in Figure 10.23.

Valuing tonnage-grade trade-offs Analysts are often required to capture the option value of projects with significant potential gradetonnage trade-offs. Traditional JORC-code-based DCF/ NPV valuations, including only proven and probable ‘run-of-the-mill’ reserves, generally do not recognise managerial flexibility and the price leverage inherent in not only these reserves, but also the surrounding halo of lower grade resources. Therefore, they grossly undervalue such projects. A number of sophisticated models to assess the optimal timing for expansion, contraction and abandonment of mining projects as a function of commodity prices have been developed following the paper by Brennan and Schwartz (1985). These include, amongst others, modelling the price, cost and reserve uncertainty of a generic copper mine by Cortazar and Cosassus (1998) and by Samis, Laughton and Poulin (2002), and of the East Rand gold mine by Samis (1995). Figure 10.24, which has been adapted from Samis (2002), displays the possible pay-offs for the options inherent in a mining project with a small core of highgrade reserves, within a large volume of ‘run-of-themill’ ore, adjacent to a significant low-grade resource. Grade-tonnage trade-offs give rise to what is known as a chooser option (Mun, 2002, p 181), as the investor can choose among more than one, mutually exclusive, possible courses of action at any one time.

above A, it becomes justifiable to develop the project to mine the high-grade core. As prices continue to rise, the project becomes increasingly more profitable, until prices exceed B, when it is financially justifiable to mine ‘run-of-the-mill’ grade ore. When prices rise above C, an expansion of production to the low-grade ore is optimal. Let us consider the options open to the manager of a mining operation worth $100 M, which is currently producing ‘run-of-the-mill’ ore. Further, assume that for five years, depending on the direction and severity of commodity price changes, he or she can: •• continue to mine ‘run-of-the-mill’ ore requiring no capital investment •• expand production by 30 per cent by mining lowergrade ore at a capital cost of $20 M •• contract production by ten per cent by mining highgrade blocks within the current ore reserves at a savings of $25 M •• abandon production and sell the project for $85 M. Figure 10.25 shows that this chooser option would add $17.27 M to the static NPV of the project even at a modest level of 15 per cent volatility in the cash flows of the project, and at a risk-free rate of interest of five per cent. The process in Figure 10.25 is the same as that used in the previous expansion model as far as the lattice of values of possible outcomes is concerned, but uses a different maximisation rule to determine the end members of the lattice of option values, namely: Max (continue, expand, contract, abandon) Thus, the expansion option is the most valuable outcome in the case of five successive up states of nature, as it is higher than the value of the underlying asset under the same states of nature but without expansion, ie: (value of underlying asset if 5 ups occur) × (1 + expansion rate) - implementation cost = (($211.7 M × (1 + 30%)) - $20 M) = $255.2 M is higher than: (present value of project in year 0) × (up factor compound over five years) = $100 M × exp (s × Δt 0.5) 5 = $211.7 M

Fig 10.24 - Types of real options due to grade-tonnage trade-offs in mining.

At a commodity price below A, the project is subeconomic and development would be delayed, or, if the mine is operating, it would close. If prices rise 170

As a matter of fact, the value of the expansion option under these states of nature is higher than any of the other options open to the investor. The option value lattice of Figure 10.25 shows the expansion option has the maximum value even if there are four ups and one down (ie $183.9 M) or three ups and two downs (ie $131.0 M), after which the contract option produces the maximum value (ie $102.5 M). In the case of one up Mineral Economics

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk

CHOOSER MULTIPLE OPTION ‐ BINOMIAL LATTICE ROV EVALUATION Investor has for 5 years the choice to (1) Continue ti mine ROM ore, (2) Expand to lower grade ore, (3) Contract to higher grade ore or abandon (sell) the mine Volatility of CF Continuous U Continuous D "risk‐free" p Risk‐free rate Continuous  Disc. Possible future project NPVs 0 100.00 Spot price (S) $M

0.15 1.162 % Change in NPV 0.861 X $M 0.633 T ( years) 0.05 Steps (total) t 0.951

Continue

Expand

Contract

0 0 5 5 1

0.3 20

1 116.18 86.07

2 134.99 100.00 74.08

3 156.83 116.18 86.07 63.76

4 182.21 134.99 100.00 74.08 54.88

1 136.08 101.24

2 158.72 116.06 89.83

3 185.78 134.23 100.94 83.24

4 217.85 156.46 114.67 91.37 80.85

86.07

63.76

47.24

86.07 91.89 102.46 85.00

63.76 62.89 82.39 85.00

47.24 41.41 67.51 85.00

102.46

85.00

85.00

ENPV $M 0 117.27

ROV $M

Abandon ‐0.1 ‐25

17.27

Year 5 value in lattice of possible future project NPVs (F10 to F15) 211.70 156.83 116.18 Matrix to determine best course of action 211.70 156.83 116.18 255.21 183.88 131.04 215.53 166.15 129.57 85.00 85.00 85.00 Maximum value 255.21 183.88 131.04

‐1 ‐85

5 211.70 156.83 116.18 86.07 63.76 47.24 Possible option values 5 255.21 Expand 183.88 Expand 131.04 Expand 102.46 Contract 85.00 Abandon 85.00 Abandon

No Continue 3 Expand 1 Contract 2 Abandon

Fig 10.25 - Estimating the value of a miner’s chooser option to expand, contract or abandon production.

and four downs and five down, the course of action that maximises value is to sell the project for $85 M.

of production in response to changes in commodity prices.

The roll back process then involves the progressive application of risk-neutral probability and continuous discounting for timing as in the expansion option of Figure 10.22. This chooser ROV of $117.27 M - $100 M = $17.27 M is not equivalent to the sum of the individual single options to expand, contract, and/or abandon, because they are mutually exclusive, but is derived as a chooser option combination of the three.

A discussion on how to overcome the conceptual complexity and computational difficulty in recognising and modelling such multiple, sequential and compound real options is, however, well beyond the scope of this paper.

This model, as well as the option models previously discussed, would determine a fair project value while the option is open, but they do not imply that the project maintains this value at any stage after the option is exercised. For instance, if the expansion option were exercised after the price increases, then the mine owner would only have the option to regress to mining ‘run-of-mill’ ore or abandon. This chooser option would have a vastly different value. A higher level of complexity is also created by the fact that, in real life, all of these options are in fact switching options, whereby management generally would have some flexibility of moving from time to time from one operational mode to another in response to price movements. This type of option is addressed in Slade’s (2001) model of all the Canadian copper mines operating between 1980 and 1993, which includes a methodology, albeit mathematically complex, to value the option of implementing temporary suspension and resumption Mineral Economics

A further significant challenge in real options evaluations arises from the resistance in general presented by management who do not fully understand and accept the validity of real options valuations. This is because it is difficult to explain the methodology and communicate the results in simple language under often-severe time constraints. It seems likely that communication problems may have been the main cause for the relatively slow rate of acceptance up to date of this otherwise powerful and more realistic way of valuing mining projects. Much can and should be done to demystify the subject and increase understanding and acceptance.

VALUING A FARM-IN/OUT SEQUENTIAL/ COMPOUND OPTION A real option is said to be sequential and compound when there is a series of chronologically sequential decisions (eg project stages), where each decision is conditional on a previous one. At the conclusion of each successive phase of an exploration program, 171

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk for instance, explorers have the option, but not the obligation, to: •• progress to the next stage •• defer further exploration if they can hang onto the license •• farm-out an equity stake in the project •• abandon the project. As an example, an exploration company is offered the following farm-in option: •• by funding statutory exploration commitments amounting to $30 000 it can carry out surficial exploration for one year •• at the end of year 1, by paying $0.5 M and guaranteeing funding of statutory expenditure commitments for the next two years, it acquires the right, but not the obligation, to drill test the project over the following two years •• at the end of year 3 the company can acquire 100 per cent equity in the project by paying $7 M, or walk away with no penalty. The project is the only asset held by a junior company which is debt-free, has little cash in the bank and is capitalised at $5 M. It has been estimated that the average volatility of return for similar, single-project junior exploration companies under foreseeable market conditions is 60 per cent. The applicable risk-free rate is seven per cent.

One must first construct the lattice for the longestterm option, the 100 per cent acquisition stage for $7 M at the end of year 3, as shown in Figure 10.26. The shorter-term option, to drill test the project, must then be superimposed on it, taking into account the related implementation cost at the end of year 1 of a $0.5 M payment plus $60 000 in statutory expenditure commitments. As it can be observed from Figures 10.26 and 10.27, the same ROV of $0.84 M is obtained by both the binomial lattice and binomial tree methods.

DIFFERENCES BETWEEN REAL OPTION VALUE USING BINOMIAL TREES AND ‘HYBRID’ REAL OPTION VALUE DECISION TREES All ROV methods considered so far make use of a single measure of project cash flow volatility encompassing all sources of uncertainty. However, the need may arise to differentiate and handle separately in ROV calculations individual sources of uncertainty. Smith and McCardle (1999) and Guj and Chandra (2012) have discussed how sources of market risk (eg commodity prices and exchange rates) can be distinguished from those relating to private or project risk (eg ore grades, metallurgical recoveries, etc) using sophisticated decision tree software in what they called ‘integrated’ or ‘hybrid’ decision trees respectively.

3‐YEAR FARM‐IN/OUT AGREEMENT FOR AN OPTION TO BUY A PROJECT ‐ A SEQUENTIAL/COMPOUND OPTION Note ‐ The longest 3‐year option (grey) is calculated first, then its year 2 values (blue) are fed into the 2‐year option and so non

p Rf RADR

 0.6 t 1 U 1.822119 D 0.548812 0.39461 0.05 0.14

Cont. Disc. Risk‐free 0.951229 Cont. Disc. Risk‐adjuste 0.869358

Possible values of underlying asset (S)

0 5.00

1 9.11 2.74

2 16.60 5.00 1.51

3 30.25 9.11 2.74 0.83

Option 3 value disregarding option 1 and 2

0 1.28

1 3.29 0.08

2 8.46 0.21 0.00

3 21.69 0.55 0.00 0.00

Option 2 and 3 disregarding option 1

0 1.03

1 2.74 0.00

2 7.30 0.00 0.00

Sequential/compound ROV 0 1 2 0.84 2.23 7.30 0.00 0.00 0.00

3 21.69 0.55 0.00 0.00

3 21.69 0.55 0.00 0.00

Acquisition price Y3 Rentals Y3 Exploration and feasibility  Y Sum T 3 Steps 3 t 1

7.00 0.06 1.50 8.56

PV PV PV Sum

6.02 0.05 1.29 7.37

Payment Y2 Rentals Y2 Drilling Y2 Sum T Steps t

0.50 0.06 0.60 1.16

PV PV PV Sum

0.452419 0.05429 0.542902 1.049611

0.25 0.06 0.20 0.51

PV PV PV Sum

0.24 0.06 0.19 0.49

Payment Y1 Rentals Y1 Exploration Y1 Sum T Steps Delta T

2 2 1

1 1 1

Fig 10.26 - Valuation of a sequential/compound farm-in/out option using a binomial lattice. 172

Mineral Economics

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk

Exercise option 0.395

17.13

up

18.67

17.13

1 0

17.13 Lapse ‐1.53 0

JV phase 3 ‐1.05

‐1.53

6.12 Exercise option 0.605 Down

0.395

‐1.06 0.47

up

‐1.06

1 1 0

0

‐1.06

6.12

Lapse ‐1.53 0

‐1.53

Pass ‐0.49 0

‐0.49

JV phase 2 Exercise option ‐0.49

2.12

0.395

‐1.06

up

0.47

‐1.06

1 0

‐1.06 Lapse

JV phase 3

‐1.53 0

0.395

‐1.05

up

0.605 down

1

‐1.53

‐1.35 0.605 down

2.12

2 0

‐1.53

‐0.49

0

‐1.53

Pass ‐0.49

ROV

0

‐0.49

0.84 Pass 0 0

0

0.605 down 0 0

0

Fig 10.27 - Valuation of a sequential/compound farmin/out option using a binomial tree.

Figures 10.28a and 10.28b, reproduced from Guj and Chandra (2012), compare the structure of the binomial and of the ‘hybrid’ decision trees used to calculate the ROV of a farm-in/out agreement for the acquisition of a copper project in its second year of operations, as opposed to buying it at Year 0 and

developing it. In the binomial tree of Figure 10.28a, a single, all-encompassing measure of volatility was used to calculate the up and down factors, and the related risk-neutral probability (p). In the ‘hybrid’ tree of Figure 10.28b, these factors (up, down and p) were calculated to encompass and neutralise only

(A)

(B)

Fig 10.28 - (A) Summary structure of a two-year binomial tree option; (B) summary structure of a two-year option

solved using a ‘hybrid’ decision tree. Note the separation of market risk from two sources of private or project risk.

Mineral Economics

173

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk the uncertainties relating to market risk, with those relating to private risk (ie copper grades and recoveries) handled as individual probability nodes. The probability distributions relating to these nodes were derived from the results of resource delineation drilling and of metallurgical pilot studies. The ENPVs obtained by the two methods are close, and support the same investment decision, namely to secure an option to acquire the project in year 2, after the proponents have developed it, rather than buying and developing it straight away.

STRATEGIC REAL OPTION VALUE CONSIDERATIONS Recognising and correctly estimating the value of real options has significant strategic value. Analysts in the petroleum industry have been the first to recognise and take advantage of these powerful techniques. Lesley and Michaels (1997), for instance, describe how British Petroleum (BP) made significant use of ROV when carrying out a rationalisation of its North Sea oil tenements at times of relatively low oil prices. Their real options valuations militated against relinquishing a number of licenses which were subeconomic at the time, but which, with the wisdom of hindsight, proved to be very valuable. Further, Smith and McCardle (1999) and Claeys and Walkup (1999) suggest ways to recognise option values in oil projects, while Faiz (2001) discusses possible approaches to integrate ROV in the strategic planning and optimisation strategy of a large integrated oil company. In the last few years, precious metals analysts have made systematic use of real options valuations to explain the equity premium on the share prices of gold and platinum-group-metal-producing companies (Morgan, 2005; Dinham, 2005). Of particular interest is the recent application by Flores (2004) of binomial lattices and risk-free probabilities to estimate the value of gold exploration projects. Asides from brokers, there have been relatively few published practical applications of ROV to the mineral exploration and mining industry, in spite of the appearance of several academic papers on the subject. This may not mean that such studies and applications are not carried out in the industrial arena, but may just be the reflection of the highly proprietary and confidential nature of these studies. As the saying goes, ‘mines are not found, they are made’. Many successful mines have been developed on the ashes of previous unsuccessful attempts. The main challenge is in recognising the real options inherent in a project that current owners have failed to spot. Invariably, the price expectations in the mind of the frustrated and risk-averse owners of projects, which 174

are subeconomic at current prices, tend to be low. This generates realistic opportunities for acquisition and value adding through more creative and flexible design, application of emerging technology and innovative contracting and financing. While the ROV methodology is generally complex with the relevant skills to apply it scarce or proprietary at this stage, the cost of carrying out a RO evaluation model is relatively low compared to its significant potential leverage in terms of value added. It is also fallacious to consider that ROV is the exclusive realm of financial analysts. Value is added primarily by the recognition of potential real options in a project, which by and large depends on good geological, mining engineering and metallurgical analytical skills. Furthermore, there is initially no need to construct an extraordinarily complex model, as an initial indication of whether there could be ROV and its order of magnitude may be obtained with a simplified model provided its structure is sound. Finally, even in the development of new mineral resources, a degree of knowledge of the ROV methodology on the side of design engineers will lead to more flexible, and therefore, more robust designs, capable of better withstanding some of the hard times that inevitably any mining operation will cross over its life. The strategic advantage of mastering RO valuations will, in the opinion of the author, soon be better recognised by shrewd operators in the mining industry in shaping both their acquisitive and divestment strategies.

CONCLUSIONS In summary, it can be concluded that: •• DCF analysis will continue to provide valid decisionmaking criteria, if a project has low expected cash flow volatility and low management flexibility. •• Investment decisions based on risk-neutral maximisation of the EMVs are unrealistic in most circumstances and greater awareness and use should be made of risk-averse investment criteria based on expected preference values or certainty equivalents (Cx). •• DCF analysis may introduce bias, and at times severe distortion, particularly when valuing financially marginal projects based on very pricevolatile commodities. There are many reasons for this, which include the application of a single riskand time-adjusted discount rate: •• To compare projects with inherently very different risk characteristics. •• To simultaneously account for uncertainty in the revenue of a project, which is generally subject to considerable price risk beyond management control, as well as its less risky and more controllable cost function. Mineral Economics

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk •• Deterministic DCF analysis does not capture the value of managerial flexibility to adjust their decisions and actions as new information progressively dispels uncertainty during the unfolding of the project. Managerial flexibility has all the characteristics of a real option to take actions beneficial to the firm with the wisdom of hindsight and avoid negative outcomes. •• Methods for the valuation of financial derivatives can be effectively adapted to the valuation of ‘real options’ inherent or deliberately planned in risky resources projects. •• Of the various methods to value real options, the use of binomial lattices, whether solved using ‘risk-free’ probabilities or ‘state prices’, is generally the most friendly and versatile approach. •• A nested system of deterministic DCF/NPV models of the main real options in a project can, in some cases, be used as a feeder for the inputs necessary to build an option binomial lattice, bypassing the need to build more mathematically complex partialdifferential-equation-based models.

REFERENCES Baker, M P, Mayfield, E S and Parsons, J E, 1998. Alternative models of uncertain commodity prices for use with modern asset pricing methods, The Energy Journal, 19(1):115-148. Bartrop, S B and Guj, P, 2009. Estimating historical probability of discovery in mineral exploration, CET Newsletter, Issue 8, June. Bradley, P, 1998. On the use of MAP for comparing alternative royalty systems for petroleum development projects, The Energy Journal, 19(1):47-82. Benninga, S, 2001. Financial Modelling, second edition (MIT Press: Cambridge). Brennan, M and Schwartz, E, 1985. Evaluating natural resources investment, Journal of Business, 58(2):135-157. Burn, R G, 1984. Exploration risk, CIM Bulletin, October, 55-61. Claeys, J and Walkup, G, 1999. Discovering real options in oilfields exploration and development, in Proceedings SPE Hydrocarbon Economics and Evaluation Symposium (Society of Petroleum Engineers: Dallas). Clemen, R T and Reilly, T, 2001. Making Hard Decisions (Pacific Grove: Duxbury). Copeland, T and Antikarov, V, 2003. Real Options (Texere: New York). Copeland, T E and Keenan, P T, 1998. How much is flexibility worth?, The McKinsey Quarterly, 2:38-49. Cortazar, G and Casassus, J, 1998. Optimal timing of a mine expansion: Implementing a real option model, The Quarterly Review of Economics and Finance, 38:755-769. Dias, M, 2002. Stochastic processes with focus in petroleum applications [online]. Available from: . Dinham, N, 2005. Platinum sector: New valuation method, Andisa Securities, 22 April 2005. Mineral Economics

Dixit, A K and Pindyck, R S, 1995. The option approach to capital investment, Harvard Business Review, MayJune:105-115 Faiz, S, 2001. Real option applications: From success in asset valuation to challenges for an enterprise-wide approach, Society of Petroleum Engineers, 42-48. Flores, V, 2004. Standing on a gold mine? HSBC Global Research, Precious Metals, December 2004. Guj, P and Chandra, A, 2012. Real option valuation of mineral exploration/mining project using decision trees: Differentiating market risk from private risk, in Proceedings Project Evaluation 2012, pp 177-188 (The Australasian Institute of Mining and Metallurgy: Melbourne). Guj, P and Fallon, M, 2009. An empirical analysis of progressive value and risk of exploration in the Plutonic Marymia gold belt, Western Australia, in Proceedings Project Evaluation 2012, pp 163-177 (The Australasian Institute of Mining and Metallurgy: Melbourne). Guj, P, Fallon, M, McCuaig, T C and Fagan, R, 2011. A timeseries audit of the Zipf’s Law as a measure of terrane endowment and maturity in mineral exploration, Economic Geology, 106:241-259 Guj, P and Garzon, R, 2007. Modern asset pricing: A valuable real option complement to discounted cash flow modelling of mining projects, in Proceedings Project Evaluation 2012, pp 113-119 (The Australasian Institute of Mining and Metallurgy: Melbourne). Greenwaldt, W A, 1981. Determining venture participation, Journal of Petroleum Technology, pp 2189-2195. Hayward, N, 2003. Risk behaviours and intuition traps, presented to AIG seminar Risk analysis and management in mineral exploration and development, November, Perth. Kim, J and Wallace, D, 1998. Mean-semivariance analysis: Risk and opportunity, in Proceedings Tenth International Conference on Design Theory and Methodology (Massachusetts Institute of Technology). Laughton, D G, 1998. The potential for use of the Modern Asset Pricing methods for upstream petroleum project evaluation: Introductory remarks, The Energy Journal, 19(1):1-11. Lawrence, R D, 2001. Should discounted cash flow projections for the determination of fair market value be based solely on proven and probable reserves?, Mining Engineering, 53:51-56. Lesley, K J and Michaels, M P, 1997. The real power of real options, The McKinsey Quarterly, 3:4-24. Lord, D, Etheridge, M and Uttley, P, 2003. Risk and value in mineral exploration – Case studies on the application of risk analysis, presented to AIG seminar Risk analysis and management in mineral exploration and development, November, Perth. Lord, D, Etheridge, M A, Willson, M, Hall, G and Uttley, P J, 2001. Measuring exploration success an alternative to the discovery-cost-per-ounce method of quantifying exploration success, SEG Newsletter, 45(1):10-16. Mamuse, A and Guj, P, 2011. Rank statistical analysis of nickel sulphide resources in the Norseman-Wiluna greenstone belt, Western Australia, Mineralium Deposita, doi 10.1007/s 00126-001-0333-z. 175

chapter 10 – Mineral Project Evaluation – Dealing with Uncertainty and Risk Morgan, J P, 2005. South African gold and platinum sector update, African Equity Research, 10 May 2005. Mun, J, 2002. Real Options Analysis (John Wiley: Hoboken). Newendorp, P and Schluyer, J, 2000. Decision Analysis for Petroleum Exploration (Planning Press: Colorado). Peirson, G, Brown, R, Easton, S and Howard, P, 2002. Business Finance, eighth edition (McGraw-Hill Irwin: New York). Salahor, G, 1998. Implications of output price risk and operating leverage for the evaluation of petroleum development projects, The Energy Journal, 19(1):13-46. Samis, M R, 1995. An option pricing analysis of the 1990 capital structure of the East Rand proprietary mine, in Proceedings Third Canadian Conference on Computer Applications in the Mineral Industry, October, Montreal. Samis, M R, 2000. Multi-zone mine valuation using Modern Asset Pricing (Real Options) Techniques, PhD dissertation (unpublished), University of British Columbia.

176

Samis, M R, 2002. Resources sector finance 602 – 2002 course notes, Western Australian School of Mines, Kalgoorlie. Samis, M R, Laughton, D and Poulin, R, 2002. An example of using real options to model a mine expansion decision at a multi-zone deposit, Application of Computer and Operation Research in the Mineral Industry, Phoenix. Slade, M E, 2001. Valuing managerial flexibility: An application of real option theory to mining investments, Journal of Environmental Economics and Management, 41:193-233. Smith, J and McCardle, K, 1999. Options in the real world: Lessons learned in evaluating oil and gas investments, Operations Research, 47:1-15.

Mineral Economics

Minerals and Public Policy

HOME

Chapter 11 Mineral Policy – An Introduction Philip Maxwell and Pietro Guj The aims and practice of economic policy The context of mineral policy Mineral policy in practice The transition of mineral policy since 1950 The post-1960 surge in public ownership The swing back to private ownership The rise of China Some other current policy realities Towards a competitive regulatory and fiscal regime for exploration and mining

THE AIMS AND PRACTICE OF ECONOMIC POLICY From the viewpoint of policy makers and citizens more generally, the most desirable state of society is a situation where there is optimal economic and social wellbeing. Randall (1987, p 132) describes this as: … a condition in which society is as well off as it can possibly be, given its resource base, its productive technology and the tastes and preferences of its members. It is possible to describe this in a simple static welfare economics framework in terms of the production possibility/community indifference curve diagram shown in Figure 11.1. The production possibility curve shows different maximum combinations of goods and services that society can produce if all factors of production are fully employed during a given period. With less than full employment of all factors of production, society will operate below the curve. It is not possible to produce above (to the right of) the production possibility curve, given the limited factors of production available and the current state of technology. In this simple view of the world, we can also draw a series of community indifference curves that show different combinations of goods and services corresponding to the same level of welfare1. As we 1

These curves implicitly assume a given distribution of income.

Mineral Economics

Goods

Community indifference curves

E

CIC3 CIC2

Production possibility curve

CIC1

Services Fig 11.1 - Maximising society’s well-being.

move from CIC1 to CIC2 to CIC3 the level of consumer welfare is increasing. Society will strive to reach the highest community indifference curve, with its current production possibility curve. In a comparative static framework, this occurs at the point E where the production possibility curve just touches (is tangential to) CIC2. The role of government in society is to seek to ensure that society reaches this point. The tangential point will change over time as the resource endowment changes, ie the production possibility curve shifts in or out and changes shape. 179

chapter 11 – Mineral Policy – An Introduction The real world differs in complexity and detail from a simple static world. In practice governments operate in a dynamic and uncertain environment in seeking to balance production, distribution and sustainability goals. Governments need to find the right balance of public and private activities such that the political unit (local community, city, region, state or province, or nation) provides: •• a foundation of law (the legal and regulatory structure in which markets operate) and welldefined property rights •• a non-distortionary policy environment that seeks to minimise unintended and unwanted consequences from policy decisions, provides macroeconomic stability and economic growth •• investment in people and infrastructure •• protection of the vulnerable •• protection of the environment2. The three levels of government in Australia – federal, state and local - share these roles. They are similarly shared between the levels of government in other nations. It is instructive to discuss these roles in a little further detail at this point, considering particularly how they relate to mining. In Australia, government manages the legal and regulatory structure in which markets operate in a variety of ways. Its various branches are responsible for areas such as: •• trade practices legislation •• environmental protection legislation •• taxation and royalty regimes for minerals (see Chapter 12) •• tax incentives and direct subsidies as well as development controls generally in mining and other industries •• tariff and quota protection for various industry sectors3 •• legislation regulating the operation of the financial sector •• legislation regulating mining and other industries •• ensuring occupational and community health and safety standards; and the list goes on. In discussing this area, it is also important to appreciate the situation relating to property rights. As Tietenberg and Lewis (2009, pp 65-66) note, the property rights to a resource describe: … a bundle of entitlements defining the owner’s rights, privileges and limitations for use of the resource. These rights are typically vested with individuals in market-based economies and with the state in 2 3

This framework, which was suggested in World Bank (1997), is also discussed in Chapter 13. Though this is now less important as a major policy area, it seems important to include it in our list.

180

collectivist economies. In most nations, however, the ownership of below ground mineral resources is in the hands of the state. This is the case in Australia where governments allow private companies and individuals to exploit these resources in exchange for the payment of exploration and tenement fees, as well as royalties and taxation when mines are in operation4. Sustaining a non-distortionary policy environment typically involves maintaining macroeconomic stability and achieving economic growth in an economy. Key elements include achieving goals such as: •• low inflation (say less than three per cent per annum) •• low unemployment (say five per cent per annum) •• strong economic growth (averaging say four per cent or more per annum) •• maintaining flexible exchange rates consistent with balance of payments equilibrium (ie the avoidance of large external deficits and surpluses. Investing in people and infrastructure are both important areas as well. Investing in people includes areas such as maintaining and improving a nation’s or region’s education system This extends to skills development, research and development spending and innovation strategies for key industries such as minerals. Another area involves developing the best possible health care system. Building roads, ports, railways, public buildings and communications systems also result in key additions to a nation’s or region’s physical capital base, which are also important to its competitiveness. Focused expenditures in each of these areas are important in developing and maintaining the competitiveness of the mining sector. Protecting the vulnerable and redistributing income and wealth on the one hand involves governments applying an equitable taxation system, based on the ability to pay. On the other hand it involves using government expenditures to provide benefits for lowincome people. In a developed country like Australia such benefits may come in the form of income and asset tested programs such as: •• •• •• ••

age and disability pensions unemployment benefits family benefits grants for students undertaking post-secondary education •• concessional charges for government services •• hospital and medical care; as well as other areas. If the mining sector is profitable and successful, its companies and workers may pay significant amounts of tax to finance these functions of government. Governments also play an important role in environmental protection. Supported by appropriate legislation, their activities seek to: 4

There is a detailed discussion of mineral taxation and royalties in the next chapter. Mineral Economics

chapter 11 – Mineral Policy – An Introduction •• restore and maintain environmental quality •• set and monitor emission levels •• mitigate against climate change. These actions directly impinge on the operations of mining companies.

Any nation’s, state’s or region’s mineral policy should in general terms be concerned with the rational development of mineral and energy resources to achieve the broad economic and social goals of government. It is through this policy that government outlines its expectations for the nation from the exploitation of minerals, and for investors in terms of their responsibilities and duties to the government itself and to communities. Developing economies often see the minerals and energy sector as providing the route to leap-frogging to developed status.

Any government’s current policy stance will reflect its efforts to achieve optimal economic and social wellbeing, given the political ideologies of its members.

THE CONTEXT OF MINERAL POLICY Governments use a range of policy instruments (tools) to achieve their objectives. The typical list includes:

Mineral policy involves a combination of fiscal, exchange rate, wages, specific occupational health and safety, and environmental policy. The typical list of goals includes high (or full) employment, price stability, sustainable economic growth over time, external stability, a clean and safe environment, an equitable distribution of income, an equitable taxation system, economic security and economic freedom. Some of the key fiscal aspects of a mineral policy relate to the application of mineral taxes and royalties, which we examine more closely in Chapter 12.

•• fiscal policy (varying and directing government spending, and raising and lowering taxes) •• monetary policy (setting interest rates) •• regulation (the statutory controls applied to economic activities) •• exchange rate policy (setting exchange rates at fixed rates relative to other currencies or letting them float) •• wages policy (setting minimum wages) •• environmental policy (setting emission standards for factories to discharge wastes into the air, nearby landfills, rivers and the sea, establishing and maintaining wilderness areas and rules about land use). It is also common to see a government’s policy stance described in terms of a set of policy tool settings applied to particular industry sectors. Hence we see reference to agricultural policy, mineral policy, manufacturing policy, transport policy, communications policy, health policy, education policy, tourism policy and so on. These policies, which are sometimes described formally in published documents, typically reflect economic, social and political views.

At this point, recall again the five key characteristics of mines5 (Garnaut, 1995) mentioned already in Chapter 1. These are that: 1. they can generate economic rent 2. they are often established most efficiently on a very large scale 3. their development is often highly capital intensive 4. they have unusually large local environmental, social and economic impacts 5. their national economic impact varies greatly over relatively short periods of time. While Frank Harman and Pietro Guj discuss mineral rent in considerable detail in Chapter 12, it is instructive to define the concept at this point. Economic rent is the payment that any resource receives in excess of its cost of supply. Mineral rents are one type of economic rent.

It is convenient to think of policy settings in a matrix format in which some or all of the elements of a government’s policy tools are applied to influence the performance of different industry sectors. The checked boxes in the simple matrix in Table 11.1 provide one classification of how some policy tools directly affect particular areas.

Garnaut and Clunies Ross (1983) provide the following definition of mineral rent: 5

We assume that mines also include oil and gas wells in the context of this discussion. This view is consistent with the definition of mining used by the Australian Bureau of Statistics.

Table 11.1 The application of economic policy instruments in industry sector policies. Policy instruments Fiscal

Monetary

Regulation

Exchange rate

Wage

Environmental

Agricultural

x

x

x

x

x

Mineral policy

x

x

x

x

x

Manufacturing

x

x

x

x

Health

x

x

x

Education

x

x

x

Housing

x

x

x

Tourism

x

Mineral Economics

x

x

x

x

x 181

chapter 11 – Mineral Policy – An Introduction Mineral rent may be defined as the returns in excess of those needed to attract factors of production into the mining industry in the long run. It is the revenue remaining after all costs have been deducted. These costs include exploration outlays, expenditures on mine establishment and cash operating costs. Unlike the accountant’s notion of costs, economic costs include the returns on capital invested which are just sufficient to attract the capital to the enterprise. Consider the example of a large iron ore mine, which produces 5 Mt of output per year. The full cost of production (including the minimum required return on capital, and transport costs to the nearest port) is $30/t. The market price of the ore is $90/t. So economic rent is $60/t, or $300 M. This is the return after there has been a reasonable return made on the capital invested. Government can, in principle, tax all this rent away from producers without reducing their economic output. It is therefore an attractive source of potential public revenue in any mineral rich economy. But as Garnaut (1995) notes, other stakeholders may also have veto power over mineral development and production, and as a result, they also have the ability or potential ability to access the economic rent stream. Furthermore Ganaut notes that such rent: … can be dissipated by uncertainty as conflict between holders of the veto power raises the supply prices of inputs into production. Garnaut’s second and third characteristics relate to the large scale and capital intensity of the modern mining sector. Many new mining ventures, often in remote areas, involve investments of many hundreds of millions or even billions of dollars. Western Australian nickel mining ventures such as Murrin Murrin, Mount Keith and Ravensthorpe, and the poly-metallic Olympic Dam mine in South Australia are good examples of large scale, capital-intensive mines. So are the major iron ore mines in the Pilbara. There are many other such mines around the world. They include copper mines such as Escondida, Collahuasi and Los Pelambres in Chile, the Yanacocha gold mine in Peru, iron ore and base metals mines in Carajas in Brazil, the Ekati and Diavik diamond mines and the Voisey’s Bay nickel mine in Arctic Canada, the Grasberg copper/gold mine in Indonesia and the Porgera gold mine in Papua New Guinea. These are all large, long-life mines in which the level of capital investment per employed worker is very high. In association with the large scale of mines, major companies become involved. These are sophisticated global corporations who wield considerable economic power. Commentators sometimes argue that they seek to exploit this power in their dealings with host governments. This may particularly be the case when they establish operations in developing nations whose 182

economic size may be similar or even less than their own. In this case a host government will have to deal with foreign investors whose interests differ from those of the nation’s citizens. Consider some of the recent indicative examples in Table 11.2 where large mining companies have mining operations in developing nations, removed from their head office locations6. Table 11.2 Selected large corporations with mining operations in developing economies in 2012. Company (and country of head office)

Mining operations in

BHP Billiton (Australia)

Colombia, Peru, Mozambique and South Africa

Vale (Brazil)

Colombia, Guinea, Indonesia, Mozambique and Peru

RioTinto (UK)

Madagascar, Guinea, Namibia, South Africa, Zimbabwe and South Africa

Anglo American (UK)

Colombia, India, Namibia, Botswana and Zimbabwe

Xstrata (Switzerland)

Colombia, Peru and South Africa

Barrick Gold (Canada)

Papua New Guinea, Peru, South Africa, Pakistan, Colombia and Tanzania

Newmont Mining (USA)

Indonesia, Ghana, Peru and Bolivia

AngloGold Ashanti (South Africa)

Ghana, Tanzania, Mali, Zimbabwe and Guinea

A more complete list of corporations, either operating mines or with interests in mining operations, also includes Chinese, Japanese and South Korean companies. The environmental, social and economic impacts in local areas near to a new mine, or in the surrounding state or region, can be dramatic, although the extent of these impacts has recently been affected significantly by the continued growth of fly-in, fly-out work practices7. They are particularly intense when they disrupt the lifestyles and livelihoods of residents of the mining area, especially if these people have a long traditional association with the local area. Attention by large mining companies to world-class environmental practice and corporate social responsibility more broadly, even in poor developing nations, is now a major issue, as is the pursuit of sustainability strategies to assist local populations as a mine moves towards closure. The volatility of national and regional impacts over relatively short periods is also an important issue. This is particularly the case for developing nations, or even smaller regions or states in developed nations such as Australia or Canada. New mining ventures will significantly increase the gross product of a nation or region in a short time period. But their closure will also dramatically reduce local incomes unless there is a sustainable alternative economy in place. In the mid- to late-1980s for example, several new mineral developments appeared to have the potential 6 7

Note that these companies also have offices in other developing nations. The examples in our list cover only recent mining operations. These impacts are also discussed in Chapters 15, 16 and 17. Mineral Economics

chapter 11 – Mineral Policy – An Introduction to more than triple the Gross Domestic Product of Papua New Guinea within five years. This did not happen, in part because of the sudden closure of the large Panguna copper mine in the middle of 1989 when a civil war erupted on Bougainville. In combination with relatively wide movements in the price of gold and copper, there has been considerable uncertainty and difficulty in managing the Papua New Guinea economy since that time.

MINERAL POLICY IN PRACTICE As noted in the previous section, any nation’s or region’s mineral policy should be concerned with the rational development of mineral and energy resources to achieve the broad economic goals of government. In Chapter 3 we also discussed the soundness of such development in considering the recent debate about whether resources are a blessing or a curse. Notwithstanding the position one takes in this debate, it is likely that the citizens of nations or regions that possess a significant mineral endowment, will wish to utilise it in the cause of national development. In seeking to facilitate this process, policymakers, operating in a competitive environment with other nations, aim to maximise the net present value of all future benefits derived from mining (Tilton, 2004, p 147). This will typically involve achieving such objectives as:

negatively affected parties. Compensation does not have to be paid as paying compensation would involve equity considerations. The result is an aggregate level of societal benefit in efficiency terms, which is higher than if re-allocation had not taken place. The KaldorHicks criterion is the conceptual basis for cost benefit analysis. The objectives of private companies will never completely coincide with the aims of government. The former must serve the needs of shareholders, their financial backers and their workforce while the latter represents the interests of the broader community. One way of perceiving this is in terms of Figure 11.2. The extent of overlap between company and community goals is likely to be greater if large numbers of shareholders live in the area in which a mining company has its operations. Yet, where this does not occur, professional managers will recognise the necessity of being ‘good corporate citizens’ to maintain their ‘licence to operate’ within the region, the nation and even globally over extended periods. STRATEGIC OBJECTIVES

PRIVATE EXPLORER/ MINER

GOVERNMENT OPTIMISATION OF ECONOMIC BENEFITS

MAXIMISATION OF VALUE TO SHAREHOLDERS

•• income generation •• job creation •• regional development •• sustaining the long-run viability of the mining industry by encouraging exploration for new deposits. It will also coincide with trying to maximise and share the rent extracted from mineral exploitation. While an optimal allocation of resources within a geographic area ensures economic efficiency, ie for those sectors of the economy that, given a certain level of income, generate the greatest output of goods and services that society demands, it does not necessarily ensure economic equity. With change there will always be differential impacts on various sectors of society – in other words winners and losers. This generates political tension and, because governments wish to be re-elected, in practice economic policy change is seldom if ever optimal but seeks second-best solutions. Government economic policy is generally influenced by the Pareto optimality principle of welfare economics. This is that reallocation of resources should only proceed if at least one actor is better off while none are worse off. More frequently the Kaldor-Hicks criterion applies whereby if some actors are worse off, then re-allocation of resources should only proceed if the overall benefit from it is large enough potentially to compensate the Mineral Economics

ECONOMIC AND POLITICAL FORCES

COMPETITIVE MARKET FORCES

Fig 11.2 - The coincidence and divergence of public and

private strategic objectives.

There is, of course the option for governments to choose to develop mineral resources themselves. In this way there could be, at least in theory, a complete correspondence between company and government objectives. The difficulty with this strategy is that such public enterprises have usually been less efficient and effective than those that are privately owned. In addition there would be substantial draw on public sector funding sources, and associated risks loaded on to taxpayers. While this may be due in part to political influences, governments in developing (and even developed) nations often do not have access: •• to sufficient investment funds to finance new resource developments •• to enough well-trained human resources to manage them. 183

chapter 11 – Mineral Policy – An Introduction As we shall see in the next section, the trend towards privatisation of government-owned mining companies between the mid-1970s and 2008 reflects this reality. In this situation, the challenge for any nation, state or region is practising mineral policy is to develop a structure that attracts investment and also ensures that its economic and social objectives are achieved. This requires a clearly understood regulatory framework, which may be underpinned by a formal mineral policy document8. While specific mining legislation is an important part of this, a variety of other laws relating with land, taxation, imports and exports, water, foreign investment, foreign exchange, labour practices, occupational health and safety and the environment also play a key role. The settings of any mineral policy, and its role in assisting the achievement of major economic and social goals, depends on the richness of a country’s or region’s mineral endowment. When the quality of mineral reserves is high, a government may be more demanding in its dealings with companies when potential rents will also be high. It is important also to appreciate the views of mining and exploration companies about mineral policy. In a study for the United Nations, Otto (1992) conducted a survey of 39 large and small mining companies to determine the importance of various investment criteria to them in the mineral exploration and mine development phases. His findings are reproduced in Table 11.39. Of particular note is his assessment that 17 of the 22 factors on the list are ‘controlled or influenced by government actions or inactions.’ A nation’s mineral policy settings are important in assisting its competitiveness as a destination for new mineral sector investment. One organisation that has annually ranked mining regions and nations since 1997 on the attractiveness of their mineral policy and mineral endowment for exploration investment is the Vancouver-based Fraser Institute. In their 2010 - 11 survey, sent to more than 3000 companies (with 494 responses) (Fraser Institute, 2011), they report on the attractiveness of 79 jurisdictions. These include 45 nations as well as key mining states and provinces in Australia (the six states and the Northern Territory), Canada (nine provinces and three territories) and the United States (15 states)10. The coverage of their study and the relative rankings of the Australian states appear in Table 11.4. While the rankings of the Australian states and the Northern Territory ranged between 11 and 38 for 8 See Otto (1997) on the importance of national mineral policies and associated policy documents. 9 This table is taken directly from Otto (2005). Other studies have generated similar rankings of factors. 10 The division is because states and provinces are largely responsible for the conduct of mineral policy in these three nations, whereas it is conducted by national governments elsewhere.

184

Table 11.3 Company rankings of key investment criteria for mineral exploration and mine stages of operation (from a choice of 60 criteria). Ranking Exploration stage 1

Decision criteria based on:

Mining Stage N/A

Geological potential for target mineral

N/A

3

Measure of profitability

2

1

Security of tenure

3

2

Ability to repatriate profits

4

9

Consistency and constancy of mineral policies

5

7

Company has management control

6

11

Mineral ownership

7

6

Realistic foreign exchange regulations

8

4

Stability of exploration/mining terms

9

5

Ability to predetermine tax liability

10

8

Ability to predetermine environmental obligations

11

10

Stability of fiscal regime

12

12

Ability to raise external financing

13

16

Long-term national stability

14

17

Established mineral titles system

15

N/A

Ability to apply geological assessment techniques

16

13

Method and level of tax levies

17

15

Import-export policies

18

18

Majority equity ownership held by company

19

21

Right to transfer ownership

20

20

Internal (armed) conflicts

21

14

Permitted external accounts

22

19

Modern mineral legislation

N/A: not applicable. Note: decision criteria appearing in bold typeface may be controlled or influenced by government actions or inactions. Source: derived from survey conducted by Otto (1992), reproduced in Otto (2005).

mineral policy attractiveness, their overall mineral potential (which takes account of the attractiveness of policy and geological endowment) in the minds of company decision-makers was lower. Only Western Australia ranked in the top ten with and other states ranking from 27 (South Australia) to 60 (Victoria). Another company, which conducts annual assessments of political risk in mineral rich nations is Behre Dolbear. In their 2011 survey (Behre Dolbear, 2011), they ranked 25 nations on the basis of the following seven criteria, which were equally weighted: •• the country’s economic system •• the country’s political system •• the degree of social issues affecting mining in the country •• delays in receiving permits due to bureaucratic and other delays Mineral Economics

chapter 11 – Mineral Policy – An Introduction Table 11.4 The relative attractiveness of mineral policy and mineral potential (source: Fraser Institute Survey 2010 - 11). Area

Jurisdictions

Descriptions

Canada

12

12 provinces and territories

United States

15

15 states

Australia

7

Six states and the Northern Territory

Oceania

4

Indonesia, New Zealand, Papua New Guinea and the Philippines

Africa

13

Botswana, Burkina Faso, DR Congo, Ghana, Guinea, Madagascar, Mali, Namibia, Niger, South Africa, Tanzania, Zambia, Zimbabwe

12

Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Guatemala, Honduras, Mexico, Panama, Peru, Venezuela

Eurasia

16

Bulgaria, China, Finland, Greenland, India, Ireland, Kazakhstan, Kyrgyzstan, Mongolia, Norway, Romania, Russia, Spain, Sweden, Turkey, Vietnam

Total

79

Latin America

Rankings of Australian regions State or territory

Policy potential

Mineral potential

New South Wales

20

49

Northern Territory

27

30

Queensland

38

28

South Australia

11

27

Tasmania

28

45

Victoria

31

60

Western Australia

17

8

•• the degree of corruption prevalent in the country •• the stability of the country’s currency •• the country’s tax regime. The survey, which has been undertaken since 1999, has consistently ranked Australia highest, followed by Canada and Chile. In 2011 the bottom five countries in its ranking were Kazakhstan, Papua New Guinea, the Democratic Republic of Congo, Bolivia and Russia (Table 11.4). Any ranking of mining jurisdictions by private organisations must reflect, at least in part, the possibility of mining companies making substantial economic rents from mineral exploitation. By contrast, an optimal ranking from a national viewpoint may be somewhere in the middle of a company-based ranking of mining jurisdictions. This may indicate that national governments are capturing at least part of the economic rents to facilitate overall economic development goals.

THE TRANSITION OF MINERAL POLICY SINCE 1950 There have been several interesting changes over the past 60 years in the structure of the world mineral Mineral Economics

industry and the conduct of mineral policy. In the immediate post World War II period much of the mining of metals in the developed and developing world stood in private hands. The public sector, was, however, responsible for all mining in the former Soviet Union and its satellites and there were public ownership positions in the mineral industries of several other European nations. Many coal mines, in countries such as Britain (and Australia), were also publicly owned in the immediate post World War II period. The motivations for such ownership, as Radetzki (2008) notes, arose from factors such as: •• the widespread perception of mineral wealth as a national patrimony •• the relative ease of exploiting mineral resources because of the immobility of deposits •• the existence of high rents, which would have been more difficult to appropriate using the fiscal system (taxes, royalties, etc) where they were under private ownership •• the perceived strategic importance of a national mineral industry.

The post-1960 surge in public ownership During the 1960s and 1970s there was a movement towards widespread public ownership of mineral production, particularly among newly independent nations. The logic behind this in new nations was that it enhanced political independence and that it would facilitate development. The success of OPEC in raising prices of oil in 1973 and 1979, as well as the sense of impending scarcity created by the Limits to Growth thesis strengthened the appeal of resource nationalism in many countries during the 1970s. As observed by United Nations Conference on Trade and Development (2007, p 108) there were 32 expropriations of foreign mining enterprises between 1960 and 1969 and 48 between 1970 and 1976. Even in market-based economies such as Australia, there was increased interest in public mineral ownership during the Whitlam Federal Labor government years between 1972 and 1975. These sentiments were accompanied, during the cold war period, by the perceived need to secure supply of strategic minerals and the establishment of significant strategic stockpiles. The modes and extent of resource nationalism varied from country to country. In some it included restricted foreign ownership, as well as restraints on dividend remittance and profit repatriation. In others there was a complete government takeover of mines. Some governments took direct equity ‘free carry’ positions in mines and mining companies. Governments in many developing nations became major mineral producers during the 1960s and 1970s. By the early 1980s state-owned mineral producers accounted for one third of overall capacity in the world outside of the Soviet Union, China and their satellites. 185

Chapter 11 – Mineral poliCy – an introduCtion According to Radetzki (2008), this was an increase from a share of only 2.5 per cent in the 1960s. Mines and mineral processing facilities became part of a broader development arm of government. More importantly, state-owned mining companies became principal sources of revenue for development projects. Their activities often subsidised other sectors but this frequently had unfortunate longer-term consequences for the resources sector. One indication of movements in state ownership of mining over the period between 1975 and 2008 can be seen in Figure 11.3. These data are derived from Raw Materials Group (2011, p 16). They cover mine production of nine key minerals – bauxite, copper, gold, iron ore, lead, manganese, nickel, tin and zinc – which have consistently accounted for between 85 and 90 per cent of metal production during this period.

Efficiency 

Before  state  ownership 

Post‐nationalisation Time 

Fig 11.4 - State ownership and mining company efficiency – the Radetzki view.

such as Zambia, Bolivia, Guinea, Jamaica, Peru and Papua New Guinea. Richard Auty‘s ‘Caribbean model’ – adapted from Auty (1993) and illustrated in Figure 11.5 – seems more in line with these experiences. Despite possessing large mineral endowments, the economic performance of these nations was disappointing. Most state ownership of mining in developing nations between the early 1960s and 1985 had been a failure.

Fig 11.3 - State percentage shares of global metal mine production in selected

years between 1975 and 2008 (source: Raw Materials Group, 2011).

Note that total state ownership and control, which stood already at almost 40 per cent of total production in 1975, continued to rise. By 1984 it exceeded 47 per cent. In his study for Resources for the Future, Radetzki (1985) argued that, despite some initial dislocation following nationalisation, the performance of stateowned mining companies would then improve. After say ten or 15 years, their efficiency would be still slightly inferior to that of private companies but the benefits from state ownership to the entire community would more than compensate for this. A simple view of the Radetzki vision appears in Figure 11.4. One might argue that the success of state owned mining enterprises such as Codelco in Chile, Outokumpu in Finland, MMC in Malaysia, LKAB in Sweden and Pechiney in France provides examples to support this view. Yet because of falling mineral prices after about 1980, poor management and underinvestment, state operation of mineral enterprises was unsuccessful in many nations with large mineral endowments. This appears to have been particularly the case in nations 186

Fig 11.5 - State ownership and mining company efficiency –

the Auty Caribbean model.

Political instability, sovereign risk and the fear of nationalisation by foreign companies resulted in major disinvestment from new African nations particularly but more generally from other developing nations. Changes in ownership rules and regulations on dividend and profit remittances additionally created an unstable investment climate particularly during the 1970s. Africa’s mineral production capacity gradually declined as a result of under-investment in the sector and because of the lack of technical and human capacity in independent nations. Mineral sector reinvestment fell, as profits from the sector became a source of revenue for other development objectives. Major technical problems emerged at most state-owned mines and this adversely affected production. Important support services such as the collection of basic geological information also were adversely affected as decisionMineral economics

chapter 11 – Mineral Policy – An Introduction makers transferred resources from profitable mining companies to boost agriculture and newly emerging manufacturing industry. During this period, established mineral producers such as Australia, the United States, Canada and South Africa were favoured strongly by established private mining and exploration companies. While they received 60 per cent of world mineral exploration spending in the 1960s, this had risen to 80 per cent two decades later.

The swing back to private ownership As can be seen above in Figure 11.3, beginning in the mid-1980s a counter trend back towards privatisation of mineral development and production began emerging in many nations. Policy makers in many mineral-rich nations recognised that only new foreign investment would enable the orderly development of their mineral sectors. The demise of the Soviet Union and the freeing up of its Eastern Europe satellites in the late 1980s strengthened this view and many nations moved to revise their national mineral policies. The change in policy direction in many developing countries was also facilitated by the role of the World Bank in the crafting of the new investor-friendly policy frameworks. Many new company-generous policies emerged from these reviews. Otto (1997) notes that in the ten years after 1985, almost a hundred nations introduced or began serious work on revising their mineral related legislation. This resulted in the publication of many revised national mineral policies, which reduced or completely removed impediments applying to foreign investment. The process continued significantly until about 2005 when the most recent major minerals boom emerged. As a result of this change, there has been growing foreign investment in mineral exploration and mining ventures in Africa, Latin America, Asia and Oceania. Australian and Canadian mining companies have been prominent in this development. Maponga and Maxwell (2000) observed for example that by the mid-1990s, Australian mining companies had interests in more than 80 nations. Canadian mining investment seems to have been even more widespread. By 1998, the 80/20 split of exploration spending between the established mining nations (Canada, the United States, Australia and South Africa) and the rest of the world had changed to an estimated 37/63 split. Part of this quite dramatic change was associated with a range of policy forces in developed nations, which have encouraged the development of the mining sector. In describing a ‘Global Policy Revolution that is Affecting Access to Minerals’ Otto (2005) points to issues in developed nations such as changed land use priorities, reduced security of tenure, nimbyism11, native title 11 ‘Nimby’ is the acronym for ‘not in my back yard’ where local communities oppose the new operations of industries with questionable environmental credentials. Mineral Economics

legislation, permitting delays and exploration maturity as negatively affecting mineral extraction activity. Other important factors in the evolution of mineral exploration and development during this period were the liberalisation of financial markets and the easy availability of equity funds through stock exchanges particularly in Australia, USA, Canada as well as the demonetarisation of gold. In the wake of these policy changes, large companies strongly expanded their influence while state ownership declined. As can be seen from Figure 11.3 above state ownership in the major metals mining sector fell from just under 40 per cent in 1989 to just over 22 per cent by 2000. Operations in different sectors of the mineral industry have also become more concentrated. As noted in Chapter 7 above, many sectors of the industry are now dominated by a small number of large transnational mining companies (oligopolies) (see Table 7.1). Their market power is counteracted in several places by oligopsony (a small number of influential buyers of mineral output for downstream production) and enhanced by strategies of vertical integration (where companies or nations operate mines and they also participate in downstream production).

The rise of China Since adopting the ‘open door’ policy in 1978, China has re-emerged as a major economic power. This has been particularly apparent since 2000, with China continuing its strong economic growth and playing a key role in the world economy as the major manufacturing nation. The role of minerals in supporting manufacturing, as well as building national infrastructure, has been particularly important. By 2009, China stood as the world’s leading producer of several key minerals including aluminium (though not bauxite), coal, gold, iron and steel, lead, phosphate rock, rare earths and tungsten as well as a prominent producer of several other minerals. Yet after 2000, the nation’s economic expansion had been so profound that national mineral production did not meet growing domestic demand. As well as moving to utilise internal mineral resources more efficiently, many State-owned or partially privatised Chinese companies began looking abroad to acquire interests in mining properties. In its paper for the World Bank, the Raw Materials Group (2011, pp 25 - 26) provides an interesting recent paper of this activity. Quoting from Chau (2008), they note that outbound mining investments increased from US$440 M in 2005 to US$1.8 B in 2006 to more than US$16 B in the first five months of 2008. As Figure 11.3 shows these increases were associated with a rise in state ownership in the mineral sector between 2005 and 2008 – the first percentage rise since 1984. Yet during this period non-Chinese state ownership in mining continued to decline in percentage terms. 187

chapter 11 – Mineral Policy – An Introduction Quite notably, Australia has been the focus for much recent Chinese activity. In 2009 for example, it attracted an estimated 42 per cent of total Chinese foreign direct investment in mining. Major Chinese corporations have acquired controlling interests in several smaller iron ore producing companies, in the coal sector and in base metals, copper and nickel in the Australian mineral sector. Chinese companies have also become major actors in the African minerals industry in recent years. Through the institutional framework established via the Forum for Cooperation between China and Africa (FOCAC), the Chinese government has used specific targeted initiatives to facilitate Chinese investment in Africa including establishment of the China-Africa Development Fund and facilitating cheap loans for infrastructure investment. Resources for Infrastructure (R4I) deals have become common in the ChineseAfrican countries transactions in the sector. The investment activities of Chinese companies are now a global phenomenon. They are active as well in North and South America, in other Asian nations and in the Pacific. It is interesting to note the investment positions of large Chinese companies in large corporations – for example, Rio Tinto and Teck. While there are other examples of major companies with partial or even full state ownership have invested abroad (eg Vale, Outokumpu, etc), the size of investments by partially privatised Chinese companies has been an area of recent discussion by policy commentators in a number of mineral rich nations.

Some other current policy realities Relationships between large mining companies and the nations that host their investments have now become important in economic and social terms. Andrews (1998) points out, for example, that the size of mining transnationals often compares favourably with the size of the economies of the small nations in which they operate. Consider the case of Rio Tinto. In 2010, the reported cash flow from operations from Rio Tinto was US$23.5 B. It had operations in about 15 nations. Rio Tinto as a company may be larger economically than Guinea, Madagascar and Namibia, three of the smallest nations where it has operating mines. Companies such as Rio Tinto provide a major source of government revenue through their payment of taxes and royalties and they make major contributions to the development of remote regions. For example, Rio has been particularly influential in regions such as the Pilbara in Western Australia. The interaction between mining companies, national and regional governments and local communities is very important. In developing nations, but also in developed nations, central or provincial governments may be unable to provide suitable infrastructure facilities to the local 188

communities close to the area of mining operations. In such cases companies must sometimes pursue major corporate social responsibility programs in the local communities in which they operate to complement government activities. This may involve the provision of roads, housing, schools, health services, electricity and other community infrastructure. In some cases (eg Porgera in Papua New Guinea), national governments may be willing to reduce taxation if the mining company builds and maintains local infrastructure. The effective management of relations with local communities is also a key factor in determining whether or not a mining operation is successful. In the current world of competition for foreign investment, mineral policies must be framed in a competitive way by host governments. Yet all of the stakeholders must be satisfied if mining is to be a success. As we shall see in Chapter 14, this includes company shareholders, local communities, workforces, Indigenous populations, financial backers, regional and national governments. It is and will continue to be a major task to manage these interactions effectively. Good mineral policy has an important role to play in facilitating this outcome.

TOWARDS A COMPETITIVE REGULATORY AND FISCAL REGIME FOR EXPLORATION AND MINING So, how does government translate all this in practice? The task is difficult because, as already mentioned, different levels of government, ie federal, state and local, as well as other stakeholders with a legal or perceived power of veto, lay separate claims to parts of the mineral rent. Also the level of this mineral rent varies over the life of any project, depending on mineral prices and mine output. There is however significant evidence of the types of regulatory and fiscal regimes that have generated strong mineral exploration and large mining sectors in their countries. All of them seem to have certain common characteristics. A prerequisite to success is that a nation or region should generate a perception of high geological prospectivity. A perception of prospectivity is distinct from an actual mineral resources endowment, although evidence of previous mineral discoveries and an abundance of successfully operating mines provides an encouraging base. Government can however, enhance the perception of prospectivity in the eyes of potential investors by facilitating effective collection and inexpensive dissemination of regional geoscientific data and information as well as the reports relating to previous exploration programs carried out by private industry. Thus a fundamental policy component is good strategic planning and resourcing of the activities of the relevant geological survey organisations and support of related research institutions. Mineral Economics

chapter 11 – Mineral Policy – An Introduction Another critical policy aspect for industry is the presence of sound, fair, and predictable legislation to regulate the awarding and maintenance in good standing of exploration and mining titles. Allocation of titles should be fair and non-discriminatory (eg on a first-in-time basis). There should be clear provisions for the transition from exploration to mining titles, giving the discoverer a guaranteed right to develop and mine. Ideally the mining legislation should not be capable of being subverted by other laws or at least there should be in place clear protocols to resolve any potential conflict. This may arise with respect to rights of other land-users, community stakeholders including landowners and Indigenous communities and the state of the environment. In addition to fairness and predictability it is important to emphasise transparency throughout the mineral value chain. One notable initiative in this area is the Extractive Industries Transparency Initiative (EITI). Parallel regional approaches to policy development focus on policy harmonisation to level the playing field among nations. One recent example in Africa is the launching of the Africa Mining Vision in 2011. Its thrust is on a development-oriented sector, which addresses the earlier failures of the World Bank frameworks. The conditions under which a mine can be developed and operated throughout its life should be clearly stated, understood and agreed when the development is approved. These conditions should reflect community expectations for occupational health and safety, and technical and environmental management of the project, including stringent rules for progressive or final rehabilitation of the mine site. The various regulatory roles of government in this context should be well coordinated and ideally there should be a ‘one-stopshop’ to facilitate project development. While legislation should embody appropriate penalties for breach of tenement and operating conditions, the philosophy of the regulatory institutions should be to support and encourage effective, outcome-focused planning and management by industry, with a progressive shift from policing to an advisory and auditing role to ensure that appropriate systems are put in place. Fiscal arrangements should be competitive and stable. Given the capital-intensity and up-front nature of mining investment and the ‘captive’ nature of mining operations, industry values fiscal stability more than just lower but uncertain tax rates. When considering fiscal arrangements, their components cannot be valued in isolation. A more objective view will come from analysing the ‘package’ of all government-levied imposts. As discussed in detail in Chapter 12, these can be divided into: •• provisions which are specific to the mining industry •• those fiscal measures that are in common with all other tax-payers. Mineral Economics

The latter include mineral royalties and taxes, which in Australia are levied by the states and most recently by the Commonwealth. In addition there are a host of mining-specific provisions embodied in the Australian income tax legislation, primarily providing for immediate write off of exploration expenditure and accelerated depreciation of some mining assets. In terms of broader investment, policy provision for repatriation of profits and dividends overseas, for foreign equity participation in mining projects and the absence of mandatory government equity participation has served Australia well in attracting foreign investors. Interestingly, with globalisation and the opening of many countries encouraging foreign investment in mineral exploration and mining, there has been widespread drafting of new mining acts and regulations, and revisions of old laws. In this process the legislation of traditional and successful mining countries such as Australia and Canada has been used as a model. As a result there has been a tendency for regulatory and fiscal packages to become more similar. The ultimate decision of whether to invest in a country may increasingly depend on the degree to which the country’s administrative reality reflects the intents of its legislation. There is now emerging evidence that many administrative structures are failing effectively to enforce what in better-organised countries would be excellent legislation. In many cases it will take many years for the relevant institutional strengthening to take place and for the administrative systems to work in an effective and efficient manner. This may be a symptom of potentially more serious inadequacy and instability in the country’s general political and administrative capacity. If so, it can bring greater sovereign risk and a significant disincentive to invest in a nation in spite of it having all the right attributes on paper.

REFERENCES Andrews, C B, 1998. Emerging trends in mining industry partnerships, Natural Resources Forum, 22(2):119-126. Auty, R M, 1993. Sustaining Development in Mineral Economies: The Resource Curse Thesis (Routledge: London). Behre Dolbear, 2011. 2011 ranking of countries for mining investment: Where ‘not to invest’ [online]. Available from: . Garnaut, R, 1995. Dilemmas of governance, Mining and Mineral Resource Policy in Asia-Pacific: Prospects for the 21st Century, pp 61-66, Canberra. Garnaut, R and Clunies Ross, A, 1983. Taxation of Mineral Rents (Clarendon Press: Oxford). Maponga, O and Maxwell, P, 2000. The internationalisation of the Australian mineral industry in the 1990s, Resources Policy, 26(4):199-210. Otto, J, 1992. A global survey of mineral company investment preferences, Mineral Investment Conditions in Selected Countries of the Asia-Pacific Region, New York, United Nations ST/ESCAP/1197, pp 330-342. 189

chapter 11 – Mineral Policy – An Introduction Otto, J, 1997. A national mineral policy as a regulatory tool, Resources Policy, 23(1-2):1-8. Otto, J M, 2005. Competing for investment – Competitive position of countries seeking exploration and development investment, Economic Geology. Radetzki, M, 1985. State Mineral Enterprises: An Investigation into their Impact on the International Mineral Markets (Resources for the Future: Washington). Radetzki, M, 2008. A Handbook of Primary Commodities in the Global Economy (Cambridge University Press: Cambridge). Randall, A, 1987. Resource Economics: An Economic Approach to Natural Resource and Environmental Policy (Wiley: New York).

190

Raw Materials Group, 2011. Overview of State Ownership in the Global Minerals Industry: Long Term Trends and Future, Extractive Industries for Development Series No 20, May (World Bank: Washington). Tietenberg, T and Lewis, L, 2009. Environmental and Natural Resource Economics, eighth edition (Addison Wesley: Boston). Tilton, J, 2004. Determining the optimal tax on mining, Natural Resources Forum, 28:144-149. United Nations Conference on Trade and Development, 2007. World investment report: Transnational corporations, extractive industries and development, Geneva. World Bank, 1997. World Development Report 1997: The State in a Changing World (Oxford University Press: Oxford).

Mineral Economics

HOME

Chapter 12 Mineral Taxation and Royalties Frank Harman and Pietro Guj Introduction

Minerals sector taxation



Why are there special taxation and royalty regimes for the minerals sector?



Contents of this chapter

A note on terminology Economic rent Economic rent and normal profit Economic rent and scarcity Economic rent, scarcity and the minerals sector Pursuing economic rent Design principles for the taxation of mineral rents Economic efficiency Equity Administrative cost Transparency Stability Taxes designed to capture economic rents Evaluating mineral taxation and royalty systems An initial assessment Problem areas International experience with the taxation of mining rents Relevant constitutional powers in Australia

Ownership and control of mineral resources

Powers to raise mineral taxes Current mineral taxation regimes in Australia Tax and royalty regimes in the Australian states, the Northern Territory and the Commonwealth

Other issues in the collection and use of economic rents in Australia

Mineral Economics

191

chapter 12 – Mineral taxation and royalties

Commonwealth company income tax

Deductibility of exploration expenditures



Depreciation of capital expenditures



Other issues

Mineral revenue policies for the future

Introduction Minerals sector taxation In 2012 there have been dramatic legislative changes to the ways in which the minerals sector in Australia (including oil and gas exploration and production) is exposed to taxation. As from 1 July 2012 the iron ore and coal sectors are subject to additional Commonwealth government taxation while the former Commonwealth taxation regime that applied to offshore oil and gas production has been extended to onshore oil and gas production and the North West Shelf Project. The driver for such fundamental change was the perception that the existing state-based mineral and petroleum taxation system had failed to capture a significant share of the economic rents generated by the sectors in recent years. This perception of the minerals sector had been argued strongly in the publication: Australia’s future tax system, Report to the Treasurer, better known as the Henry Report – Commonwealth of Australia (2010). This report provided the catalyst, though not the final design, for the changes subsequently introduced by the Commonwealth government to taxation in Australia. The introduction and extension of Commonwealth taxation in the minerals and petroleum sectors did not, however, involve a replacement of the state and Northern Territory regimes that applied to these sectors. Instead, the provision of offsets for taxes paid to state and territory governments is part of the new Commonwealth approach. In this new framework the special taxation regimes applicable to the minerals sector consist of: •• mineral royalties collected by the states and the Northern Territory under a variety of state-based statutory provisions and related regulations as well as the Commonwealth’s Offshore Minerals Act 1994 •• petroleum royalties and resource taxation collected by the states, NT and Commonwealth from both the onshore and offshore oil and gas sector under the amended Petroleum Resource Rent Tax Assessment Act 1987 and other imposition Acts •• taxation collected by the Commonwealth from the iron ore and coal sectors under the Minerals Resource Rent Tax Act 2011 192

•• company income tax collected by the Commonwealth Government under special provisions contained in division 40 of the Income Tax Act 1997.

Why are there special taxation and royalty regimes for the minerals sector? Australian governments cite a number of reasons why the minerals sector should be subjected to a special taxation and royalty regime, in addition to the range of taxes normally imposed on all business sectors in the economy. These relate to the depletion of nonrenewable resources and the desirability to generate a return to the public as the owners of natural resources. As we have seen in previous chapters it is the existence of economic rent that provides the basis for the imposition of additional taxation regimes on the minerals sector. Economic rent is the surplus revenue after all costs of production have been recovered, where costs of production include the appropriate level of a return on investment (normal profit) that would be necessary to attract investment into an activity in the minerals sector. This focus on economic rent as the basis for special taxation regimes for the minerals sector is clearly stated in the first paragraph of the Explanatory Memorandum (The Parliament of the Commonwealth of Australia, 2011, p 3) presented to the Commonwealth Parliament with the introduction of the Minerals Resource Rent Tax Bill 2011: The Minerals Resource Rent Tax (MRRT) is a tax on the economic rents miners make from the taxable resources (iron ore, coal and some gases) after they are extracted from the ground but before they undergo any significant processing or value add.

Contents of this chapter The second section of this chapter begins with a detailed analysis of the concept of economic rent as the basis for the mineral taxation and royalty regimes. This demonstrates how economic rents arise in the minerals sector in unique ways, relative to other sectors of an economy, and it shows why economic rents in the minerals sector are the object of special taxation regimes. Mineral Economics

chapter 12 – Mineral taxation and royalties The third section sets out the design principles required to ensure that important social objectives are achieved with the taxation of economic rents in the minerals sector. These principles include:

economic rent is the surplus revenue over and above costs of production, where costs of production are counted as including the appropriate level of normal profit.

•• economic efficiency in the way in which minerals are extracted

Normal profit is the financial return to investors necessary to attract and maintain their investment in a business activity. It is determined by the return on alternative activities with the same risk profile. In other words, it is the minimum rate of return to investors that is acceptable, given other comparable investment opportunities. Normal profit is an important concept in economic theory, and it is sometimes described by other terms, such as the opportunity cost of capital and the threshold rate of return.

•• fairness or equity in the way the tax burden is allocated •• a low administrative burden in terms of the costs of complying with and enforcing the tax system •• transparency in the liability for taxation from mining activity •• stability in the revenue flow to governments. We then discuss international practice in the taxation of the minerals sector as a reference point for the Australian regimes. This is followed by a discussion about how governments, if they wish to capture part of these rents, should have the constitutional powers to do so through the ownership of mineral resources, and a legal right to impose tax regimes on the minerals sector. The chapter then moves to a discussion of the various mineral taxation and royalty systems currently in place by the Australian Commonwealth government, the states, and the Northern Territory together with data on the economic significance of minerals sector taxation for government finances. The provisions of the Commonwealth company income tax specifically formulated for the Australian mineral exploration and mineral sectors are then explained and the Chapter concludes with a discussion of mineral taxation policies for the future in Australia.

A note on terminology In the literature on the taxation of the minerals sector, the discussion is frequently couched in terms of mineral royalties rather than mineral taxes. The use of the term royalty goes back to the time when monarchs claimed a right to the so-called royal minerals of gold and silver. In its modern usage, royalty has come to mean a payment in return for awarding a right of some form. Royalties are a payment for the transfer of ownership of the resource from the community to the tenement holder. For the purposes of this chapter, royalties collected by Australian state governments are considered as taxes, though reference will be made to royalty regimes. However, it is important to understand that taxes are general revenue raising instruments and therefore differ from royalties.

Economic rent Economic rent and normal profit It is important to be clear about the meaning of economic rent and normal profit. As already mentioned, Mineral Economics

Considering normal profit as a cost of production differs substantially from the general accounting treatment of profit. The accounting approach is an income approach that determines profit as an overall surplus after costs – including interest expenses, but not normal profit – have been recovered. The accounting framework does not distinguish between normal profit and economic rent and it groups the equity return component of normal profit and economic rent together as accounting profit. Accounting profit (subject to some differences over the tax and accounting treatment of a number of expenses applicable to the minerals sector such as depreciation) is the measure of profit that forms the base for the imposition of company income tax by the Australian Government. Normal profit as a cost of production is a notion that is sometimes difficult to comprehend. An intuitive understanding can be grasped by looking instead at wages. What does an employer have to pay workers to attract and hold them in the business? The answer is, at least what they could get in wages from another employer, that is, their opportunity cost. If entrepreneurial activity was separated from the ownership of capital, a comparable question would be: What rate of return do entrepreneurs have to pay the owners of capital to attract and hold capital in their business? The answer is at least the rate of return that the owners of capital could get from another entrepreneur with the same risk characteristics. This is the opportunity cost of capital (normal profit) and it is comparable with wages as a cost of production. Consider the consequences if an entrepreneur did not continue to pay the opportunity cost of labour and capital. The owners of labour and capital would transfer their labour and capital to other businesses and the business would close. Paying both capital and labour their opportunity cost is clearly a cost of keeping the business running. Regulatory decision-making agencies such as the Australian Competition and Consumer Commission (ACCC) make use of the concept of normal profit in determining prices in regulated industries such as 193

chapter 12 – Mineral taxation and royalties natural gas pipelines. They typically refer to normal profit as the weighted average cost of capital (WACC). The concept of normal profit is also used in economic evaluation techniques such as net present value (NPV) and economic value added (EVA). The origin of the term rent is in the application of the concept of surplus to the earnings of landlords. With land in limited supply, landowners could extract any surplus over costs of production from tenant farmers (where their cost of production would include the opportunity cost of the tenant farmers’ own labour) through the rent they charged. More fertile land would yield higher rents than less fertile land. Where land was of such limited fertility that the cost of producing crops to the tenant farmer (excluding rent to the landlord) was equal to the revenue from their sale, there could be no rent for the landowner. This is the marginal farm, and this concept, recast as the marginal mine, has an important application in the design of mineral taxation systems. In the modern minerals sector, the application of the concept of rent is the same. The owner of mineral resources has the ability to acquire economic rents either by undertaking mining activity directly, or through the terms and conditions imposed on any proposed mineral extraction by another party. Where the government is the owner of the resource, it has the same capability of extracting rents as any private owner. In recent times, however, governments have generally been reluctant to engage in mining activity directly and they rely on extracting rents through taxation systems imposed on private sector mining activities.

Economic rent and scarcity In general, economic rent is the result of scarcity due to the following factors: •• changes in supply and demand for a product •• the deliberate actions of governments or businesses to restrict supply and hence generate higher prices •• the introduction of new technologies or products •• the parsimony of nature (high-grade ores are not as common as low-grade ores and all ores are in limited supply). All of these factors give rise to either higher prices or lower costs, or both, and so are able to generate a surplus over costs of production. It is important to note that economic rent does not determine price, but rather that price determines economic rent. Economic rents are not restricted to the minerals sector, but the minerals sector classically generates and can maintain economic rents because of some of its unique characteristics. These include: •• Volatility in both the demand and supply of mineral products, leading to large fluctuations in mineral prices independent of costs of supply. 194

•• Differences in the quality of mineral resources, where differences in the quality (grades) result in differences in the cost of producing a standardised unit of product – with the same market price for the product, low-cost producers will achieve higher surpluses over costs of production. •• The high entry costs in the industry creates the natural conditions for the formation of cartels which then can operate successfully in a way that generates a higher price than the competitive market price. The OPEC cartel is the obvious example. When the cartel manages supply it increases price for all producers and the surplus is enhanced. Politicians and political commentators tend to describe the rents that result from these factors as excess profits, supernormal profits, or windfall profits, but economic rent is the correct analytical and policy-relevant term.

Economic rent, scarcity and the minerals sector It is possible to refine further the concept of economic rent in the minerals sector by considering the several sources of scarcity that give rise to economic rents. Firstly, there is the idea of generalised scarcity that arises because a product is in short supply relative to its demand. This generalised scarcity can be either a shortrun or long-run phenomenon depending on whether, in the long run, increased supply can alleviate a short term scarcity. In the minerals sector an increase in demand for a particular product, without an increase in supply, will give rise to economic rents in the short term as a result of price increases that flow from the scarcity induced by the increase in demand. This is common in the minerals sector as its capital-intensive nature and extensive approvals processes create long lead times in the development of new sources of supply. The substantial investment required to develop new operations reduces the ability of mining companies to increase production rapidly. In the longer term, however, these demand and price increases should encourage an increase in the supply and a reduction in the economic rents as long as previously untapped mineral resources are available at a competitive cost of production. If new resources are not available, prices can rise because of the increasing scarcity as the currently exploited reserves are depleted resulting in increased rents. At some point, the rising prices may make substitutes worthwhile, and the depletion process will then stop with the switch to the substitutes. This analysis of generalised scarcity for the mineral sector is associated with the work of Hotelling (1931)1. Secondly, there is the situation where mineral resources are available for exploitation, but they differ 1 The original Hotelling analysis was not widely appreciated until the oil crisis of the 1970s (see Solow, 1974). Mineral Economics

chapter 12 – Mineral taxation and royalties in quality, some high-grade and others low-grade2. The owners of high-grade resources will then receive what are termed differential rents. These arise because high quality resources have a lower cost of extraction and yet the uniform final product sells for the same price regardless of the original quality of the resource. At the limit, there is the marginal mine that earns no rent3. If there is a fall in final product prices, low-grade resources may lose their economic rent and become marginal, but the operations based on high-grade resources will continue to earn economic rent. What was previously the marginal mine now becomes submarginal and it no longer earns sufficient revenue to pay all costs of production, including normal profit, and will close down. Figure 12.1 illustrates the relationships between generalised rents, differential rents and the no rent case for a given market price.  

High-grade

Low-grade

Marginal

mine

mine

mine (zero rent)

Generalised

Generalised

rent

rent

Differential rent

Price

Cost of production Cost of production

Cost of production

Fig 12.1 - Generalised rents, differential rents and zero rents for different mines.

Thirdly, there is the possibility of a location rent. This is an extension of the previous case of differential rent. In the case where two mining operations may have the same quality resource, and the same extraction technology applied equally efficiently to the resource, and sell at the same price in the market, but if one is closer to the point of sale of the final product than the other, its total costs, including transport costs, will be lower, resulting in a location rent. Finally, there is the case of monopoly rents where producers artificially induce scarcity by restricting supply and increasing the price, hence increasing the 2 3

Other factors contribute to the ‘quality’ of a resource, such as the size of the mineralisation and deleterious impurities. However, high-grade versus low-grade is a useful simplification for ease of comprehension. The concept of differential rent is associated with the 19th century economist David Ricardo (see Ricardo, 1821) and differential rents are also referred to as Ricardian rents.

Mineral Economics

economic rent. The classic way this has occurred in the minerals sector is through cartel arrangements where a number of producers (and all producers if the cartel can organise it) agree to accept reductions in production through the use of quotas. The consequent contrived scarcity may be sustained as long as the producers in the cartel stick to their quotas, and the higher prices do not encourage non-members or new entrants to expand output. Generally, cartel activities are illegal and they do suffer from cheating by members and increased production by non-members.

Pursuing economic rent Given the existence of sustained economic rents in the minerals sector, it is not surprising that governments wish to share in the rents. The preferred method to do this is through the taxation system. While there are other methods available, these are less satisfactory from an economic perspective. In addition, other participants in the minerals sector also try to gain access to economic rents. For example, employees will seek higher levels of wages for their labour, and suppliers of other inputs into mining operations will attempt to increase their prices. The development of native land title rights in Australia is also seeing rents flowing towards Aboriginal people, sometimes quite explicitly as a royalty. Similarly, the transfer of mineral rights between companies will sometimes include provisions that indirectly relate to the economic rent of the deposit. Pursuing economic rents that initially accrue to mining companies is possible because economic rents are a surplus, rather than a cost of production. Theoretically, then, the extraction of part of the economic rents through taxation should not change the optimal level of production activity of the mining operation because costs of production, including normal profit, will still be covered. For governments, the source of economic rent is captive in the sense that, once mineralisation has been discovered or a mine has been established, its locality cannot be changed. This contrasts with manufacturing, which can physically relocate to a region with lower taxes. However, a heavy rent taxing regime relative to the tax regime in other states or countries with comparable geological prospectivity and mining opportunities may discourage investment in mineral exploration in the high tax jurisdiction. The proposition that all participants in the economy pursue economic rent is a central focus of economic analysis generally, not just in the mineral sector. The difference is that, in the wider economy, such rents are usually only short-term in nature. Economists call these rents quasi-rents and they generally appear because of: •• changes in consumer tastes •• new products •• new methods of production. 195

chapter 12 – Mineral taxation and royalties Quasi-rents will disappear in the short or long term where there is no constraint on the long-term supply of goods and services, and no restriction on entry by new companies into the rent-earning sectors and depending on how quickly economic resources can be moved to overcome any scarcity generated by any changes in tastes, new products or new methods of production. This is because owners of land, labour, and capital currently invested in a sector that does not have any economic rents – only normal profit – will shift their resources into the rent-producing sector in an attempt to capture rents. The existence of economic rents thus acts as an important signal about how resources should be allocated between sectors of the economy, and the pursuit of these rents brings about a desirable reallocation of economic resources in an economy. As a general principle, therefore, it is not appropriate for governments to tax quasi-rents. To do so stifles the economic resource reallocation process that these quasi-rents induce and leads to a lower level of social well-being as a result of the failure to bring about a reallocation of economic resources in accordance with the demands of consumers. For the minerals sector, however, it is appropriate to tax economic rents that arise from the inherent scarcity of mineral resources, the differential qualities in mineral resources, location advantages, and the long-term lagged supply response to any changes in the demand for minerals. Hence the argument for government accessing mineral sector rents (or at least a proportion of them) differs from any argument about accessing all economic rents, including quasi-rents. It is important to acknowledge that it is not necessary to devise a special taxation regime to collect economic rents. The company income tax has a tax base of company profits that includes both normal profit and any economic rent, and so this tax collects some economic rents. The company income tax, however, is primarily designed as a tax on the income accruing to the owners of capital in all corporate sectors of the economy. It is not designed as a tax on economic rents in the minerals sector4.

Design principles for the taxation of mineral rents The well-established principles for the design of a good tax system are: economic efficiency, equity, administrative cost, transparency and revenue stability.

Economic efficiency One objective of a taxation system designed to collect economic rents for a government should be to ensure that, as far as possible, there is no impact on the exploration and production activities of mining 4

A company income tax could be an efficient tax on economic rents if it had the design principles of the Brown tax (see Garnaut and Clunies Ross, 1983).

196

operations. That is, the same activities would occur whether the rent-collecting tax was in place or not. This is the condition of neutrality, meaning that the system being used to collect economic rent does not change the behaviour or decisions of a mining company. This neutrality concept is also captured in the terms efficient or non-distorting. A neutral tax means that it is consistent with the idea of allocative efficiency, where the tax does not change (distort) the way economic resources are employed away from what they would be if the tax was not in place. By contrast, taxes that do not achieve this condition are characterised as non-neutral, or inefficient or distorting. In practical terms, a tax that is non-neutral, gives rise to either: •• extracting too much of the resource (overexploitation) •• not extracting enough (high-grading) relative to what would be the case in the absence of the tax system. Unless there is a case for over-or under-extraction based on some criteria other than collecting economic rents, these results are undesirable where the only objective of government is raising revenue through the collection of economic rents. There are circumstances where imposing a tax that changes the behaviour of a mining operation is in the social interest. This applies particularly where negative externalities would otherwise apply. Negative externalities are those costs of mining activity that are not borne by the mine operator in the form of costs of production covered by mine revenue, but rather costs that are borne by society as a whole through, for example, pollution or environmental degradation. Negative externalities are examples of market failure where competitive market forces alone do not deliver a socially optimal outcome. In these circumstances, policy makers often consider some form of social intervention through taxation or other appropriate regulatory instruments. There may be an arguable case that the operation of competitive markets for minerals in the face of uncertainty about the future: •• leads to over-exploitation of non-renewable mineral resources in the current period •• fails to consider the interests of future generations. The consequence is that future generations may be relatively impoverished because the stock of nonrenewable resources passed on to them is lower than it otherwise might be. This issue has been the subject of long-standing discussion and any firm conclusions are generally deferred while the prospects of making new discoveries through further exploration exist (Tilton, 2003).

Equity The equity issue is concerned with whether a tax is fair on taxpayers. There are a number of dimensions to Mineral Economics

chapter 12 – Mineral taxation and royalties fairness. The first is whether the tax is fair with respect to horizontal equity. Horizontal equity implies equal treatment of equals and would ask the question ‘are miners who generate the same amount of economic rent all paying the same amount of tax?’ By contrast, vertical equity is concerned with whether miners who generate different amounts of economic rent are treated differently in the amount of tax they pay. The principle of vertical equity is violated when a tax system fails to discriminate between high rent and low rent operations and instead imposes a tax on a base that does not give explicit recognition to the differences in levels of economic rents associated with different mining operations. Another dimension to equity is fairness over how the tax revenues raised from economic rents are utilised. In particular, this is concerned with whether the revenues should be combined with all other revenue and dispersed in the normal budgetary processes, or appropriated, at least in part by the local government or communities of the various areas hosting the mining operations. There has recently been a build-up of political pressure for the return of some of the rents directly to the regions and the communities affected by mining. The payment of royalties to Aboriginal communities is one reflection of this pressure. Another is the Royalties for Regions scheme in Western Australia. Company contributions towards locally based community services are another example of the results of this pressure. The final aspect is intergenerational equity. Depletion of mineral resources has the potential to leave future generations without the ability to earn comparable levels of income as the asset stock inherited by future generations is diminished. Intergenerational equity is an aspect of economic sustainability. The general policy prescription for sustainability, where income initially depends on the exploitation of natural resources that face eventual depletion, is that the economic rents should be used to acquire other income-earning assets that will ensure a flow of income to future generations when the natural resources are depleted (Hartwick, 1977).

Administrative cost Administrative cost has two components. First, there is the issue of whether the cost to government of operating the tax system is high relative to the revenue received. In a worst-case outcome, a tax system may cost more to run than it receives in revenue. Ideally, the cost should be as low as possible consistent with the other objectives of a tax system. The second element is the cost to the mining company of complying with the tax requirements, other than the revenue actually handed over to the government. Compliance costs include the administrative, accounting and legal costs borne by a mining company and similarly they should be as low as possible, consistent with the goals of the tax. Mineral Economics

Transparency This principle relates to whether miners are fully informed about the tax liabilities that may flow from any proposed activity. Transparency also refers to the openness of the taxation arrangements and tax collections to examination by the community. The transparency case argues for liabilities to be predictable and (ideally fixed for the life of the mine) before any proposed mining activity takes place. Subsequent changes to the mining tax regime create additional costs for the miners like all taxation changes in the economy. Near full compliance with this criterion is found in the statutory state agreements in Western Australia discussed below. By contrast, where governments arbitrarily change the laws to impose tax burdens that were not indicated originally, then the condition of sovereign risk applies.

Stability Finally, governments often see stability in their revenue flows as desirable. This is because large inflows of revenues in one period in a highly volatile context may encourage government spending programs or cuts to other taxes that cannot be sustained when revenues from mining taxes fall away. The problem with the principles outlined above is that conflict between them may occur in their application. For example, a tax designed to meet the efficiency criterion may suffer from high administrative costs, or it may be subject to unstable revenue flows. This leads to trade-offs in the design of mineral taxation systems so that the criteria set out above are never fully applied in a mineral taxation system. The nature of the tradeoffs accepted in any particular mineral taxation regime reflects the administrative capabilities of the taxation authorities, and the strength of the influence of the minerals sector in the political decision-making process.

Taxes designed to capture economic rents There are several types of tax that attempt to capture economic rents in the minerals sector. They include specific (unit-based) royalties, ad valorem (value of production-based) royalties, accounting profit-based taxes and resource rent taxes. Although these taxes are designed to capture economic rents, they do not always succeed in their objective as they may only approximately target economic rent and have the effect of adding to the cost of production. In addition these taxes can be evaluated using other relevant criteria such as fairness (equity), administrative cost, transparency, and revenue stability. Specific (unit-based) royalties. Here, the royalty is levied on a tax base relating to the physical rather than a financial measure of a mineral resource. The most common form is as dollars per unit measure of weight or volume (dollars per tonne, dollars per barrel). 197

chapter 12 – Mineral taxation and royalties In some cases, the specific royalty may be subject to an adjustment over time according to changes in the price of a mineral. Ad valorem royalties. In their simplest form, ad valorem royalties consist of a uniform percentage (the rate) of the gross sale price (the base) of a mineral product where the sale is made by the entity that extracted the resource. Although the ad valorem form is a relatively straightforward concept, when it comes to its application, governments introduce complexities to achieve other objectives. For example, they may reward further local processing with a reduced level of royalty, or allow the deduction of downstream processing costs. There may also be an allowance for the deduction of those costs associated with the transport of the mineral from the mine to the point of sale. Such a net back approach attempts to generate an approximate ex-mine value. A similar situation occurs in the petroleum sector, where the royalty is based on the wellhead value, which is the point where the petroleum reaches the top of the well. The wellhead value then is the revenue from sales after deducting costs downstream from the wellhead. Also governments may accept the sale value as determining the ad valorem tax base as the actual amount displayed by the company invoices, or alternatively the value determined independently using a market price for the mineral product rather than the price actually received by the company. Where forward sales are involved, the government may, or may not, take the gains or losses on forward sales into account in determining the tax base. Profit-based taxation regimes. Profit regimes are based on a measure of profit, which normally includes both normal profits and economic rent. This tax base may not be directly comparable with the accounting profit base on which general company income tax is levied. A profit regime may incorporate a minimum specific or ad valorem royalty component to limit the risk that government may collect no revenue if there are no taxable profits and to ensure a minimum stability of revenue. Such systems are referred to as hybrid regimes. Resource rent tax. Resource rent taxes seek directly to identify economic rents as the tax base by allowing the deduction of all costs of production from revenue, and then taking a share of any resulting rents. The foundation for rent-based regimes is that the government shares in both the economic rents (the positive net cash flows) and the losses in a mining project (the negative net cash flows). The public finance economist, E C Brown, formulated the original prescription for a tax system that would tax only economic rents (Brown, 1948). Under the Brown tax (the original blueprint for rent based taxes) the government takes its share of the positive net cash flows as determined by the tax rate and contributes to 198

losses as determined by the tax rate. Because it is a cash flow tax, capital outlays are a deductible expense in the year they are made, and depreciation is not a feature of the tax. Under these conditions normal profits are not taxed (because investors are able to recover their outlays in the year in which they are made), and so the tax will not distort investment decisions by taxing costs of production. Thus the Brown tax will be neutral (or non-distorting or efficient) with respect to investment and operating decisions. The Brown tax applied to the minerals sector effectively makes government a partner in a minerals project through its willingness to make a payment to a project to cover off a proportion of any losses as determined by the tax rate. The success of a Brown tax in achieving neutrality is therefore dependent on a government’s commitment to share in the losses. The nature of this government commitment is a source of concern in the policy context, and has led to modifications that change the way this commitment can be maintained without reducing the desirable neutrality aspect of the tax. The Garnaut and Clunies Ross version of the Brown tax (the model adopted in the Australian Commonwealth Petroleum Resource Rent Tax and the Minerals Resource Rent Tax) has an important change from the Brown specification. Rather than a government sharing in the losses in the years as they occur, losses can be carried forward into the next year’s accounts and their value enhanced by uplifting them by the rate of return that has been fixed by the government as the risk-adjusted rate of normal profit. This rate of up-lift, applied by the Commonwealth, is composed of the government’s long-term borrowing rate (LTBR) plus a risk premium that recognises the industry risk. In effect, this approach treats a loss in one year the same as a capital investment that is allowed to earn the rate of normal profit. These up-lifted losses are then deductible, along with all other cash expenses, against any positive net cash flows in future years. When the net cash flow turns positive after the deduction of all expenses, including up-lifted losses, the resulting positive value represents the economic rent, and constitutes the tax base on which these types of taxes are levied. The risk for the project is, however, that it may never earn sufficient positive net cash flow in future years to extinguish all the accumulated up-lifted losses, and that as a consequence it may be effectively denied the government contribution to losses which it would have derived under a pure form of Brown tax. An offset to this risk is to allow up-lifted losses from a project to be transferred to other projects with positive net cash flows within the same company structure, or through the sale of the project to another company that could take advantage of the enhanced losses. The critical factor with the Garnaut and Clunies Ross version is the choice for the government of the rate of normal profit to be allowed for a project. If the rate is set Mineral Economics

chapter 12 – Mineral taxation and royalties too high relative to the company’s own required rate, then there is an implicit subsidy and an incentive to over-explore and over-produce. If set too low, there will be a disincentive to explore and produce. Moreover, there is the problem that a single risk-adjusted rate of normal profit is not common to all mining projects. This requires (to achieve neutrality and equity objectives) that a normal profit rate be uniquely determined for all projects, or at least for each mineral. From the perspective of the community, the Garnaut and Clunies Ross approach involves a delay in the receipt of tax revenues. This is because the company first recovers all capital and operating outlays and the rate of normal profit before paying any taxes. This situation can be offset through the use of hybrid ad valorem taxes that in effect are an early loan to the government once production begins. The government refunds these to the company when tax receipts are positive. The allowance for corporate capital (ACC) tax, the version of the Brown tax recommended in the Henry report (but subsequently rejected by the Commonwealth) which, like the Garnaut Clunies Ross version does not contribute to losses as they occur. Instead the government contribution to the losses is treated as a loan by the project to the government to be repaid by deduction against taxable rent. Unlike the Garnaut Clunies Ross version, the ACC is not a cash flow based tax. Instead assets are depreciated according to their effective life. The value of undepreciated assets is, however, treated like a loss and also considered as a loan by the company to the government. The combination of the annual value of losses and the annual value of undepreciated assets is then combined into the ACC base and carried forward into the next year and enhanced (uplifted) by the government’s long-term bond rate (LTBR). The enhanced ACC base is then deductible against future revenue before the determination of any tax in the ACC framework. The use of the government’s borrowing rate, rather than a rate of normal profit, as the uplift factor, is justified by a corresponding guarantee from the government that in the event of the closing of an unsuccessful operation the tax value of the losses would be paid to the operation. In this way the ACC version of the Brown tax avoids the problem of setting a normal profit rate for mining projects. All projects receive the long-term bond rate (the risk free rate of return) as the uplift factor on the value of their combined loss and undepreciated assets. A risk premium over the LTBR (as is the case with the Garnaut and Clunies Ross version through the determination of risk-adjusted rate of normal profit) is not required because the ACC framework incorporates a government guarantee that removes the risk that the government will not pay its share of the losses if the project closes with an undeducted ACC base. Mineral Economics

The ACC approach thus solves two problems inherent in the Garnaut and Clunies Ross versions: first, the need to set a risk adjusted rate of normal profit and second, the absence of a guarantee that the government share of losses would be paid if a project closes with undeducted losses. Cash bidding. Cash bids can be used to allocate exploration tenements or production licences, this is a common system of extracting economic rents in the United States, but it is rarely used in Australia. Other methods. Australian state governments have used other less orthodox methods in the past in seeking to capture economic rent. These include rail freight rates, pipeline licence fees, export levies, and government equity. The next section sets out the design principles that may used to evaluate the above taxation regimes.

Evaluating mineral taxation and royalty systems An initial assessment Now that the different types of mineral tax and royalty regimes for the minerals sector have been identified, and evaluation criteria established, it is possible to make an assessment of the quality of the regimes using these criteria. Specific (unit-based) royalties. A tax based on physical measures, such as dollars per tonne, offends notions of efficiency and equity, as it adds to costs of production by not distinguishing rent from normal profit and by failing to discriminate between high rent, low rent and no-rent operations. This type of royalty leads to ‘high grading’ with ore left in the ground that would, in the absence of the royalty, be extracted. It may be relatively easy to administer and comply with, is transparent, and as long as production remains constant it will deliver a steady flow of income. Revenue will remain constant irrespective of whether the unit price of the relevant mining product rises or falls. As a consequence, politically difficult royalty rate adjustments become necessary. Because of these considerations, specific royalties are generally applied to low-value, bulk mining and quarry products. Ad valorem royalties. These suffer, albeit to a lesser degree, from the same problems as the specific royalty with respect to efficiency and equity, and they may become complex to administer if governments attempt to tailor the royalty to achieve efficiency and equity objectives. The amount of royalty payable rises and falls in line with movements in commodity prices, giving the ad valorem system an advantage over the specific royalty. But the ad valorem system still fails to discriminate between high rent, low rent and no rent mining operations, thereby failing the equity criterion. The system also fails the efficiency criterion because it is a tax that adds to costs of production. As a tax on 199

chapter 12 – Mineral taxation and royalties sale revenue, it applies both to the costs of production and to any economic rents that are included in sales revenue. In the case of the marginal mine with no rent, the outcome could contribute to mine closure or inhibition about the opening of new mines. Accounting profit based royalties. These, in theory, should be an improvement over the previous two systems from an economic efficiency and equity point of view, but they still have the problem of taxing costs of production by taxing normal profits as well as economic rents. This approach may also introduce significant administrative complexity, ambiguity, compliance costs and potential for litigation. These outcomes arise because the profit calculation on which the royalty is based generally has significant differences from conventional profit calculations and it is also different from the calculation of net income used for the purpose of the company income tax. A profit-based regime may also have the effect of a delay in revenue receipts as well as a negative impact on a government’s revenue stability objectives when mineral prices are volatile. Rent-based regimes. Rent-based regimes based on the original Brown tax should be efficient and equitable as they focus directly on economic rent and where there is no rent, there is no tax to be paid. With the Garnaut and Clunies Ross version of the Brown tax (the model adopted in the Commonwealth Petroleum Resource Rent Tax and the Minerals Resource Rent Tax) the important choice is the rate of normal profit allowed to a company. As well as the incentive effects associated with setting the wrong rate discussed earlier, there are also equity problems if the system does not discriminate on the basis of the risk characteristics of different mining projects. In addition there is a revenue stability problem because of the delay in the receipt of tax revenues as a result of a company first recovering all outlays, and the volatility observed in minerals prices. The allowance for corporate capital version overcomes the problem of defining a risk-adjusted rate of normal profit for all mining projects by removing the risk element that the government will not contribute its share of project expenses whether or not the project succeeds or fails. Both the Garnaut/Clunies Ross and the allowance for corporate capital rent taxes entail substantially more administrative and compliance costs than an uncomplicated ad valorem system, particularly with the need to determine economic rent at the mine-head or the wellhead before further value adding occurs.

Problem areas Taxation and royalty systems based on values or revenues can give rise to administrative problems with transactions, which are not at arm’s-length. This is particularly the case for commodities not frequently traded on recognised markets. Some companies 200

may seek to manipulate the values on which taxes and royalties are based to produce lower revenue for the jurisdiction in which mining takes place. High levels of vertical and horizontal integration combined with trans-jurisdictional operations (mining in one jurisdiction, processing in a second and selling in a third) in some parts of the mineral sector can give rise to transfer pricing and monopoly pricing systems that effectively transfer economic rents to other jurisdictions, particularly those with low or zero tax liabilities. Governments have recognised this problem and responded by incorporating provisions in mineral revenue systems to establish values for mineral production or economic rent, based not on the prices as declared in royalty returns but on a deemed value. Where mineral commodity markets are thin, and the value of commodity contract prices difficult to obtain or confidential, government may use independent experts to advise on values. For some intermediate mineral products (raw ores and concentrates) for which markets may not exist, a suitable proxy may be provided by determining the value of the product sold on the basis of the value of the actual metal contained in it at the price prevailing at the time of shipment. This practice is common for many commodities including nickel and gold in Western Australia as well as for copper and cobalt when they are co-products or by-products in nickel concentrates. There may also be a transfer-pricing problem with a resource rent type mineral revenue system, even if the mining, processing, and sale are carried out in the same jurisdiction. Where a raw mineral goes straight into processing, the issue of its value for the purpose of calculating the economic rent tax liability arises. Where there are competitive markets for the raw mineral that are alternative supply options instead of direct processing, government can use these market values. Where there are not good proxy values based on competitive markets, government must find some alternative mechanism. In the case of natural gas that goes into integrated liquefied natural gas (LNG) projects, the Petroleum Resource Rent Tax (PRRT) has incorporated a residual price methodology (RPM) to determine the gas transfer price that is then used to determine tax liability. Two approaches used in this RPM methodology are netback pricing and cost-plus pricing. The netback method involves subtracting all downstream costs from the final LNG sale price. The cost-plus approach is based on the total cost of producing natural gas that is fed into the LNG process and so determines the notional minimum price the upstream producer requires to continue supplying natural gas to the LNG plant. Where there is a difference between the two measures, the price at the taxing point is determined by the difference between the net back price and the cost plus price. Mineral Economics

chapter 12 – Mineral taxation and royalties

International experience with the taxation of mining rents There are significant differences between the international fiscal regimes that apply to the minerals as compared to the petroleum industry. To some degree these differences reflect the different size and profitability of the related projects as well as each country’s history of mining and petroleum development. Most of the international fiscal regimes applying to the mining industry tend to be based on a combination of traditional mineral royalties (mainly specific and ad valorem royalties) and corporate income tax. The corporate income tax legislation may contain provisions specific to the mining industry or be overridden by taxation provisions embodied in the relevant mining act or other resource-related legislation. These provisions may single out the mining industry both in terms of fiscal incentives (eg tax holidays, immediate write off or accelerated depreciation of mining assets, depletion allowance, reduced rates of income tax specifically for mining, etc) or higher impost (eg higher than normal rates of income tax for mining). Aside from mining specific taxes, the mining industry is subject with all other sectors of the economy to a range of other common imposts. These include sales and excise taxes, import and export duties, withholding tax on remitted dividends and loan interest, value-added tax (VAT), stamp duty and so on. In spite of a general trend towards greater harmonisation of its tax regime, in most jurisdictions mining still enjoys reductions generally in the level of import and export duties on mining plant and equipment and exportation of ores and concentrates and in VAT. An exhaustive comparison of mineral royalty and other mining taxes regimes throughout the world can be found in Otto et al (2006) from which much of the following discussion is derived. Almost all African countries levy mineral royalties. These are mainly ad valorem charges. While rates range from two per cent and 12 per cent, most are between three per cent and six per cent. Central governments normally collect these payments. Traditionally different royalty rates have been applied to different minerals, but some countries, such as Zambia and Ghana, have standardised their rates at five per cent for all minerals. Royalty exemptions or special conditions apply to artisanal mining. In many African nations, governments require that individual mining companies be registered with the unique purpose of owning and managing individual mining projects. These companies are generally subsidiaries of foreign corporations. This enables government to levy not only mineral royalties but also income tax at the project rather than the consolidated Mineral Economics

holding entity level. This ring-fencing approach facilitates the frequently encountered requirement of government holding equity in various projects and the establishment of ‘stability’ agreements. Yet it may also create significant administrative complexities particularly as it concerns transfer pricing if mineral products are transferred to related companies for downstream processing in non-arm’s-length transactions. It also creates administrative challenges in determining to what extent the cost of corporate and technical services provided by related companies should be deductible for the purpose of assessing the royalty value base and taxable income. Particular issues also arise in determining to what extent remittance of interest payments on loan provided by related overseas companies represent a genuine deductible interest charge as opposed to non-deductible dividends to which withholding tax should apply. In the Asia-Pacific region the diversity of cultures and forms of government is reflected in a variety of royalty systems. The prevalent forms are specific royalties for industrial minerals, and ad valorem royalties for base and precious metals with rates mainly in the range of two per cent to three per cent. In many jurisdictions (eg North America, Canada, Australia, China, Malaysia, Pakistan, Indonesia and for some commodities India) royalties are administered and collected at the state or provincial government level. Some countries have provisions for production-sharing contracts (eg the Philippines and Indonesia). As discussed later in more detail, Australian mineral royalties are levied on-shore by the states and territories mainly using ad valorem, unit-based and subordinately, profit-based systems. The Australian Commonwealth government also recently introduced a resource rent type tax to iron ore and coal production. At the same time the Commonwealth government applies a resource rent type tax to off-shore petroleum and also recently on-shore petroleum, in the form of a Petroleum Resource Rent Tax (PRRT). Most countries in Latin America use modest rates of ad valorem royalties. Some important mineralproducing countries, such as Peru, Mexico and Chile, have relatively recently introduced mineral royalties in their mining fiscal regimes. In North America mineral royalties are primarily collected at the provincial or state government level. Royalties based on profits, or net revenues, are prevalent in Canada, with a single rate usually applying. In some cases royalties are levied after a minimum profit threshold is exceeded. The province of Ontario provides a three-year tax holiday up to a C$10 M profit threshold and encourages investment in remote locations by charging half the normal rate of royalty and providing a ten-year tax holiday. 201

chapter 12 – Mineral taxation and royalties The royalty system in the United States is very complex as it depends on the nature of the land holding, whether federally, state or privately owned or part of a Native American Reserve. Royalties also generally differ depending on the mineral commodity. No royalty, other than bidding for coal mining licenses, applies in federal land. Most states levy royalties generally on an ad valorem base but also on a unit base, and rarely on a profit base. Some states, like Nevada and Michigan, apply a sliding-scale rate to net proceeds for metallic minerals and in the case of Michigan flat rates for coal and limestone. In any final analysis, the individual components of the tax system of different countries cannot be compared in isolation in terms of their attractiveness to potential foreign investors as they represent only one element of the total effective tax rate levied on mining profits by each country’s tax package. A comparative analysis of the total effective tax rate for the same copper mine modelled under the fiscal regime of various countries (Otto et al, 2006) shows effective tax rates ranging between 28.6 per cent for Sweden and 63.8 per cent for Ontario with the bulk of jurisdictions being in the 40 to 50 per cent range. Western Australia at 36.4 per cent was in the lowest quartile of Otto’s distribution. In his financial modelling of a typical medium-size iron ore mine, Guj (2011) showed that this effective tax rate would increase to 44.7 per cent after the introduction of the Australian Minerals Resource Rent Tax (MRRT), placing Western Australia in the second quartile of Otto’s distribution. Profit-based mineral royalties/taxes are rare and, as this chapter is written in early 2012, the only mineral royalty/tax based directly on economic rent is the MRRT in Australia for iron ore and coal. Other jurisdictions, such as Ghana and South Africa, have indicated an intention to introduce resource-rent-based forms of mineral taxation in the near future. Production Sharing Contracts (PSC) are also relatively rare in the context of minerals, where they have been applied only in a handful of countries and with relatively mixed results. By contrast resource-rent-based royalty/tax systems are widely and generally successfully used in the petroleum industry. It is interesting to note that national mining tax regimes became more globally uniform between the mid-1970s and the mid-1980s, following a series of reviews. As noted already in Chapter 11, this followed the modernisation of mining legislation of many countries, seeking to position themselves competitively to attract foreign mineral exploration and development investment. These mining tax regimes have been relatively stable for as long as mineral commodity prices remained relatively stagnant, ie until the early 2000s. 202

However, with the rapid escalation in commodity prices, the significant consequent rise in mining companies’ profits has not been matched by growth in government revenues from royalties and other mining taxes. The problem has been exacerbated because many developing countries are compelled to continue to apply very low tax rates, which were originally designed to attract foreign investment in the mining sector, and which were frozen by ‘stability’ agreements. This has generated a perception in many governments’ and communities’ minds that the benefits from the current resources boom are not being shared fairly. There has been greater determination to address this imbalance by increasing the level and range of mining taxation. This trend is evident in both developed and developing nations. It is particularly the case in Africa, which is the current focus of significant exploration and mining investment. In South Africa, for example, an independent panel of experts, set up by the ruling African National Congress (ANC) to study the possibility of greater state intervention in the mining sector has put forward a proposal to impose a 50 per cent windfall tax on mining ‘super profits’ and a 50 per cent capital-gains tax on the sale of prospecting rights. Zambia has recently doubled its copper royalty rate to six per cent. Zimbabwe is doubling the platinum royalty rate from five per cent to ten per cent. It will also ban exportation of unrefined platinum group metals. This will force current operators to build a domestic refinery at a cost of around $2 B. Ghana has recently announced a review of its fiscal mining regime including possible renegotiation of all mining agreements designed to appropriate a larger share of mining profits. Initial plans will see the corporate income tax rate for mining rise from 25 per cent to 35 per cent, and a windfall tax of ten per cent on ‘super profits,’ in addition to existing ad valorem royalties of five per cent. Most African jurisdictions also require a level of carried interest, generally around ten per cent, as a condition for granting a mining license, with the possibility of acquiring further equity at a fair market price. In this environment there is growing concern among mining companies about renewed resource nationalism. In seeking to allay this concern, South African authorities have rejected suggestions of possible compulsory acquisitions of mining projects equity beyond the level of 26 per cent by 2014, as currently envisaged by the country’s black-economic-empowerment laws. Yet some other recent developments have been disturbing to foreign investors. Prominent among these are: •• the new Zimbabwean indigenisation law requiring government acquisition of 51 per cent equity in all mining projects, apparently without compensation Mineral Economics

chapter 12 – Mineral taxation and royalties •• Guinea’s compulsory acquisition of a 15 per cent stake in all mining projects and an option to buy a further 20 per cent •• Namibia’s decision to transfer all new mining and exploration to a state-owned company. While many mining companies are generally receptive to sharing a greater proportion of their profits with host countries, changes in the fiscal regime affecting existing operations must be negotiated and introduced in a manner that does not potentially raise perceptions of sovereign risk. Amendments to the current fiscal regimes must also keep in mind the capacity of countries to administer them. Proposed increases in the any government’s share of economic rent, should favour greater administrative simplicity rather than complexity.

Relevant constitutional powers in Australia Ownership and control of mineral resources The Australian Constitution confers on the Commonwealth Government specific powers in areas such as defence, customs and excise, and monetary and fiscal management. Where the Constitution is silent, however, relevant powers rest with the six states. As a consequence, the states have ownership and control of mineral and petroleum resources within their jurisdiction. The Northern Territory is not in the same constitutional position as the states as it is a territory that derives its powers from the Commonwealth Government under the Northern Territory (Self-Government) Act 1978. Although the Territory has extended powers of self-government, major powers retained by the Commonwealth include rights in respect of Aboriginal land, the mining of uranium and industrial relations. The Seas and Submerged Lands Act 1973 declared Commonwealth Government ownership of mineral resources as extending to the high water mark of the seas adjoining the states. The High Court upheld the constitutional validity of this legislation in 1975. There is, however, an agreement between the Commonwealth and the states, the offshore constitutional settlement (OCS), (concluded at the Premiers’ conference in 1979), which provides the basis for an agreed division of powers between the Commonwealth and the states in relation to coastal waters and in relation to, amongst other matters, the regulation of offshore petroleum exploration. The Commonwealth assumed ownership, legislative powers over, and management of, offshore petroleum resources including natural gas, subject to a number of compensatory measures and royalty-sharing provisions with the states. Included in these powers was that of setting and collecting mineral and petroleum royalties. Mineral Economics

Under the settlement the Commonwealth has given some de facto sovereignty to the states by recognising both a baseline that determines the extent to which any waters are under state jurisdiction, and the concept of a territorial sea extending three nautical miles (5.6 km) out from a baseline5. This gives the states control over mining activities on the landward side of the territorial sea border, including the right to impose tax and royalty regimes. In the offshore areas under exclusive Commonwealth jurisdiction, the states, under the OCS, have an administrative role under the Offshore Petroleum and Greenhouse Gas Storage Act 2006 in determining mineral extraction activities and there is a sharing of some of the revenues collected by the Commonwealth. It was only in the late nineteenth century that the Australian colonies adopted the principle of Crown ownership of subsurface mineral rights (effectively state government ownership) (O’Hare, 1971). Before this time, owners of freehold title (land alienated from the Crown) had rights both to the surface and to subsurface minerals. The number of cases in this situation still prevailing is small and in some circumstances the Crown has resumed subsurface rights. Holders of surface rights in the Australian states have only a limited ability to influence the extent of exploration and mining activity on their land. Generally, this is restricted to the granting of permission to access the land to explore and to the recovery of compensation for any costs the landowner may incur due to exploration and mining activity. In some cases, however, the compensation process and related potential delays may amount to a de facto power of veto. Where land has been granted Native Title under the Native Title Act 1993, the Crown maintains subsurface rights, but Native Title holders can insist on compensation for any disturbance to surface rights and compensation may be paid. A negotiation process involving native title claimants, mining companies and state governments can give rise to Indigenous land use agreements. These agreements do not confer Native Title on the land, but they grant recognition to the interests of Aboriginal people that are parties to the agreement. In these agreements, a wide range of outcomes is possible that can give rise to Aboriginal people effectively obtaining access to economic rents (Denolder, 2000). One of the most recent and relevant agreements is that negotiated over a diamond mining operation in the Kimberley region of Western Australia.

Powers to raise mineral taxes Section 90 of the Commonwealth Constitution proclaims that ‘duties of customs and excise shall be the exclusive responsibility of the Commonwealth Government’. 5

The baseline has been drawn to incorporate offshore islands into state jurisdictions.

203

chapter 12 – Mineral taxation and royalties The Australian High Court has interpreted this clause broadly, so that the states are effectively precluded from using any tax applied on goods and services. The consequence is that when they seek to extract rents from mining operations, it is necessary for the states to assert that what is being imposed is not a tax, but instead a charge on private-sector mining companies relating to the conversion of public property into private property (Crommelin, 1996). Calzada (2000) discusses the legal arguments over the issue of whether royalties constitute a tax or a charge. Generally the states have imposed these charges through the relevant administrative department that deals with the minerals sector. The charges then appear in state budgets as departmental revenues rather than tax revenues. States can also obtain revenues as a result of a statutory agreement with a specific company, where the enabling statute contains a mineral royalty provision based on the transfer of minerals from public to private ownership. Statutory agreements, sometimes referred to as state agreements, are particularly relevant in Western Australia, but there are also instances in other states. At the Commonwealth level, the relevant legislation provides directly for the collection of revenue through the taxation of economic rents in the mining and petroleum sectors. The main tax instruments of the Commonwealth are the Minerals Resource Rent Tax (MRRT) Act 2012 and the Petroleum Resource Rent Tax (PRRT) Act 2012.

Current mineral taxation regimes in Australia In designing any mineral taxation regime, the critical ingredients are the tax base and the tax rate. The tax base refers to the object from which tax revenue is being collected, while the tax rate is the proportion to be applied to the base to calculate mineral revenue proceeds. Ideally, in the context of the minerals sector, the base should be the economic rent derived from mining activity, and the tax rate should be the optimal rate at which economic rents are shared between the government and a company subject to a mineral taxation regime. While in principle it should be possible for a government to take 100 per cent of any economic rent, in reality, governments take something less so as to maintain the incentive for efficiency in mining operations and to account for the complexity in correctly measuring the level of economic rent.

Tax and royalty regimes in the Australian states, the Northern Territory and the Commonwealth Queensland In Queensland royalties are payable under the Mineral Resources Act 1989 (in respect of minerals) and the 204

Petroleum and Gas (Production and Safety) Act 2004 (in respect of petroleum). Details of the royalty regimes are found in the Mineral Resources Regulation 2003 and the Petroleum and Gas (Production and Safety) Regulation 2004. The royalty on coal, the most important mineral in Queensland, is seven per cent of the net value up to $100/t and ten per cent of the subsequent value. A number of deductions from the gross sale value (actual sale value or an arms length determination) are deductible, including ocean freight costs. Rail and road haulage costs are non-deductible expenses. The minimum ad valorem rate for base and precious metals (cobalt, copper, gold lead, nickel and silver) is 2.5 per cent up to a maximum of five per cent depending on average metal prices. The value of a mineral is determined by the price on the company invoice adjusted by the value of the Australian dollar on the day of cash receipt. The variable rates system enables adjustment to the royalty rate to take into account fluctuations in the value of the Australian dollar. Royalty discounts are available for some of these metals where further processing occurs in Queensland. For the purpose of determining the royalty for base and precious metals there are certain allowable deductions. These include exchange gains and losses under a fluctuating exchange rate and ocean freight costs. They do not include rail and road haulage costs and other marketing costs. Other lower-value commodities attract specific unit-based rates of royalty. Queensland also operates a ten per cent wellhead value royalty system for petroleum, natural gas and coal seam methane. Details of recent royalty collections appear in Table 12.1. TABLE 12.1 Queensland mineral royalty collections from 2006 - 07 to 2010 - 11 ($ M) (source: Queensland Government, Office of State Revenue). Year ended 30 June

Coal

Base and precious metals

Petroleum

Other minerals

Total

2007

1019

203

67

40

1329

2008

1035

189

73

49

1346

2009

3103

122

61

56

3342

2010

1786

132

48

49

2015

2011

2357

236

52

53

2698

New South Wales In New South Wales, coal provides 95 per cent of the total royalty revenue for the state government. (New South Wales Department of Primary Industries, 2012). The 2011 - 12 budget estimate for royalty receipts is $1768 M compared with $1240 M in 2010 - 11 and $985 M in 2009 - 10. Mineral Economics

chapter 12 – Mineral taxation and royalties For the 2011 - 12 financial year the ad valorem royalty rates (introduced in 2009) were set at 6.2 per cent for deep underground mines, 7.2 per cent for underground mines and 8.2 per cent for open cut mines. In the 2011 - 12 budget it was announced that these rates would be increased to apply for the 2012 - 13 financial year, with the new rates yet to be announced. Because the MRRT effectively allows the deduction of payments of state royalties from MRRT revenue, the only impact of any royalty rate increases will be a loss of Commonwealth revenue from the MRRT.

TABLE 12.2 Victorian Government mineral royalties by sector, 2009 - 10 financial year (source: Department of Primary Industries, Minerals and Petroleum Statistical Review, 2009/10).

For other minerals, the royalty rate is four per cent of the ex-mine value, where an ex-mine value is calculated as the sale value less allowable deductions. In the case of low-value minerals, specific royalty rates of 35 c/t or 70 c/t apply.

combination of ad valorem and profit-based royalties for most metallic mining products (Tasmanian Government, 2012). The ad valorem rate is 1.9 per cent of net sales, while the profit component provides additional revenue, up to a maximum of 5.35 per cent of net sales. In addition, there is a rebate system for those mining operations that undertake significant downstream processing.

New South Wales also has a profit-based royalty system, which applies only to specific mining operations in Broken Hill. In the petroleum sector, the royalty rate is ten per cent of the wellhead value, though this is only applicable after ten years, with rates rising from zero in the first five years to six per cent in the sixth year up to ten per cent in the tenth year. The same regime is in place for methane extracted from coal seams when the extraction is not associated with coal mining. When associated with coal mining, no royalty applies.

Victoria The Mineral Resources Development Regulations 2002 based on the Mineral Resources Development Act 1990, prescribe a 2.75 per cent ad valorem royalty to the net market value of all minerals, except for gold, which is royalty free (State Government of Victoria, Department of Primary Industries, 2009). The net market value relates to prices prevailing at the time when the mineral is first sold, transferred or disposed of, less any costs reasonably, necessarily and directly incurred in connection with the sale, transfer or disposal (including insurance, freight and marketing expenses) of mineral products. The specific royalty rate for brown coal was set in June 1993 at $0.0239/GJ with values subsequently indexed by the Consumer Price Index. Specific royalty rates applying to quarry products from Crown land are prescribed under the Extractive Industries Development Act 1995. A petroleum royalty for onshore oil and gas is set at 10 per cent of wellhead value under the Petroleum (Submerged Lands) Act of 1982 (Vic) and the Petroleum Act 1997.

Sector

($ million)

Mining

40.6

Extractive

4.4

Onshore petroleum

0.1

Total

45.1

Specific royalty rates of between $0.66 and $2.64/t apply to most non-metallic and quarry product, with $5.50/m3 for building and dimension stone. Petroleum royalty rates (including coal seam gas) are set 12 per cent of the wellhead value onshore. The Tasmanian Government collected royalties totalling $36.2 M in 2010 and $48 M in 2011. (Tasmanian Government, 2012).

South Australia Based on the Mining Act 1971, from 1 July 2011, royalties in South Australia have been payable on an ad valorem basis of 3.5 per cent of the value of refined metallic products, including refined copper, gold and silver as well as industrial minerals and construction materials, including limestone and gypsum. A royalty rate of five per cent applies to other mineral products, generally concentrates or minimally processed products, including copper concentrate, uranium oxide concentrate and iron ore. A two per cent royalty concession applies to new mines for the first five years (South Australian Government, 2011).

Tasmania

The Roxby Downs (Indenture Ratification) Act 1982, as amended in 2011 to allow future mine expansion, was specifically designed for the Olympic Dam copper, uranium and gold project. The South Australian Government has an agreement with BHP Billiton to pay royalties in line with the general rates in the current Mining Act 1971 for the next 45 years. Those royalty rates are 3.5 per cent for refined mineral products (copper and gold metal), five per cent for uranium oxide and five per cent for uranium bearing copper concentrates. The expanded mine will not be eligible for the royalty concession available for new mining projects in South Australia.

The Mineral Resources Development Act 1995 prescribes, through the Mineral Resources Regulations 1996, a

A petroleum royalty of ten per cent of the wellhead value applies onshore and to state coastal waters within

The value and origin of mineral royalties in the 2009 - 10 financial year, which amounted to $45.1 M, appears in Table 12.2. In the 2011 - 12 budget the estimate was $47.1 M.

Mineral Economics

205

chapter 12 – Mineral taxation and royalties three nautical miles. A royalty of 2.5 per cent applies to the wellhead value of geothermal energy. In the 2011 - 12 budget the South Australian Government expected to collect $202.7 M in mining and petroleum royalties, well above the 2010 - 11 estimate of $154.9 M.

Western Australia In Western Australia, the Mining Act (1978) and related Regulations (1981) specify two general royalty systems for minerals that are not the subject of statutory state agreements (Western Australian Government, Department of Mines and Petroleum, 2012): •• a specific royalty, mostly of $0.60 or $1.00/t, is applied to most low-value, bulk, generally nonmetallic mining products •• an ad valorem royalty is applied to the value of most higher-value, generally metallic minerals, with the rate of royalty reducing as a function of increased downstream processing of the product sold •• crushed and screened, bulk material: 7.5 per cent •• concentrates: 5.0 per cent •• metal: 2.5 per cent. The Western Australian Government has used State Agreements Acts as the preferred method of setting out terms and conditions (including obligations on the government) under which specific mining and minerals processing projects proceed (Western Australian Government, 2008). These agreements cover most of the important mining projects in Western Australia in iron ore, nickel, diamonds, mineral sands and bauxite-alumina. Their statutory nature means that the obligations are legally binding and, where expressly designated, can only be changed by mutual agreement followed by legislative amendment. However, when either of the parties is seeking changes to agreement conditions trade-offs can occur and by agreement a variation to the Act of Parliament can be made. In 2011, the renegotiations of iron ore special agreements with BHP Billiton and Rio Tinto to amend them for production expansion and development of new mines, gave the state government an opportunity to renegotiate the applicable royalty rates. The State Budget of 19 May 2011 announced a phased increase in the State Agreement iron ore royalty rates for ‘fines’ being increased from 5.625 per cent to 6.5 per cent and then 7.5, to take effect on 1 July 2012 and 1 July 2013 respectively. This brings the State Agreement rate into line with the rate paid by other iron ore miners under the regulations. Royalty arrangements have always been an integral component of state agreements, as the royalty obligations have always been negotiated in the context of other obligations imposed an on the mining or processing project that is the subject of the agreement. 206

These other obligations have variously included requirements to provide township and transport infrastructure and commitments to further processing of mineral products. Bradley (1986) referred to these other obligations as de facto royalties. Petroleum royalties in Western Australia are levied under four different Acts. Following the offshore constitutional settlement in 1979 and successive negotiations, the State and Commonwealth governments agreed to allocate petroleum royalties derived from onshore and territorial sea production, Barrow Island production and the offshore North West Shelf (under Commonwealth jurisdiction but administered by the state as the designated authority) as set out below: •• The Offshore Petroleum (Royalty) Act 2006, which covers production from fields originating from the North West Shelf project areas covered by permits WA-1-P and WA-28-P. This is an area of Commonwealth jurisdiction in which a wellhead value royalty system is used for the purpose of revenue sharing with Western Australia. Royalty rates vary between ten and 12.5 per cent. Revenues are shared with Western Australia (two thirds going to Western Australia) in accordance with section 75 of the Offshore Petroleum and Greenhouse Gas Storage Act 2006. These arrangements will remain in place after the extension of the PRRT to the North West Shelf Project from 1 July 2012. •• The Petroleum (Submerged Lands) Act 1982 which covers fields within a defined coastal waters area, generally being three nautical miles seaward from the baseline, as well as certain ‘subsisting’ permit areas located within State inland waters. The State administers a wellhead value royalty system. •• The Petroleum Resources Rent Tax Assessment Act 1987, that previously applied only to all offshore waters seaward of the outer limit of coastal waters other than the North West Shelf project Area, will, from July 2012, will be extended to cover all offshore and onshore petroleum projects. Despite the extension of the coverage of the Petroleum Resource Rent Tax (PRRT) Western Australian royalty regimes remain in place, with onshore petroleum projects receiving compensation for royalties paid to the State through adjustment in the PRRT liability. The revenue sharing arrangements based on the ad valorem royalty on the North West Shelf Project will also remain in place. •• The Petroleum and Geothermal Energy Resources Act 1967 applies to onshore areas and waters landward of the baseline of the coastal waters, other than ‘subsisting’ permit areas under the Petroleum (Submerged Lands) Act 1982. The State administers a wellhead value royalty system. Mineral Economics

chapter 12 – Mineral taxation and royalties •• The Barrow Island Royalty Variation Agreement Act 1982 applies only to Barrow Island. The resource rent royalty regime was developed in negotiations between the WAPET consortium, the State and the Commonwealth. It replaced the wellhead royalty and excise system that had previously applied. Western Australia receives 25 per cent of the receipts; the balance goes to the Commonwealth. Table 12.3 sets out mineral royalties received by the Western Australian Government including shared Commonwealth royalties. TABLE 12.3 Western Australian mining and petroleum royalties, 2011 calendar year (source: Government of Western Australia, Department of Mines and Petroleum). Sector

Revenue ($ million)

Iron ore

3875.1

Petroleum

949.1

Alumina

68.4

Diamonds

13.5

Heavy mineral sands

19.2

Nickel

103.0

Gold

210.9

Other

139.4

Total mineral royalties

a

5288.8

a. Includes royalties collected by the Commonwealth from the North West Shelf Project, two thirds of which paid to Western Australia, and Western Australia’s share of the Barrow Island Resource rent royalty.

In a move to spread the benefits of royalty receipts by the state, the government has introduced the Royalties for Regions policy that involves the equivalent of 25 per cent of the state’s mining and onshore petroleum royalties being returned to the state’s regional areas each year as an additional investment in projects, infrastructure and community services (Western Australian Government, Department of Regional Development and Lands, 2012). There were estimates of $6.1 B expenditure through the Royalties for Regions fund from 2008 - 09 to 2014 - 15, with $1.2 B allocated to 2011 - 12.

Northern Territory The Northern Territory has a profit-based royalty regime for minerals based on the provisions of the Mineral Royalty Act 1982. The system applies a rate of 20 per cent to the net value of minerals, where the net value is the gross realisation value (or sale value), less: •• operating costs •• a capital recognition deduction on eligible expenditure •• eligible exploration expenditure •• any additional deduction approved by the minister. Mineral Economics

The capital recognition deduction combines depreciation and normal profit. Normal profit is defined as the long-term bond rate plus two per cent. A threshold royalty free net value of $50 000 applies. Because ownership of uranium still rests with the Commonwealth Government, the Commonwealth through the Uranium Royalty (Northern Territory) Act 2009 imposes the same royalty regime as the Territory’s on any new uranium mine and returns the revenue to the Northern Territory as a grant. Existing mining operations at the Ranger mine attract a Commonwealth royalty of 1.25 per cent of net sales, which is then paid as a grant to the Territory government. A ten per cent wellhead ad valorem royalty applies to petroleum production. Revenue generated from mining activity (including petroleum production) in 2010 - 11 was $145.7 M and this was expected to rise to $162.3 M in 2011 - 12 (Northern Territory Government, Territory Revenue Office, 2012).

The Commonwealth of Australia The Commonwealth applies crude oil excises to crude oil production offshore in the North West Shelf Project area and onshore. Excises are in the nature of an ad valorem royalty in that they are levied on the volume weighted average of the realised free on board (fob) price. The excises are applied to categories of oil production (old oil, new oil, and intermediate oil) depending on the date of discovery with the critical dividing date between old oil and new oil being 18 September 1975. The excise rates vary according to annual production for each production category with the highest rates applying to old oil (rates up to 55 per cent) while new oil in the largest production category has a rate of 30 per cent. The first 30 million barrels of crude oil and condensate from a field are excise exempt. The ability to apply these excises comes from the section of the Australian constitution providing exclusive authority to the Commonwealth to levy duties of customs and excise (section 90). On 13 May, 2008 the Commonwealth announced the extension of the crude oil excise to cover previously exempt condensate. The extension applied to production from the announcement date. Imposing an excise on condensate results in a reduction in royalties payable to the Western Australian government because crude oil excise payments are a deductible expense for calculating the offshore petroleum royalty applicable to the North West Shelf which Western Australia shares with the Commonwealth. The Commonwealth provides compensation to the Western Australian government for this loss. The Petroleum Resource Rent Tax (PRRT) was first introduced in 1987 in the Petroleum Resource Rent Tax Assessment Act 1987. It has been amended significantly since then, with the most significant change being in 2012 with the extension of the coverage of the tax to 207

chapter 12 – Mineral taxation and royalties all onshore oil and gas projects and the North West Shelf project. The only area where the PRRT will not apply is the Joint Petroleum Development Area in the Timor Sea. The extension to oil and gas projects included the newly emerging coal seam gas and shale gas projects. The tax (as distinct from coverage of the tax) is imposed in three new acts6 designed to ensure that the constitutional validity of the tax is secure. The extension of the tax to onshore oil and gas projects does not eliminate the existing state-based taxes applied to the oil and gas sectors (largely ad valorem royalties) as the Commonwealth does not have the power to legislate the removal of these taxes. Instead any amounts paid to state governments will be grossed up to calculate their mining revenue equivalent and then deducted from mining revenues before determining the PRRT amount. Similar treatment will be applied to the Commonwealth crude oil excise and ad valorem royalty that remains in place for the North West Shelf Project. The grossing up procedure involves finding the revenue equivalent of the amount paid in a state tax if that revenue was taxed at the PRRT rate of 40 per cent. For example if $1 was paid as a state royalty, the revenue equivalent is the amount that, if taxed at the PRRT rate of 40 per cent, would generate $1 in PRRT revenue. In this example the revenue equivalent would be $2.50 and so $2.50 would be deductible. The PRRT is a project-based cash flow tax with a tax rate of 40 per cent applied to the tax base (The Parliament of the Commonwealth of Australia, Explanatory Memorandum, Petroleum Resource Rent Tax, 2011). Where negative cash flows occur in one year, they are carried into the next and increased by the governmentdetermined level of normal profit (the uplift factor in the legislation). The level of normal profit set in the PRRT is the combination of a risk-free rate of return (the Commonwealth long-term bond rate (LTBR) and a premium depending on the type of activity on which the expenses are incurred. In general, and depending on the timing of expenditures, exploration expenses are uplifted at the rate of LTBR+15 per cent, while general project expenditures are uplifted at LTBR+5 per cent. Exploration expenditures are, under prescribed conditions, transferable to other petroleum projects where they can be used to offset taxable revenue. Interest is not counted as a deductible cost as it is part of the normal profit. Other non-deductible expenditures include financial outlays (dividends and capital return, private royalties (though native title payments remain deductible) income tax and GST. Amounts paid under the PRRT are however deductible in determining company income tax. The transition to coverage of the PRRT over onshore petroleum projects required arrangements to be put 6 The Petroleum Resource Rent Tax (Imposition—Customs) Act 2012, the Petroleum Resource Rent Tax (Imposition—Excise) Act 2012, the Petroleum Resource Rent Tax (Imposition—General) Act 2012.

208

in place to determine the capital expenditures prior to the start of onshore coverage that would be eligible to be deducted from future project revenues after 1 July 2012, the start date for the extended tax and eligible for uplift at LTBR+5 per cent where project revenues were insufficient. For this purpose 2 May 2010 (the date of the Government’s announcement of the extension of the PRRT) was set as the date to establish a starting base. Two choices were offered as methods of establishing the starting base: 1. the market value of the starting base assets, including the value of rights to the resource 2. the book value of assets, though not including the value of rights to the resource. Alternatively a ‘look back’ approach could be applied to take into account actual expenditures from 1 July 2002. Starting base amounts are not transferable between projects, and nor are exploration expenses prior to 1 July 2012 under the look back approach. The most recent data on PRRT revenue collections are shown in Table 12.4. The effect on revenue from the extension to onshore projects is uncertain because of the deductibility of state royalties, and the deductibility of starting base and look back deductions. TABLE 12.4 Petroleum Resource Rent Tax receipts (source: Australian Tax Office, Taxation Statistics, 2011 (2008 - 2009)). Year ended 30 June

Amount ($ M)

2006

1997

2007

1768

2008

1943

2009

1641

2010

1260

The MRRT was the final result of an extensive public debate that began with the initial proposal for a resource super profits tax based on the recommendations of the Henry report. As discussed earlier in this chapter, the Henry report recommended a tax based on the Allowance for Capital Cost approach to the taxation of economic rents, but the final result takes on the Garnaut and Clunies Ross approach and has a similar structure to the PRRT (The Parliament of the Commonwealth of Australia Explanatory Memorandum, Minerals Resources Rent Tax, 2011). The similarities and differences from the resource super profits tax and the PRRT may be summarised as follows: •• As with the PRRT, the MRRT is a tax on economic rent associated with the value of a mineral resource at the run-of-mine stockpile, and before further processing or transport value-adding activity. •• The resource super profits tax was planned to encompass all minerals sectors including the petroleum sector, but the MRRT only covers iron ore Mineral Economics

chapter 12 – Mineral taxation and royalties and coal and the PRRT stands as a separate tax for the petroleum sector. •• The tax rate is set nominally at 30 per cent but effectively at 22.5 per cent because of an extraction factor allowance that reflects the value of the specialist human resources involved in the extraction process, and not just the value of the natural resources at the run-of-mine stockpile. •• The mining loss allowance provides an uplift rate for the carry forward of undeducted expenditures for the MRRT at LTBR+7 per cent. •• The starting base allowance for previous capital expenditures is determined in in similar ways to those available in the PRRT. Unlike the situation in the PRRT where the starting base is immediately available in its entirety as a deduction against mining revenue, with the MRRT under the market value approach the base is depreciated over time. The undepreciated value of the starting base has its real value maintained by being uplifted by the Consumer Price Index each year. Under the book value approach the starting base is depreciated over five years, and the undepreciated value uplifted each year by the LTBR+7 per cent. •• Exploration expenditures under the MRRT fall into the category of pre mining expenditures and are deductible like any other mining expense. Exploration expenditures that are undeducted are carried forward at the same general uplift rate of LTBR+7 for up to ten years, after which the uplift rate is only the LTBR. •• The threshold net cash flow of $75 M concession for all a taxable mining entity’s projects means that an entity with a combined net cash flow less than the threshold in a year pays no tax in that year. •• State royalties are grossed up in the same way as in the PRRT to reduce MRRT payments. •• As with the PRRT the relevant legislation consists of a main assessment Act, the Minerals Resource Rent Tax Act and three imposition Acts to ensure constitutional validity. •• Natural gas is taxed under the MRRT rather than the PRRT when the gas extracted is incidental to coal mining and when gas is extracted as a result of underground coal gasification. The critical issue that will impose substantial administrative and compliance costs on the operation of the MRRT is the necessity to determine the run-of-mine values for minerals that do not have a market price at that point, and that undergone extensive transportation and processing before reaching a value that is the basis of a market transaction. Net back pricing in which all costs incurred beyond the run-of-mine position are deducted from an ultimate market price will probably be the most common approach, while other arm’s length methodologies may be used. Mineral Economics

Other issues in the collection and use of economic rents in Australia In the past, constitutional provisions and policy approaches have led to the development of innovative indirect ways of collecting mineral revenues other than through the standard mineral revenue collection systems outlined above. In addition, there have been suggestions to use alternative or modified approaches to conventional royalty regimes. This section also discusses how the states that raise revenue through tax or royalty regimes on the mining sector do not always get to keep their revenues.

Export levies In 1975, the Australian Government imposed levies on coal exports. As these exports came from resources in Queensland and New South Wales, the Commonwealth could not have sought to collect what it perceived to be economic rents in the coal export business directly, but could do so through constitutionally appropriate, though economically inefficient, export levies. The relevant state governments were not able or willing to extract these rents for themselves. The levy was abolished from 1 July 1992.

Rail freight rates For a number of years, the Queensland Government extracted rents from the coal industry by imposing a surcharge on rail freight rates for coal. Although initially omitted from Commonwealth Grants Commission calculations for mineral revenues, they were finally captured in 1999 and treated as a quasiroyalty. Subsequently, the Queensland Government phased out excess rail charges and introduced a single royalty regime for all coal mines.

Pipeline licence fees In Victoria, in 1981, the state government attempted to impose a pipeline licence fee on onshore pipelines carrying crude oil from the Bass Strait oil fields. The licence fee was set at $20 M. The oil producers appealed against the legality of the fee to the High Court. The Court ruled in favour of the oil producers7. The Victorian Government was forced to repay money raised by the fee to Esso/BHP.

Infrastructure contributions In Western Australia, Bradley (1986) identified the practice of the government, by means of state agreements, which required mining operations to fund social infrastructure and to enter into further mineral processing commitments. Bradley referred to these requirements as de facto royalties and argued that their consequence was effectively to reduce the formal royalty arrangements. 7

Hematite Petroleum Pty Ltd v Victoria (1983) 151 CLR 599.

209

chapter 12 – Mineral taxation and royalties

Cash bidding One method rarely used in Australia is to auction the exploration and development rights of well-defined tenements either for an upfront cash payment, or an ongoing ad valorem royalty or some combination of upfront cash and royalty payments. Bidding systems are in common use in the United States, particularly for petroleum tenements on the outer continental shelf. The argument in favour of cash bidding is that it allocates tenements to those prepared to make the highest bid. This should indicate that the exclusive rights to exploration and development of mineral tenements are held by those who have the best understanding of the prospectivity of a tenement and who have the ability to operate it efficiently, or at least have the financial resources to do so. The cash bid should reflect the present value of the expected economic rents from a tenement and, unlike production or cash-flow-based systems, gives the government money at the start of the mining process. In addition, being a sunk cost, the cash bid will have no impact on later investment and production decisions, and therefore has the desirable attribute of neutrality. By contrast, ad valorem royalty bidding systems are subject to all of the same criticisms that apply to ad valorem royalties generally. Provision for an up-front cash bidding approach to the allocation of petroleum tenements exists in the Commonwealth Petroleum (Submerged Lands) Act 1967, but it has been used sparingly. The Australian states have not adopted cash bidding. Even though up-front bidding has significant benefits relative to the other methods of allocating petroleum exploration tenements, the states have preferred to stick with the work commitment bidding approach that gives emphasis to maximising the quantity of exploration activity rather than the collection of economic rents.

Government equity participation Rather than rely on a tax system that may be inadequate to collect part of the available rents, governments in a number of jurisdictions throughout the world have taken direct equity in mining operations. For the most part, this is free equity given to the government in return for the right to mine. In recent years in Australia there has been one case of government equity participation as a means of accessing and distributing rents directly to citizens. This was in the context of the Argyle diamond mine in Western Australia. The original exploration joint venture included, along with the majority participant CRA, a small company known as Northern Mining with a five per cent participation level. When the project turned from an exploration to a mining activity in 1983, the Western Australian Government bought Northern 210

Mining. The company was subsequently sold on the stock exchange as the Western Australian Diamond Trust. In 1989 the trust was bought out by CRA.

Hybrid resource rent taxes The Bradley Report into mineral revenues in Western Australia recommended that the existing systems of royalties in Western Australia be replaced by a resource rent type tax in combination with an ad valorem system. The benefits claimed for this hybrid approach were that, as well as providing a more efficient and equitable tax regime, the government would receive an early flow of income from new mining projects, thus producing a more stable and certain revenue flow to government than a pure rent-based system. The ad valorem royalty would be set at a low rate and apply only until the company had recovered all of its outlays and was generating economic rent. Amounts paid initially under the ad valorem system would then be repaid to the company through reduced resource rent tax payments until all ad valorem payment was returned. In effect, the ad valorem payment was a loan made by the company to the government against future rent tax payments and subsequently repaid.

Using economic rents for the future While it is granted that known mineral resources are being depleted, there is a long-term question about the future of mineral revenues as mining activity proceeds. There is the prospect that price increases will offset a declining resource base and thus maintain mineral revenues. There is also the prospect of the known resource stock being enhanced through further exploration, or technological changes that make lower grade orebodies economic to mine. In any case, the ultimate reduction in the flow of mineral revenues and the corresponding effects on state or Commonwealth income levels can be offset if the mineral revenues are reinvested in new human or physical capital along the lines suggested by Hartwick (1977). To some extent this approach has been implemented by the Alberta Heritage Fund (2012), the Alaska Permanent Fund (2012), and the Government Pension Fund in Norway (2012). Yet, the experience of Nauru suggests that mineral revenues put into a central fund opened the possibility of corrupt and uneconomic use of those revenues, prompting the view that it would be better to direct the funds to individual (as is the case with the Alaska Permanent Fund) or family units that might make more efficient choices (Hughes, 2004).

Net impact of Australian federalism on state royalty revenues The net value of royalties to state governments in Australia is influenced by the Commonwealth Grants Commission (CGC) process. The Commission recommends the formula for distributing revenues Mineral Economics

chapter 12 – Mineral taxation and royalties from the goods and services tax (GST) between the states on the basis of a state’s overall tax effort, fiscal capacity and revenue need. The proceeds of the GST collected by the Commonwealth Government are distributed to state governments, not on the basis of equal per capita amounts, but on the basis of ability to raise their own revenue and the costs of supplying state government services. The objective is to achieve some degree of comparability in the standard of government services between the states (horizontal fiscal equalisation). Where a state raises considerable revenue out of its mineral sector, it effectively does not keep all of that revenue. The Grants Commission methodology has the effect of reallocating part of that revenue to those states that have a less than national average ability to raise money from the mining and other sectors. This is achieved by reducing the share of national GST allocation to the mineral revenue-earning states.

Commonwealth company income tax The discussion so far has focused on those taxation and royalty systems explicitly designed to raise revenue from the economic rents from the minerals sector. There are a number of other imposts that are applied across all industrial sectors that incidentally raise revenue from any economic rents. These include stamp duty, payroll tax, fuel excises, and most importantly, company income tax. The company income tax liability is computed by applying a tax rate (currently 30 per cent) to taxable company income determined according to the provisions of the Income Tax Assessment Act 1997. The majority of the income tax provisions embodied in the Income Tax Assessment Act 1997 (as amended) are applicable to taxable income irrespective of its origin. There are, however, a number of special taxation arrangements in the company income tax system that have the effect of reducing the income taxes that companies in the minerals sector pay relative to companies in other sectors. These special arrangements have the objective of encouraging mining companies to undertake more exploration, and in some cases development, than they would otherwise have carried out. The capital-intensive and upfront nature of exploration and development outlays, together with the risks inherent in the industry, have traditionally been recognised as the reasons why the minerals sector should receive more favourable treatment.

Deductibility of exploration expenditures Division 40 of the Income Tax Assessment Act 1997 contains the provisions that are relevant to mineral (including petroleum) exploration and quarrying and mining activities. Subdivision 40-H Mineral Economics

allows immediate deductibility for exploration and prospecting expenditure. The definition of exploration or prospecting is very wide and includes (in section 40.730): •• For minerals generally •• geological mapping, geophysical surveys, systematic search for areas containing minerals or quarry materials, and the search by drilling or other means for minerals or materials within those areas •• the search for ore within, or near, an orebody or search for quarry materials by drives, shafts, cross-cuts, winzes, rises and drilling. •• For petroleum particularly •• geological, geophysical and geochemical surveys •• exploration drilling and appraisal drilling. •• Feasibility studies to evaluate the economic feasibility of mining minerals (including petroleum) once they have been discovered. •• Obtaining mining, quarrying or prospecting information associated with the search for, and evaluation of, areas containing minerals or quarry materials. Subdivision 40-H also allows immediate deduction for expenditure on mining site rehabilitation (section 40.735) and immediate deduction for environmental protection activities (section 40.755). Additional deductions are available as a result of Tax Ruling 95/36. In particular the removal of overburden in mining operations is a deductible expense. In strict accounting terms, exploration expenses are directed towards the accumulation of knowledge about the geological characteristics of a specific area and therefore represent the acquisition of (intellectual) capital. In the case of other industries, the tax authorities would not normally allow this type of expenditure as a current deduction in the calculation of taxable income in the year in which it has been incurred, but would require that it be depreciated or amortised over time. Yet, as shown above, for mining companies, the Australian Government does allow the deduction of exploration expenses in the year in which they are incurred.

Depreciation of capital expenditures Subdivision 40-I deals with capital expenditure that is deductible over time. Capital expenditures on mining incurred after 30 June 2001, are deductible as a project amount through a project pool over ten years or the lifetime of the project, whichever is least. Mining capital expenditure is capital expenditure incurred on: •• •• •• ••

carrying out eligible mining or quarrying operations site preparation necessary buildings or improvements provision of water, light or power to the site of those operations 211

chapter 12 – Mineral taxation and royalties •• building used directly for operating or maintaining treatment plant •• buildings and improvements for storing minerals or quarry •• materials for treatment •• housing and welfare – except for quarrying operations. Transport capital expenditure is depreciable over ten years. It includes capital expenditure on: •• a railway, road, pipeline, port or other facility used principally for mining or quarrying transport •• obtaining a right to construct or install such a facility •• compensation for damage for constructing or installing such a facility •• earthworks, bridges, tunnels or cuttings •• contributions made in carrying on business to someone else’s expenditure on the above items. There may, therefore, be significant differences between shorter asset lives used to determine income tax payable and the longer asset lives used, according to accounting standards, to determine the annual profit in the financial statements in a company’s annual report. Where shorter asset lives are allowed in the determination of company tax liabilities, the result is that some tax is deferred. The Australian depreciation provisions for mining may not be attractive compared to some of the other fiscal regimes with which Australia competes for investment in the industry. Recent changes have seen the removal of accelerated depreciation for mining activities and a move to establish common depreciation principles (the Uniform Capital Allowance system) across all sectors of the economy. Current taxation laws discriminate in favour of large integrated companies compared with pure explorers. The former can write off their exploration and prospecting expenditure in the year in which they incur it against taxable income generated by a related company, thus accelerating cash flows. A related company is one that either owns or is owned by the exploration company or which is co-owned by a common parent company. By contrast, a pure explorer may lack any taxable income against which to write off its exploration expenditure, and can only capitalise it and, in effect, carry forward the relevant loss until the company generates some taxable income or is sold. This may take many years, during which cash flow is delayed and, under inflationary conditions, the tax-shield effect of exploration expenditure is gradually eroded. It is for the foregoing reasons that small and middlesize exploration companies have lobbied strongly but unsuccessfully for the introduction of a ‘flow-through share scheme’ where exploration expenditure would become a legitimate tax deduction in the hands of shareholder subscribing equity funds to the company. 212

The introduction of such a scheme in Canada has resulted in a marked revival of exploration investment in that country (Clark, 2007).

Other issues It is possible to rationalise the special tax treatment of exploration using the concept of positive externalities. When a company undertakes exploration activity at its own cost: •• it adds to geological knowledge by doing so •• that knowledge is available to all other mineral explorers. Exploration therefore creates a spillover effect or positive externality. Other exploration companies will be able to use that geological knowledge in adjoining areas and conduct exploration at a lower cost than if the initial exploration had not been undertaken. The activity of one company therefore reduces costs for another, but the company that incurred the initial costs is not always able to benefit from this information spillover because its property rights to the information may be limited. For this to be true it is, however, important that the geoscientific information generated by the mineral exploration industry be properly collated, managed and widely and freely distributed by the relevant state institutions, generally the geological surveys. In the light of this mismatch between costs incurred by the initial exploration and benefits generated for the initial explorer and all other explorers, the amount of exploration without some form of subsidy would be less than what was socially desirable. The special tax treatment of exploration expenses provides a benefit to exploration companies that reflects the benefits they provide to the exploration sector as a whole when they carry out exploration activities. Another area of federal taxation that bears a strong influence on the viability of mining projects is the treatment of hedging gains and losses on forward sales. In recent years, many commodity markets have tended to be in contango rather than in backwardation. Recall from Chapter 7 that contango is a state of affairs whereby the forward price of a commodity is higher in succeeding months than in the nearest delivery month. Backwardation is the opposite situation. With contango in place, mining companies selling forward, part or the whole of their production, may realise higher prices than if they sold on the spot market. They derive this benefit, however, by foregoing the benefit that they would have derived if the spot price on the delivery date were to exceed the corresponding forward price. Aside from neutralising market risk, however, hedging has been used as a funding mechanism for mining operations. Providers of project finance may insist on part of the first few years’ production to be sold forward to reduce potential revenue volatility while their loans are outstanding and therefore at risk. Mineral Economics

chapter 12 – Mineral taxation and royalties The Australian Taxation Office draws a clear distinction between companies or individuals making use of forward or future sales for speculative purposes and genuine mining companies using a schedule of successive forward contracts as an insurance and funding mechanism. In the latter cases, companies are allowed to roll contracts over for a specified and clearly planned period of time without incurring a tax liability on the gain realised at each rollover. By contrast, in the case of speculators, each contract closure would engender a tax liability.

Mineral revenue policies for the future The prevailing situation in Australia at the time of writing is one of potential instability both politically and economically. The Commonwealth is committed to the use of the resource rent approach for the taxation of economic rents and has extended this approach through recent legislation applicable to onshore petroleum projects, as well as the iron ore and coal industries. At the same time, however, a dual taxation system still applies in those industries (onshore oil and gas, iron ore, and coal) that were previously the sole preserve of State governments and taxed largely through ad valorem royalties. The sources of the potential instability to this system come from: •• the pledge by the Opposition to repeal the recent Commonwealth legislation •• the ability of the states to increase their royalty rates in a way that in effect diminishes Commonwealth receipts from its resource rent based taxes •• the threat by the Commonwealth to use other means to effectively diminish the total revenue of a state government that increases its royalty rates •• the potential for the Commonwealth taxes to generate zero revenue for the Commonwealth if the prices of commodities subject to Commonwealth taxation were to decline to levels that eliminated economic rents associated with those commodities, while at the same time state royalty payments continued. While there is general consensus that the current dual system of state royalties and the Commonwealth’s MRRT and PRRT is inefficient from an administrative point of view, there are no obvious, politically feasible solutions to the problem. On the one hand, it is clear that the states would be reluctant to forego their right to levy royalties, one of their main sources of revenue and financial independence from Canberra. On the other, it may be difficult to reach agreement about the conditions under which the Commonwealth would be prepared to transfer the resource rent tax systems to the states and territories, with concomitant abolition of the royalty Mineral Economics

systems on commodities subject to the resource rent taxes. Furthermore, the states would have to accept the tax base and tax rates as set by the Commonwealth and that given the administrative nature of the MRRT there would be significant synergy if the tax would be administered by the Commonwealth. Apart from political reasons, the states would be reluctant to accept such an arrangement without a Commonwealth guarantee that they would receive a minimum level of revenue. This would be the case even if falls in commodity prices brought a situation where there would be no economic rents to be taxed and no MRRTrelated revenue.

Note on the literature The oil price increases of the 1970s and early 1980s, as well as the concern over the apparently limited supply of mineral resources provoked an interest in the economic rents that were or would be accruing in the face of apparent scarcity. The result was a major contribution to the economics literature of the time, which focused on the meaning of economic rent and the means by which governments might share in economic rents. A number of issues were settled in the academic literature of that time, such as the theoretical preference for rentbased mineral revenue systems over production- or value-based systems. More recently, further research has gone into the design of neutral company income tax systems that build upon the approach initiated by Brown in 1947. The allowance for corporate capital (ACC) system is one such recent development. The Internet provides ample resources dealing with the taxation of the mining sector. The items listed below are those for which specific reference is made in the text.

References Alaska Permanent Fund, 2012. APFC Alaska Permanent Fund Corporation [online]. Available from: [Accessed: 8 March 2012]. Alberta Heritage Savings Trust Fund, 2012. Alberta Treasury Board and Finance [online]. Available from: [Accessed: 8 March 2012]. Australian Taxation Office, 2011. Taxation Statistics 2008 - 09 [online]. Available from: . [Accessed: 8 March 2012]. Bradley, P G, 1986. Report of the Mineral Revenues Inquiry, volumes 1 and 2 (Western Australian Government: Perth). Brown, E C, 1948. Business income, taxation, and investment incentives, in Income, Employment and Public Policy: Essays in Honor of Alvin H Hansen (ed: L A Metzler), pp 300–316 (Norton: New York). Calzada, M, 2000. State government mining royalties: Requited taxes or duties of excise? Murdoch University Electronic Journal of Law, 7(3) [online]. Available from: [Accessed: 8 March 2012]. 213

chapter 12 – Mineral taxation and royalties Clark, R J, 2007. Flow-through share financing for junior mining companies: Canada’s Experience, Natural Resources Canada [online]. Available from: [Accessed: 8 March 2012]. Commonwealth of Australia, 2010. Australia’s future tax system, Report to the Treasurer, Canberra. Crommelin, M, 1996. State agreements: Australian trends and experience, in Australian Mining and Petroleum Law Association Yearbook, pp 328-349 (AMPLA: Melbourne) Denolder, T, 2000. Terms of the deal: Native title agreements, in Australian Mining and Petroleum Law Association Yearbook, pp 537-556 (AMPLA: Melbourne). Garnaut, R and Clunies Ross, A, 1983. Taxation of Mineral Rents (Clarendon Press: Oxford). Government Pension Fund, Norway, 2012. Ministry of Finance [online]. Available from: [Accessed: 8 March 2012]. Guj, P, 2011. Is the MRRT competitively neutral?, Centre for Exploration Targeting, The University of Western Australia, Quarterly News, issue 17, September. Hartwick, J M, 1977. Intergenerational equity and the investing of rents from exhaustible resources, American Economic Review, 67(5):972-74, December. Hotelling, H, 1931. The economics of exhaustible resources, Journal of Political Economy, 392:137-175. Hughes, H, 2004. From riches to rags: What are Nauru’s options and how can Australia help?, Issue Analysis, Centre for Independent Studies, 50:18. New South Wales Department of Primary Industries, 2012. NSW minerals and petroleum-Royalty [online]. Available from: [Accessed: 8 March 2012]. Northern Territory Government, Territory Revenue Office, Royalties [online]. Available from: [Accessed: 8 March 2012]. O’Hare, C W, 1971. A history of mining law in Australia, The Australian Law Journal, 45(June):281-293. Otto, J, Andrews, C, Cawood, F, Doggett, M, Guj, P, Stermole, F, Stermole, J and Tilton, J, 2006. Mining Royalties – A Global Study of their Impact on Investors, Government, and Civil Society, The World Bank, Directions in Development, Energy and Mining, Washington, DC. Parliament of The Commonwealth of Australia, The, 2011. Explanatory Memorandum, Petroleum Resource Rent Tax, The Parliament of The Commonwealth of Australia, House of Representatives, Petroleum resource rent tax assessment amendment Bill 2011 Petroleum Resource Rent Tax (Imposition — Customs) Bill 2011, Petroleum Resource Rent Tax (Imposition — Excise) Bill 2011 Petroleum Resource Rent Tax (Imposition — General) Bill 2011 (Circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP).

214

Parliament of The Commonwealth of Australia, The, 2011. Explanatory Memorandum, Minerals Resource Rent Tax, The Parliament of The Commonwealth of Australia, House of Representatives Minerals resource rent tax bill 2011, Minerals resource rent tax (Consequential Amendments and Transitional Provisions) Bill 2011, Minerals resource rent tax (Imposition – Customs) Bill 2011,Minerals resource rent tax (Imposition – Excise) Bill 2011, Minerals resource rent tax (Imposition – General) Bill 2011 (circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP). Queensland Government, Office of State Revenue, 2012. Royalty rates [online]. Available from: [Accessed: 8 March 2012]. Ricardo, D, 1821. On the principles of political economy and taxation, chapter 2 [online]. Available from: [Accessed: 8 March 2012]. Solow, R W, 1974. The economics of resources or the resources of economics, American Economic Review, 64:1-14. South Australian Government, Department for Manufacturing, Innovation, Trade, Resources and Energy, 2011. Mineral royalties [online]. Available from: [Accessed: 8 March 2012]. State Government of Victoria, Department of Primary Industries, 2009. Victorian royalty regime [online]. Available from: [Accessed: 8 March 2012]. State Government of Victoria, Department of Primary Industries, 2010. Victoria’s minerals, petroleum and extractive industries — 2009/10 statistical review [online]. Available from: [Accessed: 8 March 2012]. Tasmanian Government, 2012. Fees, Rents and Royalties under the Mineral Resources Development Act 1995 [online]. Available from: [Accessed: 8 March 2012]. Tilton, J E, 2003. On Borrowed Time? Assessing the Threat of Mineral Depletion (Resources for the Future: Washington DC). Western Australian Government, Department of Mines and Petroleum, 2012. Royalties, 2012 [online]. Available from: [Accessed: 8 March 2012]. Western Australian Government, Department of Regional Development and Lands, 2012. Royalties for Regions, 2012 [online]. Available from: [Accessed: 8 March 2012]. Western Australian Government, Department of State Development, 2008. State agreements [online]. Available from: [Accessed: 8 March 2012].

Mineral Economics

HOME

chapter 13 Mining, Sustainability and Sustainable Development Roderick Eggert Introduction Sustainability and sustainable development Mining and environmental sustainability Mining and economic sustainability Mining and social/cultural sustainability Public policy – principles and concepts Putting sustainability and sustainable development into practice in mining Final thoughts

Notes on the literature

Appendix A – The Mining, Minerals and Sustainable Development project: Nine key challenges Appendix B – The International Council on Mining and Metals sustainable development framework Appendix C – summary findings of the Extractive Industries Review Appendix D – ten principles of the Global Compact

Introduction Mining inevitably affects the natural environment and local communities. The economic benefits of mining sometimes come with significant environmental and social costs to mining communities and regions. Balancing the economic, environmental and social benefits and costs of mining is the focus of the quest for sustainable development in mining. Popular and professional interest in sustainability and sustainable development stems from concerns that many current activities may be unsustainable – that is, that some current economic activities, including some mines, may result in such significant environmental and

Mineral Economics

social damage and disruption that they will leave future generations worse off than the current generation. This chapter provides an overview of sustainability and sustainable development as they relate to mining. It begins by defining the various aspects and dimensions of sustainability and sustainable development generally. The discussion then suggests how these concepts apply to the mining sector. It concludes by outlining an appropriate role for government in ensuring that mining is consistent with sustainability and sustainable development and by noting several of the more significant efforts to promote sustainability and sustainable development in mining.

215

chapter 13 – Mining, Sustainability and Sustainable Development

Sustainability and sustainable development The concepts of sustainability and sustainable development include subjective elements and mean different things to different people. Different perspectives and priorities among stakeholders can lead to difficulties in determining how successful the mining industry is in achieving the objectives of sustainability and sustainable development. Sustainability perhaps is best thought of as a onedimensional concept, with three variants: environmental, economic and social/cultural sustainability. Environmental sustainability is a physical goal – sustaining environmental quality and the stock of natural resources. One can imagine managing a renewable resource such as a fishery, in such a way that the rate of harvest does not exceed the rate of natural regeneration; thus the stock of the resource is sustained indefinitely. Or a set of natural resources – such as an ecosystem with plants, animals, water, soil, air and so on – could be managed in such a way that the overall stock of the set of resources is at least maintained. Still another version of environmental sustainability involves maintaining air quality or water quality at some prescribed level, recognising that there are natural fluctuations and trends in air and water composition. Maintaining biodiversity is an important issue in this form of sustainability. Environmental sustainability emphasises maintaining the ability of the natural environment to provide life-sustaining and aesthetic services, such as clean air and water, the energy and mineral resources necessary for the human economy and so on. It also emphasises the belief that the natural environment should be preserved for its own sake, independent of how human beings use the natural environment for their activities.1 Economic sustainability emphasises sustaining improvements in human living standards or human well-being. Narrow measures of economic sustainability are the level and growth rate for a nation’s Gross Domestic Product per capita, the estimated per-person value of a nation’s output of goods and services, which in turn is equivalent to per-capita income. Broader measures of economic sustainability include indexes that attempt to capture other (less purely economic) aspects of human living standards, such as literacy rates, life expectancy, income distribution and other indicators of economic development. One such index is the Human Development Index (HDI) of the United Nations Development Programme (United Nations, 2011b). Another conceptual measure of economic sustainability is what economists call the capital stock – the total value of inputs to the production of goods and 1

The often mistaken belief that the recent state of the natural environment is somehow special and needs to be frozen in time (preserved), and all trends (even natural) should be resisted, is counterproductive but often promoted by antidevelopment organisations.

216

services, including natural resources, labour, buildings, equipment and processes. The larger the capital stock, here defined broadly to include natural resources and environmental quality, the larger the capacity of an economy to generate income and economic well-being. Economic sustainability requires that the capital stock remain intact over time. Social and cultural sustainability, a third form of sustainability, emphasises minimising undesired social and cultural impacts while facilitating social and cultural development (through, for example, education). This form of sustainability focuses primarily on the search for fairness in the distribution of benefits and burdens associated with economic activities. It also focuses on the process through which decisions are made about whether and how new commercial activities occur. The distribution of the benefits and costs of commercial activities rarely is equal across society. For example, a large new commercial development may be beneficial for a national or provincial economy overall and yet leave the local community or Indigenous peoples in the vicinity of the new investment entirely different (and even arguably worse off) than before the new investment. What level and form of compensation, if any, is appropriate for local communities or Indigenous peoples to receive for the social disruption, loss of cultural identity, or environmental damage caused by the new commercial activity? How should the affected local communities or Indigenous peoples share in the net benefits of the new commercial activity? Sustainable development was defined by the Brundtland Commission of the United Nations on March 20, 1987, as ‘development that meets the needs of the present without compromising the ability of future generations to meet their own needs’ (World Commission on Environment and Development, 1987). In contrast to sustainability, it is inherently and explicitly multidimensional. Sustainable development can be considered the simultaneous pursuit of sustained or enhanced: environmental quality, economic growth and social/cultural development. In other words, sustainable development represents economic development that is consistent with society’s preferences for environmental quality and social/ cultural development. There is no single measure of progress toward sustainable development; rather there are various indicators of progress in the three different realms of sustainability, often referred to as the ‘triple bottom line’ (Elkington, 1997). Progress toward sustainable development involves striving for all three types of sustainability simultaneously. Often trade-offs exist between the environmental, economic and social and cultural elements. For example, a mining operation could reduce air emissions by capital investment in pollution controls, which in turn reduce the mine’s profitability. These trade-offs inevitably lead both to conflict among Mineral Economics

chapter 13 – Mining, Sustainability and Sustainable Development competing environmental, economic and social goals and to the search for common ground between stakeholders to balance impacts. While progress toward the three forms of sustainability individually can be (relatively easily) measured, progress toward sustainable development is more difficult to measure. It requires engagement between stakeholders such as mining companies, government agencies and community groups and established processes through which development decisions are made. One area of common ground is sometimes called ‘no regrets’ actions, where environmental, economic, or social outcomes are aligned. For example, some energy-efficiency initiatives may reduce emissions while simultaneously reducing operating costs and improving profitability. Whether one is concerned about sustainability or sustainable development, there are several important issues that cut across all versions of these concepts. The first is the issue of scale or scope. Are we concerned about the sustainability or sustainable development in a local community or ecosystem; a subnational state or province; a nation; some other scale of focus independent of human-imposed political boundaries, such as a transnational ecosystem; or the world as a whole? A second cross-cutting issue is the magnitude of human activity relative to the carrying capacity of the natural environment to support this activity. Most people would agree that the lower the level of human activity, the greater the ability of the natural environment to absorb environmental degradation and to regenerate itself. Where people disagree, however, is how great the current level of human activities is relative to carrying capacity. A third important issue is how to balance the needs of the current and future generations. For example, consider a new commercial activity, such as a mine, that raises the incomes and helps improve the overall wellbeing today of impoverished people in a poor country. Further imagine that this commercial activity also leads to environmental damage that could over a period of decades lead to possible increased sickness in some people, the reduction of scenic vistas or elimination of pristine wilderness, again over a period of decades. What is the most appropriate way to balance the economic benefits received today with the possible future damages to the human health or the environment? Economists typically use the process of discounting to balance benefits and costs that occur over time. All current and future benefits and costs – economic, as well as social and environmental – are identified and estimated. All future benefits and costs then are discounted at a rate that represents society’s rate of time preference. A dollar of benefits or costs today is worth more than a future dollar – for two reasons. The first is simply that humans are impatient and thus give higher values to current rather than future benefits and costs. The second, and perhaps more significant, justification Mineral Economics

for discounting is based on opportunity costs or capital growth. That is, by waiting to receive a benefit in the future, a person foregoes the opportunity to put money to a productive use today that grows in value over time. The opportunity for capital growth is lost. The higher the discount rate, the more valuable the present is relative to the future. Critics of the first justification of discounting argue that impatience is inherently unethical and unfair to future generations. Critics of the second justification (capital growth) argue that, while discounting may be appropriate for evaluating commercial investment opportunities with benefits and costs that largely affect the current generation, discounting is fundamentally inappropriate for decisions involving future generations and environmental resources that arguably are critical to the survival of these future generations. For more discussion on discounting and how to define what is fair for future generations, see Portney and Weyant (1999). This general introduction to sustainability and sustainable development sets the stage for the next section of the chapter, which focuses on the implications of sustainability and sustainable development for mining.

Mining and environmental sustainability Environmental resources include the stock of natural resources as well as environmental quality. Environmental sustainability, therefore, has two important dimensions for mining. The first is the physical sustainability of mineral production. To be sure, at the scale of an individual mine, mining is inherently unsustainable. A mineral deposit contains a finite amount of mineral ore, and mining eventually will deplete this ore. Nevertheless, mineral production is more sustainable than it appears initially. Rarely is the full extent of a mineral deposit known at the time mining commences. Mining companies routinely extend mine lives by exploring for and developing additional reserves at existing mines. At a broader scale, mining companies extend mineral production and support ever-increasing rates of mineral consumption by discovering and developing previously unknown mineral deposits. Improved technologies (for exploration, mining, and mineral processing) also serve to sustain mineral production by making it technically and commercially feasible to mine mineral resources that previously were technically or commercially infeasible to mine. In a broader sense, recycling sustains the benefits of mineral use even if it does not sustain mine production. The second dimension is the sustainability of environmental quality, which can be considered the ability of the natural environment to provide lifesupporting and aesthetic services to humans, plants and animals. Mining inevitably disturbs the natural environment. During mineral exploration and mine 217

chapter 13 – Mining, Sustainability and Sustainable Development development, environmental damage typically is localised and relatively easy to minimise. Mining and mineral processing, however, are associated with more extensive environmental disturbances, the exact nature and extent of which vary considerably from mine to mine. Mining disturbs surface land, typically more so for surface mines than underground mines. Mining creates solid waste in the forms of overburden, waste rock and tailings. Often a large quantity of waste rock must be removed to uncover the ore. Large quantities of tailings are also often generated as the recoverable metal usually represents only a small weight percentage of the ore mined. Habitat destruction in the areas of mining and waste disposal could lead to habitat loss for flora and fauna. Some types of mining create acid rock drainage when water interacts with newly exposed mineralised surfaces of mined waste rock or tailings, affecting water quality, plants, and animal habitats. Metallurgical processing, such as smelting and refining, often creates air pollution. After mining and mineral processing end, environmental damage can continue if a site is not rehabilitated; this is especially true for acid rock drainage and the aesthetic damage of unsightly landscapes. Sustaining an appropriate level of environmental quality has both short-term and long-term aspects. In the short term, the appropriate level of environmental quality should be determined by finding the appropriate balance between the benefits and costs of environmental protection. Indicators of this dimension of sustainability include the amount of energy and water used, land disturbed, waste and emissions generated per unit of product produced. Planning and provisions for closure should be incorporated early in proposals for mine development, to reduce environmental costs to future generations. Over the longer term, technical innovations in mining and mineral processing hold forth the possibility of reducing both production costs and environmental impacts.

Mining and economic sustainability The degree to which mining contributes to the creation and sustainability of economic benefits in a community, region, or nation depends on three factors, as suggested by Tilton (1992). First, economic deposits of minerals in the ground must be developed; otherwise they represent a dormant asset. Second, an appropriate portion of the proceeds from mining must be invested in activities that will sustain the economic benefits created by mining once mining ceases. Third, an economy (whether local, regional, or national) must avoid the potentially negative macroeconomic and political consequences of mineral development. Let us consider each of these three factors in turn. Whether the private sector develops a nation’s or a region’s mineral wealth depends on a variety of 218

factors, including importantly the nation’s or region’s institutional framework. Some of this framework is common to all commercial activities in a particular political jurisdiction – the rules, regulations, customs, government institutions, and risk perceptions that define the jurisdiction’s legal, fiscal, and business environment. See the World Bank’s World Development Report 2002 for a comprehensive examination of how institutions influence markets (World Bank, 2002). More narrowly, an important part of a jurisdiction’s institutional framework is specific to the mining sector. Public policies influence the availability of basic geologic information upon which private investors make decisions about mineral exploration. Most governments collect basic geologic information in the hope of attracting private investment in detailed exploration that might lead to discoveries and mines. The economic explanation for this public investment in geologic information is that the private sector alone likely will under-invest in the collection of basic geologic information, either because it is more risk averse than society as a whole toward risky ventures or because the benefits of collecting basic information are difficult to fully appropriate or capture. Mineral policies also help define an institutional framework for mining. What constitutes mineral policy varies considerably from place to place. Some political jurisdictions have single comprehensive documents with all or most relevant rules. In other cases, mineral policy simply represents the overall set of rules governing mining as set forth in separate policies governing land use, taxes, environmental regulation, and so on. In any case, mineral policy can be thought of as legislation and rules governing: •• ownership of mineral resources and mining operations •• land access and security of tenure for mineral exploration and mine development, including preproduction approvals and the role and rights of local communities in the mine-development process •• mineral royalties and taxation •• environmental protection, including post-mining requirements for closure and rehabilitation. The second requirement for economic sustainability is that the economic benefits of mining continue as a mineral resource is depleted, through investment in assets that continue to generate economic well-being as mining declines or ceases. In other words, the depleting mineral asset in the ground needs to be replaced with a sustainable, man-made asset. These substitute manmade assets can take a variety of forms. At the scale of a community or region, investments might be made in other types of business for which the community or region has a competitive advantage. Or rather than investing in a specific line of business, local or national governments might invest in social infrastructure that facilitates economic activities generally, including Mineral Economics

chapter 13 – Mining, Sustainability and Sustainable Development education, health care, transportation, water, electricity and technological research and development. The third requirement for economic sustainability is that a region or nation avoids the potentially negative macroeconomic and political consequences of mineral development. These potential consequences can take a variety of forms. One form involves income instability (boom and bust) and associated problems resulting from unstable mineral prices and arguably excessive dependence on mineral production. Another form is the adjustment problem associated with a booming natural resource sector, which we have seen in Chapter 3, is often called the Dutch disease. This problem leads to a shrinking of the non-boom sectors of an economy (often agriculture or manufacturing) even as overall national output and income increase. Still another potential problem involves incentives; the argument is the presence of surplus revenues or rents from mineral production invites competition among special interest groups over sharing of the surpluses, diverting efforts away from creating the surpluses in the first place. An aspect of this phenomenon is the seeming propensity for some mineral-dependent economies to be corrupt. Finally, mineral dependence may encourage the illusion of plenty, leading to irresponsible economic and political decisions, too much consumption and too little investment. Although there is considerable ongoing debate about the seriousness and inevitability of these potentially negative consequences of mineral dependence, the predominant view is that they are avoidable with appropriate public policies.

Mining and social/cultural sustainability Social and cultural sustainability is largely a moral and ethical issue. It is much more difficult to define and measure than environmental and economic sustainability because it requires agreement on what is fair, just and ethical. Although there are considerable disagreements about how to define environmental and economic sustainability, these types of sustainability lend themselves more readily to quantification (eg using a physical measure of environmental degradation to measure environmental quality, using monetary values of income to estimate net economic benefits). Having said this, there are semi-quantitative measures available for social and cultural sustainability, such as literacy rates, health standards, and maintenance of Indigenous languages. Much of the discussion and disagreement around this element of sustainability involves distribution – that is, what is the fair distribution of benefits and costs associated with mining. Many of the benefits and costs of a mine are ‘private’ in the sense that a mining company incurs costs from mining (construction, labour, Mineral Economics

management, raw materials, etc) in exchange for which it receives revenues from the sale of minerals. Other benefits and costs, however, are ‘external’ to a mining company in the sense that it does not directly receive the benefit or incur the cost. External benefits can include: regional economic development coming in the form of, for example, local purchase of inputs by the mine and local spending of mining wages on food, entertainment, furniture, clothing and other goods and services; and improved educational and health-care systems from spending on schools and hospitals. External costs can include: environmental degradation; social problems often accompanying frontier development such as increased rates of alcoholism, prostitution and teenage delinquency; and cultural disruption when Indigenous peoples are confronted with mine development. A major source of contention is the distribution of mining’s benefits and costs between national governments and local communities. Many of the benefits of mineral development go to mining companies (as revenues) and to national governments (as taxes and royalties). Many of the costs are external and borne by local communities in the form of environmental degradation and costs of social disruption. In jurisdictions where lawful and transparent processes exist for mining-development approvals, local communities usually benefit from mining. However, the level of benefit, as well as the distribution of benefits among local stakeholders can vary. Critical issues include: •• Are mining companies implementing practices that minimise environmental and social costs in accordance with regulatory requirements and stakeholder expectations? •• Are local communities appropriately compensated for the external costs they bear from mining? •• Do local communities receive an appropriate portion of the net benefits of mining, relative to mining companies and national governments? •• Are benefits appropriately distributed among different local stakeholders? It is easy to say that local communities should be compensated for the external costs that they bear. This begs the question, however, of how exactly to quantify and value the magnitude of these external costs and how to design institutions, policies and regulations to facilitate appropriate compensation. Nevertheless, the concept of compensation for external cost or damage is not controversial, even if compensation mechanisms are difficult to establish.2 2

With respect to some Indigenous issues for example, there are occasions where it is not just a compensation issue. These stakeholders cannot accept any negotiated compensation agreement. The only thing that they might accept is no development or a development plan the company thinks is not feasible. As pointed out by one chapter reviewer, compensation mechanisms require work and commitment from all parties to engage, build understanding, collaborate and negotiate.

219

chapter 13 – Mining, Sustainability and Sustainable Development The same cannot be said, however, about the second question – defining and ensuring the appropriate distribution of net mining’s net benefits. Eggert (2004), drawing on Young (1994), writes that achieving equitable distributions of mining’s net benefits is promoted by institutional arrangements that answer the following questions: •• What are the eligibility criteria? Who is eligible to share in the net benefits of mining and on what basis? •• What determines the relative priority among several eligible parties? Contributions to the project, such as financial capital or land? Need, such as when the mining region has higher poverty rates than the nation as whole? Whether an entity (such as a local community) receives direct compensation for environmental or social costs of mineral develop-ment or, alternatively, would rather share in the net benefits? •• What are the relevant precedents? Are there existing allocation schemes for similar circumstances elsewhere that might form the basis for a new scheme? •• How should competing principles and criteria be reconciled? Many allocation schemes incorporate more than one principle. For example, net benefits might be allocated both according to need (eg elimination of poverty) and according to contribution to the project. If the overall net benefit is large, there may not be any conflict between the competing principles. But if the net benefit is small, which principle takes priority? •• What incentives does a rule or allocation scheme create? For example, what effect might an allocation scheme have on mineral exploration if it awards a larger share of net benefits to local communities than to a mining company? Or conversely, what effect does an allocation scheme have on community support for mining if it awards almost all net benefits to a mining company? Neither mining companies nor local communities should expect a simple set of rules or a specific allocation scheme to be viewed as equitable in all circumstances. Rather, most approaches to achieving equitable outcomes focus on a process that involves all interested parties to mineral development. Not only does a mining project need to be economically (or commercially) and environmentally feasible, it needs to be socially feasible as well. Mining companies often will need to establish a social license to operate, that is, an agreement with Indigenous and community stakeholders that defines the standards to manage environmental and social impacts and the sharing of economic benefits. This in turn will provide a higher degree of certainty to the mining company to ensure that mining can proceed without social unrest that could affect the continuity of operations (eg avoiding situations such as the shutdown of the Bougainville copper mine in 1989). 220

Public policy – principles and concepts Governments – whether local, regional, or national – play a critical role in defining how a society balances the environmental, economic and social and cultural goals of the various forms of sustainability and sustainable development. Different systems of government – and different people within a given system – have different philosophies about the appropriate role for government. One starting point for a philosophy of government in a market economy argues that governments need to find the right balance of government and private activities such that the political unit (local community, state or province, or nation) satisfies five conditions (World Bank, 1997):3 1. a foundation of law and property rights 2. a non-distortionary policy environment, including macroeconomic stability 3. investment in people and infrastructure 4. protection of the vulnerable 5. protection of the environment. Most economists, in turn, believe that governments should focus their efforts on the following types of activities in defining government’s role in meeting each condition: •• Facilitating market activities by establishing and maintaining well-defined property rights and a money and banking system (see Condition 1). •• Promoting economic efficiency by intervening in situations in which markets by themselves do not function well. Such situations include: lack of sufficient competition, providing the economic basis for antitrust policy; provision of public goods, which typically will be under-provided by the private sector alone, including national defence, education, and various types of infrastructure (see Condition 4); correction of negative externalities or spillover effects, such as environmental pollution (see Condition 5). •• Promoting equity (or fairness) in the distribution of income and wealth and of the benefits and costs of human activities (see Condition 4). How do these general principles relate and apply to public policy toward mining, sustainability, and sustainable development? It is useful to organise the various policy issues around four aspects of mineral development. First, government plays an important role in the creation of mineral wealth (following from the earlier discussion in this chapter on mining and economic sustainability). Mineral wealth is created when there is sufficient knowledge of minerals in the ground for someone to purchase exploration, development, 3

These conditions have been previously mentioned in Chapter 11. Mineral Economics

chapter 13 – Mining, Sustainability and Sustainable Development or mining rights, leading ultimately to mining. Government’s role here is primarily to facilitate market activities. Most of this facilitating role involves the legal and regulatory framework governing mineral exploration, mine development, and mining. Important aspects of this framework include rules governing: ownership of mineral resources in the ground and of ownership of mineral-production facilities; collection and dissemination of basic geologic information, including the roles of government geological surveys; land access and security of tenure; and mineral royalties and taxation. There is discussion of several of these issues in Chapters 11 and 12. Second, government plays an important role in ensuring that mineral development occurs in an economically efficient manner – that is, not simply efficient in a technical or engineering sense but also consistent with society’s preferences for environmental quality and social/cultural values. In terms of the list of microeconomic roles for government (above), the issue primarily is identifying and dealing with the potential negative externalities of mineral development, which in turn relate to mining and its environmental and social (and cultural) sustainability. Externalities can be thought of as spillover effects on third parties that might not be sufficiently considered by private entities involved in decision making about mining, at least not without the involvement of government. Another way to view negative externalities is as unpaid costs; in this view, public policy plays an important role in making sure that these costs ultimately are paid (which might come in the form of compensation to those parties negatively affected). Environmental damage and the social disruptions that sometimes accompany mining are possible negative externalities. Developing public policies and procedures ensuring that these potential externalities are sufficiently considered is not simple and straightforward. At a conceptual level, one can think of project approval as depending on the requirement that expected net social benefits from a project are positive. Net social benefits include the private revenues and costs that a private investor would consider in assessing commercial feasibility, augmented to include any positive and negative external benefits important to society at large. (Positive external benefits would include spillover regional economic activity, such as local purchase of mining inputs, stimulated by mining.) In practice, at the level of a single mining project, the critical policy issues are: Who decides whether proposed mineral development occurs? On what basis? Through what process? One could imagine two basic models for decision making. One model would require that each mining project undergo a separate and public process, on a stand-alone basis, through which social preferences were elicited and after which a decision would be made on whether to permit mine development. At the other extreme, the second model would establish objective Mineral Economics

and transparent rules and criteria for permitting and other preproduction approvals for environmental compliance, water availability and quality, activities to offset potentially negative social consequences of mining (eg increased rates of divorce and alcoholism), and so on – in other words a ‘checklist’ of requirements necessary for approval of mine development. After a mining project satisfied the checklist, government automatically would give approval to the mining project. In practice, most political jurisdictions use a combination of the two models, involving both public participation to discuss whether and how a specific mineral deposit should be developed and a general ‘checklist’ of necessary preproduction activities. Benefit-cost analyses and environmental and social impact assessments are two types of study that often serve as analytical tools to frame issues and aid decision making about mineral development. Third, government plays an important role in ensuring that the surpluses from mining are distributed fairly among private mining companies, national governments, local governments and communities, and other organisations. Mines often generate economic surpluses or net benefits, called rents, even after they provide compensation for the negative environmental and social consequences of mining (or alternatively, undertake activities to minimise or avoid these consequences). How these net benefits are distributed can be controversial. As noted earlier, the frequent concern is that local communities suffer most of the environmental and social costs of mining and yet share inappropriately in mining’s surpluses; mining companies, national governments, regions not affected by mining, or government officials, in this perspective, are seen as unfairly benefiting from mining’s surpluses. The core of this issue is defining what is fair. The previous discussion in this chapter on social justice identified several practical issues in defining fairness. At a more conceptual level, the philosophers Aristotle, Jeremy Bentham, and John Rawls – although not writing about mining in particular – offer three very different definitions of fairness in the context of distributing surpluses (see Young, 1994). The Aristotelian approach would be to distribute surpluses according to each party’s contribution to the creation of the surplus (sometime called proportionality). Business partners share in profits in proportion to the financial contribution they provide to a project. In the case of mining, putting proportionality into practice is more difficult. To be sure, those entities providing funding for the mine deserve to share in the surpluses in proportion to their financial contributions. But governments can argue that they are deserving when they provide some of the infrastructure used by the mine, including roads, electric power, sanitation facilities, and workers educated at publicly funded 221

chapter 13 – Mining, Sustainability and Sustainable Development schools and universities. Even more broadly, society as a whole (including local communities) can claim that a mineral deposit is a gift of nature and thus belong to society at large. The Bentham approach would be to distribute surpluses such that the distribution created the greatest good for the greatest number (sometimes called utilitarianism). Although appealing, it is difficult to know how to put this into practice at a mine. In whose hands is the greatest good created? In the hands of a mining company, which might invest in additional mineral exploration and mine development? In the hands of a local community, which might invest in schools and hospitals? In the hands of a national government, which might invest the surpluses on the highest national needs, including to reduce poverty in other regions of the nation? In principle, one should be able to estimate social rates of return for each alternative use of the surpluses, but again such calculations are difficult to make in practice. The Rawls approach would concentrate the surpluses from mining on the least well-off groups in society. However, his approach is more complicated than it appears. His theory recognises that allocation schemes that redistribute resources from rich to poor may reduce incentives for creating surpluses in the first place. Thus Rawls seems to argue that priority go to those who are least well-off in such a way that mining companies do not, at the same time, lose the incentive to create surpluses in the first place. Fourth, government plays an important role in ensuring that the benefits of mining are sustained even after a mine closes – by investing an appropriate portion of the revenues from mining in sustainable assets so that, in effect, the depletable mineral asset in the ground is made permanent and converted into a sustainable asset. This is an important part of mining and economic sustainability discussed earlier. The idea is akin to a trust fund that wealthy families sometimes use to pass along their wealth to their children or to an endowment that universities use to fund educational activities: save and invest a portion of current income, spend (or consume) only the income on the investment, and in so doing sustain the ability of the original investment to fund spending indefinitely into the future. With respect to investing a portion of the proceeds from mining, several issues are important (see Hanneson, 2001): •• How much to save and invest? Answering this question requires identifying the investment goal. Is it to sustain the current level of well-being? Or to sustain growth in the level of well-being? The more ambitious the goal, the higher the required saving rate. In addition, it is important to consider the expected rate of return on investments. The higher the rate of return, the lower the necessary saving rate. 222

•• By whom? There are several possibilities here. Mining companies might invest in sustaining mining operations through mineral exploration and reservedevelopment activities. Governments might invest in non-mining assets that facilitate economic activities (public goods), such as physical infrastructure (roads, electric power systems), education, health care, and basic scientific and technological research. Partnerships involving mining companies, government and civil society (non-governmental and non-company organisations) also are a possibility. •• In what? Should savings be invested in assets that earn a financial return, such as business enterprises, real estate and financial assets like stocks and bonds? Or should savings be invested in assets with less-visible, harder-to-evaluate, and broader social returns, such as physical infrastructure, education, health care and basic research? Governments may find it difficult to invest appropriately in infrastructure, education, health care and other public goods precisely because the full social benefits and costs of these investments are difficult to quantify. The result is that such projects are open to manipulation by special-interest groups. The key here is to develop formal mechanisms for evaluating social projects and including open and public participation in the evaluation process. There is general consensus that governments should not invest in commercial enterprises or target specific industries with their saving (Auty and Mikesell, 1998). •• Where? In the mining community or region? Somewhere else in the nation? In another country? Hanneson (2001) suggests that the appropriate location of investment will vary from situation to situation, depending on: the size of the economy (the larger the economy, the more likely there are to be productive investments within the economy); the level of economic development in the economy (the lower the level, the larger the potential returns to social infrastructure investments in the domestic economy but the less developed financial institutions may be and the lower the capacity to absorb domestic investment); and the degree of mineral dependence (the more dependent an economy is on mineral production, the greater the urgency of domestic investment that over the longer term will allow the economy to diversify). There is a fifth aspect of public policy and mineral development: managing the potentially negative macroeconomic and political consequences of mining, as noted earlier in this chapter.

Putting sustainability and sustainable development into practice in mining Most governments and mining companies have specific efforts aimed at incorporating aspects of sustainability Mineral Economics

chapter 13 – Mining, Sustainability and Sustainable Development and sustainable development into common practice. Many national governments have policy documents focused at a philosophical, even if not at an operational, level on making mining consistent with sustainability and sustainable development. Likewise, most large mining companies have annual documents, similar to annual reports to shareholders, summarising efforts related to environmental protection and how they operate in and interact with local communities. At a broader, multi-participant level, there have been several significant efforts aimed at or with implications for mining, sustainability, and sustainable development. Between 2000 and 2002, a group of multinational mining companies carried out the Global Mining Initiative (GMI), studying and attempting to clarify the roles of mining in sustainability and sustainable development. The GMI had three principal activities. These were: 1. to commission an independent study of the key issues 2. to conduct a global conference, at which the findings of the study were presented and discussed 3. to establish an industry association to carry on the work in the initial study. Initiated through the World Business Council on Sustainable Development and carried out by the International Institute for Environment and Development, this project was known as the Mining, Minerals and Sustainable Development Project (MMSD). The MMSD process, as it came to be known, involved regional partnerships focusing on specific issues of importance in southern Africa, South America, Australia and North America; 23 global workshops and expertgroup meetings involving some 700 people from diverse backgrounds; and some 175 pieces of commissioned research. This work culminated in the publication of the book Breaking New Ground (2002), which summarises the work and presents findings and recommendations in all three dimensions of sustainability and sustainable development (environmental, economic, social), with special focus on public policy and governance. The executive summary of the MMSD Project identifies nine challenges for the mining sector (see Appendix A). The second activity was to organise a global conference in Toronto in May 2002, at which the findings of the MMSD Project were presented and discussed. The third and arguably most significant GMI activity was to establish an industry association to carry on the work investigated by the MMSD Project. This organisation is the London-based International Council on Mining and Metals or ICMM, which in 2012 had 22 member mining and metal companies and 34 member national and regional mining associations and global commodity associations (http://www. icmm.com). All its members agree to adhere to the ICMM sustainable development framework (see Appendix B). The framework commits ICMM members to a set of principles and practices, public reporting of Mineral Economics

performance relative to the principles and third-party verification of performance. Another important initiative was the Extractive Industries Review. Carried out between 2001 and 2004, this assessed the role of the World Bank in the extractive industries, including the oil, gas, and mining sectors. Although the Review was not, strictly speaking, an effort to put sustainable development into practice, it contained a number of recommendations that speak to sustainability and sustainable development. Commissioned by the World Bank, the Review was carried out by an independent group that facilitated communication among the various interested parties to the extractive industries worldwide – governments, nongovernmental organisations, Indigenous peoples, local communities, industry, academia, and trade unions, among others. The Review was a response to strong criticisms of the World Bank’s role in financing and facilitating the extractive industries. It asked the question, are the extractive industries consistent with the goals of sustainable development and poverty alleviation? World Bank critics argued that the extractive industries are inconsistent with these goals – that is, actually often promoting unsustainable development and creating poverty. The Review found that the extractive industries can be consistent with poverty alleviation and sustainable development but only if several enabling conditions are present (see Appendix C). The Review and the World Bank’s response are available at: www.ifc.org/ eir. Since the Review’s publication, the World Bank has recommitted itself to the goal of ensuring that the extractive industries contribute to poverty alleviation and sustainable development. A group of mineral industry professionals has also convened international conferences every other year starting in 2003 on Sustainable Development Indicators in the Minerals Industry (http://www. sdimi.org). With plans for a sixth meeting in 2013, this group aims to develop operational measures or indicators of progress toward sustainable development in the mining industry. Four other initiatives, not aimed directly at mining, have important implications for the mining sector. First, the Equator Principles are a set of voluntary guidelines adopted by a number of banks and financial institutions, committing the signatories to follow environmental and social guidelines developed by the World Bank’s International Finance Corporation on all development projects with capital costs of US$50 M or greater (http://www.ifc.org/equatorprinciples). As of July 2012, seventy-seven financial institutions in Africa, Asia, Australia, Europe, North America, and South America had adopted the principles, including ABN Amro, Banco de Brasil, Bank of America, Barclays, Citigroup, Credit Suisse, HSBC, JPMorgan Chase, Standard Bank of South Africa, and Sumitomo. Three of 223

chapter 13 – Mining, Sustainability and Sustainable Development Australia’s four major banks – ANZ, National Australia Bank and Westpac – were part of this group. Second, the Global Compact (http://www.unglobal compact.org) is an initiative of the United Nations and is a voluntary network of business and other organisations promising to adhere to a set of practices consistent with appropriate corporate citisenship in the areas of human rights, labour practices, the environment, and corruption reduction and prevention. Appendix D summarises the ten principles of The Global Compact. The first two principles focus on human rights. The third initiative is a framework to implementing the human-rights principles of the Global Compact and is known as the ‘Protect, Respect, and Remedy’ Framework, adopted in 2011 by the UN Human Rights Council. This framework emphasises the duty of states to protect human rights, the duty of businesses to respect minimum global standards for human rights, and the need for all people to have access to remedies should there be violations of human rights (http:// www.unglobalcompact.org/Issues/human_rights/The_ UN_SRSG_and_the_UN_Global_Compact.html). The fourth initiative focuses on the concept of free, prior and informed consent and aims to strengthen the rights of Indigenous peoples and forest-dependent communities when their lands and communities will be affected by commercial development, including mineral development. This initiative is not a single or centrally managed activity. Rather it is a loosely linked set of activities by different organisations establishing guidelines for stakeholder engagement and arguing that Indigenous peoples and forest-dependent communities have the fundamental right to approve or disapprove activities affecting their lands in a manner that is freely given, prior to commencement of the activity, and on the basis of complete information about the activity (Colchester, 2010; United Nations, 2011a).

Final thoughts Sustainability and sustainable development, and their implications for mining, have become mainstream concepts, topics and goals – aimed at elevating the role that environmental and social considerations play in decisions about whether and how mineral developments occur. Despite much progress, differences remain in how environmental, economic and social aspects of sustainability are balanced, and there is no consensus on the processes by which stakeholders engage and development decisions are made. The mining industry should continue to report on and develop sustainability metrics, and engage with regulators and stakeholders to elicit scientific opinion and social preferences for how to balance the environmental, economic, and social benefits and costs of mining. Increased participation by the mining industry in sustainability reporting initiatives will help increase transparency and effective 224

communication with stakeholders. By moving towards sustainable development principles, the mining industry can reduce the risk of losing access to potential mineral resources, and can gain support from stakeholders to allow predictable development of projects.

Notes on the literature This chapter draws significantly on three earlier papers of mine (Eggert, 2000, 2001 and 2004). Readers interested in the topics of sustainability and sustainable development in general should read: Our Common Future (World Commission on Environment and Development, 1987), often referred to as the Brundtland report and credited with invigorating and launching popular and professional discussion of sustainable development; National Research Council (1999); World Bank (2003); and Pezzey and Toman (2005). For more on how sustainability and sustainable development relate to mining, see: Auty and Mikesell (1998), Otto and Cordes (2000) and Breaking New Ground (2002).

REFERENCES Auty, R M and Mikesell, R F, 1998. Sustainable Development in Mineral Economies (Clarendon Press: Oxford). Colchester, M, 2010. Free, prior and informed consent: Making FPIC work for forests and people, research paper No 11 (The Forests Dialogue Publication: New Haven). Eggert, R, 2000. Sustainable development and the mineral industry, chapter 1, in Sustainable Development and the Future of Mineral Investment (eds: J M Otto and J Cordes) (United Nations Environment Programme and Metal Mining Agency of Japan: Paris). Eggert, R, 2001. Mining and Economic Sustainability: National Economies and Local Communities, monograph commissioned by the Mining, Minerals, and Sustainable Development Project (available on the CD-ROM accompanying Breaking New Ground: Mining Minerals and Sustainable Development (Earthscan Publications: London)). Eggert, R, 2004. The mineral economies: Performance, potential problems, and policy challenges, in Managing Mineral Wealth, pp 7-48 (UN Economic Commission for Africa: Addis Ababa). Elkington, J, 1997. Cannibals with Forks: The Triple Bottom Line of 21st Century Business (Capstone Press: Minneapolis). Hanneson, R, 2001. Investing for Sustainability: The Management of Mineral Wealth (Kluwer Academic Publishers: Boston). International Council on Mining and Metals, 2012. International Council on Mining and Metals [online]. Available from: [Accessed: 13 July 2012]. International Finance Corporation, 2013. Extractive industries review [online]. Available from: [Accessed: 13 July 2013]. International Forum for Sustainable Development Indicators in the Minerals Industry, 2012. SMIMI [online]. Available from: . National Research Council, 1999. Our Common Journey: A Transition Toward Sustainability (National Academy Press: Washington). Mineral Economics

chapter 13 – Mining, Sustainability and Sustainable Development Otto, J M and Cordes, J (eds), 2000. Sustainable Development and the Future of Mineral Investment (United Nations Environment Programme and Metal Mining Agency of Japan: Paris). Pezzey, J C V and Toman, M A, 2005. Sustainability and its economic interpretations, in Scarcity and Growth Revisited: Natural Resources and the Environment in the New Millennium (eds: R D Simpson, M A Toman and R U Ayres) (Resources for the Future: Washington). Portney, P R and Weyant, J P (eds), 1999. Discounting and Intergenerational Equity (Resources for the Future: Washington). Tilton, J E, 1992. Mineral wealth and economic development: An overview, in Mineral Wealth and Economic Development (ed: J E Tilton) (Resources for the Future: Washington). United Nations, 2011a. UN-REDD Programme Guidelines for Free, Prior and Informed Consent, draft for comment, December 2011 [online]. Available from: [Accessed: 13 July 2012]. United Nations, 2011b. Human development index of the United Nations Development Programme [online]. Available from: . United Nations, 2013. The global impact [online]. Available from: . World Bank, 1997. World Development Report 1997: The State in a Changing World (Oxford University Press: Oxford). World Bank, 2002. World Development Report 2002: Building Institutions for Markets (World Bank and Oxford University Press: New York). World Bank, 2003. World Development Report 2003: Sustainable Development in a Dynamic World (World Bank and Oxford University Press: New York). World Business Council for Sustainable Development, International Institute for Environment and Development, World Business Council for Sustainable Development, International Institute for Environment and Development, 2002. Breaking New Ground: Mining, Minerals, and Sustainable Development: The Report of the MMSD Project (Earthscan Publications: London). World Commission on Environment and Development, 1987. Our Common Future (Oxford University Press: Oxford). Young, H P, 1994. Equity: In Theory and Practice (Princeton University Press: Princeton).

APPENDIX A The Mining, Minerals and Sustainable Development project: nine key challenges 1. Viability of the minerals industry: The minerals industry cannot contribute to sustainable development if companies cannot survive and succeed. This requires a safe, healthy, educated, and committed workforce; access to capital; a social license to operate; the ability to attract and maintain good managerial talent; and the opportunity for a return on investment. 2. The control, use and management of land: Mineral development is one of a number of often-competing land uses. There is frequently a lack of planning or Mineral Economics

other frameworks to balance and manage possible uses. As a result, there are often problems and disagreement around issues such as compensation, resettlement, land claims of Indigenous peoples, and protected areas. 3. Minerals and economic development: Minerals have the potential to contribute to poverty alleviation and broader economic development at the national level. Countries have realised this with mixed success. For this to be achieved, appropriate frameworks for the creation and management of mineral wealth must be in place. Additional challenges include corruption and determining the balance between local and national benefits. 4. Local communities and mines: Minerals development can also bring benefits at the local level. Recent trends towards, for example, smaller workforces and outsourcing affect communities adversely, however. The social upheaval and inequitable distribution of benefits and costs within communities can also create social tension. Ensuring that improved health and education or economic activity will endure after mines close requires a level of planning that has too often not been achieved. 5. Mining, minerals and the environment: Minerals activities have a significant environmental impact. Managing these impacts more effectively requires dealing with unresolved issues of handling immense quantities of waste, developing ways of internalising the costs of acid drainage, improving both impact assessment and environmental management systems, and doing effective planning for mine closure. 6. An integrated approach to using minerals: The use of minerals is essential for modern living. Yet current patterns of use face a growing number of challenges, ranging from concerns about efficiency and waste minimisation to the risks associated with the use of certain minerals. Companies at different stages in the minerals chain can benefit from learning to work together exploring further recycling, re-use, and remanufacture of products and developing integrated programs of product stewardship and supply chain assurance. 7. Access to information: Access to information is key to building greater trust and cooperation. The quality of information and its use, production, flow, accessibility, and credibility affect the interaction of all actors in the sector. Effective public participation in decision-making requires information to be publicly available in an accessible form. 8. Artisanal and small-scale mining: Many millions of people make their living through artisanal and smallscale mining (ASM). It often provides an important, and sometimes the only, source of income. This part of the sector is characterised by low incomes, unsafe working conditions, serious environmental impacts, 225

chapter 13 – Mining, Sustainability and Sustainable Development exposure to hazardous materials such as mercury vapours and conflict with larger companies and governments. 9. Sector governance: roles, responsibilities and instruments for change: Sustainable development requires new integrated systems of governance. Most countries still lack the framework for turning minerals investment into sustainable development: these need to be developed. Voluntary codes and guidelines, stakeholder processes, and other systems for promoting better practice in areas where government is unable to exercise an effective role as regulator are gaining favour as an expedient to address these problems. Lenders and other financial institutions can play a pivotal role in driving better practice. Source: Quoted from Executive Summary, Breaking New Ground: Mining, Minerals, and Sustainable Development, 2002.

Assurance ICMM members are required to obtain independent third-party assurance of performance against the principles set forth above. Source: International Council on Mining and Metals, 2012.

APPENDIX C Summary findings of the Extractive Industries Review The Extractive Industries Review finds that the World Bank has a role to play in the oil, gas, and mining sectors, but only if its activities promote sustainable development and poverty alleviation, which in turn only can occur if three enabling conditions are met:

The International Council on Mining and Metals sustainable development framework

First, pro-poor public and corporate governance, measured by criteria such as: quality of the rule of law, absence of armed conflict or of a high risk of such conflict, respect for labor standards and human rights, recognition of and willingness to protect the rights of Indigenous peoples, and government capacity to promote sustainable development through economic diversification.

The ten principles

Other characteristics of good governance that the World Bank should promote include:

APPENDIX B

1. Implement and maintain ethical business practices and sound systems of corporate governance. 2. Integrate sustainable development considerations within the corporate decision-making process. 3. Uphold fundamental human rights and respect cultures, customs and values in dealings with employees and others who are affected by our activities. 4. Implement risk management strategies based on valid data and sound science. 5. Seek continual improvement of our health and safety performance. 6. Seek continual improvement of our environmental performance. 7. Contribute to conservation of biodiversity and integrated approaches to land use planning. 8. Facilitate and encourage responsible product design, use, re-use, recycling and disposal of our products. 9. Contribute to the social, economic and institutional development of the communities in which we operate. 10. Implement effective and transparent engagement, communication and independently verified reporting arrangements with our stakeholders.

Public reporting Consistent with the Global Reporting Initiative (http:// www.globalreporting.org). 226

•• transparency of revenue flows •• disclosure of project documents •• capacity to manage fluctuating revenues •• capacity to manage revenues responsibly •• modern policy and regulatory frameworks •• integrated public participation in local and national decision-making. At the local-community level, the World Bank should: •• require companies to obtain free and informed consent from local communities and other affected parties •• require revenue sharing with local communities •• require the use of poverty indicators, which are monitored frequently •• encourage the establishment of public-health goals in all extractive projects •• encourage non-governmental organisations to help build community capacity •• encourage companies to set up independent grievance mechanisms. Second, stronger environmental and social requirements for extractive projects, including: •• required integrated environmental and social impact assessments •• updated and fully implemented natural habitat policy •• updated and fully implemented resettlement policy •• revised disclosure policy Mineral Economics

chapter 13 – Mining, Sustainability and Sustainable Development •• sector-specific guidance for tailings disposal, waste management, and use of toxic substances (including an outright ban on riverine tailings disposal and extreme caution on submarine tailings disposal) •• guidelines for integrated closure planning •• guidelines for emergency prevention and response •• responses to legacies of the past. Third, respect for human rights, verified by third parties and including adoption of the Core Labour Standards of the International Labour Organization. Source: International Finance Corporation, 2013.

APPENDIX D Ten Principles of the Global Compact Human rights 1. Businesses should support and respect the protection of internationally proclaimed human rights. 2. Businesses should make sure they are not complicit in human rights abuses.

4. Businesses should uphold the elimination of all forms of forced and compulsory labour. 5. Businesses should uphold the effective abolition of child labour. 6. Businesses should uphold the elimination of discrimination in respect of employment and occupation.

Environment 7. Businesses should support a precautionary approach to environmental challenges. 8. Businesses should undertake initiatives to promote greater environmental responsibility. 9. Businesses should encourage the development and diffusion of environmentally friendly technologies.

Anti-corruption 10. Businesses should work against corruption in all its forms, including extortion and bribery. Source: http://www.unglobalcompact.org (accessed 13 July 2012).

Labour 3. Businesses should uphold the freedom of association and the effective recognition of the right to collective bargaining.

Mineral Economics

227

Mining and Local C o mm u n i t i e s

HOME

Chapter 14 Stakeholders, Local Communities and Regions Philip Maxwell Mining and its stakeholders Local communities and mines

Occupational, residential and Indigenous communities

Mining regions Australia’s regional framework and its mining regions

Mining and its stakeholders Suppose that there is a major new mineral discovery in a region that has previously depended on other industries such as agriculture or manufacturing or tourism. How will this affect the local community? The surrounding region? The nation? The world? What will happen in each of these geographical areas if a large mine closes, or significantly reduces its mineral production? While our discussion in Chapters 2 and 3 has broadly considered the effects of mining at a national level and on the world, it is important also to analyse its influence at local community and regional level. This is because, in the words of Garnaut (1995), mines ‘have unusually large local environmental, social and economic impacts’. The purpose of this chapter is to provide a brief introduction to the economic and social dimensions of local communities, and also to report on the importance of mining regions in Australia. One way to consider local area effects is in terms of how they influence key stakeholders, many of whom are located in the local community in which a mine and its associated processing plants operate. The term stakeholder has been widely used in management literature for perhaps 50 years. In the words of Carroll (1991), it describes: ... those groups or persons who have a stake, a claim, or an interest in the operations and decisions of the firm. A more complete definition of stakeholders, following International Finance Corporation (2007), is: Mineral Economics

Stakeholders are persons or groups who are directly or indirectly affected by a project, as well as those who may have interests in a project and/or the ability to influence its outcome, either positively or negatively. This definition then identifies these stakeholders to include: •• locally affected communities or individuals and their formal and informal representatives •• national or local government authorities •• politicians •• religious leaders •• civil society organisations and groups with special interests •• the academic community •• other businesses. As already noted, mines have a notable impact on their local communities. This has both positive and negative components. Some stakeholders in these communities expect or seek to obtain an economic rent windfall that will either enhance their own wellbeing or the welfare of the groups that they represent. In their manual Stakeholder Engagement: A Good Practice Handbook for Companies Doing Business in Emerging Markets, the International Finance Corporation (2007) makes the additional useful distinction between internal stakeholders and external stakeholders. Internal stakeholders include employees, shareholders, suppliers, contractors, distributors and customers. Interacting with these groups is part of any company’s core business function. 231

chapter 14 – Stakeholders, Local Communities and Regions External stakeholders comprise affected local communities, local institutions, non-governmental and other civil society organisations, local government authorities, state or regional governments and national governments. More broadly, a nation’s citizens are also external stakeholders in the fortunes of a successful minerals and energy sector. An indicative taxonomy of these groups appears in Table 14.1. Table 14.1 Classifying mining industry stakeholders. Internal stakeholders

External stakeholders

Local Local employees, local communities shareholders, local suppliers, local contractors, local distributors and local customers.

Local residents, local institutions, local non-government organisations and other civil society organisations, local (and regional) governmentsa.

Outside Fly-in, fly-out employees, communities non-local shareholders, outside suppliers, fly-in, fly-out contractors, outside distributors and outside customers.

A nation’s citizens, outside nongovernment organisations and other civil society organisations, state (and regional) governments, national governments.

a. Depending on the geographical area involved it is possible to classify a regional government as being either an external stakeholder for a local community, or as part of an outside community.

The ‘stake’ of each interested or affected party in a project will vary. People living in close proximity to a mine will generally be more profoundly and directly affected than those living in other regions or nations. As a result, their stakes will be greater. But government regulators and political and other community leaders, often located in distant towns and cities, may exercise considerable influence on whether and how a mineral project proceeds. This will occur because of the implementation of regulatory requirements, as well as the taxation framework in place. Other stakeholders may make a positive contribution in mediation roles because of their knowledge of, or stature in, the industry. A mining company’s executives must balance their commitments to shareholders with those of its other internal and external stakeholders. In this regard there has been an active discussion over many years about the dimensions and practice of corporate social responsibility (CSR). Writers such as Carroll (1991) have explained and developed this effectively using the well-known ‘CSR Pyramid’ framework, which consists of economic, legal, ethical and philanthropic components. Notable recent contributions with respect to the extractive industries include those by Crowson (2009), Hilson (2012) and Pegg (2012). The latter papers are contributions to a special issue of the 232

mineral economics journal, Resources Policy, edited by Gavin Hilson. It is useful to distinguish between a pre-CSR focus by corporations on the traditional bottom line of profits and losses and the now common post-CSR acceptance of the ‘triple bottom line’ approach. Suggested by John Pilkington in 1994, the triple bottom line encourages corporations to consider simultaneously their financial, environmental and social bottom lines. Conceptualised in wholly voluntary and non-legally binding terms, there has been rapid growth and increasingly widespread acceptance of CSR. Mining and oil companies have been some of its most prominent advocates and enthusiastic adopters of this strategy. This has occurred through their participation in global initiatives like the UN Global Compact or the Global Sullivan Principles and in industry-specific initiatives like the Kimberley Process, the Extractive Industries Transparency Initiative (EITI) and the Voluntary Principles on Security and Human Rights. There is now also a developed literature that promotes the area of stakeholder engagement for companies doing business in different markets. The already mentioned International Finance Corporation (2007) Stakeholder Engagement manual provides one interesting example of this. Another example of the utilisation of the stakeholder approach in assessing the impact of a large mine relates to the social impact analysis undertaken by Kalgoorlie Consolidated Gold Mines (KCGM) at the Super Pit1 project in Kalgoorlie Boulder in Western Australia. This has been Australia’s largest gold mine since the early 1990s and the area involved has been a major area of gold production since the early 1890s. Its close proximity to the regional city, as well as its limited future life2, has provided an interesting setting for the identification and analysis of stakeholder positions. Kalgoorlie Consolidated Gold Mines (2010) identified seven key stakeholder groups in the project. They are residents, businesses, employees and contractors, Indigenous communities, government, Williamstown residents and pastoralists.

Local communities and mines Since mining has major local area impacts, it is important to appreciate further the meaning of the term, ‘local community’. It seems clear that Kalgoorlie Boulder is the local community for the super pit since the mine sits prominently close to residential housing at the eastern end of the city3. KCGM workers live in some of these houses. One can make similar findings about the situation with the main mines in Broken Hill, Mount 1 2 3

As noted recently on the KCGM web site ‘KCGM manages the operation for Newmont Australia Limited and Barrick Gold of Australia Ltd. Their ownership includes the Fimiston Open Pit (Super Pit), Mt Charlotte Underground Mine, Fimiston Mill and Gidji Roaster’. As this chapter is written, the mine is expected to close in 2021. Any reader can confirm this with a suitable exercise using Google Maps on the internet. Mineral Economics

chapter 14 – Stakeholders, Local Communities and Regions Isa, Johannesburg and many other mining cities. But the situation becomes less clear when mines are located outside of well-defined mining towns and cities. Is Kalgoorlie Boulder, for example, the local community for the Kambalda mines, located variously about 80 km to the south? Residents of Kambalda shop and undertake other personal business activities regularly in Kalgoorlie. Some Kambalda mine workers also commute daily from Kalgoorlie, while Kambalda residents also work in Kalgoorlie. Because of these links there seems a good argument to sustain the case that Kambalda is, in certain respects, also part of the Kalgoorlie Boulder local community. Similar arguments will apply around the world to smaller mining towns close to larger centres. When one discusses local communities in the context of mining, it is important to be clear that its ‘local community’ may be a considerable distance from a mine4.

Occupational, residential and Indigenous communities In considering how local communities are affected by mining, it is also helpful to distinguish between the different components of these communities. One useful classification, suggested by the authors of Breaking New Ground: Mining, Minerals and Sustainable Development (International Institute for Environment and Development, 2002), distinguishes between: •• occupational communities – those households or families who derive all or most of their income from mining •• residential communities – those households or families who live in the geographical area which will be affected by mining •• Indigenous communities – households or families with an ancient and cultural attachment to the land where mining occurs or has an impact. Both of the latter two groups typically live in the local community prior to a mine being developed. They will usually work in a different industry (eg agriculture) or live a traditional lifestyle. With the emergence of fly-in, fly-out (FIFO) working patterns in mining (see Chapter 17), it is also possible that few or even none of a mine’s workers (the occupational community) will live in a local community. The commencement of a new mine will bring both gains and losses to members of local communities. It is important that these local communities perceive on balance that they have received net positive benefit from a mine. Any assessment of this will involve 4

In reviewing this chapter, Scott Pegg pointed to the different, but related issue in mineral-rich nations (eg in the Niger Delta of Nigeria) of whether communities nearby to mines or oil wells that are adversely influenced by environmental impacts, are eligible to receive corporate social responsibility (CSR)-related benefits. See Frynas (2005) on inter-communal conflicts that have arisen because of this.

Mineral Economics

economic, social, political, cultural and environmental assessments of benefits and costs. Among the economic dimensions, residential and Indigenous communities often receive compensation and substantial flows of revenue when a large mine is established. However, they lose homes, land and access to other sources of their previous livelihoods. It is important also that any previous poverty is reduced. Mining can directly provide local communities with employment and enable their populations to join the outside world economy. Yet the complexity of mining operations often means that well-qualified outsiders need to be recruited. There may also be significant employment, output and income multipliers (see next chapter for further discussion). These come into play where mining supports local business ventures and thereby provides new jobs to members of residential and Indigenous communities. Mining may bring new shops, restaurants and cafes, hotels and motels, service stations, accountants, doctors, nurses and teachers5. Increased mining activity may also lead to basic metal processing and sometimes other further downstream manufacturing. Communities in mining towns may also benefit from better infrastructure (airports, railways, roads, water supplies, sanitation systems, electricity and gas). Other industries, that otherwise would not be established, may benefit from this infrastructure. Mining also brings social benefits. Significant improvement to the quality of life may come from improved health care facilities including hospitals, as well as better schools. This may enhance the social fabric of a community. In other respects the development and operation of a new mine may increase social problems and social costs. Particularly in developing nations, the arrival of new migrants may cause disputes about land. There can also be a large group of migrants moving into mining areas with weak links to society. They may tend to be a disruptive influence on local social control, leadership and lifestyles. Local citizens in cities such as Kalgoorlie and Calama sometimes complain about these problems. Though increased incomes from mining are typically associated with better health services and improved nutrition, mine workers often lead excessive lifestyles. Social problem areas associated with mining communities often include: •• widespread availability and consumption of alcohol •• an increase in gambling •• introduction or increase of prostitution and the attendant risks of sexually-transmitted diseases •• increased alcohol-induced and domestic violence. 5

Mining can do these things, but they are not inevitable and can be quite difficult to achieve in rural, underdeveloped areas, in working in remote communities with both Indigenous and non-Indigenous populations.

233

Chapter 14 – StakehOLderS, LOCaL COMMunItIeS and regIOnS As well as occupational communities, these activities may also adversely affect members of residential and Indigenous communities. Previously isolated communities, including Indigenous populations, may be particularly vulnerable to outside diseases brought by miners or mining activities. These include influenza, malaria and HIV/AIDS. Many countries in Southern Africa (eg Botswana, Namibia and South Africa) are presently suffering from this in a dramatic way. Some commentators also argue that mining operations widen gender disparities within communities. Mining incomes are relatively high and there have been few employment opportunities for women in mining. Eftimie, Heller and Strongman (2009) comment that:

One way to picture the economic and social situation facing the different parts of local communities is in terms of Figure 14.1. This diagram perceives all members of the occupational community as being net gainers from mineral sector development. Some members of the residential community will gain from mining, while others will lose. Members of any local Indigenous community are most likely to lose from new mineral development. The overlapping areas in the diagram reflect those community members who belong to more than one group, eg Indigenous members of the occupational community, etc.

In many communities, formal EI jobs go primarily to men. Worldwide it is extremely rare to find any EI companies with higher than 10% female employment, with many being less than 5%. Until recently in Australia, for example, 90 per cent of the mining workforce was men and only ten per cent women. This has changed in recent years so that by 2008, the International Labour Organisation reported that almost 18 per cent of workers in the sector were women. By contrast, in Chile in 2008, less than five per cent of mine workers were women and this was also the case in South Africa, though the government had maintained that a ten per cent target should be achieved by 2010. So though change is apparent, the industry remains maledominated. In mining towns, male workers typically make considerably greater incomes than female workers. With male dominance in the workforce, there have been long standing imbalances between the number of men and women residents. The Australian Bureau of Statistics data in Table 14.2, for four Western Australian mining local government areas in 2009, illustrates this point. TablE 14.2 Four Western Australian mining local government areas in 2009 (source: Australian Bureau of Statistics). local government area

Main centre

Men

Women

Male/female ratio

Kalgoorlie Boulder

Kalgoorlie

17082

15088

1.132

Ashburton

Tom Price

3861

2813

1.373

Coolgardie

Kambalda

2284

1810

1.262

Leinster

1012

654

1.547

Leonora

In mining towns women more typically remain at home to maintain the household economy. With the growth of FIFO working patterns there has also been a greater tendency for families to reside in distant cities and towns. When they are reunited with their partners there is often greater stress on family life. 234

FIG 14.1 - The initial impact of new mining activity on a local community.

The challenge is for companies and local authorities to push the ‘ovals’ and ‘circles’ for residential and Indigenous communities to the right so that all members of a local community derive net benefit from new and established mineral extraction activities.

Mining RegionS Economists writing about subnational regions6 typically use the term to ‘refer to administrative areas and political jurisdictions as large as states and provinces’, but sometimes they also use it to refer to areas as small as municipalities and shires. As Armstrong and Taylor (2000, p 2) note, they are typically more open than the national economies in which they are located, being free from tariffs and other trade barriers. All national regions use the same currency, and labour and capital can flow freely between regions. Also government’s role in transferring income between regions plays an important part in influencing regional incomes and their standard of living. This is a particularly important issue for mining regions. At one level the establishment of regions in countries such as Australia involved political decisions at key points in history to create the six colonies that have become our six states. The subsequent establishment of substate regions emerged from a combination of ‘bottom 6.

Commentators sometimes also use the term, ‘region,’ to describe supranational regions (eg the Asia Pacific region) or transnational regions (eg the Basque region in Spain and France). Mineral economics

chapter 14 – Stakeholders, Local Communities and Regions up’ development generated by entrepreneurial activity to create new industries (including agriculture, mining, manufacturing, tourism, etc) as well as ‘top down’ planning and regulatory decisions by government to support these geographical entities. As Meyer (1963) and other writers since have noted, there are three broad approaches to defining regions, which tend to overlap with one another. These involve use of the key criteria of homogeneity, functionality and administrative coherence. A homogeneous region is an area identified by its internal uniformity. This may relate to its industry base, its cultural homogeneity, the nature of its income distribution, or some other appropriate criterion. Many mining regions are homogeneous regions in terms of their industry structure, relatively even income distributions among families, cultural similarity and educational backgrounds of their populations. Good examples include: •• the Pilbara in Western Australia and Minas Gerais in Brazil that are iron ore mining regions •• gold mining regions such as the Eastern Goldfields of Western Australia, the Lake Victoria area in Tanzania, or the Witwatersrand in South Africa •• coal mining regions such as the Hunter Valley and Illawarra in New South Wales and the Bowen basin in Queensland •• copper mining regions such as Chile’s Antofagasta and Atacama regions or Zambia’s copper belt region •• nickel mining regions such as the area around Sudbury in Canada, Norilsk in Russia, or much of New Caledonia •• oil and gas regions such as those in West Texas and Oklahoma in the United States, Alberta in Canada and the Niger delta in Africa.

Australia’s regional framework and its mining regions Since Federation in 1901, the dominant regionalisation of Australia has been associated with the constitutional framework and with the sharing of powers between the national government and the state governments (ie the six states and two territories). But there have been other formal exercises to classify regions at a substate level as well. These have been based variously on the application of the criteria of homogeneity, functionality and administrative coherence just discussed. Brown (2006) provides an interesting recent discussion of some of these categorisations. Perhaps the two most relevant classifications for our discussion are: 1. the 58 statistical divisions, based on agreed definitions of a ‘region’, identified cooperatively by federal and state statisticians and used by the Australian Bureau of Statistics since the early 1970s Mineral Economics

2. the more recent classification exercise by the Bureau of Infrastructure, Transport and Regional Economics to classify Australia into five regional groups according to their degree of remoteness – major cities, inner regions, outer regions, remote and very remote. This has been associated with the publication of the report About Australia’s Regions (Bureau of Transport and Regional Economics, 2003). Based on the statistical division framework, one classification of Australia’s mining regions appears in Table 14.3. Nineteen of the 58 statistical divisions arguably are mining regions7, based on recent activity within them. TABLE 14.3 A taxonomy of Australian mining regions. State or territory

Statistical divisions

Mining regions

New South Wales

Hunter (coal), Illawarra (coal), Far West (base metals)

3

Victoria

Gippsland (coal), East Gippsland (oil and gas)

2

Queensland

Fitzroy (coal), Mackay (coal), North West (base metals), Far North (bauxite)

4

South Australia

Northern (gold, copper, uranium, silver)

1

Western Australia

South West (gold, bauxite, mineral sands, coal), Peel (bauxite), Midlands (gold, mineral sands, iron ore), Central (gold, iron ore, base metals), South East (gold, nickel), Pilbara (iron ore, oil and gas), Kimberley (nickel, diamonds)

7

Tasmania

Mersey Lyell (gold, tin, base metals)

1

Australian Capial Territory

Nil

Northern Territory

Balance of Northern Territory (manganese, gold, uranium, bauxite)

1

Total mining regions

19

In the next chapter we briefly review some of the standard techniques now in use to assess the economic and social impacts of mineral and energy projects. The final two chapters reflect on the relationship between mining and local Indigenous communities, and then on mining’s occupational community.

References Armstrong, H and Taylor, J, 2000. Regional Economics and Policy, third edition (Blackwell Publishers: Oxford). Brown, A J, 2006. Federalism, regionalism and the reshaping of Australian governance, in Federalism and Regionalism in Australia (eds: A J Brown and J A Bellamy), pp 11-32 (ANU E Press: Canberra). Bureau of Transport and Regional Economics, 2003. About Australia’s Regions, report (Australian Government: Canberra), 40 p. 7

Typically one might classify a mining region using criteria such as the value of mineral production, the value of mineral exports or the level of mineral industry workers as a percentage of the total workforce. Employment data are available on an industry-byindustry basis at national censuses but regional product and export data are not available for substate regions in Australia.

235

chapter 14 – Stakeholders, Local Communities and Regions Carroll, A B, 1991. The pyramid of corporate social responsibility: Toward the moral management of organisational stakeholders, Business Horizons, JulyAugust, 34(4):39-48. Crowson, P, 2009. Adding public value: The limits of corporate responsibility, Resources Policy, 34(2):105-111. Eftimie, A, Heller, K and Strongman, J, 2009. Mining for Equity: Gender Dimensions of the Extractive Industries, June (World Bank: Washington), 61 p. Frynas, J G, 2005. The false developmental promise of corporate social responsibility: Evidence from multinational oil companies, International Affairs, May, 81(3):581-598. Garnaut, R, 1995. Dilemmas of governance, in Mining and Mineral Resource Policy in Asia-Pacific: Prospects for the 21st Century (eds: D Denoon, C Ballard, G Banks and P Hancock), pp 61-66 (Australian National University: Canberra).

236

Hilson, G, 2012. Corporate social responsibility in the extractive industries: Experiences from developing countries, Resources Policy, 37(2):131-137. International Finance Corporation, 2007. Stakeholder Engagement: A Good Practice Handbook for Companies Doing Business in Emerging Markets (Washington). International Institute for Environment and Development, 2002. Breaking New Ground: Mining, Minerals and Sustainable Development, final report (London). Kalgoorlie Consolidated Gold Mines, 2010. 2010 Social Impact Assessment, May, Coffey Environments, Perth. Meyer, J R, 1963. Regional economics: A survey, The American Economic Review, 53(1):19-54. Pegg, S, 2012. Social responsibility and resource extraction: Are Chinese oil companies different?, Resources Policy, 37(2):160-167.

Mineral Economics

HOME

Chapter 15 Minerals and Regional Development Philip Maxwell Some introductory considerations Socio-economic indicators for local communities and regions. Summary socio-economic measures for small areas Economic impact assessment Economic (export) base analysis Input-output analysis Computable general equilibrium models Social impact assessment Origins and development Conducting a full social impact assessment Some examples of recent social impact assessments Appendix – the structure of and solution to the input-output model

SOME INTRODUCTORY CONSIDERATIONS Having established a local community and subnational regional perspective, we now move to consider some of the broader economic and social impacts of mining. One’s level of analysis is a matter of deciding where to draw the ‘ring fence’. Whenever a mining company considers operating in a region or a community, it is important to: •• appreciate the initial economic and social situation in this region or community •• assess the way that the arrival of the mine will affect and change this area, and then •• manage the operation of the mine in a manner acceptable to the area’s occupational, residential and Indigenous communities and to its other stakeholders.

Socio-economic indicators for local communities and regions There are a range of socio-economic indicators potentially available to assess living conditions in small areas and regions. It is useful to classify them into three categories – efficiency-based economic indicators, equity-based economic indicators and social indicators. Mineral Economics

Efficiency-based economic indicators include measures of income, investment, production (such as GDP), exports and imports, employment by industry class and occupational category, unemployment, public and private debt, costs of living and inflation. Equity-based economic indicators cover areas such as the distribution of income and wealth, the number of people below the poverty line, access to telephones, the Internet and to motor vehicles and rates of home ownership. Social indicators include measures of life expectancy, infant mortality, a population’s age distribution, information about health service provision, access to safe drinking water, literacy rates, enrolments in primary, secondary and tertiary education, the place of women in society and percentages of single parent families. The main sources of these data are national statistical bureaus such as the Australian Bureau of Statistics (ABS). Such organisations typically report national data on a quarterly or annual basis, large subnational regional data annually and smaller area data less regularly or not at all depending on the size of the area of interest. The best 237

chapter 15 – Minerals and regional development data for local government areas and local communities usually come from national censuses.1 These occur every five years in Australia, but sometimes less often (say every ten years) in other countries. At the 2006 Australian Census, for example, the ABS generated a comprehensive database for people living and working in each of Australia’s statistical divisions, as well as in its more than 600 local government areas, in the following broad categories: •• •• •• •• •• •• •• •• •• •• •• •• •• •• •• •• •• •• ••

population age birthplace citizenship education ethnicity housing incomes employment by industry class Internet access indigenous status labour force participation language marital status motor vehicle ownership occupation qualifications religion travel to work. Data for most of these areas are now also available for several censuses. Thoughtful analysis can provide an appreciation of recent social and economic trends in regions and communities. Two brief case studies – one for the Port Hedland in the Pilbara region of Western Australia, and a second for the Antofagasta region in Chile2 – provide insight into the availability of these data in two important mining nations.

BOX 15.1 Port Hedland – A socio-economic snapshot at the 2006 Australian Census Port Hedland is a major regional centre for the Pilbara region of Western Australia. Since the 1960s, the Pilbara has been a world-class iron ore and oil and gas province. The following economic and social indicators provide an assessment of some of the differences between the structure of this region and the Australian nation. They are derived from 1 2

Sometimes these data can be hard to use in specific communities because of the area boundaries that have been used. The Chilean case study provides an interesting comparison with Australian mining regions from a key mining region in the nation which has become the world’s leading copper producer in the past two decades.

238

the basic community profile tables from the 2006 National Census. The dimensions presented are as follows: Broad dimension

Indicator

Port Hedland

Australia

Port Hedland as % of Australia

Efficiency – economic

Income (median weekly household income)

$1865

$1027

181.6

Efficiency – economic

Workforce participation rate (% of adult population)

68.3

59.6

114.6

Equity – economic

Median household rent ($ per week)

110

190

47.8

Equity – economic

High school graduates (% of adult population)

39.4

46.9

83.9

Equity – economic

Internet use (% of population)

67.7

63.6

106.5

Equity – economic

Living in own home (% of total)

39.3

70.7

55.2

Equity – economic

Motor vehicles per dwelling

1.8

1.65

110.2

Social

Average age (years)

31

37

83.7

Social

Male/female (%)

112.9

97.4

115.9

Social

Indigenous persons (% of population)

14.9

2.3

647.8

Social

Health/Community services (% of health and community workers )

10.2

10.8

94.4

Social

Residential stability (% at same address as last census)

35.0

56.9

61.6

Compared to Australia, Port Hedland performs well on economic efficiency dimensions – such as average incomes and workforce participation rates and there are mixed results on economic equity dimensions – median household rents (low)3, education levels (low), Internet access (high), home ownership (low) and motor vehicles (high). There is considerable variation from national averages among key social indicators. Median age is six years less than the nation. There is a notable gender imbalance in the population. There is a much higher indigenous population and considerably less residential stability. Health and community service workers make up a lower percentage of the workforce than they do nationally. 3 This contrasts with several mining areas in Queensland, where the rent was high due to high level of demand. Low median rental levals in Port Hedland seem due to high housnig stocks controlled by government agencies in association with the migration detention facility. Mineral Economics

chapter 15 – Minerals and regional development

Mining has apparently made a positive contribution to the economic welfare of residents of Port Hedland, though much of this income may ‘leak’ from the region because of a large oresence of fly-in, fly-out (FIFO) workers. Some of its social impacts are more open to question. Any definitive assessment of this should involve comparisons with the fortunes of other non-metropolitan regions. Such an analysis may indicate directions for remedial policy.

Equity – economic

Income inequality (Gini coefficient, households – 2006)

0.45

0.54

0.35

Social

Life expectancy (years – 2007)

75.9

77.8

81.4

Social

Infant mortality (deaths/1000 live births – 2005)

7.4

8.7

5

Human Development Index (2005)

0.877

0.872

0.967

Socioeconomic

BOX 15.2 Chile’s Antofagasta region – An economic and social perspective Located in the arid northern part of Chile, the Antofagasta region is a world-class mining province – currently producing about 20 per cent of the world’s copper. It is also the world’s leading lithium region, as well as a significant nitrate, iodine and molybdenum mining area. In their recent study, Lagos and Blanco (2010) provide an interesting assessment of the movement of key economic and social indicators after 1985. They argue that ‘the region has advanced towards development since the 1990s, especially … [with] economic indicators such as income per capita and income distribution where it ranks ahead [of] the rest of Chile and close to some developed countries. However, it is still far behind in some of the key social indicators such as quality of education and health, access to health services, life expectancy and large differences in the quality of life within the region.’ The table below summarises some key indicators for Antofagasta, comparing them with those in Chile and in Australia. Lagos and Blanco note that lower life expectancy in the region was in large part caused by high arsenic levels, present in the water until 1978. This issue was addressed by the installation of an arsenic removal plant.

Summary socio-economic measures for small areas National statistical offices also produce a range of summary measures of the socioeconomic status for small areas, such as municipalities and shires, towns suburbs and even census collection districts. In Latin American nations such as Brazil, Chile and Peru, studies estimating small area Human Development Index (HDI) measures for regions and local government areas have appeared at irregular intervals. The ABS also produces a range of summary indicators under the banner of Socio-Economic Indices for Areas (SEIFA). At the 2006 Census it compiled four indexes in this group (Australian Bureau of Statistics, 2008b). These were: 1. The Index of Relative Disadvantage – ‘summarises a range of information about the economic and social resources of people and households within an area. …(It) includes only measures of relative disadvantage’. 2. The Index of Relative Advantage and Disadvantage – ‘also summarises information about the economic and social resources of people and households within an area, however includes both relative advantage and disadvantage measures’. 3. The Index of Economic Resources – ‘focuses on the general level of access to economic resources of people and households within an area’. 4. The Index of Education and Occupation – ‘focuses on the general level of education and occupationrelated skills of people within an area’.

Broad dimension

Indicator

Antofagasta

Chile

Australia

Efficiency – economic

Gross domestic product per capita (US$ at PPP in 2008)

$27 061

$14 436

$38 784

Efficiency – economic

Unemployment rate (% of workforce 2008)

6.9

7.8

4.2

Developed using Principal Components Analysis, each of these measures provides a standardised normal distribution with a mean of 1000 and a standard deviation of 1004 for Census Collection Districts (CDs).5

Adult literacy (% of adult population)

98.6

96.5

99

4 Observations, within two standard deviations of the mean (between 800 and 1200), cover more than 95 per cent of the population.

Equity – economic

Mineral Economics

5

’A CD is equivalent to a group of suburban blocks, roughly 250 households in a urban area. However, in a rural area, a CD can represent far fewer households’ (Australian Bureau of Statistics, 2008b).

239

chapter 15 – Minerals and regional development Wales and Latrobe City in the Gippsland region of Victoria reflect relatively low SEIFA values for mature coal mining centres.

In its promotional brochure, the ABS (2008b) claims that: There are a number of ways the indexes can be used, such as targeting areas for business or services, ‘demographic profiling’, strategic planning, design of sample surveys, and social or economic research.

The low SEIFA values for Cobar, Laverton and West Coast (Tasmania) seem representative of the status of older small mining districts. By contrast, newer mining areas such as Port Hedland, Emerald and Roxby Downs perform well in the area of the first three indicators. The former gold mining towns of Ballarat and Bathurst have reinvented themselves over the past century as regional centres of reasonably prosperous agriculturally based regions. The final two entries for Nedlands and Kuring-gai are included as reference points, representing high income metropolitan municipalities.

Lower than average values in a potential mining region might suggest the desirability of importing workers from other regions or making strategic investments in key infrastructure or human capital development. Higher values might be useful in promoting mining areas as relatively desirable places to live and work. Some 2006 estimates of these indices for selected mining, former mining and high-income metropolitan local government areas (LGAs) appear in Table 15.1. Despite a traditional image as being less desirable places to live and work, several mining areas show values of three of these indices as being above average:

An alternative information source available in some developing nations is to compare HDI values for local areas and larger regions. Recall from Chapter 2 that these summary measures are based equally on income, life expectancy and levels of education. Offices of the United Nations Development Programme in several developing nations have computed these measures on a regional basis, often in association with the host country governments. They typically show low HDI values for remote regions and high values for affluent areas in the major metropolises. Access to summary measures such as these can provide a useful initial source of data

1. the Index of Relative Advantage and Disadvantage 2. the Index of Relative Disadvantage 3. the Index of Economic Resources. As a remote centre, apparently close to the end of its mine life after nearly 130 years of major mineral production Broken Hill appears to be in decline, with lower than average values of these measures. In a parallel fashion Cessnock near Newcastle in New South

Table 15.1 Australian Bureau of Statistics estimates of socio-economic indices for selected areas at the 2006 Census (source: Australian Bureau of Statistics, 2008b). Area

Index of relative advantage and disadvantage

Index of relative disadvantage

Index of economic resources

Index of education and occupation

Kalgoorlie Boulder (WA)

1000

1007

1023

944

Mount Isa (Qld)

976

975

985

936

Older large mining towns

Broken Hill (NSW)

895

912

912

885

Latrobe City (Vic)

932

951

935

919

Cessnock (NSW)

915

939

957

878

Yilgarn (WA)

943

1006

1020

949

Cobar (NSW)

939

958

967

906

Older small mining towns

Laverton (WA)

854

798

831

906

West Coast (Tas)

881

909

921

862

1016

988

996

954

Newer mining towns Port Hedland (WA) Emerald (Qld)

1013

1031

1057

949

Roxby Downs (SA)

1075

1085

1075

983

Former mining towns Ballarat (Vic)

965

983

958

975

Bathurst (NSW)

989

1004

998

982

High income metropolitan local government areas Nedlands (WA)

1167

1118

1122

1138

Ku-ring-gai (NSW)

1207

1143

1178

1194

240

Mineral Economics

chapter 15 – Minerals and regional development for a mining company which is trying to assess the financial viability and risks associated with developing or purchasing mines in a developing nation. By way of example, one of my students was working with a small company on a project to mine limestone for cement in one of the poorer communes (local government areas) of Southern Chile. The commune in question was Lonquimay, based around a small town in Chile’s Ninth region (some 1000 km south of Santiago). He was concerned about the working environment in the small region, given its estimated HDI value of 0.618 ranked it 305th in Chile’s 333 communes. The range of HDI values in Chile’s communes was between 0.565 and 0.924. The national HDI in 2003 was 0.834. Australia’s HDI in 2003 was 0.939. Located at high altitude in the foothills of the Andes close to the Argentinian border, Lonquimay has been a depressed economic region. The new mine seemed to offer new development and income potential for Indigenous and non-indigenous communities alike. Yet its cultural, social and economic profile made it difficult to attract well-qualified resource sector personnel. Despite the further questions that a low value for such a measure might provoke, it provides potential investors with interesting summary information about the ‘playing field’ in which they will be operating.

ECONOMIC IMPACT ASSESSMENT Against this background it remains an interesting challenge to assess the effect of new mine developments on their surrounding regions. Two broad approaches have emerged. The first is economic impact assessment and the second the more broadly focused social impact assessment. The use of each approach6 has been influenced recently by the rise of the sustainable development concept, with its focus on the economic, environmental and social/cultural changes associated with such development over an extended period. New mineral investment, the expansion or contraction of a mining operation, or the closure of a mine or a mill, will generate a series of direct, indirect and induced effects on its surrounding regional economy. An active exploration program, followed by the building and operation of a mine, concentrator, smelter or refinery will directly increase, regional output, income and jobs for workers living nearby. Local firms will typically also supply transport and commercial services for the mine or mill – an indirect impact. Also, the arrival of a large mine in a region will generate a larger demand by resident workers for health, education, better shopping, entertainment and a variety of other services. Analysts typically describe these as induced effects. They appear 6

In many jurisdictions the environmental impact assessment process requires economic and social impact assessment, as well as physical environmental impact assessment for new mine development and mine expansions.

Mineral Economics

in movements in the economic efficiency and economic equity indicators that we have described above. One interesting way of visualising the effects on a small region or local community in the area of a mine is to adapt a diagram used by Armstrong and Taylor (1993, p 7) in their influential treatise on regional economics. The version of this diagram in Figure 15.1 seeks to capture the flow of impacts of increased (or reduced) mineral sector activity on a community’s employment, output and imports.  






 

 
 
  


 
  

 


!
 #$!




#$
  
 


 








 

 # $



 


 

 

 
 

 !
  


! 


  

 




  



Fig 15.1 - The effect of changed mineral sector activity on a host community’s

employment, output and imports.

It shows how changes increases (decreases) in mineral production will have either a positive (or negative) impact of labour demand and the demand for other inputs. Labour demand changes will be accommodated from several sources and these will bring changes to the demand for goods and services, which can be met from either local production or from changing imports. The demand for other inputs may be accommodated by changes to imports or from greater (or lesser) local production of goods and services. Regional scientists and economists have developed a range of techniques to measure the total impact on a region of a small increment or decrement to investment). These include: •• economic (export) base analysis •• Keynesian income-expenditure models •• input-output models •• computable general equilibrium (CGE) models that estimate the size of income, output and employment multipliers associated with these investments. The nature of these models varies from the rather simplistic economic (or export) base models, from which one can quickly estimate indicative multipliers, through to CGE models that are more challenging and expensive to build but which provide a broader range of more complete impact estimates. In the middle are the more widely used input-output models While it is beyond the scope of this volume to review these techniques in great detail, in the following subsections 241

chapter 15 – Minerals and regional development we introduce economic base analysis, input-output analysis and CGE modelling in a simple way.7

and by dividing both sides of this equation by Δ X we get:

Economic (export) base analysis The essence of export (economic) base analysis is the view that the growth (or decline) of a region, a city or town is determined by its function as an exporter to the rest of the world. This arises from the complementary argument by Sombart in the early years of the 20th century that for a community to exist: … it must import from the outside world food as well as other goods, specifically raw materials. Its economic base lies, therefore, in its inhabitants and in those elements of their activities which enable it to pay for imports.8 The presence, or absence, of export activities to pay for these imports determines the economic health of a region. Subject to recognition of the possibility of ‘resource curse’ effects discussed in Chapter 3, this model seems to be quite appropriate in considering the development of small regions that depend on the export of mineral products for their economic wellbeing. A great appeal of the economic base approach arises from its simplicity. In its simplest form, an economy is divided into two parts – its export sector and its domestic sector. The community’s (or region’s) income or (more usually) its employment is allocated to one of these two categories. Let us assume that employment in a small remote mining town (such as Kambalda) can be allocated as follows: Total employment = Employment in export sector (mining or mineral processing) + Employment in domestic sector or simply, following Armstrong and Taylor (1993, 8 - 11) and others, that: T=X+D Then by assuming that domestic employment is some fraction of export employment (or income) we can write: T = dX and T = X + dX = X (1 + dX) Taking first differences we can then write: ΔT = (1 + d) ΔX 7

Authors such as Armstrong and Taylor (2000), Hoover and Giarratani (1984) and Schaffer (2010) provide more complete explanations, discussing the ways in which they are estimated, and considering their limitations.

8

This is a quotation from the paper by Dziewonski (1967).

242

ΔT/ΔX = 1 + d This is the expression for the export base multiplier. Consider now how we might translate this algebra into considering the fortunes of a small mining town. Suppose there is a hypothetical small mining town in Western Australia (like Kambalda or possibly Norseman, Leonora, Laverton or even Southern Cross) with a mining workforce of 500 people (X) and a domestic sector workforce of 600 people. The total employment (T) is 1100 people. So we can write: D = (600/500) X = 1.2X According to our model, therefore, the export base multiplier will be: ΔT/ΔX = 1 + d = 1 + 1.2 = 2.2 So what happens to employment in the town if a brilliant young geologist makes a major new nickel find which generates 200 new mining jobs for people living in the town? Our model tells us that the change in total employment will be: ΔT = (1 + d) ΔX or ΔT = (1 + 1.2) 200 = 440 The total employment of residents in the town will rise from 1100 to 1540, with 240 of the new jobs being in other sectors of the economy, eg construction, transport and communications, utilities, local shops and restaurants, education, health services and so on. It is possible also to make estimates of economic decline with this model. If a local gold mine, which employs 100 people closes after 20 years of operation, then the town would lose 220 jobs. Although this is a believable estimate, it is more realistic to recognise that employment in a community’s domestic sector is also determined by other factors. Armstrong and Taylor (1993) suggest that a more plausible equation relates employment in the domestic sector to total employment in the community as follows: D = d0 + d1 T where d0 denotes other (exogenous) influences on domestic sector employment (such as income earned outside the community but spent on domestic services within the region or social welfare disbursements such as old age pensions, unemployment benefits or disability payments). Such a term may be important in long-term Mineral Economics

chapter 15 – Minerals and regional development mining towns (eg Broken Hill) with stable or declining populations where mining is coming to the end of its economic life. It may also be important in Kambalda where some residents commute to Kalgoorlie Boulder on a daily basis to work in the regional centre.

that is self-sufficient. This might be the national percentage (or even better, the world or a large highincome nation percentage).

By substituting this into our initial equation and rearranging terms we find that:

LQ =

T = d0/(1 - d1) + (1/1 - d1) X and on taking first differences and dividing both sides of the ensuing equation by ΔX that: ΔT/ΔX = 1/ (1 - d1) There are several fundamental problems in applying export base analysis. This is particularly the case where there is more than one export industry in a region. Because some export industries depend heavily on the outside world for their inputs, while others are more heavily dependent on local inputs, the size of multipliers may vary significantly between export sectors. Hence, even in a small town such as Kambalda,9 the multipliers arising from nickel mining, gold mining and the operation of the nickel concentrator, which are the key export sectors, may all vary.10 Another problem in applying the export base model is that sometimes export activity also emerges from an economy’s domestic sector, possibly being induced by factors that could not have been otherwise predicted. For example, the wife of a local mining engineer may sell her artwork widely outside the region. A local school teacher may write a best-selling textbook. There are many other possibilities. Notwithstanding these issues, it is often a useful exercise to apply an export base analysis to a mining community or region. An important initial task is to determine whether an industry is export-oriented. There are three main ways of doing this. While an obvious way is to survey local businesses to find out how much of their revenue is basic, this is expensive and is seldom undertaken. Another way is to make an arbitrary judgement. A third way is to use the location quotient method. In practice, many researchers apply this approach to published employment data by industry classification in communities and smaller areas. A location quotient is a measure of the degree to which two quantitative characteristics are dissimilarly distributed between two areas. Computing location quotients for a region or community involves comparing percentage levels of employment in different industry sectors in a region with that of a benchmark economy 9

Kambalda’s estimated population at the 2006 Australian Census was 2706.

10 While authors such as Weiss and Gooding (1968) have suggested a method to use the export base model to estimate a set of multipliers for each basic industry in a region under certain conditions, the application of their method is complex and has not attracted wide use. Mineral Economics

The formula is: % of regional employment in industry A % of benchmark economy employment in industry A

The logic is that if a region has a higher degree of specialisation than in the benchmark economy, it will generally be an exporter. This will happen if its location quotient is greater than one. Consider the percentage employment levels in Kambalda at the 2006 national census in Table 15.2. For the purposes of this exercise, we assume that Australia is the benchmark economy. In this small region the location quotients of only one industry was greater than the national percentage. This was mining whose LQ value was 37.20. The largest location quotient for another sector, that for ‘Other services’ was only 0.88. Mining is clearly the only export sector in Kambalda. If we assume that the percentage employment in mining of the benchmark economy (1.2 per cent) services domestic demand for minerals in Kambalda, this means that the rest of mining employment, ie 44.8 - 1.2 or 43.6 per cent of total employment is devoted to the economic (export) base. So 100 - 43.6 per cent or 56.4 per cent is domestic sector employment. The value of the coefficient d is 56.4/43.6 or 1.29 and the estimated value of the export base multiplier (1 + d) is 2.29. This suggests that each new mining job in Kambalda generates another 1.29 jobs. But these other jobs would have been in lower paying industries than mining. This estimate, based on the location quotient approach, implies limitations with the export base model. Clearly those employees at Kambalda’s nickel concentrator were in an export-focused industry. But the standard industry classification used by the ABS does not allow identification of these people if we mechanically apply the LQ method. Despite its limitations, economic base analysis is a useful and cost-effective way of assessing the impact of mining projects in small mining communities. In larger towns, cities and regions its application is less appropriate.

Input-output analysis Input-output analysis is based on a framework of accounts, which describe transactions between industry sectors in an economy and with the outside world, as well as among activities within the economy. This economy can be that of a nation, a region or a single community. The model assumes a proportional relationship between inputs and outputs. It generates a set of multiplier estimates that explain the relationship between an initial change in demand and its ultimate effect on output, income and employment. 243

chapter 15 – Minerals and regional development Table 15.2 Calculation of location quotients for Kambalda at the 2006 Australian Census (source: Australian Bureau of Statistics, 2008a). Kambalda

Australia (benchmark economy)

Location quotient

Agriculture, forestry and fishing

Industry Sector

0.0%

3.2%

0.00

Mining

44.8%

1.2%

37.20

Manufacturing

7.8%

10.7%

0.73

Electricity, gas, water and waste services

0.0%

1.0%

0.00

Construction

4.4%

8.0%

0.56

Wholesale trade

1.0%

4.5%

0.22

Retail trade

8.1%

11.7%

0.69

Accommodation and food services

3.3%

6.5%

0.51

Transport, postal and warehousing

3.0%

4.8%

0.63

Information media and telecommunications

0.3%

2.0%

0.17

Financial and insurance services

1.0%

3.9%

0.25

Rental, hiring and real estate services

1.2%

1.7%

0.71

Professional, scientific and technical services

1.5%

6.8%

0.22

Administrative and support services

2.2%

3.2%

0.69

Public administration and safety

2.5%

6.9%

0.36

Education and training

6.3%

7.9%

0.79

Health care and social assistance

8.6%

10.8%

0.80

Arts and recreation services

0.5%

1.4%

0.34 0.88

Other services

3.4%

3.8%

Total

100.0

100.0

The originator of the input-output model was the Russian-American economist, Wassily Leontief, who developed the approach in the 1920s and 1930s. Leontief spent much of his career as a Professor at Harvard University and received one of the early Nobel Prize awards in economics (in 1973) for his development of the technique. Miller (1998) notes that because of its use of mathematics and relative complexity for the social scientist of the time it was largely ignored. But it came into favour during World War II in the United States as a technique to assist in avoiding bottlenecks in military production. Practitioners initially applied it at national level but its application at regional and community level is now widespread. This has been the situation since the early 1980s. In their recent paper, Ejdemo and Söderholm (2011) identify several studies that have focused on the regional impacts of mining around the world. In describing its application to mining projects they observe that: This approach attempts to formalise the … impacts around the concept of backward and forward linkages between different sectors in an economy. Backward linkages implies that the prospects for the production of capital goods, supplies and services needed for investments and operations will be enhanced through the mineral project’s demand for these inputs. The forward linkages of a mining project, in contrast, 244

facilitate the setting-up of downstream activities, not the least processing, refining and fabricating the crude ores and concentrates. The framework of accounts for input-output analysis is a transactions table, which following Schaffer (2010) takes the form outlined in Table 15.3. The key part of the table is the inter-industry sector, which shows transactions between each of the key industry sectors such as agriculture, mining, manufacturing, construction, utilities, the retail sector and the various parts of the service sector. This model shows total receipts and payments for only the activities of the intermediate sector. Transactions among other sectors are overlooked. Other sectors that appear in the table are households, government, capital, imports and exports. Because of the nature of the study and the resources available, a Table 15.3 The transactions table of an economy (source: derived from Schaffer, 2010). Production Distribution

Final payments

Interindustry sector (production relationships between industrial sectors) Incomes (household incomes, taxes paid to government, imports, depreciation and retained earnings of industry)

Final demand Consumption patterns Total (households, government, output exports, capital) (Nonmarket transfers)

Total inputs

Mineral Economics

chapter 15 – Minerals and regional development regional input-output table typically contains 20 or more industry sectors while for a national table, there may be more than 100 sectors included. To illustrate the application of I-O analysis, it is easiest to use a small model. The model described in Table 15.4 covers five sectors – agriculture, mining, broad manufacturing, trade and services11 – for the Northern Statistical Division of South Australia during the 2002 2003 financial year. Our data are derived from a larger 18 sector input-output table generated by EconSearch (2005) using the GRIT methodology developed by Jensen and West in the late 1970s and early 1980s.12 South Australian mineral production has grown strongly in the past two decades. The northern region hosts mines such as the Olympic Dam copper-uraniumgold-silver deposit, the Prominent Hill copper-gold mine, the Challenger gold mine, coal at Leigh Creek, uranium at Beverley and Honeymoon and the Coober Pedy and Andamooka opal fields. As Table 15.4 shows, mining accounted for almost 25 per cent of the region’s total output in a year when mineral prices were depressed. But this table is important because it can be used to trace and evaluate the effects of vertical linkages in the region.

Fig 15.2 - Hoover’s and Giarratani’s (1984) view of the input-output framework.

spends on inputs in generating each dollar’s worth of output. The input coefficients table for the Northern region – Table 15.5 – is derived in a straightforward manner from Table 15.4 by dividing each industry sector cell by the total inputs entry.

One useful view of the structure of the I-O model is that suggested by Hoover and Giarratani (1984) that appears in Figure 15.2.

Consider the implications of this for the mining industry. For each dollar’s worth of output it purchased 0.1 cents from local farmers, 3.8 cents from other parts of the mining sector, 5.4 cents from the manufacturing, construction and utility sectors, 4.3 cents from the local trade sector and 5.4 cents worth of local services; so total local inputs made up only 18.9 cents in each dollar’s worth of output. Mining paid 8.9 cents to households as income, 24.1 cents for imports and 48.1 cents in other payments (taxes, retained dividends and depreciation of capital). So, if it increased sales outside the region

In tracing and evaluating the cumulative effects in a community or region our first step is to construct a table of input coefficients. These show what each industry 11

Broad manufacturing also includes construction and utilities as well as traditional manufacturing. Trade includes wholesale and retail trade, accommodation restaurants and cafes, transport and storage, and communications. Services cover education, health, finance, property management, public administration and defence, recreation and personal services.

12 Another interesting recent study to estimate the impact of a coal industry expansion on regional and local economies in Queensland is the recently published paper by Ivanova and Rolfe (2011).

Table 15.4 Simplified input-output table for Northern region of South Australia 2002 - 2003 (source: derived from EconSearch, 2005). Agriculture

Mining

Manuf +

Trade

Services

Total industry demand

Household spending

Other final demand

Exports

Total demand

15

1

26

1

0

43

2

0

315

360

Mining

1

50

350

2

5

408

1

0

923

1332

Manufact +

17

72

131

26

53

299

86

267

1287

1939

Trade

34

57

68

36

46

241

227

156

80

704

Services

15

72

69

50

108

314

368

421

81

1184

Total local inputs

82

252

644

115

212

1305

684

844

2686

5519

Household income

50

118

350

245

475

Other payments

139

641

232

83

253

Agriculture

Imports

89

321

713

261

244

Total inputs

360

1332

1939

704

1184

Mineral Economics

245

chapter 15 – Minerals and regional development

Table 15.5 Input coefficients for Northern region of South Australia 2002 - 2003. Per dollars’ worth of gross input in Agriculture

Mining

Manufacturing +

Trade

Services

Agriculture

0.042

0.001

0.013

0.001

0.000

Mining

0.003

0.038

0.181

0.003

0.004

Manufacturing +

0.047

0.054

0.068

0.037

0.045

Trade

0.094

0.043

0.035

0.051

0.039

Services

0.042

0.054

0.036

0.071

0.091

Total local inputs

0.228

0.189

0.332

0.163

0.179

Household income

0.139

0.089

0.181

0.348

0.401

Other payments

0.386

0.481

0.120

0.118

0.214

Imports

0.247

0.241

0.368

0.371

0.206

Total inputs

1.000

1.000

1.000

1.000

1.000

Intermediate sector

by $1000, it would buy a dollar’s worth of output from farmers, $38 in mineral output, $54 in local manufactured goods, $43 from local traders and pay $54 for locally produced services. As a result of the above inter-industry transactions, other sectors would have to increase their output. Local manufacturers (broadly defined), for example, would buy $54 × .013 = $0.70 in output from agriculture, $54 × 0.181 = $9.77 from mining, $54 × .068 = $3.67 from local manufacturers, $54 × .035 = $1.89 from traders and $54 × .035 = $1.94 from service providers. The process is endless but becomes less and less with each round and the outcome is finite. For the mining industry, it is also notable that payments to households amounted to $89, while other payments (tax payments to government, retained profits and depreciation allowances) at $481, were substantial. Imports of $241 were also very high. The leakages from these final two areas intuitively suggest that the regional multiplier for mining will be low. An initial change in sales results an overall effect, which will be greater than the initial final demand increase. This is the multiplier effect. It is possible to estimate a series of output and income multipliers from an accurately compiled input-output matrix such as our five-sector matrix for Northern. This is done in more detail in the Appendix. It generates the results shown in Table 15.6. These show the amount by which each industry group’s sales are increased as the end result of a dollar’s increase in the final demand for an industry. While they are largest for the activity experiencing the initial final demand increase (eg for mining as a result of a dollar’s increase in mineral sales), they are also significant for the other sectors. Hence the effect of a $1 increase in final demand for the mineral sector in the Northern region in 2002/2003 would have increased total output by $1.244 (0.002 246

Table 15.6 Total direct and indirect effects of a change of $1 of final demand of each intermediate sector. Agric Agric

=

Mining Manuf + Trade Services

1.045

0.002

0.015

0.002

0.001

x

= eA

Mining

0.015

1.052

0.206

0.013

0.015

= eMi

Manuf +

0.061

0.067

1.091

0.047

0.056

= eMa

Trade

0.109

0.053

0.054

1.060

0.048

= eT

Services

0.060

0.069

0.060

0.085

1.107

= eS

Type I Multiplier

1.290

1.244

1.425

1.206

1.228

Type II Multiplier

1.737

1.554

1.956

2.047

2.190

for agriculture + 1.052 for mining + 0.067 for broad manufacturing + 0.053 for trade + 0.069 for services). This is known as a Type I multiplier. Other Type I multipliers for this simple model were 1.290 for agriculture, 1.425 for broad manufacturing, 1.206 for trade and 1.228 for services. Though slightly higher for manufacturing due to stronger vertical linkages, these estimates are all disappointingly low for those supporters of export industries driving the prosperity of remote regions. One common criticism is that Type I multipliers probably underestimate the effect of changes in final demand on a small economy. This is because they do not include vertical linkages with other sectors of the economy. One way of overcoming this is to make households endogenous, ie include them in the interindustry sector.13 This increases the magnitude of vertical leakages and the size of the multiplier. The multipliers derived using this adjustment are known as Type II multipliers. As can be seen in Table 15.6, these suggest a greater impact of changes in industry output. 13 This imposes the strong assumption that households are spending in the region and that they do it proportionally to the increased output. Mineral Economics

chapter 15 – Minerals and regional development Yet though the Type II multiplier for mining increases in the above example from 1.244 to 1.554 the impact of changed mining activity is less than for the other major industry groups.

Computable general equilibrium models CGE modelling originates from the Walrasian neoclassical general equilibrium model, whose main equations require constrained optimisation of the neoclassical production and consumption functions. Producers choose their level of operation to maximise profits or minimise costs using constant returns to scale production technology. The factors of production – land, labour and capital – are paid in accordance with their respective marginal productivities. Consumers choose their purchases to maximise their utility subject to budget constraints. At equilibrium, the model solution provides a set of prices that clear all commodity markets and factor markets, and make all the individual agent optimisations feasible and mutually consistent. In his review paper, Sue Wing (2004, p 2) notes that: Computable general equilibrium (CGE) models are simulations that combine the abstract [the Walrasian] general equilibrium structure formalised by Arrow and Debreu with realistic economic data to solve numerically for the levels of supply, demand and price that support equilibrium across a specified set of markets. A CGE model typically consists of: •• a set of equations describing the model variables •• a database consistent with the model equations. For a standard listing of the equations in a CGE model see Sue Wing (2004) Section 4. He uses about 20 equations specifying the behaviour of households and producers, and then describes the general equilibrium solution to this model in an economy, which operates according to a Cobb-Douglas production function. The formulation, calibration and solution to a corresponding CGE model is described in more detail in his Section 5. CGE modellers often estimate the effect of changes in one part of an economy upon the rest of it. A recent application of interest was the Australian Government’s modelling of the proposed Resource Super Profits Tax. Parmenter et al (2010) challenged this application and suggest an alternative approach. Another application by Ahammad and Clements (1999) used a CGE model to estimate that the minerals sector has been responsible for about 40 per cent of the growth of the Western Australian economy in the 1990s. They estimated as well that several service sectors – transport and storage, wholesale and retail trade, education and health – would have been much smaller if the mining sector had not been growing. A common criticism of CGE modelling is that it is very costly. Analysts must have special training to undertake the modelling and the technique has greater data requirements than alternative techniques. Mineral Economics

SOCIAL IMPACT ASSESSMENT Origins and development The origins of the social impact assessment (SIA) are in the discipline of sociology. The technique, which has evolved since the 1970s, emerged as a by-product of environmental impact assessment, which is a necessary part of the permitting process of any new mine. Practitioners also now apply SIA in its own right in a variety of countries to new and established resource projects. A widely quoted definition of a social impact assessment (Interorganizational Committee for Guidelines and Principles for SIA, 1994) is: The process of assessing or estimating, in advance, the social consequences that are likely to follow from specific policy actions or project developments. Armour (1990) suggests that these social impacts (or consequences) are changes that occur in: •• people’s way of life – how they live, work, play and interact with each other on a day-to-day basis •• their culture – shared beliefs, customs and values •• their community – its cohesion, stability, character, services and facilities. Vanclay (2003) expands this list with the following additional suggestions: •• their political systems – the extent to which people are able to participate in decisions that affect their lives, the level of democratisation that is taking place, and the resources provided for this purpose •• their environment – the quality of the air and water that people use; the availability and quality of the food that they eat; the level of hazard or risk, dust, and noise in which they are exposed to; the adequacy of sanitation, their physical safety, and their access to and control over resources •• their health and well-being – where ‘health’ is understood in a manner similar to the World Health Organisation definition: ‘a state of complete physical, mental, and social well-being, not merely the absence of disease or infirmity’ •• their personal and property rights – particularly whether people are economically affected, or experience personal disadvantage, which may include a violation of their civil liberties •• their fears and aspirations – their perceptions about their safety, their fears about the future of their community, and their aspirations for their future and the future of their children. The economic impacts of mine development and operation that we have discussed in the previous section have social implications as well.14 When mines 14 One interesting recent study which considers social, economic and environmental aspects of development of the coal industry in the Bowen Basin in Queensland is that by Ivanova et al (2007).

247

chapter 15 – Minerals and regional development are expanding, the increased employment they provide brings larger local populations with increased incomes. Higher incomes generate a greater demand for services (educational, health, financial and other) and higher prices and higher rents create social pressures on local populations.15 When mines are contracting, local communities and small regions must either reinvent their industry bases or accept a decline in the number and quality of services, or both. Local residents are likely to experience losses in the value of their homes and other property. They may be unable to sell this property and be forced to live in a declining community because they cannot afford to move.

Conducting a full social impact assessment According to the Interorganizational Committee for Guidelines and Principles (ICGP) for SIA (1994), a properly conducted SIA is ‘The process of assessing or estimating, in advance, the social consequences that are likely to follow from specific policy actions or project developments.’ These consequences cover a broad spectrum. Vanclay (2003) suggests, for example, that a full SIA should cover the following areas: •• •• •• •• •• •• •• •• •• •• •• •• •• •• •• •• ••

aesthetic (landscape analysis) archaeological and heritage community cultural demographic development economic and fiscal gender health indigenous rights institutional political (human rights, governance, democratisation) poverty-related psychological resource issues (access and ownership of resources) impacts on tourism other impacts on society. In compiling a set of guidelines for its more consistent use, the ICGP suggested the following stages in its application: •• alternatives identification •• baseline data collection •• issues scoping •• prediction of impacts (direct, indirect, induced, cumulative) •• development of mitigation measures •• the design of monitoring and audit procedures. 15 This has led to greater use of fly-in/fly-out workforces and sometimes industrial action by resident workers and local municipal councils that fear an eventual loss of company support for the operation of current mining towns.

248

While major mining companies formally espouse the principles of sustainable development in their public profiles,16 conducting and sustaining extensive SIA exercises throughout the development, operation and closure of their mines seems an almost daunting task. This will be an even greater challenge for small and medium size mining companies.

Some examples of recent social impact assessments In their review of social impact assessment in mining Joyce and MacFarlane (2001) note its advocacy by the European Union, and its requirement in association with environmental impact statements by the US Council on Environmental Quality. They observe also that the World Bank (and some NGOs) utilise its principles. They remark as well that the principles of SIA have been applied in various formats in Canada (at the Ekati and Diavik diamond mines), and at the Antamina base metals deposit in Peru. Yet in commenting on the extent of its application by mining communities, they state that: The underlying tension that cuts across all of the issues associated with Social Impact Assessment is the difference between its potential (currently realised in a small percentage of projects) and its general current use. The difference can be extreme. At one end, the SIA is a dynamic, ongoing process of integrating knowledge on potential and real social impacts into decision-making and management practices; at the other end, it is a static, oneshot technocratic assessment undertaken to gain project approval or financing, with little or no follow through. Most SIAs fall somewhere along a continuum between the two. In the past decade in Australia and elsewhere, mining companies and industry researchers have increased their use of social impact assessment. As well as in association with environmental impact statements at the beginning of a mine’s life, the technique is being applied more during mine operations. Two significant applications have been by Kalgoorlie Consolidated Gold Mines (KCGM) for the Super Pit Project in Western Australia17 – see KCGM (2011) – as well as by researchers based at Central Queensland University to coal mining in communities in the Bowen Basin – see for example Petkova et al (2009). Kalgoorlie Consolidated Gold Mines (a joint venture between Barrick Gold and Newmont) has recently conducted regular SIA for the Super Pit, which has 16

The major mining industry body, the International Council on Mining and Metals, for example, noted on its web page (20 November, 2011) that it ‘was established in 2001 to improve sustainable development performance in the mining and metals industry.’ Its membership in late 2011 included 21 major mining and metals companies and 32 national and regional mining associations and global commodity associations.

17 There is a brief reference to this social impact assessment in the previous chapter.

Mineral Economics

chapter 15 – Minerals and regional development been operating since 1989 – see their web page at: http:// www.superpit.com.au. There have been four studies in this series. These have included a qualitative perception study in 2004, a social needs assessment in 2005 and a quantitative perceptions study in 2007. Their 2010 report contains an assessment on progress from key recommendations made in the 2007 study. It seems likely that there will be further studies in this series. The three objectives of the 2010 study were to: ... provide KCGM with … an up to date assessment of their current social impacts and community perceptions of these impacts ... ... investigate … the community’s preparedness and vision for life after the Super Pit ... ... track developed performance measure indicators to highlight specific shifts in community attitudes. The 2010 study provides a ranking on a five-point scale of perceived performance by its stakeholder groups. As noted previously, these include residents, businesses, employees and contractors, pastoralists, government, Williamstown residents and indigenous residents. Respondents ranked performance across a range of economic, environmental and social areas. The authors (Coffey Environments) observe that KCGM’s scores were well above the means received in its SIAs for other mining operations in Australia and New Zealand. KCGM’s scores in the 2010 study were similar to those in 2007. A key section then assesses a range of priority improvement areas, as identified by members of each of the recognised stakeholder groups. These cover a list of environmental and social issues. Closure of the mine is currently listed to be in 2021. Though it shows the commitment of the joint venture to managing the social performance of the mine and demonstrates a commitment to the local community, it also illustrates the importance to the two principal companies to maintaining their ‘social licence to operate’ for the future. The Bowen Basin studies have been undertaken by a group of social science researchers based mainly at Central Queensland University. Petkova et al (2009) report on a comparative study of six towns in the Bowen Basin. These are the two mining towns of Moranbah and Blackwater and the smaller agricultural and service centres of Springsure, Rolleston, Coppabella and Nebo. There has been black coal mining in the region since the mid-1960s. These researchers collected data in 2005 and 2006, using interviews and surveys of random samples of their target populations, which included households, businesses and work camp (FIFO or drive-in/drive-out) residents. They report on the extent and importance of a range of positive and negative social impacts. Mineral Economics

Positive impacts included: •• higher incomes for mineral sector employees and better opportunities for business owners operating in the local communities •• greater employment •• growth and diversification of communities •• higher property values •• higher service levels in the towns •• better infrastructure development in areas such as roads and communications •• better water supply •• grazing opportunities for stock on unused mining properties. There were negative impacts as well. These included: •• the availability and cost of residential accommodation •• the status of school enrolments in the towns •• shortages of staff to work in local businesses •• questions of whether local residents and FIFO workers spend enough money in the towns •• the impact of itinerant (FIFO) workers on the social fabric of local communities •• the effect of work rosters on physical and mental health •• increased traffic and a greater risk of accidents •• air and noise pollution and declining visual amenity •• power and water shortages •• a lack of capacity of local retail, health and other services to meet the increased demand for them •• that permanent population is outnumbered by itinerant workers. Recall again the elements of a full social impact assessment as proposed by the ICGP for SIA. These include alternatives identification, baseline data collection, issues scoping, prediction of impacts (direct, indirect, induced, cumulative), development of mitigation measures, and the design of monitoring and audit procedures. The Bowen Basin studies provide an interesting example of monitoring and auditing mine performance from a society viewpoint. There is now a considerably greater commitment to the area of community engagement. Large mining companies such as Barrick Gold use SIAs during the life of a mine, while Anglo American refers to its Socio-economic Assessment Toolbox (SEAT) reports for operating mines. Other large companies discuss their community policies, often in association with the concept of sustainable development. As we have argued earlier, mining has been historically associated with the significant development of the hinterland in Australia and many other nations. The introduction of active and formal social impact assessment techniques to assess this development requires considerable political and community will. 249

chapter 15 – Minerals and regional development If this happens, as we have seen, the ABS provides a range of social and other statistics to assess this. National statistical offices in other mining nations play a similar role.

REFERENCES Ahammad, H and Clements, K W, 1999. What does minerals growth mean to Western Australia? Resources Policy, 25(1):1-14. Armour, A, 1990. Integrating impact assessment into the planning process, Impact Assessment Bulletin, 8(1/2):3-14. Armstrong, H and Taylor, J, 1993. Regional Economics and Policy, second edition (Harvester Wheatsheaf: New York). Australian Bureau of Statistics, 2008a. 2006 Census of Population and Housing (Australian Government: Canberra). Australian Bureau of Statistics, 2008b. An introduction to socio-economic indexes for areas (SEIFA) 2006: A comprehensive profile of the Australian people, ABS Catalogue No 2039.0 (Australian Government: Canberra). Dziewonski, K, 1967. The concept of the urban economic base: Overlooked aspects, Papers in Regional Science, 18(1):139-145. EconSearch Pty Ltd, 2005. Quantifying the economic contribution of regional South Australia: A report prepared for regional communities consultative council, Local Government Association of SA, Regional Development SA, 2 May, Adelaide. Ejdemo, T and Söderholm, P, 2011. Mining investment and regional development: A scenario-based assessment for northern Sweden, Resources Policy, 36(1) March:14-21. Hoover, E and Giarratani, F, 1984. An Introduction to Regional Economics, third edition (Alfred A Knopf: New York). International Council on Mining and Metals, 2011. Home page. Available from: . Interorganizational Committee for Guidelines and Principles for SIA (ICGP), 1994. Guidelines and Principles for Social Impact Assessment (US Department Commerce: Washington). Ivanova, G and Rolfe, J, 2011. Using input-output analysis to estimate the impact of a coal industry expansion on regional and local economies, Impact Assessment and Project Appraisal, December. Ivanova, G, Rolfe, J, Lockie, S and Timmer, V, 2007. Assessing social and economic impacts associated with changes in the coal mining industry in the Bowen Basin, Queensland, Australia, Management of Environmental Quality: An International Journal, 18(2):211-228. Joyce, S A and MacFarlane, M, 2001. Social impact assessment in the mining industry: Current situation and future directions, Mining, Minerals and Sustainable Development project report No 46, December (International Institute for Environment and Development: London). Kalgoorlie Consolidated Gold Mines, 2011. Social impact assessment documents for 2004, 2007 and 2010 [online]. Available from: . Lagos, G and Blanco, E, 2010. Mining and development in the region of Antofagasta, Resources Policy, 35(4):265-275. Miller, R E, 1998. Regional and interregional input-output analysis, in Methods of Interregional and Regional Analysis (eds: W Isard, I J Azis, M P Drennan, R E Miller, S Saltzman and E Thorbecke) (Ashgate: UK).

250

Parmenter, B, Breckenridge, A and Gray, S, 2010. Economic analysis of the government’s recent mining tax proposals, Economic Papers, 29(3):279-291. Petkova, V, Lockie, S, Rolfe, J and Ivanova, G, 2009. Mining developments and social impacts on communities: Bowen Basin case studies, Rural Society, 19(3):211-228. Schaffer, W A, 1999. Regional impact models, in The Web Book of Regional Science, Regional Research Institute, West Virginia University, Morgantown [online]. Available from: . Schaffer, W A, 2010. Regional impact models, in The Web Book of Regional Science, Regional Research Institute, West Virginia University, Morgantown [online]. Available from: . Sue Wing, I, 2004. Computable General Equilibrium Models and their Use in Economy-Wide Policy Analysis: Everything You Ever Wanted to Know (But Were Afraid to Ask), 50 p (MIT Joint Program on the Science and Policy of Global Change: Boston). Vanclay, F, 2003. International principles for social impact assessment, Impact Assessment and Project Appraisal 21(1):511. Weiss, S J and Gooding, E, 1968. Estimation of differential employment multipliers in a small regional economy, Land Economics, 44:235-244.

APPENDIX The structure of and solution to the inputoutput model The input-output transactions table is shown as Table 15.7, which, following Schaffer (2010), can be summarised as: qi = / jZij + ei

for total output

and g j = / iZij + h j + v j + m j

for total input

The final demand vector (e) is exogenous and free to change. The challenge is to find the effect of a change in e on output. To do this we introduce a set of technical conditions, assuming that: aij = zij/ gj This is the set of input coefficients, showing ‘show the proportions in which the establishments in each industry combine the goods and services which they purchase to produce their own products.’ We can rewrite this relationship as: zij = aij × gj Mineral Economics

chapter 15 – Minerals and regional development Table 15.7 Input-output transactions. Agriculture

Mining

Manufacturing +

Trade

Services

Final demand and exports

Total demand

Agriculture

z11

z12

z13

z14

z15

e1

q1

Mining

z21

z22

z23

z24

z25

e1

q2

Manufacturing +

z31

z32

z33

z34

z35

e1

q2

Trade

z41

z42

z43

z44

z45

e1

q4

Services

z51

z52

z53

z54

z55

e1

q5

Household income

h1

h2

h3

h4

h5

Final payments

v1

v2

v3

v4

v5

Imports

m1

m2

m3

m4

m5

Total inputs

g1

g2

g3

g4

g5

This leads to the writing of our five output equations in the form:

-.047 A - .054 Mi + .932 Ma - .037 T - .045 S = eMa -.094 A -.043 Mi - .035 Ma + .949 T - .039 S = eT

q i = /a ij # q i + e i

which can be stated in matrix form as: q = Aq + e

-.042 A -.054 Mi - .036 Ma - .071 T + .909 S = eS This is a version of the above equation: q - Aq = e (I - A)q = e

q – Aq = e (I - A)q = e q = (I - A) e -1

In the case of our five-sector economy the relevant output equations are:

We obtain equilibrium output levels of agriculture, mining, broad manufacturing, trade and services sectors by inverting the matrix (I – A) using standard spreadsheet methods. This leads to the solution shown in Table 15.8. Table 15.8 Equilibrium output levels attained by inverting the matrix (I – A).

A = .042 A + .001 Mi + .013 Ma + .001 T + eA Mi = .003 A + .038 Mi + .181 Ma + .003 T + .004 S + eMi Ma = .047 A + .054 Mi + .068 Ma + .037 T + .045 S + eMa T = .094 A + .043 Mi + .035 Ma + .051 T + .039 S + eT S = .042 A + .054 Mi + .036 Ma + .071 T + .091 S + eS where A, Mi, Ma, T and S represent the levels of output (also denoted by q in the above equations) of the agricultural, mining, broad manufacturing, trade and services sectors respectively and the e entries denote the final demand levels in each of these sectors. We can rewrite the above equations as: .958 A - .001Mi - .013 Ma - .001 T = eA -.003 A + .962 Mi - .181 Ma - .003 T - .004 S = eMi

Mineral Economics

Agric Agric

=

Mining Manuf +

Trade

Services

1.045

0.002

0.015

0.002

0.001

Mining

0.015

1.052

0.206

0.013

0.015

x

= eMi

= eA

Manuf +

0.061

0.067

1.091

0.047

0.056

= eMa

Trade

0.109

0.053

0.054

1.060

0.048

= eT

Services

0.060

0.069

0.060

0.085

1.107

= eS

Multiplier

1.290

1.244

1.425

1.206

1.228

The sum of the columns in the (I - A)-1 matrix show the effect of a change (increase or decrease) of $1 worth of final demand on the output of each intermediate industry. Hence the effect of a $1 increase in final demand for the mineral sector would be to increase total output by $1.244 (0.002 for agriculture + 1.052 for mining + 0.067 for broad manufacturing + 0.053 for trade + 0.069 for services). These results have shown how to derive estimates of output multipliers. For parallel estimates of income and employment multipliers, see Schaffer (1999, pp 37 - 39).

251

HOME

Chapter 16 Mining and Indigenous Populations Philip Maxwell The world’s Indigenous populations Mining and the Indigenous world Indigenous Australia

Some historical background

Recent comparative data Indigenous Australia and mining An overview The Mabo case and related developments

Indigenous employment policies



Looking to the future

Appendix: Two case studies Roebourne in the Pilbara The Argyle diamond mine and the East Kimberley region

The world’s Indigenous populations My Webster’s Dictionary suggests that indigenous means, ‘living naturally in a particular region or environment’. Yet such a definition tends to romanticise and simplify this notion. The United Nations Educational, Scientific and Cultural Organization (UNESCO) Commission on Human Rights adopted a more complete but complex definition in 1982. This is that: Indigenous Populations are composed of the existing descendants of the peoples who inhabited the present territory of a country wholly or partially at the time when persons of a different culture or ethnic origin arrived there from other parts of the world, overcame them, and by conquest, settlement or other means, reduced them to a non-dominant or colonial situation; who today live more in conformity with their particular social, economic and cultural customs and traditions than with the institutions of the country of which they now form a part, under a state structure that incorporates mainly the national, Mineral Economics

social and cultural characteristics of other segments of the population that are predominant … Although they have not suffered conquest or colonisation, isolated or marginal groups existing in the country should be regarded as covered by the notion of ‘Indigenous Populations’ for the following reasons: (a) they are descendants of groups which were in the territory of the country at the time when other groups of different cultures or ethnic origins arrived there; (b) precisely because of their isolation from other segments of the country’s population they have preserved almost intact the customs and traditions of their ancestors which are similar to those characterised as Indigenous; (c) they are, even if only formally, placed under a State structure, which incorporates national, social and cultural characteristics, alien to theirs. 253

chapter 16 – Mining and Indigenous Populations Recent estimates suggest that there are currently between 300 million and 350 million Indigenous peoples. This is about six per cent of the world’s population, which has recently passed seven billion. There are more than 5000 distinct Indigenous populations in about 85 nations. The 55 national minorities in China and 32 scheduled tribes in India and Sri Lanka make up perhaps half of the total Indigenous population. But Indigenous peoples are also spread throughout the world. They include the Inuit and Sami people of the High Arctic, the Basque people of Spain and France, a wide range of highland and lowland American Indian peoples in both North and South America, Saharan peoples, pastoral, hunter/ gatherer, rainforest people in other parts of Africa, hill tribes in Asia, many distinct groups in South East Asia, Australian Aboriginal people, Maoris in New Zealand, Polynesian and Melanesian peoples of the Pacific, Mongol peoples, about 40 distinct minority groups in the former Soviet Union and the Ainu in Japan.

percentages in these areas. Authors such as Danielson and McShane (2003) acknowledge this situation in their recent report1. Danielson notes that the impacts of the European expansion of mining to the Colonial world included: •• the spread of diseases to which local people had little immunity •• the enslavement of indigenous populations •• the destruction of cultures •• the unravelling of the complex relationships with the natural environment, which provides physical and spiritual sustenance for many peoples. The continuing importance of the interface between mining and Indigenous populations is seen, for example, from statements such as ‘more than 60 per cent of minerals operations in Australia have neighbouring Indigenous communities’ (Mineral Council of Australia, 2011). There is a similar situation in many other mineralproducing nations. Warden-Fernandez (2001, p 4) notes that:

As can be seen from Table 16.1, there are large Indigenous populations in Asia, significant indigenous populations in the Americas and Africa, but small populations in Europe. In the Americas there are particularly significant Indigenous populations in Peru, Mexico, Bolivia, Ecuador and Guatemala. Table 16.1 Some indicative estimates of Indigenous populations in 2010 (sources: CIA World Factbook, Wikipedia). Country or region

Millions

China (say)

80

India

68

Other Asia (say)

85

Europe

4

Oceania

2

North America

10

Central America

7

South America

26

Africa (say)

38

Total (say)

320

Mining and the Indigenous world The growth of population and production, largely since the beginning of the Industrial Revolution, has been associated with the strong expansion of mineral exploitation throughout the world. European colonial expansion and the search for minerals was a major motive for invasion of the lands of Indigenous peoples in the Americas, Africa, Asia and Oceania. And the growing interface between mining companies and communities, particularly in remote regions, has continued in the post-colonial era. There have often been major and unfortunate consequences for Indigenous peoples, whose populations have higher 254

For the Indigenous communities their relationship with the land is deep seated and is frequently based on religious beliefs forming part of their heritage. It is difficult for Western Societies to understand the strong connection between the Indigenous Peoples, their land, and its resources. There is a big cultural chasm that in many instances can only be bridged with difficulty. A quite comprehensive list of potential negative impacts of mining on Indigenous populations has recently been provided by the International Council on Mining and Metals (2010). It is as follows: •• physical or economic displacement and resettlement •• reduced ability to carry on traditional livelihoods due to loss of access to land and/or damage or destruction of key resources (forests, water, fisheries) •• displacement of artisanal miners •• destruction of, or damage to, culturally significant sites and landscapes – both tangible and intangible •• social dislocation and erosion of cultural values as a result of rapid economic and social change (eg the shift from a subsistence to a cash economy) •• social conflicts over the distribution and value of miningrelated benefits (eg royalties, jobs) •• increased risk of exposure to diseases such as AIDS, tuberculosis and other communicable diseases •• increased exposure to alcohol, gambling and other ‘social vices’ •• further marginalisation of some groups (eg women) •• ‘outsiders’ (eg artisanal miners) moving on to traditional lands due to areas being opened up by the construction of roads 1

This report originated in the work of the major mining industry supported project – Mining, Minerals and Sustainable Development (MMSD) – which ran for two years from 2000, and aimed to evaluate the role of the minerals, mining and metals sector in the transition to sustainable development. Mineral Economics

chapter 16 – Mining and Indigenous Populations •• large-scale uncontrolled in-migration contributing to increased competition for resources and social tensions. There is, of course, a list of positive impacts of mineral development. These include better access to infrastructure, health services, education and employment opportunities, all of which have been discussed elsewhere in this volume. As we have seen in earlier chapters, there are various stakeholders in any new or continuing mineral sector investment. Many of these groups are likely to gain from new mineral exploitation. Yet, as the suggested taxonomy in Table 16.2 implies, there is potential for the interests of other stakeholders to overwhelm those of Indigenous populations in any politically-driven decision-making process to undertake new resource development.

no-one.’ This allowed the colonising power to claim all of the land mass and to set up a property rights regime that largely excluded the indigenous population. In combination with a view that indigenous Australians were, at best, ‘second-class’ citizens the results were disastrous for their ensuing development. Indeed it was only in 1967 that Aboriginal people were granted full citizenship rights. At that time, the Australian electorate passed a referendum that modified the Australian Constitution to place Aboriginal people on an equal footing to other Australians2. After Federation in 1901, two parts of the Constitution (Sections 51 and 127) had specified that Aboriginal people should be treated differently. Section 51 (xxvi) stated that: The Parliament, shall, subject to this Constitution, have power to make laws for the peace, order and good government of the Commonwealth with respect to the people of any race, other than the aboriginal people in any State, for whom it is necessary to make special laws.

It is important, however, to acknowledge that mining companies (particularly those with a global focus) have become much more culturally aware of Indigenous populations in mining regions in the past 20 years. Many have now developed policies and expertise in their interactions with these Aboriginal people.

Section 127 stated that: In reckoning the numbers of people of the Commonwealth, or of a State or other part of the Commonwealth, aboriginal natives should not be counted.

Indigenous Australia Some historical background In the report of the Aboriginal Land Rights Commission (1974), Justice Woodward noted that: At the beginning of the year 1788, the whole of Australia was occupied by the Aboriginal people of this country. It was divided between groups in a way which was understood and respected by all.

A wide majority of electors voted in 1967 to remove the highlighted words in the two key sections. This at last helped to create a foundation for more equal treatment of Aboriginal people. In a widely quoted speech Mick Dodson (1998) provides a stark perspective on the historical marginalisation of Indigenous Australians:

Over the last 186 years, white settlers and their descendants have gradually taken over the occupation most of the fertile and otherwise useful parts of the country. In doing so, they have shown scant regard for any rights in the land, legal or moral of the Aboriginal people. At the time of European settlement in early 1788, the British Government took the view that the Australian land mass had been terra nullius – ‘land belonging to

Before 1967 Aboriginal and Torres Strait Islander peoples were … not free, for example, to travel between imposed state borders nor within states – no matter where the borders of our country lay – and we were not entitled to an Australian passport although many of us had already fought and died overseas 2

It took a number of years after 1967 for full rights to be granted in all states.

Table 16.2 Stakeholders in resource sector investments. Affected group

Economic impact

Social and cultural impact

Potential total impact

Indigenous

Potentially positive

Threatening and even potentially catastrophic

Threatening and even potentially catastrophic

Residential

Potentially positive

Potential loss

Potential small gain or loss

Occupational

Positive

Minimal

Positive

National government

Positive

Variable

Positive

Total population

Positive

Variable

Positive

Shareholders

Positive

None

Positive

Financial institutions

Positive

None

Positive

Local communities

Others

Mineral Economics

255

Chapter 16 – MInIng and IndIgenouS popuLatIonS in two world wars. We had to have permission to marry and we were not even counted in the census of the people of this country. In fact, for more than a century of non-indigenous presence in our country, our humanity was actively denied – in many places the births of our children were recorded on livestock records … Only if we were prepared to embrace the dominant status quo and renounce our identity could we have access to the spoils of citizenship – education, health care, housing and paid employment, to name just a few. Studies by anthropologists suggest that the Aboriginal population of Australia in 1788 stood somewhere in a range between 315 000 and more than a million – see Horton (1993). Over the next century and a half, the impact of conflict with European settlers, land dispossession, disease and general social and cultural disruption led to a major decline in their numbers. In their paper on the health of indigenous Australians, Howitt, McCracken and Curson (2005) argue that: Prior to their colonial encounter with Europeans, Aboriginal Australians enjoyed a level of health higher than that enjoyed in many parts of Europe at the same time. They were apparently free of many of the infectious diseases such as smallpox, measles, whooping cough, syphilis, scarlet fever, tuberculosis and influenza, which were prevalent in Europe, and did not suffer from conditions such as diabetes, hypertension, renal failure, coronary disease and cancer that have plagued their recent health profile. Their relative good health disappeared over the next few decades, affected in part by their lack of immunity to many of these European-based diseases, as well as by displacement and colonisation by the dominant European society. Butlin (1983, p 175) estimated that by 1850 the combined impact of resource competition and introduced disease would result in a situation in which the Aboriginal population of South East Australia stood at only ten per cent of its level in 1788. At a national level, it was not until the immediate post-World War II period that this situation stabilised and the Indigenous population began rising again. Some details of these movements since Federation appear in Figure 16.1.

Recent comparative data In large part due to their different and discriminatory treatment, Indigenous Australians have not shared in the economic development experience in the same way as other Australians since 1788. There have been some improvement in outcomes across a range of areas since the early 1970s – see Altman, Biddle and Hunter (2004) – but Indigenous employment, income, housing, education and health outcomes still trail those of Australia’s non-Indigenous population. 256

FIg 16.1 - Estimates of Australia’s Indigenous population 1901 - 2010

(source: Australian Bureau of Statistics).

At the 2006 Census, the estimated resident population of Aboriginal and Torres Strait Islanders in Australia was 517 200. It had reached about 550 000 by 2010. This was an estimated 2.7 per cent of the total resident population. It had grown at a rate of 2.3 per cent per annum since the 1996 Census (compared with the national growth rate of about 1.5 per cent per annum). While this recent growth in the Indigenous population is more similar to that in developing rather than developed nations, one contributing factor is that some people, who have not done so previously, may now identify themselves as Indigenous. As can be seen in Table 16.3, over half of Indigenous Australians lived in New South Wales (NSW) and Queensland (Qld) in 2006. There are also significant populations in Western Australia (WA) and the Northern Territory (NT). Relatively few aborigines live in Victoria, South Australia (SA), Tasmania or the Australian Capital Territory (ACT). More than 30 per cent of the population of the NT consists of aboriginal people. The highest percentages in the states were 3.8 per cent in WA and 3.6 per cent in Qld. The comparison in the final two columns of the table provides an alternative way of recognising that the percentage shares of Indigenous people in Qld, WA and the NT are higher than the total population shares of those areas in the national total, while those in the other states and the ACT are lower. Another interesting perspective on Australia’s Indigenous population is gained by considering its age distribution. As can be seen from Table 16.4, the median age of Aboriginal people at the 2006 Census was 21 years, compared to 37 years for the non-Indigenous population. In percentage terms, there were almost twice as many Indigenous children under 15 years, but only three per cent of Indigenous people were more than 65 years, as opposed to 13 per cent of the nonIndigenous population. Another useful way to assess the fortunes of Australian Aboriginal people is by considering the component parts of the Human Development Index – life expectancy, income levels and educational achievement. Mineral economics

chapter 16 – Mining and Indigenous Populations Table 16.3 The distribution of Aboriginal and Torres Strait Islander Australians at the 2006 Australian Census (source: Australian Bureau of Statistics). State and Territory

Indigenous population '000

Total population '000

Percentage of state or territory population

Percentage of Indigenous population

Percentage share of total population

New South Wales

148

6817

2.2

28.7

33.8

Victoria

31

5128

0.6

6.0

25.4

Queensland

146

4092

3.6

28.3

20.3

South Australia

26

1568

1.7

5.0

7.8

Western Australia

78

2059

3.8

15.1

10.2

Tasmania

17

490

3.5

3.3

2.4

Northern Territory

67

211

31.8

12.9

1.0

Australian Capital Territory

4

334

1.2

0.8

1.7

517

20 184

2.6

100.0

100.0

Australia

Table 16.4 Data on age distribution of Indigenous and non-Indigenous Australians 2006 (source: Australian Bureau of Statistics). Aboriginal and Torres Strait Islander people

Non-Indigenous population

Median age (years)

21

37

Percentage under 15 years

37

19

Percentage 65 years and over

3

13

As can be seen from Table 16.5, the average life expectancy for Indigenous Australian men in the 2005 - 2007 period was 67.2 years, compared to 78.7 years for non-Indigenous men. For Indigenous women in Australia, life expectancy was 72.9 years, versus 82.6 years for non-Indigenous women. So for the total population average life expectancy for Aboriginal Australians was about 70 years, and that for non-Indigenous Australians 80.5 years – almost an 11-year difference. Table 16.5 Estimated life expectancy – Indigenous and non-Indigenous Australians – 2005 to 2007 (source: Australian Bureau of Statistics). Aboriginal and Torres Strait Islander people

Non-indigenous population

Difference

Men (years)

67.2

78.7

11.5

Women (years)

72.9

82.6

9.7

Every individual respondent in the Census is expected to complete a question about income before tax. The Australian Bureau of Statistics (ABS) reports these data in income ranges in various geographical classifications from collection districts (groups of around 250 households) to national level. It also publishes estimates of median incomes for individuals and families. At the 2006 Census the estimated median individual annual incomes for Indigenous Australians aged over 15 years stood at just under $14 500 (derived Mineral Economics

from Table 16.6). This was 59 per cent of the median annual individual income for all Australians of $24 500. Percentages for Aboriginal people varied between states and territories, with Tasmania (around 80 per cent) being the closest to parity with the total state estimate. The figure in WA was just over 50 per cent. The lowest figure was in the NT, with around 30 per cent. Median incomes in Indigenous Australian households stood at $41 100/a, around 77 per cent of the national family median of $53 600/a. But it is important also to recognise that the average Aboriginal household contained 3.4 people, compared with the average of 2.6 persons in non-Aboriginal households. As Table 16.6 shows, there were also considerable variations between the states and territories in the levels of Indigenous household incomes and their percentages of non-Indigenous incomes. Formal educational participation and outcomes of Indigenous Australians have also been notably less than for the non-indigenous population – see Table 16.7. As well as income, health and education, it is also instructive to consider labour market outcomes. Consistently over time for Indigenous Australians, compared to non-Indigenous Australians: •• workforce participation rates have been lower •• full-time employment rates have been lower •• unemployment rates have been higher. The data reported in Table 16.8, derived from ABS (2008a), identifies recent differences in employment, participation and unemployment rates between Indigenous and non-Indigenous Australians. Finally, it is instructive to report where Indigenous Australians live. The authors of ABS (2008b) estimated that 32 per cent lived in the major cities, 44 per cent in regional areas and 24 per cent in remote or very remote areas. While Aboriginal people are becoming more urban in their settlement patterns, more than 95 per cent of the non-Indigenous population now live in the major cities or regional areas, and less than five per cent in remote or very remote areas. 257

chapter 16 – Mining and Indigenous Populations Table 16.6 Median weekly incomes of Indigenous and non-Indigenous individuals and households for Australia, the states and Northern Territory at the 2006 Australian Census (source: Australian Bureau of Statistics). Individual incomes

Household incomes

Indigenous

Non-Indigenous

Per cent

Indigenous

Non-Indigenous

Per cent

New South Wales

296

464

63.8

727

1042

69.8

Northern Territory

215

712

30.2

837

1324

63.2

Queensland

318

481

66.1

899

1037

86.7

South Australia

263

436

60.3

673

891

75.5

Victoria

332

457

72.6

763

1023

74.6

Western Australia

254

507

50.1

787

1071

73.5

Tasmania

323

402

80.3

775

802

96.6

Australia

278

471

59.0

791

1031

76.7

Table 16.7 Formal educational outcomes of Indigenous and non-Indigenous Australians aged over 15 years – 2006 Australian Census (source: Australian Bureau of Statistics). Indigenous

Non-Indigenous

Completed Year 12

22.2%

47.4%

Completed less than Year 12

75.4%

51.7%

Did not go to school

2.5%

0.9%

Post-school qualifications

21.0%

43.5%

Given the economic geography of the resources sector, the entries in Table 16.9 provide an indication of the interaction between it and remote Indigenous communities. In addition to this, there has been considerable mineral exploration activity, much of it focused in WA, Qld and NT, where the interface with remote settlements has been greatest. Table 16.9 Mining operations in remote parts of Australia. Industry sector Coal mining

Table 16.8 Differences in labour market indicators between Indigenous and non-Indigenous Australians in 2008 (source: Australian Bureau of Statistics). Indigenous

Non-Indigenous

Employment/adult population ratio (%)

53.8

72.7

Unemployment rate (%)

16.5

5.1

Participation rate (%)

70

76.5

Though the coal industry in NSW is located close to significant Aboriginal populations, the main interface of the resources sector in Australia with Aboriginal people in the recent past has been in those outer regional areas that the ABS describes as ‘remote’ or ‘very remote.’ The estimated Indigenous population of these areas is around 150 000 and as Altman (2004, p 518) has noted, there are about 1200 indigenous communities in these areas. In this part of the country the related issues of land rights, native title and economic development have become much more important over the past two decades. It is important to note as well the growing significance of these issues in relation to coal in NSW and Qld and coal seam gas in Qld. By early 2012 there were around 25 native title agreements for mining leases in NSW alone, mostly in the coal industry, as well as a larger number of exploration agreements. 258

Operation in remote areas Some

Oil and gas extraction

Considerable

Iron ore mining

Considerable

Copper mining

Considerable

Gold mining

Considerable

Mineral sands mining

Little

Silver-lead-zinc mines

Some

Other metal mining

Some

Other mining

Little

Given the demographic and socio-economic profile of Indigenous people and the location of mining activities there are some important implications for many Aboriginal Australians. On the one hand mining has the potential, through employing Indigenous workers and supporting Indigenous communities, to improve their economic and social wellbeing to levels similar to those of other Australian citizens. Yet on the other hand, through the imposition of an invasive outside culture, mining also has the potential to undermine and even destroy the social and cultural framework of these Indigenous communities. Managing the positive and negative impacts is a major challenge for Indigenous communities and also for government. The public sector, through the fiscal system, will generally benefit from mining, but it must face the reality that short-term taxation benefits may be more than offset by social challenges of both a short-term and longer-term nature. Mineral Economics

chapter 16 – Mining and Indigenous Populations

Indigenous Australia and mining An overview As we have seen, Australia’s Aboriginal population declined substantially from the beginning of European settlement until the end of 1945. The impact that the expansion of mining had on surrounding Indigenous communities must have been significant following the establishment of large mineral industry-based towns – such as Newcastle, Bathurst, Ballarat, Bendigo, Wollongong, Broken Hill, Kalgoorlie and Mount Isa – as well as a variety of smaller mining towns and settlements.

land area. Furthermore, since a substantial part occurred in arid environments, surrounding environmental impacts tend to be low. With the decline of the industry between 1914 and 1960, its impact was also lessened. In remote areas cattle and sheep station development exerted considerably greater influence than mining in disturbing Indigenous lifestyles. There was a substantial change with the onset of the resources boom in the early 1960s. At this time major new development took place in regions such as the Pilbara, Central and North Qld, and the Eastern and Northern Goldfields of WA and in parts of the NT. Altman and Nieuwenhuysen (1979, p 41) noted that: A small number of extremely remote missions and settlements have come into sudden prolonged contact with the Western world owing to discoveries of minerals at or near Aboriginal reserves. The major discoveries to date have been bauxite at Gove in the Arnhem Land and at Weipa in the far north of Queensland, and manganese at Groote Eylandt off the Arnhem Land coast. Large extractive plants have been established by Nabalco, Comalco and GEMCo (… a subsidiary of BHP) respectively. The communities that have suddenly found these companies on their doorsteps (literally in some cases) are Yirkkala mission at Gove, Weipa and Aurukun in Queensland, and Angurugu mission and Umbakumbu on Groote Eylandt.

For example, in their centenary history of Kalgoorlie Boulder and the Eastern Goldfields of WA, Webb and Webb (1993, pp 176 - 226) report several cases in which gold miners and prospectors came into violent conflict with Aboriginal groups. Blainey (2003) records similar experiences relating to the gold rushes in the NT. To place the current discussion in an appropriate perspective, Table 16.10 provides a parallel chronological summary of some of the key developments that have affected Aboriginal Australians and those affecting Australian mining in the period since European settlement began. Following the exhaustion of alluvial gold, one factor militating against excessive contact between Europeans working in the mining sector and Aboriginals was that mining, in contrast to the pastoral and agricultural industries that it had stimulated, disturbed only a small

These new projects dramatically enhanced the economic growth of WA, the NT and Qld. They also

Table 16.10 Australian Aboriginals and Australian mining – some relevant dates. Dates

Key development affecting Indigenous Australia

1788

First permanent European settlement in Sydney.

1788 - 1850

Establishment of six colonies, pastoral-based economy, with limited infrastructure and slow population growth. Limited impact on Aboriginal Australia.

1851

Key mining development Discovery of copper near Adelaide in South Australia in early 1840s. Discovery of gold at Hill End, New South Wales (Edward Hargraves) followed by major finds close to Melbourne.

1851 - 1865

Aboriginal Australians driven off traditional lands.

Dramatic impact of Gold Rushes on overall economic development and diversification of the economy.

1865 - 1890

Aboriginal Australians driven off traditional lands by expansion of agricultural and pastoral economy.

Expansion of mineral economy. Gold found in Queensland, Northern Territory, Tasmania, discovery of Broken Hill (1883), Tasmanian base metals, coal in New South Wales and Victoria.

1890 - 1910

Aboriginal dispossession continues.

Significant impact of Western Australian gold rushes leads to further agricultural development.

1910 - 1960

Agriculture expands further. Further harmful impact on Indigenous Australia.

Maturation of mining industry. Coal important in New South Wales and Victoria, gold in Western Australia, iron ore in South Australia, major base metals deposits exploited in Broken Hill and Mount Isa. Mineral economy share of total production contracts.

1960 - 1990

Some undesirable impacts of mineral development on remote aboriginal populations in Pilbara, North Queensland, Northern Territory. Clash of Western and Indigenous cultures.

Industrialisation of Japan and Asia leads to strong mineral demand. Associated mineral resources boom in Australia, with development of remote areas. Dramatic emergence of iron ore, oil and gas, nickel, bauxite as well as major expansion of coal industry.

1992

High Court supports Native Title in Mabo versus Queensland case. Major implications for mining industry.

Since 2000

Large companies embrace Aboriginal employment policies in new fly-in, fly-out era Chinese expansion leads to major minerals boom (super cycle?)

Mineral Economics

259

chapter 16 – Mining and Indigenous Populations bolstered national exports and, during the early 1970s, brought strong increases in the Australian dollar exchange rate. There is now a major interface between mining and Aboriginal Australians in places such as the Eastern and Northern Goldfields of WA, the Pilbara, the Kimberley, the Murchison, all of the NT, outback Qld in places such as Weipa, Mount Isa and Cloncurry and in outback NSW. This is the continuation of a process that began in the middle of the 19th century. Writing in the early 1980s on ‘How to Balance the Aboriginal Interest in Resource Development’, in an edited volume, Resource Development and the Future of Australian Society, the eminent former Governor of the Reserve Bank, Coombs (1982, p 239), observed that: … the use of the word ‘balance’ suggests that what is sought is some kind of equality in sacrifice and benefit between the Aborigines concerned and those who direct and profit from the exploitation of the resources concerned. Frankly I doubt whether, in any real sense, such equality is possible. What the mining entrepreneur puts at risk is the opportunity to use his capital and entrepreneurial skill elsewhere and what he gains in the extra return he obtains by using those resources in the chosen mining venture. On the other hand what the Aborigines put at risk is a whole lifestyle; a lifestyle which they have demonstrated over 200 years that they prefer to that offered by the white Australians: what he ‘gains’ is financial and material benefit which past experience suggests will prove destructive of that lifestyle and of the Aboriginal values it embodies. While acknowledging that many Aboriginal people would like to incorporate some components from the European society into their lifestyles, Coombs argued that those living in a traditional lifestyle should have the right: •• to refuse to negotiate •• to reject proposed agreements and that •• they should have access to proper advice and expertise concerning the likely impacts of proposed developments. Recall our simple diagram (Figure 14.1) describing the initial impact of mining on the occupational, residential and Indigenous communities in a mining town. This is reproduced in Figure 16.2. The challenge is to move the Indigenous community ‘circle’ to the right so that all of its members derive positive benefit from the development of a mine3. One result of meeting this 3

This assumes that such an outcome is both possible and desired by Indigenous people. As Coombs’ argument shows, this is not always the case. During the last decade a number of Aboriginal groups, well informed regarding the potential economic benefits of mining, have nevertheless fought hard to stop mining projects. One prominent example is the case of the Mirrar people, who joined with environmentalists to prevent the opening of the Jabiluka uranium mine in the Kakadu National Park in the Northern Territory.

260

Fig 16.2 - The threat of mining to Indigenous communities.

challenge will be that many more Indigenous citizens obtain employment in the mining industry. The interface of mining with Indigenous populations has taken on a much higher profile in Australia in the past two decades. This prominence emerged particularly after the recognition by the High Court of Native Title in the Mabo Case in 1992 and the subsequent passage by the Australian Government of Native Title legislation. As foreign (including Australian) mining companies have moved around the world in larger and larger numbers and the globalisation of mining becomes more complete, it has also taken on considerably greater importance elsewhere. In the affected mining towns before 1990, there was usually indifference by companies towards the welfare of nearby Indigenous communities. There was minimal economic contact though there tended to be some social interaction. Rogers (1973, p 133) found that, for example, there were only 193 Aboriginal people employed by 23 large and medium-size mining companies operating throughout Australia in 1968. It seems unreasonable to attribute all of the negative effects of European culture on Indigenous Australians to the mining companies. Yet, without strong government policy intervention, the clash between the globally-focused Western capitalist system and traditional Indigenous communities was almost certainly destined to generate adverse outcomes. There is now a broad literature about the interface between the mining industry and Aboriginal Australians4. In Boxes 16.1 and 16.2 in the Appendix there are two case studies – the first of Indigenous people living in the town of Roebourne in the Pilbara region of WA, and the second of how the Argyle diamond mine in the Kimberley region of WA has affected the local Indigenous population. They illustrate trends in the relations between miners and Aboriginal people.

The Mabo case and more recent developments Our preceding discussion has largely sidestepped the issue of land rights. Deriving from the doctrine of terra 4 See for example the volumes of Cousins and Nieuwenhuysen (1984), Howitt, Connell and Hirsch (1996), Connell and Howitt (1991), Rumsey and Weiner (2004) and Langton et al (2004). Mineral Economics

chapter 16 – Mining and Indigenous Populations nullius, the ownership of mineral resources in Australia is largely vested in the Crown. The essence of the prevailing regime is described quite effectively by the following quote from Industry Commission (1991): In Australia ownership of mineral resources generally lies with the Crown (in practice State/Territory and Commonwealth governments), regardless of who owns the land on the surface. This seems to reflect a widely held belief that mineral deposits are a fortuitous ‘gift of nature’ and that any net benefits flowing from their exploitation should accrue to the community as a whole rather than to whoever happens to own the surface rights. Subsequent development of these resources is based on the ‘regalian’ system where the Crown ‘leases the rights to exploit these resources to private firms under set conditions’. Always an underlying issue in the relationship between Indigenous and non-Indigenous Australians, land rights emerged strongly as a key issue in the 1970s and 1980s. The matter reached a climax in July, 1992 when the High Court of Australia brought down the Mabo judgement. This followed a series of earlier court cases and the passage of Aboriginal Land Rights legislation in the NT and SA. It has been succeeded by at two major pieces of Commonwealth legislation and some further High Court judgements. These are summarised in Table 16.11. Table 16.11 Some key dates regarding Native Title and resource development in Australia. Date

Event

Result

1788 1992

Terra nullius doctrine in force

Indigenous Australians had no land rights

1992

Mabo judgement by High Court

Recognition of the existence of Native Title

1993

Commonwealth Native Title Act

National regime for native title including ‘right to negotiate’ for native title claimants

1996

Wik judgement in High Court

Native Title could co-exist with pastoral leases

1998

Ten-point plan and Native Title Amendment Act

Sought to overcome complexities in initial legislation. Tended to favour government and business interests.

In rejecting the doctrine of terra nullius the High Court Judges recognised Native Title in certain situations. This judgement signalled potential and actual change to the position of Indigenous Australians as stakeholders in mineral development. Mason (1996, p 3) described the decision in the following terms: The High Court held that indigenous inhabitants of Australia held customary native title in their traditional lands in unalienated Crown land in Australia so long as it had not been validly extinguished by legislative or executive action, Mineral Economics

provided they have not surrendered their title or lost their connection to the land. In explaining Native Title, Horrigan (2003, p 19) argues that: Native title rights are traditional rights of access, use, or occupation concerning lands or waters. They are personal or group rights based on traditional laws or customs. The traditional land rights of Indigenous Australians survive unless the government lawfully takes them away, they are surrendered, or the Indigenous connection with land according to traditional laws and customs is otherwise severed. In commenting on this quote, O’Faircheallaigh (2012) noted that the first sentence is contentious because it does not mention that native title may amount to ‘possession’ or ‘ownership’. Court orders determining native title often refer to ‘rights, as against the whole world, to possession, occupation, use and enjoyment of land and waters’. Also, he observes that native title is a communal right, not a personal one. At the time of the Mabo judgement, there was major concern in the resources sector that it would adversely affect mineral exploration and mine development. Yet this has not been the case. The Mabo judgement and the subsequent Commonwealth Native Title Act passed by the Australian Government in December 1993 came as a shock to the Australian mining industry. Over the next few years it introduced growing uncertainty with respect to mineral exploration in ‘greenfields’ areas and encouraged many companies to focus their exploration activity on their ‘brownfields’ current mining leases instead. As time went by, this increased the attractiveness for Australian-based companies to explore in other nations5, but there has more recently been a recovery of exploration spending in Australian ‘greenfields’ areas. One of the major industry criticisms of the new Commonwealth legislation, and the requisite State Acts to support it, related to their complexity, the delays involved in processing claims for native title compensation and the impact of this on the profitability of projects in a period in which mineral prices and exchange rate movements were unpredictable. Also while Native Title had been extinguished on freehold land, uncertainty remained about the relationship between pastoral leases and native title. In the Wik case judgement in 1996 and some later decisions, the High Court established that when government grants pastoral leases, this does not necessarily extinguish surviving native title. Importantly, however, when these two forms of title coexist, leaseholder rights take priority. This judgement had application as well to situations in which there were mining titles on leasehold land. 5 Perhaps this was a positive outcome because it encouraged domestically focused entrepreneurs to look more widely at potentially profitable opportunities.

261

chapter 16 – Mining and Indigenous Populations Competing native title claims over mineral prospective areas further confused the situation facing miners. Financial institutions were also indecisive in their views about providing finance and security requirements. With its historical sympathies towards resource sector development, in 1997 the newly elected Howard Coalition Federal government sought ‘to strike a … balance between respect for native title and security for pastoralists, farmers and miners’ when it introduced the Native Title Amendment Act, based on its ten-point plan. As Horrigan (2003, p 21) explains, this covered the following areas: •• extinguishment of native title •• validation of pre-Wik actions •• facilitation of public infrastructure and government actions •• interaction between tenure rights and native title •• restrictions on Indigenous rights to negotiate •• frameworks for Indigenous Land Use Agreements (ILUAs) •• ‘just terms’ compensation. While the Howard legislation moved the balance from indigenous interests back towards business and commercial interests, the impact of Mabo and the Keating legislation had been profound. Two key changes were: the removal of the right to negotiate in relation to mine infrastructure and renewal of mining leases. The latter has been a major issue for extending the lives of mines established in the boom of the 1960s and 1970s. Another area involved extinguishment of native title on a range of tenures including Grazing Homestead Perpetual Leases, which accounted for some 13 per cent of the land area of Qld. In the past two decades, mining companies have accepted that Indigenous Australians are key stakeholders in the mineral development process. Almost all companies now opt to negotiate directly with Native Title claimants, often working through Native Title representative bodies, rather than pursue time-consuming judgements through the court system. The large majority are Section 31 agreements involving ‘future acts.’ A smaller number of ILUAs typically for large, more complex projects, provide for Indigenous involvement in cultural heritage and environmental management access to economic rents and potential for Indigenous people to benefit from surrounding economic development. These ILUAs vary greatly in their scope and content. As discussed particularly in the next chapter, there has been an inexorable trend towards mines operating as fly-in, fly-out (FIFO) operations in remote and even not so remote hinterland areas since the 1980s. One benefit of this practice is that it provides less interference with the societies and cultures of nearby Indigenous communities than the building of new towns. 262

Furthermore, as long as mining companies exhibit some flexibility, and members of Indigenous communities are amenable to training and want employment, there are potential economic development opportunities available for them. Particularly in periods of high mineral demand, when labour turnover in traditional mining workforces is high, the opportunities for indigenous workers in nearby local communities to establish themselves as alternative cost-efficient and stable sources of labour increases significantly. As mining companies recognise this option, they become much more amenable to using their services. The case studies in the Appendix for the town of Roebourne and for the Argyle diamond mine confirm that large companies such as Rio Tinto have recognised and now take advantage of this potential. These developments follow from similar successful efforts in places such as the Red Dog zinc mine in Alaska and in remote areas of Canada such as the North West Territories where the Ekati, Diavik and Snap Lake diamond mines are now in production. Global mining corporations now follow similar practices in many developing nations. Useful recent papers, which consider company policies and practices, and identify the broader academic literature in this field are those by O’Faircheallaigh (2010) and Haley and Fisher (2012). Against this background, an important associated trend in recent years has been a move away from the ‘community management/good neighbour’ policies6 associated with projects such as the Argyle diamond mine in its early years, towards formal negotiated agreements with local Aboriginal populations. Such frameworks hold apparent promise for local Aboriginal populations to claim economic rent in a more effective manner, while also addressing important social and cultural issues. O’Faircheallaigh and Corbett (2005, p 634) classify the emergence of such agreements in Australia in ‘three distinct legal/administrative contexts’. These are: 1. those resulting from legislation that recognises Aboriginal ownership of land and does not permit mineral development without formal agreement between Aboriginal landowners and mining companies 2. those in which legislation ‘creates as opportunity for negotiation of agreements, but allows mining to proceed in the absence of consent from Aboriginal landowners’ 3. those in which mining companies have no legal requirement to negotiate with traditional Aboriginal owners because they already hold mining leases granted before the Mabo decision, but where they decide to negotiate such agreements because of company policy. 6

A typical academic critique of such policies is that they patronise local Indigenous populations in a demeaning way. Lawrence (2005) provides such an analysis in her assessment of employment and training programs available to the Warlpiri people in the Central Australian gold mining industry. Mineral Economics

chapter 16 – Mining and Indigenous Populations The authors identify the Aboriginal Land Rights (Northern Territory) Act 1996 as an important example of the first legal/administrative context, while the Commonwealth Native Title Act 1993 provides the main illustration of the second situation. In the first context, Aboriginal negotiators are in a stronger bargaining position, ceteris paribus, than in the second. The third legal/administrative context is also important. Even though they are not legally required to do so, large companies may choose to negotiate agreements with local indigenous people for a variety of reasons. The most important seems to be that such policies are more likely to ensure their continuing ‘licence to operate’ in a broader global environment over the long term. The decision by Rio Tinto in the 1990s to follow such a practice is noteworthy in this regard, and it has now been followed by several other large companies. Despite this apparently positive change for Indigenous populations, there has been some criticism of the outcomes. The papers by O’Faircheallaigh and Corbett (2005) and Lawrence (2005) provide two examples of such analysis. In focusing on Indigenous participation in the environmental management of mining projects, O’Faircheallaigh and Corbett considered 45 agreements using a range of assessment criteria. They concluded that: … while agreements certainly have the potential to enhance Aboriginal participation in environmental management, a majority do not have that effect, reflecting the weak negotiating position of many Aboriginal peoples in their dealings with mining companies.

Indigenous employment policies Reflecting the changing approach of major mining companies, the Minerals Council of Australia (representing Australia’s large mining companies) signed a Memorandum of Understanding (MOU) with the Australian Government in 2005 to work together with Indigenous Australians to ‘build sustainable, prosperous communities’. Two elements of this MOU involved increasing employment for Indigenous people in the mining industry and supporting business enterprises run by Indigenous people. An overall aim of the initiative has been to reduce the social and economic disadvantage gap that Aboriginal Australians have faced for more than two centuries of non-Indigenous settlement. One reflection of the growth of Indigenous employment policies in Australia can be seen from national Census data. At the time of writing this chapter, these data are available for 2001 and 2006. At the 2001 Census, the ABS estimated that the mining industry employed 1390 Indigenous workers (1.9 per cent of total employment in the industry at that time)7. By 2006 there were 2488 7

In their report on Indigenous employment in Australian mining, Tiplady and Barclay (2007) also refer to a study by Tedesco, Fainstein and Hogan (2003), which estimates that Indigenous mining employment in 2001 - 2002 was 2460 (or 4.6 per cent of the total mining workforce).

Mineral Economics

Indigenous mining employees (2.4 per cent). With the expansion of the industry after 2004, the subsequent initiation of more widespread Indigenous employment policies, particularly by companies such as Rio Tinto and BHP Billiton, and allowance for under reporting of Indigenous employment in Census data, it seems likely that Indigenous employment in Australian mining is currently well in excess of 5000 people. The release of 2011 Census data will serve to validate this contention.

Looking to the future The interface between global capitalism and Indigenous populations with new and existing mining projects is destined to continue. The change that has occurred in places such as the Pilbara and the East Kimberley is unlikely to be reversed. Though gaps in economic and social status have continued between Indigenous and non-Indigenous Australians, recent developments suggest that the mining industry has a reasonable chance of contributing to their closure. As a result, Indigenous Australians will emerge during the next two or three decades as successful stakeholders in a world-class mining industry. Yet they will also need to take advantage of educational and occupational opportunities so that they can pursue alternative career and lifestyle opportunities when the mines in their areas become exhausted. Withstanding the seductive appeal of the excesses of global capitalism and maintaining their cultural identity will be a major challenge for Indigenous Australians and other Indigenous peoples. The general discussion in this chapter about the interface of mining with Australia’s indigenous population is also now happening with great intensity in many other countries. Mining professionals, many of whom will be working in remote areas in mineral rich developing nations, will face the difficult, though stimulating challenge of operating in close proximity with Indigenous people. Maintaining social and cultural diversity, while delivering economic benefits and economic opportunity to generate sustainable economic outcomes, will continue to be a major task for them.

References Aboriginal Land Rights Commission, 1974. Second report, Commonwealth Parliamentary Papers, April, Canberra. Altman, J C, 2004. Economic development and Indigenous Australia: Contestations over property, institutions and ideology, The Australian Journal of Agricultural and Resource Economics, 48(3):513-534. Altman, J C and Nieuwenhuysen, J, 1979. The Economic Status of Australian Aborigines (Cambridge University Press: Cambridge). Altman, J C, Biddle, N and Hunter, B, 2004. Indigenous Socioeconomic Change 1971-2001: A Historical Perspective, discussion paper no 266 (Centre for Aboriginal Policy Research, Australian National University: Canberra). 263

chapter 16 – Mining and Indigenous Populations Australian Bureau of Statistics, 2008a. 2006 National Census Community Profile Series (Catalogue No 2005.0), Canberra. Australian Bureau of Statistics, 2008b. National Aboriginal and Torres Strait Islander Social Survey, 2008 (Catalogue No 4714.0), Canberra. Blainey, G, 2003. The Rush that Never Ended, fifth edition (Melbourne University Press: Melbourne). Butlin, N G, 1983. Our Original Aggression: Aboriginal Populations of Southeastern Australia, 1788 - 1850 (Allen and Unwin: Sydney). Connell, J and Howitt, R (eds), 1991. Mining and Indigenous Peoples in Australasia (Sydney University Press: Sydney). Coombs, H C, 1982. How to balance the Aboriginal interest in resource development, Resource Development and the Future of Australian Society, CRES monograph no 7 (eds: S Harris and G Taylor), pp 239-251 (Centre for Resource and Environmental Studies, Australian National University: Canberra). Cousins, D and Nieuwenhuysen, J, 1984. Aboriginals and the Mining Industry: Case Studies of the Australian Experience, CEDA (Allen and Unwin: Sydney). Danielson, L and McShane, F, 2003. MMSD dialogue on Indigenous peoples in the mining sector, in Finding Common Ground: Indigenous People and their Association with the Mining Sector (International Institute for Environment and Development: London). Dillon, M, 1991. Interpreting Argyle: Aborigines and diamond mining in Northwest Australia, in Mining and Indigenous Peoples in Australasia (eds: J Connell and R Howitt), pp 119138 (Sydney University Press: Sydney). Haley, S and Fisher, D, 2012. Shareholder employment at Red Dog Mine, Institute of Social and Economic Research University of Alaska Anchorage [online], ISER Working Paper 2012-2 April. Available from: . Harvey, B, 2002. Sociology before geology: The development of social competencies at RioTinto [online], Minerals Council of Australia Sustainable Development Conference, 15 p. Available from [Accessed: 24 May 2012]. Horrigan, B, 2003. Australian native title law, policy, and practice – A report card, Economic Papers, 22(4), December, 16-27. Horton, D R, 1993. Unity and diversity: The history and culture of Aboriginal Australia, Year Book Australia 1994, pp 397-415 (Australian Bureau of Statistics: Canberra). Howitt, R, 1989. Resource Development and Aborigines: The case of Roebourne, Australian Geographical Studies, 27(2):155-169. Howitt, R, Connell, J and Hirsch, P (eds), 1996. Resources, Nations and Indigenous Peoples: Case Studies from Australasia, Melanesia and Southeast Asia (Oxford University Press: Melbourne).

264

Howitt, R, McCracken, K and Curson, P, 2005. Australian Indigenous health: What issues contribute to a national crisis and scandal?, unpublished paper. International Council on Mining and Metals, 2010. Good Practice Guide: Indigenous Peoples and Mining (International Council on Mining and Metals: London). Langton, M, Tehan, M, Palmer, L and Shain, K, 2004. Honour Among Nations? Treaties and Agreements with Indigenous People (Melbourne University Press: Melbourne). Lawrence, R, 2005. Governing Warlpiri subjects: Indigenous employment training programs in the Central Australian Mining Industry, Geographical Research, 43(1):40-48. Mason, A, 1996. The judge as law-maker, James Cook University Law Review, 1. Mineral Council of Australia, 2011. Minerals Industry: Indigenous Economic Development Strategy [online], Canberra. Available from: . O’Faircheallaigh, C, 2010. Aboriginal-mining company contractual agreements in Australia and Canada: Implications for political autonomy and community development, Canadian Journal of Development Studies/ Revue Canadienne D’études du Développement, 30:1-2:69-86. O’Faircheallaigh, C, 2012. Comments on earlier draft of chapter. O’Faircheallaigh, C and Corbett, T, 2005. Indigenous participation in environmental management of mining projects: The role of negotiated agreements, Environmental Politics, 14(5):629-647. RioTinto, 2011. Sustainable Development report 2009 and 2010: Argyle Diamonds, RioTinto, Perth. Rogers, P H, 1973. The Industrialists and the Aborigines – A Study of Aboriginal Employment in the Australian Mining Industry (Angus and Robertson: Sydney). Rumsey, A and Weiner, J (eds), 2004. Mining and Indigenous Lifeworlds in Australia and Papua New Guinea (Sean Kingston: Wantage). Tedesco, L, Fainstein, M and Hogan, L, 2003. Indigenous people in mining, ABARE eReport 03.19 (Australian Government: Canberra). Tiplady, T and Barclay, M A, 2007. Indigenous employment in the Australian minerals industry, project report (The Centre for Social Responsibility in Mining, University of Queensland: Brisbane). Warden-Fernandez, J, 2001. Indigenous communities and mineral development [online], Mining, Minerals and Sustainable Development Project, International Institute for Environment and Development, April, 30 p. Available from: . Webb, M and Webb, A, 1993. Golden Destiny: The Centenary History of Kalgoorlie Boulder and the Eastern Goldfields of Western Australia, 1070 p (City of Kalgoorlie: Kalgoorlie).

Mineral Economics

Chapter 16 – MInIng and IndIgenouS popuLatIonS

aPPendIX – Two case sTudIes Box 16.1 Roebourne in the Pilbara8 Between 1960 and 1980 the development of the iron ore industry dramatically changed the nature of the economy of the Pilbara. This followed the somewhat earlier establishment, but equally as notable subsequent development, of the oil and gas sector9. During these two decades, Australia rose from being a small iron ore producer to one of the two major iron ore exporting nations. By 1980, the Pilbara iron ore mines were responsible for around a quarter of world iron ore exports10. The pastoral industry had been established in the Pilbara region since the 1860s. The small nonIndigenous population had dominated the local economy after this time and many aboriginal people worked on cattle stations. They were generally treated as second-class citizens. A notable historical milestone in this era came in 1946 with the first major strike and station walk off by Aboriginals. Some relocated to Roebourne, one of the few small towns then in the Pilbara (together with places 8 9

This discussion draws liberally from Howitt (1989). For the sake of completeness, mention should be made of the ill-fated Blue asbestos mine at Wittenoom, which operated between 1947 and 1966. 10 This situation applied until 2000, but the proportion has been closer to one-third since about 2007.

such as Port Hedland and Onslow). In the ensuing years cash payments became more frequent for station workers and there was some improvement in Indigenous employment conditions. During this period, the town of Roebourne attracted Aboriginal people from outlying parts of the region and its society became fragmented. A strong presence of Christian fundamentalist groups apparently contributed to this situation. At the 1961 Census the Shire of Roebourne (now one of the four shires in the Pilbara with Ashburton, Port Hedland and East Pilbara) – see Figure 16.3 – had a population of only 568 people, though notably this figure did not include Aboriginal people. Between 1962 and 1975 major mining companies such as BHP, Hamersley Iron (a RioTinto company) and Robe River (also now associated with RioTinto) built ten new company towns11, four new railways, three new deepwater ports and associated infrastructure. The population of the Pilbara, and of the Shire of Roebourne (which included the new towns of Karratha, Dampier and Wickham), both increased dramatically. Population data for the Shire of Roebourne are plotted in Figure 16.4. The majority Indigenous population in the early 1960s changed to become a small minority with 11 Several of these company towns have subsequently been closed (eg Goldsworthy and Shay Gap). Others such as Newman and Karratha have become open towns.

FIg 16.3 - The Shire of Roebourne and the Pilbara Region in Western Australia. Mineral economics

265

Chapter 16 – MInIng and IndIgenouS popuLatIonS

nearby company towns, and major differences in the quality of community infrastructure between Roebourne and the nearby new towns of Karratha, Dampier and Wickham.

FIg 16.4 - Estimated population in the Shire of Roebourne – 1961 to 2010.

less than five per cent of the shire’s expanded population ten years later. By 2006 the Aboriginal population of just over 1700 people had recovered to be about ten per cent of the shire’s population. The key projects affecting the Shire and Town of Roebourne were the Hamersley Iron and Robe River developments with their associated company towns, railways and ports. Yet the dramatic growth of the shire’s economic base had little initial effect on the Aboriginal population of Roebourne. In the early stages Howitt (1989, 160) notes that: … the rapid influx of a construction workforce dominated by single men, a vastly expanded cash economy and exclusion from company towns combined with a downturn in the rural sector and significant policy changes to further destabilise fragile community structures. In comparison to the relative material wealth of the new towns, the poverty and powerlessness of most Aborigines was reinforced. Few Aboriginals were employed on iron ore projects. This was apparently reinforced by a request from the state Country (now National) Party to the companies to recruit workers directly from the cities to avoid disrupting the local pastoral industry. Construction of port facilities and associated infrastructure began at Dampier in 1963. Even though it was about 60 km away, the Roebourne Hotel was the only established hotel in the area. Hamersley employees widely used its facilities. Not unexpectedly, liaisons developed between these workers and local young Indigenous women and there was an increase in childbirths as a result. These placed an additional burden on the local community and few construction workers took responsibility for their children. In the ensuing years there were major problems with juvenile delinquency, general social breakdown, excessive alcohol consumption, exclusion of Aboriginals from the workforce and from

266

In terms of the suggested impacts of resource developments in Table 16.2, the potentially positive economic impacts for Indigenous communities did not materialise, and the threatening social and cultural impacts did emerge. In the first area, local Indigenous people were not recognised as stakeholders and were therefore unable to share in the emerging economic rents. They also had little opportunity to gain employment and earn incomes that would have improved their material wealth. Significant themes in the period since Howitt’s paper have been the emergence of the Reconciliation movement and the Native Title era following the Mabo Case. The assessment by Altman, Biddle and Hunter (2003) suggested only marginal improvement in the material wellbeing of Indigenous Australians during the 1990s and at the turn of the new millennium. By the time of the 2006 Census the relative economic positions of Indigenous and non-Indigenous populations in the Shire of Roebourne still differed dramatically. Median individual incomes for Aboriginal people were 43 per cent of those of the non-Indigenous population and household incomes 53 per cent. In a local government area in which official unemployment rates were low (two per cent) the indigenous population had an unemployment rate of 16.1 per cent. The relative economic disadvantage remained at apparently similar levels to where it had been 40 years earlier. This apparent lack of progress in economic terms does, however, overlook a distinct change in view and activities about indigenous relations within many large mining companies since the early 1990s. Harvey (2002) describes this change for Rio Tinto. There is now explicit recognition of social and cultural issues in local communities by the company and with it a new willingness to employ Indigenous people who live near resource developments. In March 2005, the Rio Tinto web page reported that eight per cent of the Hamersley Iron workforce were comprised of Indigenous Australians with a goal of 12 per cent by 2005. With more than 2000 people working in their Pilbara operations, the Indigenous workforce is now close to 200 people. At the 2006 Census, 85 Indigenous residents of Roebourne Shire worked in the mining sector. This was almost 20 per cent of the Indigenous workforce. The economic implications of this change for Aboriginal people living in Roebourne are much more positive than they were in the early 1970s.

Mineral economics

Chapter 16 – MInIng and IndIgenouS popuLatIonS

Box 16.2 The Argyle diamond mine and the East Kimberley region Europeans first settled the East Kimberley region in the 1880s. Families such as the Duracks initiated the pastoral industry, and there was a gold rush at Halls Creek at about the same time. During this period, the small port of Wyndham and the inland settlement of Halls Creek were established. The next major development came in the 1960s, when there was major public investment to develop the Ord River Irrigation Scheme. Using water from the newly constructed Lake Argyle, this scheme sought to convert 70 000 ha rangeland and pasture to irrigated farming land. The new town of Kununurra was established to service its operations. Dillon (1991) studied the effect of the Argyle diamond mine, located 185 km south of the small regional centre of Kununurra – see Figure 16.5 – on local Indigenous people. Following its discovery in 1979, mining began in 1981, initially with alluvial operations. There was an open pit mine from 1986 to 2009 and now there is an underground mine, which is scheduled to operate at least until 2019. The company was initially a joint venture between Ashton Mining, Conzinc Rio Tinto of Australia (CRA), and the Western Australian Diamond Trust. It is now fully owned by Rio Tinto. The mine is large and has been highly productive. Since reaching full-scale production in 1986, the

annual average value of its output has been around $500 M. The company has paid royalties of around $1 B to the Western Australian state government, as well as company taxes to the Australian Government. It has consistently employed around 1000 people. Throughout its life, the mine has used a FIFO (drive-in, drive-out) workforce. Over the past decade the workforce has moved from being mainly based outside the Kimberley region to being locally based, with a significant Indigenous component. The impact of the mine has been important for the Shire of Wyndham East Kimberley and of some significance for the neighbouring Shire of Halls Creek, but the growth of tourism and the continuing importance of agriculture has meant that mining has affected the area’s economy relatively less than the situation in the Pilbara. As Figure 16.6 shows, population growth in the East Kimberley region has been substantial since 1976 but it has not been explosive and overwhelmed the strong Indigenous influence. Dillon was concerned with the physical, social and economic impacts of the mine. In a relative sense he assessed that the physical impacts had been small. Even though the mine is large, it is isolated and remote. The nearest Indigenous population is at Mandangala outstation, some 10 km away. There are other small aboriginal communities at Doon Doon (25 km away) and Warmun (35 km from the mine).

FIg 16.5 - The Argyle diamond mine and nearby communities. Mineral economics

267

Chapter 16 – MInIng and IndIgenouS popuLatIonS

the Kimberley Land Council – signed the Argyle Participation Agreement in 2004. With its focus on economic participation and regional development, the movement towards greater Indigenous employment is reflected in this document. According to RioTinto (2011) Argyle Diamonds’ indigenous workforce increased from 20 per cent in 2005 to almost 25 per cent in 2010. It aims to increase this to 40 per cent, although it is not clear whether this change will come about as a result of a reduced mining workforce. FIg 16.6 - Population movements in the Shires of Wyndham East Kimberley,

and Halls Creek 1976 - 2006.

Cultural impacts were more significant. Initially the Argyle site generated controversy because of conflict between sites of significance, as set out in WA’s 1972 Aboriginal Heritage Act, and the political and economic imperatives of the state government pursuing policies of vigorous resource development. The action of CRA of undertaking exploration work on three sites of significance brought court action in 1980. The plaintiffs were unable to proceed because the WA Museum refused to act to obtain evidence that CRA had breached the Heritage Act. Yet this led to an agreement between local Indigenous people and the company, and to the company’s subsequent ‘good neighbour policy’. This episode did not adversely affect the long-term development of the mine, but it highlighted the sites of significance issue and the Aboriginal relationship to the land, which has become so important in the past decade. In its early years, economic impacts on balance were positive, yet Dillon perceived them to be relatively modest. At one level the company supplemented infrastructure in the nearby communities and made small royalty payments to nearby aboriginal groups. This policy tightened up during the 1990s to try to ensure that local communities used such payments productively. During this period, however, employment of local people at the mine was low. Yet, with the emerging focus of mining companies on sustainable development from the late 1990s, significant change began to emerge. There was a major change when the key stakeholders – traditional landowners, Argyle Diamonds and

268

One assessment of the economic status of Indigenous people in the Wyndham East Kimberley Shire can be gained from the 2006 Census Indigenous Peoples’ profile by comparing labour force, education and income data – see Table 16.12. While Aboriginal people have lower workforce participation rates (55.2 per cent against 70 per cent) and higher unemployment rates (5.2 per cent against 1.9 per cent), these differences were not as large as between Indigenous and nonIndigenous groups in the Shire of Roebourne. By contrast, however, real gaps remain in educational attainment between Aboriginal and non-Aboriginal people. Relative income levels of Indigenous people to non-Indigenous people were higher than those in the Pilbara. Yet unless and until Indigenous people in the East Kimberley increase their human capital, major differences seem likely to remain in their economic status. Table 16.12 Labour force, educational and income data for Indigenous and non-Indigenous Populations – Wyndham East Kimberley Shire – 2006 Census (source: Australian Bureau of Statistics. Indigenous

Non-indigenous

Participation rate (%)

50.7

85.4

Unemployment rate (%)

5.2

1.9

labour force indicators

education Did not go to school (%)

7.9

0.4

Completed Year 12 (%)

12.9

44.9

Bachelor degree and above (%)

1.5

17.8

Median weekly incomes ($) Individual

235

779

Household

783

1338

Mineral economics

HOME

chapter 17 Occupational Communities – The Mineral Sector Workforce Philip Maxwell Inroduction

Mining’s occupational community



Mining employment in developed and developing nations

The formal mining sector Artisanal and small-scale mining Mineral sector employment in Australia Historical trends Employment, value added and wages in mining

Occupational and educational structure



Location issues

Important mineral sector workforce issues

Gender imbalance



Maintaining a supply of well-trained professionals

The growth of fly-in, fly-out workforces Summary and conclusion

Introduction

Mining’s occupational community

In this final chapter, our focus is on mining workforces. Our discussion initially considers the size of this group globally, distinguishing between the formal mining sector and artisanal and small-scale miners. The dialogue then moves to Australia, initially reflecting on historical trends in mining employment and then considering the recent status and economic contribution of workers in the sector. The final section emphasises three key areas of interest relating to mining workers – gender imbalance; the challenge of maintaining a well-trained and suitably educated workforce; and the related issue of the major growth of fly-in, fly-out (FIFO) workforces and the challenges involved in sustaining this strategy.

As we saw in Figure 14.1, reproduced again here as Figure 17.1, one way to picture the economic and social fortunes of the residents in mining areas is in terms of occupational, residential and Indigenous communities. Those people employed directly in mining are its occupational community. In contrast to residential communities and Indigenous communities, all of this group derive net benefits from working for mining companies. Yet in many cases part, or even all of this occupational community, does not now reside in the local community near a mine. This has particularly been the case with the emergence of FIFO mining workforces since the mid-1980s.

Mineral Economics

269

chapter 17 – OccupatIOnaL cOMMunItIeS – the MIneraL SectOr wOrkfOrce nations such as Chile, China, Brazil, Peru and several other nations have sustained or improved their mineral competitiveness, based on these factors. Recall the nature of the economist’s production function: Output = f (land, labour, capital, technology) Land (which includes the mineral endowment), capital and technology are all important factors in the minerals sector. To manage these factors efficiently and effectively, the labour that is utilised needs to be well trained and educated. FIG 17.1 - The initial impact of new mining activity on a local community.

An alternative way to view the situation of people living in mining communities is in terms of Figure 17.2. Here the mining workforce (occupational community) is located in the mining town or district close to the mine but it also consists of FIFO workers. The former are the ‘residential occupational community’ located in the bottom area of the figure, while the FIFO occupational community live outside the mining town in the state capital, a regional centre or in another location. There are of course now many cases where there is no local community and the occupational community are all FIFO workers.

There is often a somewhat different situation between developed and developing nations that have large mineral economies. In the ‘formal’ mining sector in developing nations, lower wage structures typically mean that workforces are larger, and managers use more unskilled labour. Capital intensity has not been quite so high. A typical large mine in Australia or Canada may employ a workforce of 400 people. Since many of these mines are now located in remote regions, it is more likely that their workforces will be commuting FIFO workers. By contrast, a similar mine in Indonesia, Papua New Guinea or Tanzania might employ, say, 1500 people. Its workforce is more likely to be drawn from the surrounding local community though indigenous workers may also relocate to the mine from their distant villages, leaving their families behind. It is also important to mention mining employment in those countries, which have recently been in transition between socialism and capitalism. In the resource-rich nations of the former Soviet Union and Eastern Europe, and in countries such as China, Vietnam and Mongolia, mines typically have employed, and even still employ, relatively large workforces. This is a legacy of a previous system that ensured full employment, even though wage levels were low.

FIG 17.2 - Fly-in, fly-out workers and local communities.

Mining employment in developed and developing nations In developed nations, mining operations are capital and technology intensive. While only employing relatively small numbers of workers – located both close to mines and flying in and flying out – they require highly professional workforces. The wages and salaries of these personnel are high. The combination of strong mineral endowments, professional workforces, large capital investment and modern technology ensured that countries such as Canada, Australia and South Africa maintained their international mineral sector competitiveness in the last half of the 20th century. As we have moved into the new millennium, developing 270

FIG 17.3 - Relative capital and labour intensity in operating mines. Mineral economics

chapter 17 – Occupational communities – the mineral sector workforce A conceptual view of mineral sector employment and its relationship to the capital (and technology) intensity in mines appears in Figure 17.3. The upward arrows reflect recent and continuing trends towards greater substitution of capital and technology for labour. As we shall see later in this chapter, artisanal and small-scale mining is also important in many developing nations. This is labour-intensive mining with little use of sophisticated physical capital or technology.

The formal mining sector The International Labour Organization (ILO) collects employment data for large industry sectors for most nations in a systematic way. It is a straightforward task to download the data for mining and quarrying from their web site. Yet delays in the availability of data make it difficult to obtain accurate comparative data that are less than about four years old. Some data for the year 2008 appears in Table 17.1. The data covers Europe, North and South America and Australia in a reasonably comprehensive way but there are notable gaps for some African economies and for several Asian nations. In Europe most mining or oil and gas extraction is for domestic consumption. The notable exceptions are Russia, Ukraine and Poland. Russia (which is also in Asia) is a major minerals and energy province, while the latter two nations still depend on coal mining exports to the rest of Europe. Despite the perception that mining is a declining industry in Europe, in 2008 it still employed more than three million people. The United States has been a leading mineral producer for much of the last 150 years. It remains a major mineral producer in areas such as coal, oil and gas, copper and gold but a significant part of its production by value in the non-fuel sector is also for industrial minerals – see Campbell and Roberts (2003). Of the estimated 773 000 workers in the sector at the end of 2011, only just over 185 000 worked in the oil and gas sector, while 220 600 were employed in other mining. There were almost 367 000 people employed in support activities for mining (Bureau of Labor Statistics, 2012). With the impact of stronger mineral prices, average annual employment in the US mining grew from 512 100 in 2002 to 735 500 by 2011. Among the major mineral exporting nations, Australia’s minerals and energy sector employment is less than in South Africa, Canada and Brazil. The higher employment in South Africa and Brazil is, in part, a reflection of their status as developing nations, with the substitution of labour for capital. Yet in the aftermath of the Apartheid regime, mining employment has fallen consistently in South Africa. Given its large land area, strong recent economic growth, and major population base of around 200 million people in 2010, one might Mineral Economics

TABLE 17.1 An estimate of the world’s formal mining workforce in 2008 (in ’000) (source: International Labour Organization, United States Geological Survey). European nations

Major exporters

Bulgaria

35

Australia

161

Czech Republic

55

Brazil

781

France

22

Canada

202

Germany

109

Chile

99

Greece

16

South Africa

328

Italy

56

Peru

47

Norway

13

Poland

234

Russia (say)

1350

Romania

107

Mexico

183

Serbia/ Montenegro

32

Colombia

149

Other Americas United States

709

Slovakia

14

Venezuela

106

Spain

53

Ecuador

40

Sweden

6

Turkey

115

China

5350

Ukraine

600

India

550

United Kingdom

127

Other Europe (say)

80

Saudi Arabia

107

Kazakhstan

200

Other nations (say)

1000

Total Europe

3244

Total formal

13 000

intuitively expect employment in Brazil’s large-scale mining sector to be much higher than in Australia. Employment in Brazil’s oil and gas sector and in its iron ore industry makes an important contribution to the total. Canada’s mineral sector employment, which exceeded 200 000 in 2008, is more than that in Australia. But, as in the US, well over half of this is based in the oil and gas sector, while only perhaps 60 000 were employed in extracting coal, uranium and the non-fuel minerals. Among the developing nations, China stands out dramatically with its formal mining sector workforce of around 5.5 million people. From the available data, nations such as India, Mexico, Colombia, Saudi Arabia and Kazakhstan also have significant resource sector workforces. As better information becomes available it will be possible to include many other nations in the list in Table 17.1.

Artisanal and small-scale mining Artisanal and small-scale mining has historically been the most traditional form of mining. For example, the 271

chapter 17 – Occupational communities – the mineral sector workforce gold rushes in Australia were largely driven by smallscale mining, which then gave way to more capital intensive and larger mining operations as easily obtainable deposits became less available. Even today in Australia, individuals or small groups still hold small tenements as they search for a mineral bonanza. Similar stories apply in other mining nations. In many developing nations with considerable mineral endowments, artisanal and small-scale mining has a more significant economic and social role. As Hilson (2002) notes in one of his significant contributions to this field, it provides employment to many people in remote regions where few other economic opportunities exist, and it also contributes positively to the foreign exchange earnings and mineral export bases of several developing nations. Unlike the formal mining sector, in which larger companies participate, artisanal and small-scale miners often operate outside the public sector regulatory framework. Such operations often cause considerable damage to the physical environment, while workers are exposed to unsafe and unhealthy working surroundings. Such mining can also lead to cultural conflicts where outsiders invade the traditional lands of Indigenous communities. As developing nations have opened up to foreign investment in the mineral sector since the late 1980s, small-scale and artisanal miners have come more into potential conflict with the formal mining sector. Some key areas of difficulty include competition for land use, the availability of water and power, limited health services and regulating the environmental damage caused particularly by small-scale mining operations. It is now quite common for large mines in the formal sector to exist side-by-side with traditional artisanal miners. This is happening more and more in many African countries, and in nations such as Indonesia, Papua New Guinea and the Philippines. Managing this interface is a major challenge for host governments and large mining companies. Estimates of the importance of the level of employment in small-scale mining vary. In one of the World Bank web pages (World Bank, 2012) the following statement has been posted for several years: Today, an estimated 13 million people in about 30 countries across the world are small scale/artisanal miners, with about 80 to 100 million people depending on such mining for their livelihood. Hilson (2002) provided some more detailed estimates in 25 selected nations. The data in Table 17.2 are derived from his figures1. His list does not include several African nations in which significant artisanal 1

Where Hilson provides a range in his estimates, we have selected the mid-point.

272

TABLE 17.2 Estimates of employment in small-scale and artisanal mining in 2001 (source: derived from Hilson, 2002). Country

Estimated employment (000)

Argentina

6

Bolivia

70

Brazil

1000

Burkina Faso

60

China

4000

Colombia

150

Ghana

200

Ecuador

92

Guyana

15

Haiti

5

India

500

Indonesia

465

Malawi

40

Mali

200

Mexico

30

Mozambique

60

Pakistan

230

Papua New Guinea

55

Peru

20

Philippines

200

South Africa

18

Tanzania

525

Vietnam

38

Zambia

30

Zimbabwe

200

Other (say)

1800

Total

10 000

and small-scale mining takes place. Among them are Angola, Cameroon, Democratic Republic of Congo, Guinea, Niger, Nigeria and Togo. Also excluded are several Asian nations and the majority of countries in the former Soviet bloc. The numbers in the modified Hilson list add up to a little more than ten million people. If one allows for some of the additional nations, our view is that the numbers are likely to exceed 13 million people. These estimates should, however, only be taken as indicative. The number of artisanal and small-scale miners at any point will depend on mineral prices, the state of the world economy and a range of political factors2. 2 For some more recent estimates of ASM employment from selected African nations, as well as another commentary on factors affecting the size of the ASM workforce, see Hilson (2009). Mineral Economics

chapter 17 – OccupatIOnaL cOMMunItIeS – the MIneraL SectOr wOrkfOrce

MIneral SeCTOr eMPlOyMenT In auSTralIa

Employment, value added and wages in mining

Historical trends

The Australian Bureau of Statistics (2011) currently reports employment, wages, total income, total expenses, and value added data by industry subdivision. For the mining industry key subdivisions are coal mining, oil and gas extraction, metal ore mining (iron, gold, bauxite, copper, nickel, silver, lead, zinc and so on), non-metallic mineral mining and quarrying, and also exploration and other mining support services.

As we have seen in the preceding section, the resources sector in Australia now employs a relatively small workforce. This has not always been the case. In discussing the gold rushes of the 1850s, Blainey (2003, p 62) commented that: Gold checked and for a time reversed Australia’s tendency to become a land that favoured the big man. Whereas Australia’s first natural asset, the sheeplands, was grasped by a few thousand men, its second rich natural asset, the goldlands, was divided among hundreds of thousands of men. During the gold rushes, mining employed perhaps 20 per cent of Australia’s workforce. The exhaustion of alluvial gold meant that more capital-intensive largescale mining replaced labour intensive small-scale mining. Yet in the midst of the Western Australian gold rushes in 1901, mineral sector employment in Australia still stood at eight per cent of total employment. The Australian Bureau of Statistics (ABS) now publishes information regularly about employment by major industry sector. It also provides useful small area data on mining employment at the five yearly national census. As Figure 17.4 shows, there was a dramatic decline in mining employment as a percentage of total employment during and after the First World War. This downward trend continued until 1960. Even the 1960s Resources Boom reversed this trend only briefly. By the turn of the new millennium, the sector accounted for approximately 0.8 per cent of total employment – a tenth of its percentage level a hundred years earlier. In the past decade, however, there has been a change. As a result of the minerals boom after 2004, minerals sector employment grew significantly. By 2010 it had risen to an estimated 189 600, which was 1.7 per cent of national employment.

As can be seen from Table 17.3, in 2009 - 10 these workers (around 1.5 per cent of the workforce) contributed almost $86 B to industry value added in 2009 - 2010 (6.8 per cent of GDP). Reflecting its high degree of capital intensity, the average value added per mineral industry employee was almost $596 000. There was a wide variation between sectors, with the average worker in oil and gas responsible for adding over $1.6 M. This was more than double the next two highest sectors – metal ore mining – where value-added per employee was just over $776 000, and coal mining – $662 735. The average value added in non-metallic mining and quarrying ($156 231), and in the mining services area ($77 789) were very much lower than in the top three capitalintensive sectors. As a benchmark, the average value added per employee for all industry classes reported by the ABS for 2009 - 2010 was $82 753. Wages and salaries for mineral industry workers were dramatically higher than the national averages, continuing a trend that has held since the emergence of the resources boom period almost half a century ago. As Table 17.3 shows, average mining wages in 2010 of $116 219, were almost three times the national total industry average. Professionals and other workers in the oil and gas sector averaged more than $170 000/a, while coal and metal ore miners both received more than $121 000/a. This contrasted with people in the nonmetallic and quarrying sector, whose average was just over $69 000/a. The high wages in oil and gas, coal and metal ore mining reflect: payment for working in harsh environments payment for living in, or commuting to, remote locations • recognition of specialist training and responsibility in operating expensive capital equipment • a continuing skills shortage. One of the remaining segments of ‘Non-metallic and quarrying sector’ group are workers in the mines and quarries near to major cities, who extract and process industrial minerals. These lower value minerals, which include construction materials, typically do not attract such highly paid workforces. • •

FIG 17.4 - Mineral sector employment as a percentage of total

employment in Australia 1900 - 2010.

Mineral economics

Volatile mineral prices and wide swings in the mining business cycle, in combination with the factors 273

chapter 17 – Occupational communities – the mineral sector workforce TABLE 17.3 Wages and value added per employee in the Australian mineral industry 2009 - 10 (source: Australian Bureau of Statistics, 2011). Industry subdivision

Employment (000)

Wages and salaries ($ mill)

Average annual wages and salaries ($)

Value added ($ M)

Annual value added per employee ($)

Coal mining

34

4120

121 176

22 533

662 735

Oil and gas extraction

14

2383

170 214

22 573

1 612 357

Metal ore mining

46

5583

121 370

35 713

776 370

Non-metallic mineral mining and quarrying

13

898

69 077

2031

156 231

Exploration and other mining support services

38

3766

99 105

2956

77 789

Total mining

144

16 750

116 319

85 806

595 875

Total industry

10057

406 920

40 462

832 247

82 753

just discussed, have ensured that that there tend to be greater movements of labour in and out of the minerals sector than in most other parts of the workforce. This has particularly influenced the exploration sector and the fortunes of geologists. The high level of wages and salaries also reflect this factor, which has led at times to skilled mining professionals and other personnel being able to derive ‘quasi rents’ because they are in short supply for specific time periods.

it compared with the national average of 28 per cent across all industry groups. It reflects the interesting reality that a small well-trained and professional workforce had enabled Australia to establish and sustain an internationally competitive resources sector. By the 2006 Census, the number of graduates working in the Australian resources sector had risen to 19 299, which was 18.2 per cent of its workforce.

Occupational and educational structure

Workers in the minerals and energy sector generally live in the states or territories where they work3. The data in Table 17.5, also derived from the 2006 Census, reflect the rather different economic geography of the resources sector in comparison with the remainder of the Australian economy. Western Australia and Queensland, which accounted for about 30 per cent of national overall employment, had more than 65 per cent of mineral sector employment in this year. These percentages have been at similar levels for several decades.

The best source of occupational and educational structure data is the five yearly Australian Census. The information on occupational structure in Table 17.4 shows the strong representation of professionals, (15.6 per cent) and ‘blue-collar’ operational workers (64.5 per cent) in the industry at the 2006 Census. Managers and other ‘white collar’ workers accounted for 18.8 per cent. TABLE 17.4 The occupational structure of employment in the Australian mineral industry at the 2006 Census (source: Australian Bureau of Statistics, 2007). Category

Number

Percentage

Managers

9672

9.0

Community and personal service workers

508

0.5

Clerical and administrative workers

9543

8.9

Sales workers

411

0.4

20 134

18.80

Professionals

White collar workers

16 673

15.60

Technicians and trades workers

26 182

24.5

Machinery operators and drivers

37 112

34.7

Labourers

5636

5.3

68 930

64.50

1159

1.1

Blue collar workers Inadequately described / not stated Total

106 896

Using 2001 Census data on educational background, Hall (2003) noted that the number of mineral sector workers in Australia who held university degrees was 12 930. Representing 17.3 per cent of the workforce, 274

Location issues

Historically, the large majority of mining professionals and workers have lived in mining towns. Yet with the rise of FIFO work practices and major developments in communications technology, this situation has been changing. One indication of the changing reality is the rise in the metropolitan-based mining workforce, as well as that based in some key regional centres. Note in Figure 17.5 how the percentage share of total mining employees rose between 2001 and 2006 in major metropolitan centres and in selected other major regional centres. In 2006, almost 35 per cent of all mining employees lived in metropolitan centres, while more than 15 per cent were in the regional centres. This represented a combined increase of more than five percentage points of the mining workforce in five years. By contrast, even though their employment numbers rose, the shares of the major regional mining centres of Kalgoorlie, Broken Hill, Mount Isa, Port Hedland and Karratha fell by around two per cent between 2001 and 3

The emergence of greater use of fly-in, fly-out work rosters is now having some influence in this area with growing numbers of workers living in Sydney, Melbourne and Brisbane, for example, commuting to Western Australia. Mineral Economics

chapter 17 – OccupatIOnaL cOMMunItIeS – the MIneraL SectOr wOrkfOrce TABLE 17.5 Mineral sector employment in Australian states and internal territories – 2006 Census (source: Australian Bureau of Statistics, 2007). Mining employment State

Total employment

Numbers

Per cent

Numbers (000)

Per cent

New South Wales

20 319

19.0

2909

31.7

Victoria

6 280

5.9

2274

24.8

Queensland

30 724

28.7

1825

19.9

South Australia

5 967

5.6

690

7.5

Western Australia

40 084

37.5

936

10.2

Tasmania

1 630

1.5

205

2.2

Australian Capital Territory

90

0.1

176

1.9

Northern Territory

1 707

1.6

87

0.9

106 876

100.0

9184

100.0

Total

FIG 17.5 - Changing employment shares of mining workers in selected

locations at 2001 and 2006 Australian Censuses.

2006. Estimates of mineral sector employment in key centres for 2006 appear in Table 17.6.

IMPOrTanT MIneral SeCTOr WOrKfOrCe ISSueS Gender imbalance Mining has traditionally been a male-dominated industry in Australia and around the world. This shows through strongly at the 2001 and 2006 Censuses. As can be seen from Table 17.7, the Australian Bureau of Statistics estimated that 86.4 per cent of workers in the industry in 2001 were men. This fell to 85 per cent by 2006. The percentage share of women in the mining workforce increased by 1.4 per cent in the intercensal period, and there were increases during this time in the three main mining states – Western Australia, Queensland and New South Wales. It is important also to see this in a broader context. The percentages of men in the formal mining sector in Australia are not dissimilar to those in the major mineral exporting nations such as Canada, Brazil and Chile. Mineral economics

Because the mining industry dominates the economies of many remote towns in Australia, male to female ratios in excess of one are common, and sometimes they are as high as two or three. With their broader employment bases, the larger mining towns reflect a more even balance between the sexes. Progress towards gender balance in the industry has been slow. More women now study in disciplines such as geology (perhaps a third of entering classes) and metallurgy than previously but the professional mining disciplines remain dominated by men.

Maintaining a supply of well-trained professionals Because it plays a leading role in the world mining industry, Australia has become a major supplier of professionals to it. Like their Canadian counterparts, large and small Australian mining and exploration companies now operate throughout the world. Maponga and Maxwell (2000) observed that, by 1995, Australian-based resource companies operated in more than 70 nations. While the Asian economic crisis and an associated drop in mineral prices in 1997 led to a dramatic decline in offshore activity, there has since been a strong recovery. The cyclical nature of mining and the general contraction of the industry in Europe and the United States have, in recent years, adversely affected the supply of new mining graduates from these places. Because Australian mining schools were struggling to meet the shortfall previously supplied from these sources, member companies of the Minerals Council of Australia4 began showing major concern by the late 1990s. Their response was to produce a major report – Back from the Brink: Reshaping Minerals Tertiary Education – (Minerals Council of Australia, 1998). Quoting from the work of Nemitz in his contribution to this report, Brady (p 140)5 observed that universities in the European Union produced about 700 mining engineering graduates in 1990, universities in the USA and Canada produced about 250 and Australian universities about one hundred. Yet the output from European schools, which provided their graduates to a broader range of areas than mainstream mining, then entered a period of contraction, with many closing or merging with one another. In response, by 1997 Brady estimated that the numbers of graduates from Australia’s six mining departments at that time6 had only grown to an estimated 175. 4

5 6

The Minerals Council of Australia is the national representative body of state-based Chambers of Minerals and Energy that represent the major mining companies. They account for the large majority of production and employment in the Australian mining sector. Barry Brady was, at this time, Professor of Mining Engineering at the University of Queensland. University of Queensland, University of New South Wales, University of Wollongong, University of Ballarat, University of South Australia and the Western Australian School of Mines (Curtin University of Technology).

275

chapter 17 – Occupational communities – the mineral sector workforce

TABLE 17.6 Residence patterns of mining personnel at the 2006 Australian Census (source: Australian Bureau of Statistics, 2007). Area

Managers

Professionals

Other (operat ional)

Other (administrative)

Total

Sydney

577

718

1423

451

3169

Melbourne

491

953

957

452

2853

Brisbane

930

1560

1743

995

5228

Perth

2831

5938

10 096

3298

22 163

Adelaide

358

885

1151

415

2809

Other capitals

109

171

689

130

1099

5296

10 225

16 059

5741

37 321

Newcastle

292

411

3958

239

4900

Wollongong

153

228

1715

111

2207

Gold Coast

88

105

435

113

741

Sunshine Coast

80

81

457

40

658

Rockhampton

34

31

600

32

697

Total metro

Mackay

169

158

2253

222

2802

Townsville

132

233

1294

149

1808

Cairns

56

76

295

51

478

Geraldton

39

43

541

39

662

Mandurah

99

111

1038

103

1351

1142

1477

12 586

1099

16 304

Eastern Goldfields

228

436

2768

215

3700

Broken Hill

33

80

565

31

709

Major other urban

Mount Isa

102

320

1895

142

2459

Port Hedland

71

100

684

105

960

Karratha

137

230

1312

211

1890

571

1166

7224

704

9718

Regional mining centres Other

2663

3805

34 220

2918

43 553

Total non-metro

4376

6448

54 030

4721

69 575

Australia

9672

16 673

70 089

10 462

106 896

TABLE 17.7 Gender balance in the Australian mining industry – 2001 and 2006 Censuses (source: Australian Bureau of Statistics, 2002 and 2007). 2006 Census New South Wales

2001

Men

Women

Total

% women

% women

% change

18 326

1993

20 319

9.8

7.7

+ 2.1

Victoria

5226

1054

6280

16.8

20.6

-3.8

Queensland

26 630

4094

30 724

13.3

11.3

+2.0

South Australia

5008

959

5967

16.1

16.7

-0.6

Western Australia

32 544

7540

40 084

18.8

18.1

+0.7

Tasmania

1482

148

1630

9.1

7.0

+2.1

85

5

90

5.6

11.6

-6.0

Northern Territory

1451

256

1707

15.0

13.3

+1.4

Australia

90 822

16 054

106 876

15.0

13.6

+1.4

Australian Capital Territory

276

Mineral Economics

chapter 17 – Occupational communities – the mineral sector workforce The authors of one of the other appendices to the report, ‘Minerals Tertiary Education – A Snapshot,’ (Minerals Council of Australia, 1998, pp 99 - 120) estimated that in 1995, 1996 and 1997, the six university mining engineering departments then operating produced 104 graduates annually. The nine metallurgy/ materials departments produced 160 graduates per year and the 23 geology departments produced 463 graduates annually. While recognising the positive record of Australian universities in producing more graduates in the miningrelated disciplines in the preceding two decades, the authors made some major recommendations, which sought to serve the local industry in the longer term. An important result of these recommendations was the establishment of the Minerals Tertiary Education Council (MTEC). Utilising significant contributions from member companies in the Minerals Council, MTEC has worked to enhance the quality of undergraduate and postgraduate minerals education. It has done so in particular by supporting the activities of selected universities that have agreed to pursue its agenda for change and improvement. Between 1999 and 2012 the Minerals Council allocated more than $20 M to assist MTEC in developing industry-focused courses and in employing academic staff and educational specialists (Minerals Council of Australia, 2012). The strong cyclical nature of the mining industry has continued in recent decades. Precipitated by the Asian crisis, and after poor mining company profits over several years, there was a dramatic drop in mineral exploration budgets in the late 1990s and the early years of the new millennium. This led to a fall in the employment of geologists. Many left the mining industry. During 1998 and 1999, as many as 1000 geologist positions may have disappeared throughout Australia. A general impression is that Australian universities coped better in meeting domestic mining industry requirements for professionals during the 1997 - 2001 period. Yet this was a time of depressed activity. The fortunes of the industry changed significantly after 2002. Driven by China’s growing demand for minerals and energy, the prices of major minerals rose dramatically. They remained that way until 2008. After a short period of decline they recovered in 2009 and experienced continuing strength in 2010 and 2011. With large investment in new mines, expansion of existing operations, and increased exploration activity, a national and global shortage of mining professionals emerged again. Senior industry leaders lamented the global shortage of mining professionals and Australian mining companies have employed growing numbers of overseas trained mining engineers, as well as expanding numbers of local and international graduates from Australian mining and other engineering programs. Mineral Economics

While the activities of MTEC and the Australian universities have moved forward it is clear that the problem of providing a steady stream of well-trained professionals to the mining industry provides a continuing challenge.

The growth of fly-in, fly-out workforces An important recent trend in the formal mining sector has been the rise of FIFO work practices. Storey (2001a) defines FIFO mining operations as: … those which involve work in relatively remote locations where food and lodging accommodations are provided for workers at the worksite, but not their families. Schedules are established whereby employees spend a fixed number of days working at the site, followed by a fixed number of days at home. What differentiates this form of organization from other work involving periodic absences from home are the regular patterns of work onsite followed by a period offsite and the nature of the accommodation arrangements. As Storey (2010) and others have noted, the FIFO terminology is misleading because some workers do not fly to the mine site or the oil rig at which they work. They drive in, travel by bus and some even come by boat or hovercraft. The incidence of FIFO work practices has become more pervasive over the past twenty years, with more than one hundred mines in remote parts Australia now fully staffed in this way. The practice now applies more and more throughout the world – in Canada, South America, Asia and Africa. It means particularly that cities such as Perth, but also to a lesser extent, places such as Brisbane, Sydney, Melbourne, Townsville, Mandurah and Cairns provide the residences of managers, mining professionals and other operational personnel. More than 50 per cent of the mining workforces in Western Australia and the Northern Territory now appear to be FIFO and the percentage is also high in Queensland. The rise of the FIFO work camp has been driven in part by market forces and the unwillingness of government to subsidise the development of short-lived and even long-term remote area mining towns. Storey (2001a, p 136) identified five key factors in this regard. These were: 1. the absence of government financial support for new town development7 2. longer lead times needed for new town approvals and construction 3. environmental implications of new town construction 4. administrative implications of managing a town, as well as a mine 7

One example of this was the introduction by the Australian government of the Fringe Benefits Tax.

277

chapter 17 – Occupational communities – the mineral sector workforce 5. increased costs associated with town closure, once the resource is exhausted and is no longer economic. He pointed also to five further factors that have encouraged the practice as well. They are: 1. Improved quality of communications and a relative decline in communication costs (ie telephone, fax, email and internet facilities). 2. Improvements in aircraft quality and safety, and relatively lower air travel costs. This has led to dramatically increased air traffic flows from places like Perth, both from scheduled and charter carriers. One relevant example of this is the rise in air travel to cities such as Kalgoorlie. 3. a lower turnover and level of absenteeism in FIFO workforces than in resource towns. Unless workers are really sick, they will tend to fly to site for extended work periods8. 4. Access to a larger supply of qualified labour. More than sixty per cent of Australia’’s population lives in five cities. FIFO provides access to a much broader potential group of workers. 5. A preference for metropolitan over rural living by many workers and their families. This arises in particular because of better health, educational and social services in major centres. Major cities and coastal centres typically also have better climates. We also need to see FIFO work practices in a broader context. Working patterns have been changing significantly throughout society over the past half century, with many forms of ‘non-traditional’ work patterns such as FIFO now common. Mangan (2000) points to a wide variety of newer working arrangements including leased or franchised workers, outworkers, teleworkers, freelancers and portfolio workers. He argues that: Those in alternative employment relations are now in such numbers that they can no longer be regarded as peripheral to the main labour market. FIFO began on oil rigs in the Gulf of Mexico in the late 1940s. It has been widely used in the offshore oil and gas sector since that time – in the North Sea, the Atlantic, off Indonesia, and in the Bass Strait and on the North West Shelf. The first on shore FIFO work practices began at Polaris in Canada’s High Arctic region. In Australia, the first mine to utilise the practice was the Argyle mine in the Kimberley region of Western Australia. It commenced operations in 1982 and is still in operation in 2012. Since 1982, the number of FIFO (including drive-in, drive out, bus-in, bus-out) mines in Australia has grown dramatically.

Department of Mines reported in 1991 that there were 26 FIFO operations in that state employing 4220 people. Our estimates, based on a count of employees by mine site, are somewhat higher than that. They suggest a figure of about 7000 people following FIFO rosters at that time in WA – see Table 17.89. TABLE 17.8 Estimates of fly-in, fly-out workforces in Western Australia (source: Department of Mines and Petroleum Western Australia Minerals and Petroleum Statistics Digest: 1990-91, 2003-04 and 2010-11). Estimated number of workers Resident

278

2002/03

2010/11

29 500

19 000

18 000

Fly-in, fly-out

7000

17 000

48 000

Total

36 527

36 000

66 000

By 2003 - 04 the number of FIFO mineral sector workers in Western Australia had risen to 19 000 – more than 50 per cent of total mining employment. There were 51 mines in WA following FIFO rosters and about twenty in the rest of the country. FIFO work practices are common in gold mining, oil and gas extraction, diamond and nickel mining and for base metals exploitation in WA. They do not apply in the bauxite and coal sectors, which are located much closer to the Perth metropolitan area. However, in 2012, two mineral sands operations north of Perth had ‘drive-in, driveout’ workforces. On the other side of the country many families of coal miners and base metal miners in Central and North Queensland now live at the coast where the weather and services are much better. By 2008 there were an estimated 78 FIFO mines in Western Australia. With the expansion of the iron ore and gold sectors after 2006, the FIFO workforce has continued to increase. As Table 17.8 shows, it stood at close to 70 per cent of the mining workforce by 2010 2011. There are elements of FIFO mining in Papua New Guinea, Chile, Indonesia, and in several African nations. There is also considerable potential for the practice in many of the nations of the Former Soviet Union. In a number of cases, expatriate mining professionals have been following extended FIFO work rosters from Australia and Canada to these nations. There has been much discussion about the social implications of FIFO work practices in mining for workers and their families. Storey (2001b) argues that commentators perceive FIFO: … to have negative social consequences for individuals, families, and by extension, for the communities in which they live, by contributing to:

There was quite dramatic growth in the practice during the 1980s. The then Western Australian 8 Anne Sibbel (2012) notes however that FIFO also facilitates people changing jobs because they only have to ‘jump on a different plane’ and not move the family. She observes that some anecdotal evidence suggests a higher FIFO turnover than residential.

1989/90

9

•

greater alcohol and drug abuse,

•

family violence and break-ups,

It should be noted that it is difficult to derive authoritative estimates of FIFO and this area requires further development by statistical agencies. Mineral Economics

chapter 17 – Occupational communities – the mineral sector workforce •

parenting problems, and

•

reduced community involvement.

Yet, people who choose this form of employment often do so because it suits their needs at the time. Sibbel (2004) reports that FIFO workers typically see both positive and negative points about the practice. In following typical 14/7, 9/5, 8/6, 5/2/4/3 and other rosters they see the following positive points about FIFO: Work and home are separate. Salaries are excellent. Longer breaks provide an opportunity to engage in family activities and to socialise. With minimal disruption to the family there is more opportunity to play a supervisory role on the job. Access to educational, health and other facilities for families, as well as employment opportunities for family members are other positive features. Because residences are set, it is quite easy for both FIFO workers and their family members to change employers. Families are often very supportive. Negative points include roster impacts on relationships, missing out on family activities (birthdays, children’s sporting events, etc), less involvement with the community, inability to attend to home emergencies, time consuming travel, general tiredness because of long shifts, fear of flying, and the problem of binge drinking at the end of work rosters. As FIFO work rosters in mining have developed there is now an emerging literature about dealing with its negative and positive impacts on the mining workforce. One notable contribution has been the paper by Sibbel, Sibbel and Goh (2006). The authors suggest strategies to manage worker fatigue and loneliness, family communication, changing roles and responsibilities at the mine site and the impacts of regular parent absence. A parallel series of papers focusing on the implications of FIFO for community sustainability has also appeared. Storey (2010) provides a useful recent review of that area. Continuing technological change, which reduces the workforce size at remote mines10, will continue to make this a dynamic and challenging field.

Our indicative estimates suggested that the world’s mining workforce in 2010 was almost equally divided between the formal and small-scale and artisanal sectors. Although perhaps 25 million people now work in the minerals and energy sector throughout the world, the workforces in major mining nations such as Australia, Canada and Chile are small and they will remain that way. Even though the sector has recently contributed more than six per cent annually to GDP in Australia and more than 50 per cent of our exports, it now employs only about 1.7 per cent of the workforce. This contrasts with the situation at the turn of the twentieth century when mining employed an estimated eight per cent of the workforce. The value added per employee in the Australian minerals sector has recently been almost $600 000/a. Despite wide swings in the mining cycle, the wages of workers in the sector are high – more than double the national average. While this dramatic difference reflects the specialist training of skilled workers and their responsibility in operating expensive capital equipment, it is also a reward for working in harsh environments, and living in, or commuting to, remote locations. Our discussion concluded with a review of some topical mineral sector workforce issues. These included the historical issue of gender imbalance of mining sector workers, the challenges of maintaining a supply of well-trained professionals and the growth of FIFO workforces. These and related issues will have an important continuing influence on the structure of mineral sector workforces both in Australia and more broadly as the economic geography of mining moves towards other parts of the world in the coming decades. The industry will continue to operate in a dynamic and changing environment. Those who choose to work in the sector will need to adapt continuously to this.

Summary and conclusion

References

Our discussion in this chapter considered the size and distribution of the global minerals and energy sector workforce. Its focus then reflected more particularly on the Australian industry’s workforce and a range of factors that have recently been influencing it. In conducting this exercise, a major aim has been to appreciate some of its dimensions more closely.

Australian Bureau of Statistics, 2002. National Census of Population and Housing 2001, Canberra. Australian Bureau of Statistics, 2007. National Census of Population and Housing 2006, Canberra.

We noted that the labour and capital intensity of mining differs between nations, depending on their stage of economic development and the extent of their transition from socialist to free enterprise operating environments. We noted also the difference in labour intensity between the formal and small-scale mining sector. 10 For an interesting recent contribution to this field see Bellamy and Pravica (2011). Mineral Economics

Australian Bureau of Statistics, 2011. Australian Industry 2009-10 (Catalogue No 8155.0), Canberra. Bellamy, D and Pravica, L, 2011. Assessing the impact of driverless haul trucks in Australian surface mining, Resources Policy, 36(2):149-158. Blainey, G, 2003. The Rush That Never Ended: A History of Australian Mining, fifth edition (Melbourne University Press: Melbourne). Bureau of Labor Statistics, 2012. Mining, quarrying and oil and gas extraction: NAICS 21 [online]. Available from: [Accessed: 28 February, 2012]. 279

chapter 17 – Occupational communities – the mineral sector workforce Campbell, G and Roberts, M, 2003. Urbanization and mining: A case study of Michigan, Resources Policy, 29(1-2):49-60. Hall, B, 2003. The size of the bucket 2001: Employment trends in the Australian minerals sector, report to The Australasian Institute of Mining and Metallurgy, October, Melbourne. Hilson, G, 2009. Artisanal mining, poverty and development in rural sub-Saharan Africa: An overview, Resources Policy, 34(1):1-5. Hilson, G M, 2002. Delivering aid to grassroots industries: A critical evaluation of small-scale mining support services, Minerals and Energy: Raw Materials Report, 17(1):11-18. International Labour Organization, various years. LABORSTA database of labour statistics [online]. Available from: . Mangan, J, 2000. Workers Without Traditional Employment: An International Study of Non-Standard Work (Edward Elgar: Cheltenham). Maponga, O and Maxwell, P, 2000. The internationalisation of the Australian Mineral Industry in the 1990s, Resources Policy, 26(4):199-210. Minerals Council of Australia, 1998. Back from the brink: Reshaping minerals tertiary education, National Tertiary Education Taskforce discussion paper, Canberra.

280

Minerals Council of Australia, 2012. Minerals Tertiary Education Council [online]. Available from: . Sibbel, A, 2004. FIFO or residential: Choices for life?, presentation to The AusIMM Perth Branch, 16 September, Curtin University of Technology, Bentley campus. Sibbel, A M, Sibbel, J and Goh, K, 2006. Fly-in, fly-out operations — Strategies for managing employee wellbeing, in Proceedings International Mine Management Conference, pp 25-34 (The Australasian Institute of Mining and Metallurgy: Melbourne). Storey, K, 2001a. Fly-in/fly-out and fly-over: Mining and regional development in Western Australia, Australian Geographer, 32(2):133-148. Storey, K, 2001b. FIFO mining in Australia: What do we really know about its social and economic impacts?, mimeo, November, 22 p. Storey, K, 2010. Fly-in/fly-out: Implications for community sustainability, Sustainability, 2:1161-1181, doi:10.3390/ su2051161. World Bank, 2012. The World Bank Group Web Page [online]. Available from: .

Mineral Economics

HOME

glossary of terms Accounting profit The surplus of recurrent revenue over expenditures for an operating period. This is typically the base for the imposition of company income tax by a national government.

Bayesian probability analysis Calculating the conditional or posterior probability of an event occurring given that another event, the probability of occurrence of which is known, does occur.

Ad valorem royalties A royalty levied as a percentage of the financial market value of a produced mineral resource.

Benchmark pricing A system of pricing of key commodities such as iron ore and coal based on annual negotiations between major producers and large buyers. The system operated between the 1960s and about 2008 when it began to be replaced by spot and futures markets for these commodities.

Allocative efficiency This condition occurs where goods and services are distributed in an optimal way. Annual equivalent value (AEV) A technique to distribute the initial capital investment over the number of periods in the life of the investment by dividing it by the annuity factor at the desired discount rate. Anti-trust legislation A range of laws implemented by governments around the world to limit the market power of firms and control how they compete with one another. The ‘anti-trust’ terminology originates from the United States. Artisanal and small-scale mining The traditional form of labour-intensive mining that continues to persist in developing nations with significant minerals endowments and which provides employment for many people in poor and otherwise backward regions. Asian options An options contract, the pay-off of which is determined by the average underlying price over a pre-set period of time. Average cost The ratio of total cost to the number of units of output that a firm produces. Backwardation A situation in which cash prices for immediate delivery of minerals in a market exceed the forward price. Balance of payments The balance of a nation’s exports, imports, income and capital flows in a given period. Barriers to entry Any factor that prevents an entrepreneur from immediately creating a new firm or starting business in any particular sector. Mineral Economics

Binomial lattices Graphical expression of the evolution of a binomially distributed variable (for instance the possible value of the underlying asset in an option) over successive intervals of time during which the value can either go up or down as a function of its volatility. Binomial lattices in combination with risk-neutralising factors are the basis of a user friendly methodology to calculate the value of options. Brown tax Suggested by E C Brown in 1948 this is a tax on economic rents. In its original version the government takes its share of any positive net cash flows as determined by the tax rate and contributes to any losses also in proportion to the tax rate. By-product A product so unimportant that its price has no influence in determining the output of a mine. Capital As one of the three factors of production with labour and land, capital described all of the manufactured aids used in the process of production. Capital Asset Pricing Model (CAPM) CAPM provides an estimate of the cost of equity funds appropriate to investment opportunies with different levels of risk. It does so by determining the magnitude of the risk premium that would have to be added to the risk-free rate of interest to compensate for the risk inherent in each investment. The risk premium in turn is derived by multiplying the market portfolio risk premium by a beta factor unique to each investment, and denoting its sensitivity to overall market movements. 281

GLOSSARY OF TERMS Capital budgeting The process of allocating budget funds available for investments in capital assets to various investment opportunities.

Comparative advantage Countries tend to export those goods and services where their margin of superiority is greater, or their margin of inferiority smaller, than their trading partners.

Capital efficiency index (KE) The ratio between the NPV of an investment and its capital cost.

Competition policy A range of laws implemented by governments to limit the market power of firms and control how they compete with one another. Similar to anti-trust legislation but this terminology is used more widely in Europe.

Cartel A group of producers which explicitly agrees to coordinate its production and selling activities in a given market. Cash bidding Auctioning the exploration and development rights of well-defined tenements either for an up-front cash payment, or an ongoing ad valorem royalty or some combination of upfront cash and royalty payments. Cash cleared Users of the market do not have to contribute additional cash when their contracts are making losses, nor can they take out profits ahead of the prompt date. Rather the contracts are cleared against bank guarantees, with brokers granting credit to their clients. Cash costs All fixed and variable costs sustained in cash rather than accrued as ledger entries in financial accounts when operations are taking place. They include all site costs of mining such as stripping, mining, processing, concentrating and transporting, and also incorporate sales and marketing. Certainty equivalent (Cx) It represents the value to be received with certainty at which an investor, with a specific individual tolerance to risk, would be indifferent whether to accept the certain amount or bear the investment risk for a higher but uncertain expected value. It is in effect the utility value to an investor of a higher but uncertain expected value. Co-product Where two or more mined products affect the viability of a mine, they are considered to be co-products. Collusion Agreements, either tacit or explicit, between firms in an industry on either pricing or other policies, or both, that reduce competition between them. Community indifference curve A curve which shows different combinations of goods and services corresponding to the same level of welfare in a community, with a given distribution of income. Company income tax A tax on Australian companies currently computed by applying a 30 per cent tax rate to taxable company income determined according to the provisions of the Income Tax Assessment Act. 282

Competitive markets Markets in which prices are determined by the free interplay of supply and demand and in which no individual producers or buyers have the ability to influence the market clearing price. Complements A mineral used jointly with another mineral to produce a final good. Computable General Equilibrium (CGE) models These are simulations that combine the Walrasian general equilibrium structure with economic data to solve numerically for the levels of supply, demand and price that support equilibrium across a specified set of markets. Consumption The process of individuals, households, business and government using up goods and services. Contango Markets are in contango when prices for future delivery of minerals exceed cash prices by a margin that represents the costs of storage and insurance, and the cost in terms of interest foregone or paid of holding the physical stock until the date of future delivery. Corporate Social Responsibility (CSR) The process of balancing a company’s commitments to its shareholders with those of other internal and external stakeholders in its operations. Corruption The abuse of office for private gain. Cost of equity (RE) The future return that investors should expect to receive to justify investment in an opportunity, taking into account adequate compensation for its risk. Created demand Demand generated by continuing promotion for a final product (eg jewellery) in which a particular mineral (eg gold) is an input. Cross-price elasticity of demand This shows how the quantity demanded of one mineral changes if the price of another mineral changes. Mineral Economics

GLOSSARY OF TERMS Dealer market Mineral markets facilitated by individual dealers or commodity houses. Depreciation The reduction in the value of fixed assets acquired through lumpy investments in the past, due to their being consumed or worn down during operations.

Economic efficiency The situation where an optimal allocation of scarce resources generates the greatest output of goods and services. Economic equity The situation in an economy in which the sharing of production among the people is considered fair.

Derived demand Demand arising because minerals, with their unique physical and chemical properties, are used as an input into inputs into one or more final commodities.

Economic growth The growth in total production over a given period or in per capita production of the average citizen over a given time period.

Developed nations Those nations with high per capita incomes and well developed economic, governmental and social institutions.

Economic rent The payment that any good (commodity) or service receives in excess of its supply price when a market is in equilibrium. It is a surplus in excess of the minimum profit required by shareholders in a company or firm to stay in business.

Developing nations Nations with less developed economic, governmental and social institutions. Development A process involving major changes in social structures, popular attitudes and national institutions, as well as the acceleration of economic growth, the reduction of inequality, and the eradication of absolute poverty. Differential rent A situation that arises where the mineral resources available for exploitation differ in quality and grade. This allows different producers to make different levels of above normal profit and generate different levels of economic rent. Discounted cash flow (DCF) model A techno-financial model that simulates the financial performance of an asset/project over its whole life and which take into account the time-value of money by applying an appropriate rate of time and risk-adjusted discount. Distribution The way in which a country’s citizens share the proceeds of their production. Dutch disease The effects arising from the uncomfortable co-existence of booming and lagging sectors in an economy, which often brings significant structural adjustment, typically following the discovery and initial exploitation of major new mineral resources. Economic base model A simple model based on the argument that the growth (or decline) of a region is determined by its function as an exporter to the rest of the world. Economic development A term used interchangeably with ‘development’ (see above). Mineral Economics

Economic sustainability Sustaining improvements in human living standards or human material wellbeing. Economics The most widely used definition is that of Robbins, which argues that economics is the science that studies human behaviour as a relationship between ends and scarce means which have alternative uses. Economies of scale These are factors that cause the average cost of producing something to fall as the volume of its output increases. Efficiency-based economic indicators A range of measures relating to the optimal allocation of scarce resources generating the greatest output of goods and services. They include measures of income, investment, production (such as GDP), exports and imports, employment by industry class and occupational category, unemployment, public and private debt, costs of living and inflation. Elasticity of demand A measure of the quantitative impact on the amount of a good demanded of a change of one of the other factors affecting demand (own price, income or the price of related goods). Elasticity of supply A measure of the way in which the amount of minerals supplied to a market responds to the changes in key influencing factors, such as the price of the mineral. Engineering economics An area of study concerned largely with the financial analysis of engineering decisions, incorporating project evaluation, risk analysis and related techniques. 283

GLOSSARY OF TERMS Environmental sustainability Sustaining environmental quality and the stock of natural resources. Equity This terms has several different meanings. In discussion of economic issues, it relates to the achievement of fairness. By contrast, when relating to finance it decribes the value of an ownership interest in property, including shareholders’ equity in a business. Equity-based economic indicators A range of measures including the distribution of income and wealth, the number of people below the poverty line, access to telephones, the internet and to motor vehicles and rates of home ownership. European options An option that may be exercised only at its expiry date.

External stakeholders People who do not work for a mining company that are affected by the company’s operations. They include nearby local communities, local institutions, nongovernmental and other civil society organisations, local government authorities, state or regional governments, and national governments. A nation’s citizens are also external stakeholders in the fortunes of a successful minerals and energy sector. Final product A product that is produced for its final user and not as a component of another good or service. Financial leverage The degree to which the return on equity funds invested is increased by the introduction of debt in the funding structure of an investment/project, due to the lower cost of debt relative to equity and to the tax deductibility of related interest expenses.

Excess capacity This arises in established mines and smelters as a result of reduced consumption of minerals or less than expected growth in consumption. It has tended to act as a key barrier to entry of new mines and mineral processing facilities.

Financial risk Additional risk introduced by the use of debt in the funding structure of an investment/project. The risk arises because interest payments are not related to profit and need to be satisfied, even in periods when cash flows may become inadequate to cover them rendering a firm illiquid.

Exchange rates The rate at which a unit of one nation’s currency will exchange for that of another nation’s currency.

Financing (funding) decision The process of determining the most appropriate funding structure for an investment. It entails determining what level of debt maximises leverage, ie the return on equity consistent with the investors’ willingness to accept progressively increasing financial risk.

Expected monetary value (EMV) EMV is the mean of all possible financial outcomes from an investment weighted by their respective probabilities of occurrence. Export levies Taxes on exports by a host government. These may be a way to encourage downstream production. External benefits These are benefits that arise from mining that flow to the surrounding community, region or nation. They may include a variety of things. Some obvious examples are local purchase of inputs by the mine and local spending of mining wages on food, entertainment, furniture, clothing, and other goods and services; and improved educational and health-care systems from spending on schools and hospitals. External costs These are costs that arise from mining that flow to the surrounding community, region or nation. They may include environmental degradation, social problems such as increased rates of alcoholism, prostitution, and teenage delinquency; and cultural disruption, for example when indigenous peoples are confronted with mine development. 284

Fiscal policy Government’s use of its spending, taxing and debtissuing authority to faciltate development, as well as smooth out the business cycle and otherwise influence economic performance. Fixed costs These are costs that do not change with the level of output that a firm produces. They cannot be varied or avoided in the short term. Fixed exchange rates The situation where a nation’s currency is set at a specific level in relation to other key currencies. Floating exchange rates Exchange rates that vary continuously to ensure that a nation’s exports, imports, international income flows and capital movements are always in balance. Flow-through shares A mechanism by which exploration losses incurred by junior exploration companies can be transferred to their shareholders, who may be able to deduct them from their respective taxable incomes, thus creating a fiscal incentive to invest in mineral exploration. Mineral Economics

GLOSSARY OF TERMS Fly-in, fly-out (FIFO) A working pattern in mining operations involving workers travelling long distances from their normal residences to remote locations, working several days at the site where food and accommodation are provided, and then travelling home for several days of leave. Forward contract A contract between two parties to buy or sell an asset at a specified future time at a price agreed at the time of the negotiation of the contract. Gambler’s ruin The cumulative probability that successive uncertain investments may result in cumulative losses large enough to exceed an investor’s risk capital, thus ruining them. Gender balance The tendency for equal numbers of men and women to work in the same industry, or reside in the same area. Generalised scarcity The idea that a product is in short supply relative to its demand. Global Mining Initiative (GMI) This was a major initiative by a group of multinational mining companies, carried out between 2000 and 2002, studying and attempting to clarify the roles of mining in sustainability and sustainable development. Gross Domestic Product (GDP) A measure of the market value of final goods and services produced in an economy during a given period. Hedging The elimination of market price uncertainty for a mineral or currency at a known cost. Hicks-Marshall laws of derived demand A series of four propositions attributed to Alfred Marshall and John Hicks that describe the relationship between own price elasticity of demand (for a mineral) and a range of other influencing factors. Historical demand Demand for minerals such as gold which arised from historical tradition. Homogeneous products Products that buyers perceive to be identical. Homogeneous regions Regions identified because of their homogeneous economic characteristics. Horizontal equity Implies equal treatment of equals and asks questions such as ‘Are miners who generate the same amount of economic rent all paying the same amount of tax?’ Mineral Economics

Idiosyncratic risk That part of the risk of an investment that is unique to the investment/project, diversifiable and not dependent on broader economic factors generating systematic or non-diverifiable market risk. Immediate run A period in which the market conditions facing a mining firm are fixed, and it is not possible to change the current rate of production. Income elasticity of demand This measures how the quantity demanded of a mineral changes if consumer income increases. Indigenous communities (in mining areas) Households or families with an ancient and cultural attachment to the land where mining occurs or has an impact. Indigenous populations ‘Existing descendants of the peoples who inhabited the present territory of a country wholly or partially at the time when persons of a different culture or ethnic origin arrived there from other parts of the world, overcame them, and by conquest, settlement or other means, reduced them to a non-dominant or colonial situation; who today live more in conformity with their particular social, economic and cultural customs and traditions than with the institutions of the country of which they now form a part, under a state structure that incorporates mainly the national, social and cultural characteristics of other segments of the population that are predominant …’ (UNESCO 1982). Individual demand curve A graphical representation of the quantity of a good or service that each individual demands, at various prices of this good or service, other influencing factors being held constant. Individual product A geological occurrence where it is profitable only to recover one mineral commodity from the material mined or drilled. Inelastic demand When a percentage change in an influencing factor leads to a less than proportional increase in quantity demanded. Initial public offering (IPO) This occurs where shares in a company are sold, for the first time on a securities exchange such as the Australian Stock Exchange, to the general public. Initial public offerings are used by companies to raise exploration, development or expansion capital, possibly to monetise investments of early private investors, and to become publicly-traded enterprises. 285

GLOSSARY OF TERMS Input-output analysis This technique, originated by Wassily Leontief, is based on a set of accounts describing transactions between industry sectors in an economy and the outside world. Assuming a proportional relationship between inputs and outputs, it generates a set of multiplier estimates that explain the relationship between an initial change in demand and its ultimate effect on output, income and employment. Intensity of use The demand for a mineral (usually measured in physical units like tonnes) per unit of income discounted or per capita. Intergenerational equity In the minerals and energy sector this is concerned with whether depletion of mineral resources leaves future generations without the ability to earn comparable levels of income as the asset stock inherited by future generations is diminished. Interindustry sector A key part of an input-output table that shows transactions between the major sectors such as agriculture, mining, manufacturing, services and households. Internal rate of return (IRR) A measure of a project’s return on equity showing the discount rate at which its net present value (NPV) is equal to zero. Internal stakeholders Persons or groups who directly interact with a company as part of its core business function. This includes employees, shareholders, suppliers, contractors, distributors and customers. International trade Trade that occurs between nations. Interregional trade Trade that takes place between regions within a nation. Intraindustry trade The is trade that occurs in similar products within distinct industry groups. Intraregional trade Trade that takes place within a region. Investment Spending on capital formation, both physical and human. Investment decision The act of determining which asset base is most appropriate to achieve the financial-return based on the objectives of an enterprise. 286

Joint Ore Reserves Committee (JORC) Code This is a professional code for the public reporting of exploration results, Mineral Resources and Ore Reserves to the Australian Securities Exchange and other relevant bodies. Labour The skills and capabilities used by humans in the production process. Land This refers to all of the natural resources used in production. As well as land it also includes water, forests, fisheries, oil, gas and mineral deposits. Law of demand The proposition that, other things being equal, if price goes up, quantity demanded will decrease; and if price goes down, quantity demanded will increase. List prices The publishing of indicative mineral prices, mainly for minor metals and some industrial minerals. This often takes place in industry newsletters, subscription web sites or in trade journals. Location quotient method A method based on comparing percentage shares of economic activity in a region or nation with other regions or nations to assess whether an area is a net exporter of goods and services. Once this is established, it is possible to estimate the multiplier effect on income, employment or output of a change of economic activity within the region or nation. Location rent A similar concept to differential rent. London Metal Exchange (LME) The leading terminal market for trading non-ferrous metals. It accounts for over 90 per cent of global exchange business for those metals it trades. These presently include aluminium, aluminium alloy, cobalt, copper, lead, molybdenum, nickel, steel billet, tin and zinc. Long run A period in which all the market conditions facing a mining firm can change. In the long run it is possible to develop new mines, build mineral processing facilities and expand the capacity of existing operations. Long-term contracts These apply in mineral markets such as coal and iron ore. They fix prices for agreed delivery of output for periods of a year or more, or they index prices according to an agreed formula. Macroeconomics The study of the operations of national economies and the world economy. Its focus has been on measures of Mineral Economics

GLOSSARY OF TERMS economic performance such as gross domestic product, inflation, investment, saving, economic growth and the balance of payments. Main product A product so important to the economic viability of a mine that its price alone determines a mine’s output. Marginal benefit The amount of money that someone is willing to pay to enjoy the attributes of an additional unit of a good or service. Marginal benefit curve A curve that plots marginal benefits for each additional unit of a good or service. This is the same as an individual’s demand curve for a good or service. Marginal cost The change in the total cost of production from producing an additional unit of output. Marginal physical product This is the increase in output generated by adding an additional unit of the variable input. Marginal revenue The change in total revenue that a producer receives from selling an additional unit of output. Marginal revenue product The additional revenue associated with adding a further unit of a variable factor of production (eg a mineral). Market demand curve This shows the total number of units of a good or service that buyers are willing to purchase in a market at every possible price during a given period. It is also the sum of all individual demand for a good or service. Market equilibrium A situation where the price of a good or service is such that the quantity that buyers want to buy is the same as the quantity that sellers want to sell. Market power The ability of a producer to set prices above competitive levels, so that greater profit can be generated. Market share Obtaining and holding a nominated percentage share of a mineral market a common corporate objective of many large and small mineral producers. Market structure The competitive nature of the market for a particular mineral. Is is influenced by the number of buyers and sellers and their respective market power. Markets can range from being perfectly competitive with many buyers and sellers to monopolistic and monopsonistic. Mineral Economics

Market supply curve This shows the total number of units of a good or service that sellers are willing to deliver to the market at every possible price during a given period. Market value (of a mineral asset) Following the VALMIN definition, this is ‘the estimated amount of money (or the cash equivalent of some other consideration) for which the mineral asset should change hands on the valuation date. It must be between a willing buyer and a willing seller in an arm’s length transaction in which each party has acted knowledgeably, prudently and without compulsion’. Material composition of products The amount of minerals used to produce goods and services in an economy. Microeconomics The study of economic decision-making by consumers, households and firms, and the way in which these relate to the operation of markets. Mineral economics The application of economics in the study of all aspects of the mineral sector. Mineral policy A combination of public policy positions for development of mineral and energy resources to achieve the broad economic goals of government. Mineral rent The returns in excess of those needed to attract factors of production into the mining industry in the long run. It is the revenue remaining after all costs have been deducted. These costs include exploration outlays, expenditures on mine establishment and cash operating costs. Mineral Reserves These are the quantities of a mineral commodity in subsurface deposits that are known and potentially profitable to exploit with existing technology and current prices. Mineral Resources Mineral Reserves; together with deposits that could be economic but have not yet been adequately explored or delineated; or reasonably well delineated mineralisation which is expected to become economic as a result of changes in prices, new technology or other developments within the foreseeable future. Mineral royalties These are payments by a tenement holder (typically a mining company) for the transfer of ownership of a mineral resource owned by the community as it is progresively depleted by mining. 287

GLOSSARY OF TERMS Monetary policy Deliberate action by government setting interest rates or otherwise controlling the money supply to influence the performance of the economy.

Net present value (NPV) The sum of all the discounted cash flows generated by an investment/project from the point of investment over its entire life.

Monopoly A market in which there is one supplier who can control either the amount supplied or the price of the product.

Net smelting return The value of a refined metal at the mine gate, ie net of all smelting and refining charges and of the transportation and associated costs to convey the mineral concentrates from which the metal is extracted to the smelter.

Monopoly rent The excess profits which monopolistic producers generate because they have induced scarcity or restricted supply of a good or service. Monte Carlo simulation A computational algorithm that relies on repeated sampling of input variables to compute its results. These input variables are sampled randomly and simultaneously from their assumed distributions according to their respective probability of occurrence for a large number of model iterations. Each successive iteration constitutes one of a large number of possible scenarios that define the distributions of all possible values for each of the model outputs, their respective means and other statistical parameters. Multipliers A measure of the total impact on a variable such as spending, income or employment of a unit increment or decrement to this variable. Nationalisation The process of moving from private to public ownership of key industry sectors in a nation. Native title Traditional rights of access, use, or occupation concerning lands or waters. They are personal or group rights based on traditional laws or customs (Horrigan). Natural capital The stock of environmentally provided assets such as the soil, minerals, the atmosphere, the forests, wildlife and water. Negative externalities Those costs of resource exploitation activity that are not borne by the mine operator in the form of costs of production that have to be covered by mine revenue. Rather they are costs borne by society as a whole through, for example, pollution or environmental degradation. Negotiated agreement These typically refer to binding agreements between Indigenous communities and mining companies which describe benefits that will flow from new mineral ventures located close to these communities. 288

New scrap ‘When metals are converted into shapes – bars, plates, rods, sheets, etc new scrap is generated in the form of turnings, stampings, cuttings and off-specification materials’ (USGS). New trade theory This extends classical and neoclassical international trade theory based on comparative cost differences between nations, which was developed by scholars such as Ricardo, Hecscher, Ohlin and Samuelson. Associated with economists such as Krugman, it focuses on economies of scale, as well as on monopolistic competition as conditions that explain modern trade patterns. New York Mercantile Exchange (Nymex) Trades in futures and options contracts for crude oil, gasoline, heating oil, natural gas, electricity, gold, silver, copper, aluminum, and platinum; futures contracts for coal, propane, and palladium; and options contracts on the price differentials between crude oil and gasoline, crude oil and heating oil, Brent and West Texas Intermediate crude oil, and various futures contract months (calendar spreads) for light, sweet crude; Brent crude; gasoline; heating oil; and natural gas (source: Nymex web page). Nodal regions Regions identified according to the ‘magnetic’ attraction of a key nodal centre for the economic and cultural activities of people living in the surrounding area. Non-renewable resources Resources whose rate of natural replenishment is so low that it does not provide any hope of replenishment within a reasonable time period. Normal profit A profit level just sufficient to keep a producer operating in a particular industry and not moving to another competitive industry. Normal profits apply in competitive markets but above normal profits are typical in other market forms. North-North trade International trade between developed economies. Mineral Economics

GLOSSARY OF TERMS Occupational communities Those households or families whose members work in the mineral sector and who therefore derive all or most of their income from mining.

Price volatility The tendency for market prices to move up and down and by large relative amounts in relatively short time periods.

Old scrap Mineral supply obtained from products that have reached the end of their useful lives.

Price wars A situation in which cartel and non-cartel members undercut nominated cartel prices, typically during periods of reduced product demand in a business cycle downturn. Such actions may lead to the effective end of cartel arrangements or other collusion between producers.

Oligopoly Markets dominated by a few selling firms, where there are substantial barriers to entry. Oligopsony A market in which there are a small number of buyers. Opportunity cost of capital This is the rate of return that entrepreneurs have to pay the owners of capital to attract and hold their capital in their business. Options These are contracts that give their owners the right, but not the obligation, to buy or sell an asset at a specified strike price on or before a specified future date. Organisation of Petroleum Exporting Countries (OPEC) The group of major oil producers, led by Saudi Arabia, which has influenced oil prices and output in the world since the early 1970s. Own-price elasticity of demand This measures how the quantity demanded of a mineral changes if its price changes. Pay back period The time (in years) it takes for a project to repay the original capital invested. It can be calculated either on an undiscounted or a discounted manner. Political risk Risk generated by the potential lack of stability government, its policies and related institutions in a country considered as a potential investment destination. Pooled development funds Instruments for investors to narrow their focus on advanced exploration and resource development projects which may attract preferential tax treatment. Present value (PV) The value today of a cash flow to be received in the future after discounting for its timing and possible risk. Price takers A situation where mineral producers exert little or no influence on the prevailing market price for their production. This occurs particularly in purely competitive markets. Mineral Economics

Producer pricing A market in which dominant companies nominate the selling price of a mineral. Product composition of income A measure of the mix of goods being produced in an economy. Product differentiation This is the process of distinguishing one product from others, to make it more attractive to a particular market. Such differentiation may come from differences in quality, different impurities in the case of minerals, differences in design, sales promotion or differences in the timing of availability. Production The process of converting economic resources to useful final goods and services. Production function Describes the technical relationship regarding the generation of final key factor inputs such as land, labour, capital and technology. Production possibility curve A curve showing different maximum combinations of goods and services that society can produce if all factors of production are fully employed during a given period. Progressive risk and value analysis The study of how the value of a project changes over time as a function of progressive information dispelling uncertainty. Project finance The provision of generally syndicated debt finance for the development of a specific project secured by the expected cash flows of the project, ie with limited or no recourse to the other assets of the project proponents. However, project finance contracts may contain covenants requiring that a large proportion of production be hedged and restricting the capacity of the proponent company to further borrow, issue shares or pay additional dividends. Funds may amount up to 80 per cent of the relevant capital costs and are generally to be repaid over the first few years of production. 289

GLOSSARY OF TERMS Prospectus A document describing a financial security issued by a company for potential buyers. It commonly provides details about the company’s business, financial statements, biographies of officers and directors, detailed information about their compensation, any litigation that is taking place, a list of material properties and any other material information. Purchasing Power Parity A measure of cost of living differences between nations and regions. Quasi-rents Rents that emerge because of changes in consumer tastes, new products and new methods of production but which eventually disappear as more production comes on stream. Real option value (ROV) ROV is the value of a contingent claim where the underlying asset is a real asset, eg a mineral or petroleum project, which is not continuously traded. ROV represents the value of managegial flexibility, ie of the capacity to take advantage of emerging information progressively displelling uncertainty. Registered warehouses In 2011 the London Metal Exchange maintained a series of 36 warehouses in major centres around the world, serving as stores for the metals which it traded. Renewable resources Those resources whose rate of natural replenishment occurs at a non-negligible rate. Replicating portfolios A fundametal concept in option theory whereby, in a perfect market with no opportunities for arbitration, the cash flows of a risky asset (say a call option) can be replicated by constructing a portfolio made up of a risky asset (say shares) and a risk-free asset (bonds). Residential communities (in mining areas) Households or families who live in the geographical area affected by mining. Resource curse The paradoxical finding that natural resource abundance is negatively related to an economy’s economic performance. Resource nationalism The tendency of governments to assert control over minerals and other natural resources located on their territory. Resource rent tax A tax that seeks to identify economic rents by allowing the deduction of all costs of production from revenue, including normal profit, and then taking a share of any resulting rents. 290

Revenue-cost scenario matrix A matrix that portrays the effect of every likely combination of real revenue and cost escalation on various measures of the the value of a project. Risk Most project inputs are uncertain with values that can be either lower or higher than their expected or mean value. That part of the distribution of the values of an input that would negatively affect an investor’s objective function represents the risk raised by the particular input. Risk averse Risk aversion is an investor’s behaviour whereby his willingness to invest and the value he places on an uncertain investment opportunity are affected progressively more by increases in potential lossses than equivalent increases in potential gains. This behaviour is a function of the investor’s risk tolerance, ie of his risk capital relative to the magnitude of potential losses and their probability of occurrence. At very high levels of risk capital investors will value gains and losses equally and this behaviour is called risk-neutral. Risk management While risk analysis is the identification and quantification of risk, risk management addresses the question of how to handle various sources of risk, ie whether to bear risk or insure against it. Risk neutral criterion A behaviour whereby an investor values potential gains and losses of the same magnitude the same and is not deterred by the potential consequences of occasional losses no matter how high. This attitude arises when the investor’s wealth is very large relative to the magnitude of potential losses. A risk-neutral investor maximises expected or mean value. Risk tolerance The degree to which an investor can withstand possible losses, which is a function of the magnitude of his risk capital, as measured by the risk tolerance coefficient RT. Saving The amount of money generated from abstaining from consumption in any given period. Scenario analysis The study of the changes in a project model outputs as a function of changes in a combination of variables selected to portray specified realistic states of nature or scenarios both optimistic and pessimistic. Selling pressure This arises where consumers wish to consume less than producers wish to produce at a given price. Sensitivity analysis The study of the changes in a project model outputs as a function of changes in any input taken one at the time. Mineral Economics

GLOSSARY OF TERMS Short run A period in which the market conditions facing a mining firm are fixed. These include the firm’s lease, its existing production capacity, employment contracts, and several other operating conditions. A firm can vary its rate of production but it cannot exceed its current mine capacity.

Supply curve A graphical representation of the quantity of a good or service that producers will supply at various prices of this good or service, other influencing factors being held constant.

Shorter-term contracts Contracts less than a year, which set prices for agreed purchases of mineral output.

Sustainability This is the capacity of the Earth to maintain all forms of life. Our discussion focuses on three elements of the concept – environmental, economic and social/cultural sustainability.

Social and cultural sustainability Fairness in the distribution of benefits and burdens associated with economic activities to all participating interest groups.

Sustainable development The simultaneous pursuit of sustained or enhanced: environmental quality, economic growth, and social justice.

Social impact assessment (SIA) The process of assessing or estimating, in advance, the social consequences that are likely to follow from specific policy actions or project developments.

Systematic (market) risk Risk which depends on broad economic/market rather than project specific parameters and which cannot be diversified.

Socio-economic indexes Measures typically computed by central statistical agencies such as the Australian Bureau of Statistics, which measure particular social characteristics of a population.

Tax base The object from which a tax is being sought.

Solvency The degree to which the assets of an entity exceed its liabilities. South-South trade International trade between developing economies. Sovereign risk This arises when where host governments arbitrarily change the laws to impose tax burdens, or other operating rules and regulations, that were not indicated originally. Specific royalties A royalty levied on the physical rather than the financial measure of a mineral resource. Spider diagram A diagrammatic display of the sensitivity of the outcome of a project to variations in different inputs considered individually but plotted individual curves in the same diagram. As the various sensitivity curves intersect at a point representing the base case, ie where all the variables assume their respective expected values, the diagram resembles a long-legged spider. Stakeholders Persons or groups who are directly or indirectly affected by a mining project, as well as those who may have interests in a project or the ability to influence its outcome, or both. Substitute good A good that be used as an alternative to another good because it possesses a similar range of attributes. Mineral Economics

Tax neutrality This arises when the system that collects economic rent from a mining company has no effect on its production decisions. Tax rate The rate applied to the base to calculate mineral revenue proceeds. Terminal markets Mineral markets such as the London Metal Exchange and the New York Mercantile Exchange where prices are set, at least on a daily basis to balance that day’s marginal offerings and demand. These markets also perform a variety of other functions. Terms of trade The ratio of the prices of the goods and services that a nation exports to the price of the goods and services that it imports. Terra nullius Land belonging to no one. Tornado diagram A graphical representation of the effect of changes in individual inputs on an output of a project ordered in descending level of sensitivity along the vertical axis. The impact of each variable is displayed as a minimum to maximum impact bar on the horizontal axis with the expected (base case) input values aligned vertically. Trade A process of exchange between individuals, business and governments which generally makes each participating party better off as a result of the transaction. 291

GLOSSARY OF TERMS Trade liberalisation The movement towards freer trade between nations. Trade-weighted index A weighted average of a basket of currencies that reflects the importance of the sum of a nation’s exports and imports of goods by country. Transfer pricing This applies where firms, who control different stages of downstream processing of a mineral through vertical integration, make sales of mineral output at agreed prices to other branches of the firm. Governments monitor these prices closely to try to ensure that their levels do not reduce profits and the liability of a firm to pay company taxes. Transport cost market value curve An inverse relationship between the market value of a mineral and the importance of transport costs in its sale price to end users. Type I multiplier An estimate of the sum of direct and indirect effects of a change of one monetary unit in final demand for the output of an industry such as mining, using an interindustry input-output analysis model. Type II multiplier An estimate of the sum of direct, indirect and induced effects of a change of one monetary unit in final demand for the output of an industry such as mining, using an input-output model, which includes key industry sectors as well as households in its interindustry matrix. Uncertainty The variability of the value of an uncertain variable around its mean value. Unsecured covertible notes A borrowing instrument whereby investors buy the notes, ie lend money to the company over a fixed term at a fixed or variable rate of interest, and at their expiry they can either be reimbursed the face value of the notes, or convert the amount into ordinary shares of the company according to some pre-determined formula. Utilitarian philosophy The view that each person makes decisions with the objective of maximising his or her happiness, both intellectual and sensual. VALMIN Code This is a code for the technical assessment and valuation of mineral and petroleum assets and securities for independent expert reports. With its particular focus on Australia and New Zealand, it is compiled by a joint committee of The AusIMM, the Australian Institute of Geoscientists and the Consultants Society of The AusIMM in consultation with other interested parties.

292

Value adding argument The proposition that mineral producers should engage in downstream processing of those minerals extracted within their borders to increase the benefit to the nation’s citizens. Value additivity principle Various line items in the cash flow model of a project characterised by different levels of risk can be separately discounted at an appropriately risk-adjusted rate of discount and then recombined to derive the NPV of the project. Value consistency principle In a no-arbitrage market, cash flows of the same magnitude to be received at the same time and subject to the same degree of risk should have the same value in the present independently of how they have been generated. Variable costs These are costs that change with the level of output that a firm produces. Venture capita Equity capital provided by venture capitalists in the early stages of a project to enable the project to reach the point where it may float on a stock exchange, after which venture capitalists generally cash in their investments and look for the next opportunity. Vertical equity Concerned with whether miners who generate different amounts of economic rent are treated differently in the amount of tax they pay. Very long run ‘The constraint imposed by existing known mineral deposits no longer holds and firms have the time to conduct exploration and find new deposits. New technology induced by the exhaustion of known deposits and higher metal prices may also permit the exploitation of new types of deposits’ (Tilton, 1985). Weighted average cost of capital (WACC) Firms use a mixture of equity and debt to fund their projects/operation. The cost of servicing these funds is the mean of the cost of equity and the cost of debt weighted by their respective proportion of the total (equity plus debt) funds employed.The WACC can be used as the minimum discount rate a firm may use when valuing an investnent. As DCF models generally include tax calculation, the cost of debt used to calculate the WACC should be before tax, as the model would take care of the tax shield generated because of the tax deductibility of interest expenses.

Mineral Economics

HOME

subject Index A

C

accounting profit, 193

capital, 11

accounting profit based royalties, 200

capital asset pricing model (CAPM), 116, 133

adjusted net savings, 15

capital budgeting, 108

administrative cost of taxation system, 197

capital efficiency index (KE), 132

ad valorem royalties, 198–200

capital intensity of mining industry, 108, 182

allocative efficiency, 196

cartel, 82–3, 85

allowance for corporate capital (ACC) tax, 199

cartel action, preconditions for successful, 86

alternative pricing arrangements, 83–5

cartels

annual equivalent value (AEV), 140

De Beers and diamonds, 88

Antofagasta, socio-economic indicators for, 239

examples other than OPEC and De Beers, 86–8

artisanal and small-scale mining, 271–2

history in mineral industry, 85–8

Australasian Code for Reporting of Identified Mineral Resources and Ore Reserves (JORC Code), 126

OPEC, 85

Australia discovery of copper, 31

US anti-trust legislation and, 87–8 cash bidding, 210 mineral rents and, 199

gold rushes, 31–3

cash costs, 77, 79

minerals and economic development of, 31–4

certainty equivalent (Cx), 146

mining and population growth, 31–2 production and trade in minerals, 42–4

commodity forward prices as, 164–6 Chile

Australian mining regions, taxonomy of, 235

minerals and economic development of, 30–1, 34–6

Australian Securities and Investment Commission (ASIC) Act 2001, 126

mining and population growth, 34–5

Australian Stock Exchange, 126 average physical product (APP), 55

China, economic re-emergence of, 187–8 civil wars, mining and, 27 collusion, producer prices and, 89

B

collusive behaviour, 83

balance of payments accounts, 47

Commonwealth company income tax, 211–13

barriers to entry, 79, 80, 82, 83, 86

Commonwealth of Australia, mining taxes and royalties, 207–9

Bayesian decision trees, 155–60 benchmark pricing, iron ore and coal, 85 binomial lattice method, valuing mine expansion, 168 binomial lattices in valuing real options, 166–7 binomial tree method, valuing mine expansion, 168, 170

community indifference curve, 179 company income tax, economic rent and, 196 comparative advantage defined, 40 transport costs and, 45

Black and Scholes formula, application to Sally Malay, 162–3

complements, mineral and cross-price elasticity, 62

Botswana, minerals and economic development of, 30 Brown tax, 198–9

constitutional powers in Australia, mining and Native Title Act 1993, Australian, 203–4

buying pressure, 53

consumer preferences, 54

Mineral Economics

computable general equilibrium (CGE) models, 247

293

subject index consumption, 12

economic growth, 15

corporate finance, 117

economic impact assessment of mining, 241–7

corporate social responsibility, 188, 232

economic policy, aims and practice of, 179–81

Corporations Act 2001, Australia, 126

economic policy instruments, 181

corruption, 26–7

economic rent, 4, 181, 192–6

mining and, 26

defined, 25

Corruption Perception Index, 26

factors affecting, 194

cost of equity (RE), 122, 133

generalised scarcity and, 194

cross-price elasticity of mineral demand, 61–2

investment for the future, 210

D

pursuing, 195–6

debt, 108, 110 advantages and disadvantages, 117 debt and financial leverage, modelling, 134–6 demand categories of mineral, 51 created, 51 derived, 51, 54 final product, 52–4 historical, 51 demand curve individual, 53 market, 53 depreciation, 110 of capital spending, 211–12 derived demand, Hicks-Marshall laws of, 59–60 development of mineral-rich nations, factors affecting, 23 differential rents, 195 discounted cash flow analysis, weaknesses and common traps, 141–3 discounted cash flow (DCF) model, 127–39

taxes collecting, 197–9 economics, 1 areas of, 2 defined, 1–2 economic sustainability, 216 mining and, 218–19 economies of scale, 84 educational investment, natural resources and, 27, 29 elasticity of supply, 73 employment in the formal mining sector, 271 energy economics, 2 engineering economics, 1 entrepreneurial activity, natural resources and, 29 environment, 11 environmental impact assessment, 247 environmental protection, 180 environmental sustainability, 216 mining and, 217–18 equilibrium, 53 equity, 108–10 cost of, 115–17

basic version, 127–30

horizontal and vertical, 197

converting from nominal to real dollars, 136

intergenerational, 197

distribution, 12, 219–20

sources of, 111–15

dividend payments, mining and exploration company, 108

utilisation of economic rents and, 197

Dutch disease, 23–5, 27, 30, 219

exchange rates fixed, 47

E

floating, 47

economic base analysis, 242–3

mineral and energy trade and, 46–8

economic development, 15–16 institutional and policy effects, 30–1

expected monetary value (EMV), 146 exploration spending, as a tax deduction, 211

economic efficiency, 183

export base analysis, 242–3

economic equity, 183

export base multiplier, 242–3

294

Mineral Economics

subject index export levies, 209

estimates of, 14

exports, 13

limitations of concept, 14

value of mineral and energy, 41–2 external benefits and costs, 219 external market forces, 23

H Heckscher-Ohlin-Samuelson (HOS) model, 40 hedging, 148

F

Henry Report, the, 192, 199, 208

farm-in/farm-out sequential compound options, valuing, 171–2

history, periods of, 17

final product demand curve expectations and, 54 income and, 54 final product demand curve shifts, factors affecting, 54 financial leverage, 109, 121 financial managers, role of, 109

horizontal fiscal equalisation, 211 Human Development Index (HDI), 16, 216 for small areas, 240 hybrid decision trees, 166 hybrids between equity and debt, 119

I

financial models, components of, 128

immediate run, mining and, 68

financial objectives, mining and exploration companies, 108

Indigenous Australia, 255–8

financial risk, 109, 121 identifying and quantifying, 146–8

income elasticity of mineral demand, 61 mining and, 259–63 Indigenous Australians

financial structure of mining companies, 121–2

age distribution, 257

financing decision, 108

education of, 258

flow-through shares, 114

health of, 256

fly-in, fly-out (FIFO)

incomes of, 257–8

growth of workforces, 277–9

labour force status, 257–8

work patterns, 233

life expectancy of, 257

forces of political economy, 25

remoteness of and mining, 257–8

fuel, exports and imports, 42–3

Indigenous communities, 233

funding decision, mining company, 108

Indigenous employment policies, 263

funds, sources and application of, 109–11

Indigenous population of Australia, historical, 255–6

G

Indigenous populations

Gambler’s Ruin, 151

definition of, 253–4

GDP deflator, 15

estimates of, 254

gender disparities, 234

infrastructure contributions, 209

gender imbalance in Australian mining industry, 275–6

initial equity, off-market sources, 111–12

generalised scarcity, 194

initial public offerings (IPOs), Australian mining, 112

gold, demand for, 54

input coefficients table, 246

government

input-output analysis, 243–7

key activities of, 180

intensity of use, 18

role of, 220

intensity-of-use curves, 63–4

government equity participation, 210

internal economic stresses, 23–5, 27

GRIT methodology, input-output analysis and, 245

internal rate of return (IRR), 132

Gross Domestic Product (GDP), 2–3

international trade, neoclassical theory, 40

at Purchasing Power Parity (PPP), 14–15 Mineral Economics

intraindustry trade, 40 295

subject index investing in people and infrastructure, 180

marginal benefits, 52

investment, 13

marginal cost, 82

investment decision, mining company, 108

marginal physical product (MPP), 55

investment incentives, mining companies and, 114

marginal revenue, 82

issues of scale or scope, sustainability and, 217

marginal revenue product (MRP), 55

J

market asset disclaimer (MAD) method, 162

Joint Ore Reserves Committee (JORC), 69 joint ventures, 115 risk spreading and, 153–5 JORC Code, 126

K Kambalda, estimating export base multiplier for, 243

market demand curve, mineral, 56 market power of mineral producers, facts affecting, 84 market risk, 147 market share, pursuit of, 84 market structure competitive markets, 79–80 imperfect markets, 80–5

L

markets, 2

labour, 11

microeconomics, defined, 2

land, 11

mineral consumption, 17–18

large scale of modern mines, 182 liquidity, 108 list prices, 73 validity of, 91 local communities CSR benefits and, 233 mines and, 232–4 location of Australian mining workforce, 274–5 location quotient method, 243 location rent, 195 London Metal Exchange (LME), 88, 92–7, 101 basic contract, 93 other contracts, 93–4 registered warehouses, 95–6 speculators and turnover, 94–5 London Metal Exchange (LME) prices, contango and backwardation, 96–7 long run, mining and, 68 long-term contracts, 84 long-term debt, 117–18

complicating factors, 19 mineral demand elasticity of, 57–64 long run elasticity, 62–4 mineral demand curve, shifts in, 56–7 mineral dependence, 21–2 mineral economics, 2, 4–6 key questions, 6 mineral economy, size of, 2–4 mineral exchanges active current, 92 role of, 91–2 mineral markets concentration in, 81 recent trends, 97–103 mineral policy, 181, 218 elements of a competitive regime, 188–9 in practice, 183–5 objectives of, 183

M

public and private strategic objective coincidence and divergence, 183

Mabo Case and more recent developments, 260–3

transition since 1950, 185–8

Mabo Case, High Court of Australia, 260–2, 266

mineral prices, transparency of, 91

Mabo judgment, 72

mineral production, complicating factors, 19

macroeconomics, defined, 2

mineral rent, 181

management flexibility, 160

absorption and dissipation, 26

marginal benefit curve, 53

defined, 25

296

Mineral Economics

subject index mineral rent taxation, international experience with, 201–2

mining company efficiency, state ownership and, 186–7

mineral resources and reserves, 69–70

mining company financial decisions, 108

mineral royalties, 193

mining employment

as a blessing, 22, 28

in Australia, 273–5

as a curse, 23, 27–9

in developed and developing nations, 270–1

categories of, 67

mining professionals, supply of in Australia, 275, 277

characteristics of, 4, 67

mining regions, 234–5

classifications of, 4–5

mining tax and royalty regimes, Australian, 204–9

mineral supply by-products, 70–1, 74 co-products, 70–1, 75 cost curves and, 77 disruptive events and, 72 government activity and, 72 individual products, 70–1 input costs and, 71

mining’s occupational community, 269–70 modern asset pricing (MAP) using commodity forward prices, 163–7 monopoly, 82 monopoly rents, 195 cartels and, 195 Monte Carlo simulation, 146, 148–50 multipliers employment, 233

issue of adequate, 67

income, 233

joint products, 70 main products, 70 market structure and, 72 new scrap, 76 old scrap, 76 own price and, 71 process, 68–9

output, 233 mutually exclusive projects with different lives, comparing, 140–1

N nations of the world, 21 Native Title Act 1993, Australian, 203

security and stability of, 36

Native Title and resource development in Australia, key dates, 261

strategic stockpiles, 75

natural capital, 13

technological change and, 71

negative externalities, 221

total, 76–7

negative externalities of mining, 196

mineral supply curves, 69 for different time periods, 73 Minerals Resource Rent Tax (MRRT), Australian, 192, 202, 204, 208

negotiated agreements, mining companies and Indigenous residents, 262 negotiated prices, 83 factors affecting, 83–4

mines, economic characteristics of, 4, 181

net present value (NPV), 128

mining

net smelting return (NSR), 131

estimating the value of, 40

neutrality, economic, 196

exports and imports, 43–4

New South Wales, mining taxes and royalties, 204–5

production and, 12

‘new’ trade theory, 40

return to private ownership, 187

New York Mercantile Exchange, London Metal Exchange and, 97

state-ownership of, 185–6 mining and Indigenous Australia, 259–63 mining and the Indigenous world, 254–5 mining companies, size versus GDP of host nations, 188 Mineral Economics

non-renewable resources, 13 normal profit, 82, 192 Northern Territory, mining taxes and royalties, 207 North-North trade, 40 297

subject index

O

financial ratio tests, 120

occupational and educational structure in Australian mining industry, 274

risk underpinning, 120–1

occupational communities, 233 oligopoly, 82

project risk, 147 project valuations cost-based, 126–7

oligopsony, 82

fundamental or technical (income-based), 127–8

Olympic Dam, 71 opportunity cost of capital, 193 optimal mine life, 129 ownership and control of mineral resources in Australia, 203 ownership of mineral resources, Australia, 261

P Pareto optimality, 183 pay-back period, 132 period to break up cash flows, 129

market-based, 126–7 property rights, 180 prospectus, 112 protecting the vulnerable, 180 public policy, principles and concepts, 220–22 Purchasing Power Parity (PPP), 14

Q quasi-rents, 195–6 Queensland, mining taxes and royalties, 204

Petroleum Resource Rent Tax (PRRT), 200–1, 204, 206–9

R

physical sustainability of mining, 217

rail freight rates, 209

pipeline licence fees, 209 political economy, 1

real GDP per capita growth, natural resource abundance and, 28–9

political risk, 184

real mineral prices, 23

pooled development funds (PDFs), 114

real option valuations

Port Hedland, socio-economic indicators for, 238–9 preference shares, 119 preproduction period, modelling, 136–9 present value (PV), 132 price takers, 73, 79 price volatility, mineral, 24 price wars, 84 primary mineral supply, key determinants, 71–5 probabilistic financial models and Monte Carlo simulations, 148–50 producer pricing, 73, 83, 85, 87–91

differences using binomial trees and ‘hybrid’ decision trees, 172–4 from static DCF/NV to, 160–3 strategic considerations, 174 real option value (ROV), 113, 127, 146, 160 real option values, market setting, 161–2 real options, types of in mining projects, 160–1 reconciling cash and financial accounting accrual figures, 133–4 recycling, 4, 75–6 redistributing income and wealth, 180

average costs and, 89

regional frameworks in Australia, 235

history of, 90

regions, criteria used in defining, 235

product differentiation, 40

regions, homogeneous, 235

production, 11

renewable resources, 13

factors of, 11

rent, historical origin of term, 194

function, 11, 54

rent-based royalty schemes, 200

possibility curve, 179

rent seeking, 27

profit-based taxes, 198

replicating portfolios, 164

progressive risk and value analysis, 155–60

representative producer

project base case, 129

long-run equilibrium, 82

project finance, 117, 119–21

short-run equilibrium, 81

298

Mineral Economics

subject index residential communities, 233

Specialised Listed Investment Companies (LICs), 114

resource nationalism, 185

specialty finance (royalty) companies, 115

resource rent tax, 198–9

specific (unit-based) royalties, 197–9

resource rent taxes, hybrid, 210

spider diagram, 147

revenue/cost scenario matrix, 148

stability of revenue flows from taxation system, 197

risk, 146

stages of mining project development, 125

attitudes towards, 150–3

stakeholders, mining and its, 231–2

country, 128

Standard Industrial Trade Classification (SITC), 41

financial, 128

stock market indices, mining companies in, 113–14

idiosyncratic, 116

subsequent (secondary) equity raisings, 112

management, 146

substitute good, 53

market, 128

substitutes, 82

nature of, 150–1

summary socio-economic measures for small areas, 239–41

private (project), 128 systematic or market, 116 risk-aversion, 151 risk-neutral criterion, 150–1 risk tolerance coefficient (RT), 152

Super Pit, KCGM and, 232 supply curve, market, 53 sustainability and sustainable development, 216–17 mining in practice and, 222–24

Roebourne, Aboriginal people and mining, 265–6

sustainable development, 216

S

T

saving, 13 scenario analysis, 146 selling pressure, 53 sensitivity analysis, 128, 146 short run, mining and, 68 short-term debt, 118 shorter-term contracts, 84 simple discounted cash flow model, construction of in nominal dollars, 130–1

tariffs, as a barrier to entry, 82 Tasmania, mining taxes and royalties, 205 taxation and royalty systems, evaluation of, 199–200 taxation, minerals sector in Australia, 192 taxation of mineral rents, design principles in, 196–9 Taylor mine life formula, 129 terminal markets, 80 terms of trade, 24 terra nullius, 255, 260–1

social and cultural sustainability, 216

tonnage-grade trade-offs, valuing, 170–1

social benefits, 233

tornado diagram, 147–8

social costs, 233

trade, 13

social/cultural sustainability, mining and, 219–20

gains from, 39–40

social impact analysis, 232

international, interregional or intraregional, 40

social impact assessment (SIA), 247–50

tradeable and non-tradeable goods, 25

socio-economic indicators for local communities and regions, 237–8

trade-weighted index, 47–8 transfer prices, 89

Socio-Economic Indices for Areas (SEIFA), 239–41

transfer pricing, problems with, 200

solvency, 108

transparency of taxation system, 197

sources of debt, 117–19

transport costs

South Australia, mining taxes and royalties, 205

as a barrier to entry, 83

South-South trade, 40

market value curve, 45

sovereign risk, 121

minerals and energy trade and, 45–6

Mineral Economics

299

subject index Type I multiplier, 246

venture capital, 111

Type II multipliers, 246–7

very long run, mining and, 68

U uncertainty, 146

Victoria, mining taxes and royalties, 205 volatility of economic impacts of modern mines, 182

unsecured convertible notes, 119

W

utilitarianism, 52, 222

wages in Australian mining, 273–4

V

Walrasian neoclassical general equilibrium model, 247

VALMIN Code, 125–6 valuation methodology, most suitable, 125 value added in Australian mining industry, 274, 279 value-adding, argument for and against, 43

weighted average cost of capital (WACC), 122 normal profit as, 194 Western Australia, mining taxes and royalties, 206–7 Wik case judgement, 261–2

value additivity principle, 164

Z

value consistency principle, 164

Zipf law, 159–60

300

Mineral Economics

HOME

Name Index A

BHP Billiton, 71, 263

Aboriginal Land Rights Commission, 255

Biddle, Nicholas, 256, 266

Adams, Robin, 116

Blainey, Geoffrey, 12, 31, 32, 259, 273

Ahammad, Helal, 247

Blanco, Edgar, 239

Aitlan, O, 62

Boskin, Michael, 23

Alaska Permanent Fund, 210

Boundy, R G, 64

Alberta Heritage Fund, 210

Bourassa, Michael, 126

al Rawashdeh, Rami, 28

Bradley, Paul, 164, 206, 209

Altman, Jon, 256, 258, 259, 266

Brady, Barry, 275

Amax, 89

Breaking New Ground, 223, 224, 226

Amos, Q C, 120

Brennan, Michael, 170

Andrews, Craig, 188

British Petroleum, 86

Anglo Pacific Group, 115

Brons, M, 63

Antikarov, V, 162, 166, 167

Brown, A J, 235

Aristotle, 221

Brown, E C, 198

Armour, A, 247

Brown tax, 198, 199

Armstrong, Harvey, 234, 241, 242

Brundtland report, 216, 224

Arrow, Kenneth, 247

Brunetti, Celso, 24

Atkinson, Giles, 27, 28

Bureau of Labor Statistics, 271

Australasian Code for Reporting of Identified Mineral Resources and Ore Reserves (JORC Code), 126

Bureau of Resources and Energy Economics, 42 Bureau of Transport and Regional Economics, 235

Australasian Institute of Mining and Metallurgy, The (The AusIMM), 126, 127

Burn, R G, 154

Australian Bureau of Statistics (ABS), 42, 237, 239, 273 Australian Securities and Investment Commission (ASIC) Act 2001, 126

Butlin, Noel, 32, 33, 256

C Calzada, M, 204

Australian Stock Exchange, 126

Campbell, Gary, 56, 58, 64, 271

Auty, Richard, 21, 27, 28, 30, 31, 186, 222, 224

Carroll, Archie B, 231, 232

B Backhouse, Roger, 1, 2

Chandra, Atul, 166, 172, 173 Chavez-Martinez, M L, 70

Baker, M P, 165

China Beijing International Mining Exchange (CBMX), 92

Barnett, Harold, 23

CIA World Factbook, 254

Bartos, Paul, 71

Claeys, J, 174

Bartrop, Stephen, 158

Clark, Robert, 212

Bedworth, David, 4

Clarke, B, 62

Behre Dolbear, 184

Clemen, R T, 157

Bellamy, Drew, 279

Clements, Kenneth, 247

Benninga, Simon, 166, 167

Clunies Ross, Anthony, 25, 181, 196, 198, 199, 200, 208

Bentham, Jeremy, 221, 222

Coffey Environments, 249

Mineral Economics

301

name index Collins, James C, 108

European Bank of Reconstruction and Development, 60

Commonwealth of Australia, 192, 207, 208

Explanatory Memorandum to MRRT Bill, 192, 208

Connell, John, 260

Extractive Industries Review, 223, 226

Coombs, Herbert C, 260

F

Copeland, T E, 160, 166, 167 Corbett, Tony, 262, 263 Corden, Max, 24, 25 Cordes, John, 224 Cortazar, Gonzalo, 170 Corts, K, 68 Cosassus, Jaime, 170 Cousins, David, 260 Crommelin, Michael, 204 Crowson, Phillip, 46, 74, 77, 232 Cueller, S S, 62

Fainstein, Marat, 263 Fallon, Matthew, 158 Fell, Harrison, 61 Fisher, David, 262 Flores, V, 174 Franco Nevada, 115 Fraser Institute, 184, 185 Frynas, Jedrzej, 233

G Galbraith, John Kenneth, 2, 5

Curson, Peter, 256

Garnaut, Ross, 4, 25, 26, 181, 182, 196, 198, 199, 200, 208, 231

D

Gelb, Alan, 21, 27, 28

Danielson, Luke, 254

Geoscience Australia, 69

Davis, Graham, 21, 23, 28, 29, 33, 40

GFMS Limited, 59

Davis, S C, 64

Giarratani, Frank, 242, 245

Debreu, Gerard, 247

Gilbert, Christopher, 24

Deer, P W, 121

Gillett’s Jewellers, 62

Denolder, T, 203

Global Compact, The, 224, 227

de Valdivia, Pedro, 34

Global Mining Initiative (GMI), 223

Diegel, S W, 64

Gooding, Edwin, 243

Dillon, Michael, 267, 268

Gordon, Richard, 1, 5, 6

Dinham, N, 174

Greenwaldt, W A, 153

Dixit, Avenish, 160

Grubel, Herbert, 40

Dodson, Mick, 255

Grytten, J, 59

Drucker, Peter, 64

Guj, Pietro, 112, 113, 130, 158, 159, 164, 166, 172, 173

Ducker Worldwide, 60

Guzmán, Juan Ignacio, 26, 64

Dziewonski, Kazimierz, 242

Gylfason, Thorvaldur, 27, 28, 29

E

H

EconSearch, 245

Haley, Sharman, 262

Eftimie, Adriana, 234

Hall, Brigette, 274

Eggert, Roderick G, 21, 23, 220, 224

Hamilton, Kirk, 27, 28

Ejdemo, Thomas, 244

Hanneson, Rögnvaldur, 222

Elkington, John, 216

Hargraves, Edward Hammond, 31

Equator Principles, 223

Harris, DeVerle, 70

Eriksson, Rickard, 59

Hartwick, John, 197, 210

Ernst & Young, 111, 121

Harvey, Bruce, 266

Etheridge, Michael, 112, 113, 115, 158

Haynes, B, 60

302

Mineral Economics

name index Hayward, N, 155

J

Heckscher, Eli, 40

Japan Oil, Gas and Metals National Corporation (JOGMEC), 75

Heilbroner, Robert, 1 Heller, Katherine, 234 Henry Report, the, 192, 199, 208 Hicks, John, 59, 183 Hilson, Gavin, 12, 232, 272 Hirsch, Philip, 260 Hirshleifer, Jack, 115

Jeffrey, William, 12 Jensen, Rod, 245 Jevons, William Stanley, 1, 68 Johnson Matthey, 62 Joint Ore Reserves Committee (JORC), 69 Joyce, Susan, 248

Hogan, Lindsay, 263

K

Hoover, Edgar, 242, 245

Kaldor, Nicholas, 183

Horrigan, Bryan, 261, 262

Kalgoorlie Consolidated Gold Mines (KCGM), 232, 248

Horton, Donald, 256 Hotelling, Harold, 68, 194 Howie, Peter, 68 Howitt, Richard, 256, 260, 265, 266 Hughes, Helen, 210 Hughes, J E, 63 Hummels, David, 45 Humphreys, David, 61 Hunter, Boyd, 256, 266

Kandelaars, P, 64 Kay, John, 108 Keenan, P T, 160 Kim, J, 151 Knittel, C R, 63 Krautkraemer, Jeffrey, 68 Kreuzer, Oliver, 112, 113 Krugman, Paul, 40 Kuznets, Simon, 2, 13

I

L

Inco. See Vale Inco

Lagos, Gustavo, 239

Independent Pricing and Regulatory Tribunal of New South Wales, 116

Langton, Marcia, 260

Infomine, 71

Lawrence, Michael, 126

International Copper Study Group, 72, 87, 98, 99

Lawrence, R D, 161

International Council on Mining and Metals (ICMM), 12, 223, 226, 248, 254

Lawrence, Rebecca, 262, 263

International Energy Agency, 99

Leontief, Wassily, 244

International Finance Corporation, 231, 232 International Institute for Environment and Development, 23, 233 International Labour Organization (ILO), 271 International Monetary Fund, 61, 98, 102 International Petroleum Exchange, 92, 99 Interorganizational Committee for Guidelines and Principles for SIA (ICGP), 247 Interorganizational Committee for Guidelines and Principles (ICGP), 249

Laughton, Douglas, 164, 170

Lederman, Daniel, 28 Lesley, K J, 174 Lewis, Lynne, 180 Li, Shanjun, 61 Loferski, P J, 60 London Bullion Market (LBMA), 92 London Metal Exchange (LME), 88, 92, 93, 94, 95, 96, 97, 101 Lord, Deborah, 158 Lundgren, Nils-Gustav, 45, 46

Interorganizational Committee for Guidelines and Principles (ICGP) for SIA (ICGP), 248

M

Ivanova, Galina, 245, 247

MacKenzie, Brian, 1, 2, 4, 5, 67, 68

Mineral Economics

MacFarlane, Magnus, 248

303

name index Maddison, Angus, 28, 35

Northern Territory Revenue Office, 207

Malenbaum, Wilfred, 18

Norway Government Pension Fund, 210

Maloney, William, 28

O

Mamuse, Anthony, 159 Mangan, John, 278 Manning, W G, 59 Maponga, Oliver, 187, 275 Marshall, Alfred, 1, 2, 59 Mason, Anthony, 261 Maxwell, Philip, 30, 31, 34, 187, 269, 275 Mayfield, M P, 165 McCardle, Kevin, 172, 174 McCracken, Kevin, 256 McDivitt, James, 12 McLean, Ian, 32 McShane, Frank, 254 Meadows, Donna, 68 Medema, Steven, 1, 2 Metals Economics Group, 100 Meyer, J R, 235 Michaels, M P, 174 Mikesell, Raymond F, 222, 224 Mill, John Stuart, 52 Miller, Merton, 122 Minerals Council of Australia, 263, 275, 277 Mining, Minerals and Sustainable Development Project (MMSD), 223, 225, 226, 254 Mitchell, G D, 57 Modigliani, Franco, 122 Morgan, J P, 174 Morse, Chandler, 23 Mun, Johnathan, 161, 163, 166, 167, 168, 170

N Nakamura, Shigetoshi, 130 Nankani, Gobind, 21, 27 Neary, Peter, 25 Newendorp, Paul, 152, 153 New South Wales Department of Primary Industries, 204

O’Brien, Juan, 34, 35 O’Faircheallaigh, Ciaran, 261, 262, 263 O’Hare, C W, 203 Ohlin, Bertil, 40 Olewiler, Nancy, 72 Olsson, Anna, 64 Otnes, C C, 51 Otto, James, 184, 187, 201, 202, 224

P Pareto, Vilfredo, 183 Parmenter, Brian, 247 Parsons, J E, 165 Paul, Anthony, 61 Pegg, Scott, 232, 233 Pei, Fanyu, 61 Peirson, Graham, 109, 112, 163 Pequignot, J L, 51 Petermann, Andrea, 26 Petkova, Vanessa, 248, 249 Pezzey, John C V, 224 Phelps, C E, 59 Pilkington, John, 232 Pindyck, Robert, 160 Platts, 60 Pleck, E H, 51 Porter, Michael, 108 Portney, Paul R, 217 Poulin, Richard, 170 Pravica, Luca, 279 Pulvermacher, K, 61

R Radetzki, Marian, 46, 185, 186 Randall, Alan, 179 Randhawa, Sabah, 4 Rappaport, Alfred, 113

New York Mercantile Exchange (Nymex/Comex), 94, 97

Rawls, John, 221, 222

Nieuwenhuysen, John, 259, 260

Reilly, T, 157

Nishiyama, Takashi, 64

Reserve Bank of Australia, 47, 48

304

Raw Materials Group, 81, 186, 187

Mineral Economics

name index Ricardo, David, 40, 195

T

Riggs, James, 4

Tasmanian Government, 205

Rio Tinto, 262, 263, 267

Taylor, H K, 129

Robbins, Lionel, 2

Taylor, Jim, 234, 241, 242

Roberts, Mark, 271

Tedesco, Leanna, 263

Rogers, Peter, 260

Tietenberg, Tom, 180

Rolfe, John, 245

Tilton, John, 1, 5, 6, 22, 23, 24, 26, 61, 63, 64, 67, 68, 69, 71, 73, 76, 183, 196, 218

Roscoe, William E, 127 Ross, Michael, 27 Royalco Resources, 115

Todaro, Michael, 15, 16 Tokyo Commodity Exchange, 92

Rumsey, Alan, 260

Toman, Michael A, 224

S

Torvik, Ragnar, 29

Sachs, Jeffrey, 27, 28, 29 Salahor, G, 142, 163, 164, 165 Sally Malay Mining Ltd, 161, 162, 163 Samis, Michael, 164, 165, 170 Samuelson, Paul, 40 Schaffer, William, 244, 250, 251 Schluyer, John, 152, 153 Schwartz, Eduardo, 170 Shanghai Futures Exchange, 92 Shaw, A G L, 31 Sibbel, Anne, 278, 279 Sinclair, William, 31, 32 Singapore Exchange, 92, 94 Sirower, Mark, 113 Slade, Margaret, 171 Smith, Adam, 1, 85 Smith, James, 172, 174 Söderholm, Patrik, 244 Solow, Robert, 194 Sombart, Werner, 242 South Australian Government, 205

Torries, Thomas F, 127, 132 Trench, Allan, 111, 112, 113, 116

U UNESCO Commission on Human Rights, 253 United Nations Development Programme, 16, 216 United States Bureau of Economic Analysis, 100 United States Commodity Futures Trading Commission, 54 United States Energy Information Administration, 60 United States Federal Reserve Board, 100, 101 United States Geological Survey, 42, 75, 271 Uttley, P A, 158 Uttley, P J, 115

V Vale Inco, 89 Vanclay, Frank, 247, 248 van Dam, J D, 64 Vásquez Cordano, Arturo, 40 Venkatesh, R, 59 Victorian Department of Primary Industries, 205 Vogely, William, 12

Sperling, D, 63

W

Stewardson, Robin, 44

Walkup, G, 174

Storey, Keith, 277, 278, 279

Wallace, D, 151

Strongman, John, 234

Ward, C, 60

Sue Wing, Ian, 247

Warden-Fernandez, Janeth, 254

Sullivan, Daniel, 23

Warner, Andrew, 27, 28, 29

Sustainable Development Indicators in the Minerals Industry, 223

Wårrel, Linda, 64

Svedberg, Peter, 23, 24

Webb, Audrey, 259

Mineral Economics

Watts, J C, 62

305

name index Webb, Martyn, 259

World Bureau of Metal Statistics, 98, 99

Weber-Fahr, Monica, 30 Webster’s Dictionary, 253

World Commission on Environment and Development, 216, 224

Weiner, James, 260

World Gold Council, 54

Weiss, Steven J, 243

World Steel Association, 98, 99

West, Guy, 245

World Trade Organization, 41, 42

Western Australian Department of Mines and Petroleum, 206

X

Weyant, John P, 217

Xenophon, 1

Wikipedia, 254

Y

Wilson, A J, 17

Young, H Peyton, 220, 221

Woodward, Justice A E, 255 World Bank, 180, 187, 189, 218, 220, 223, 224, 272

306

Mineral Economics