Mining cash flow can be as lucrative as succesful mining itself

Mining concerns devote the majority of their time and creative talents to the traditional aspects of the industry exploration, discovery and production. Cash flow is always important, but has been viewed as a beneficial result of production.

In many cases and especially for junior companies, cash flow following production is a chicken-and- egg situation. You require cash to begin production — yet you have little or no cash. The ability to issue equity has sharply decreased with the decline in flow-through financings, so that avenue to funding is drying up.

In this situation, the above equation would be vastly improved if the sequence were exploration, discovery, cash flow, production. In certain situations this can now be arranged, and quickly.

Looking at cash flow from a different angle reveals that gross margin is a slippery item in mining, particularly precious metals mining. Operations that are profitable today may be much less so in a month because of declines in prices. Current cash flow can be an unknown factor which, in turn, has its impact on exploration, future production and future cash flow.

In other words, for a growing company, current cash flow provides the seed for much greater cash flow, and it makes sense to protect it. This too can now be done.

Innovative financing and hedging techniques can allow you to “mine” current and future cash flow. The flexibility and value that various strategies offer enhance rather than neutralize the entrepreneurial process.

A situation similar to the first example involves Newmont Mining. Newmont raised $448 million in a deal led by the Bank of Nova Scotia and used the funds to partially pay down debt acquired in paying a large dividend. Newmont basically borrowed against future production. The arangement works as follows:

Bns loaned Newmont one million oz of gold under an arrangement whereby the gold is repaid (replaced) over a 5-year period. The interest rate, which was really a borrowing fee, was 2 1/2 %. Newmont sold the gold and raised $448 million. The company can replace it from future production.

This method of financing essentially allowed Newmont to generate cash flow before production.

For smaller companies, the borrowing fees may be higher and the lenders will examine these on a deal-by-deal basis. Only a select number of banks are involved in this type of financing and knowing your way around them helps.

The recent run-up in copper prices provide a pointed example of managing gross margin. Copper rose from around the 80 cents (US) level in November to a high in the $1.40 range by early January. The March Comex copper contract traded to $1.27 and the futures market was sharply inverted, with May copper trading at $1.10 at that time.

I was involved with a junior company that had just brought production on-stream. Its production costs average 66 cents to 70 cents a pound and the company waited for some years for prices to rise to the point where a decent margin would be obtained. The company will produce 12 million lb this year and nine million next year. Production falls rapidly after that, but there are other, smaller reserves that will be opened up.

The unexpected sharp rise in copper prices was really like found money. I did a cash flow analysis whereby the operation hedged enough production so that at the minimum the company covered start-up costs. Ideally, though, the analysis proposed that the company hedge the entire year’s production at what would have been an average price of $1.20. This would have returned a gross of $6 million.

The company did nothing, and if copper remains at 95 cents , the gross will be $3 million. At 95 cents , the $6 million gross represents another orebody, of the same size, in production. This particular deposit will not, at 95 cents , be able to gross $6 million, and it is now forecast that increasing costs and depletion make it unprofitable.

These events are an excellent example of the economic rationale for mining cash flow.

Of course, the argument can be advanced that in January, no one really knew where copper prices were headed, and additional profit could have been forfeited.

First of all, copper is produced all over the world. Many older mines have been shut down but could be brought back into production quickly, as soon as margins permitted. As well, many less developed countries have large operations that must produce at any price because they are a source of hard currency. New deposits could be brought on stream quickly and production of older deposits could be increased. In macro- economic terms, all this was overhanging the market.

Finally, the futures market was trading at a tremendous inversion with the spot more than 45 cents higher than the September. Markets just do not sustain large extremes for extended periods of time. (In fact, many of our clients who trade futures contracts profited handsomely from our recommendation to sell March and buy September futures.) Something had to give.

All the indicators were stating that locking in $1.20 made sound business sense. This hedge is not the antithesis of the entrepreneurial spirit. Rather, it complements it. The company had already enjoyed profits from speculation by doing nothing as copper rose. Hedging would have allowed it to take profits and, let’s face it, every successful speculator has learned how to exercise the mental discipline required to take profits after a good run.

More advanced strategies involve spreading and option trading. With the sharp inversion in futures, the market was paying to buy copper today, not six months forward. A producer, however, is limited, within constraints, to daily production and to speed this up increases costs.

The alternative was to spread the contract months. March was trading at 35 cents over September. Selling March and buying September locks in this spread. If the spread narrows because the back month rises, the spread profits and at the same time the company is selling higher- priced copper into the cash market. If the spread narrows because the front month decreases, the company is selling lower priced copper into cash markets, but spread profits offset this. If the spread widens because back month prices fall, this loses money, but at least daily production is still being sold at the higher cash prices.

If the spread widens as a result of rising front month prices, the company is at least selling at the already high levels that existed when the spread was put on. Locking in this spread made sense.

Option strategies represent more advanced cash flow management techniques. Let us examine one.

Let’s say March copper is currently around 95 cents and September 86 cents . September 94 cents calls are trading at 8 cents . Because the company is long copper, even though that copper is in the ground, it is in a situation to do what option traders call a covered write. It can sell September options and take 8 cents a lb into income. If September copper prices rise above 94 cents , which they would over time if prices stay the same, what the call loses the company recovers by selling into the cash market. If front end prices fall from 95 cents , the 8 cents means that the company is still effectively selling at 8 cents higher than whatever the market is. And remember, these are 6-month calls. If volatility stays the same, the annual capture is 16 cents . The company could effectively sell copper at 95 cents + 16 cents = $1.11.

It forfeits any increase over $1.11 but proper management of the option portion can reduce the amount forfeited

These strategies can be attractive. Futures traders are willing to pay sizeable sums to speculate on metals through the use of options, and the company is in the position where it has the metal and can accept these payments (write calls) and still be protected on the upside.

These types of techniques require proper ratioing to match production to option expiries and time value decay rates, but there are a few specialists who can do this. For the company, writing calls at these levels is
equivalent to selling 18 million lb at 25 cents gross, instead of 12 million.

These two examples highlight the fact that mining cash flow can be as lucrative as successful mining itself. William Gates is president of Business Risk Management and is a senior partner of Rosenthal Futures Ltd.