Agricola Consultants

DUE DILIGENCE IN MINING INVESTMENTS

By M. Norman Anderson and Harleigh V. S. Tingley; The authors are directors of Anderson Genssler & Schwab, Inc., Management Consultants, headquartered at 645 Madison Avenue, New York, N.Y. 10022-1065, U.S.A. (Source: Mining Journal, April 1988) The authors consider the many factors involved in making a good minerals investment and explain the need for a businesslike due diligence review before committing major capital expenditure to a new project. How times have changed in the mining business! Ten to fifteen years ago, metals and other minerals appeared about to become so scarce as to threaten to limit world economic growth. Minerals prices, profits and new projects soared. Even second rate properties were profitable and investment risks were all but ignored in our haste to serve the markets. In the early 1980s almost all minerals markets collapsed. Many miners, since 1981, have lived in a depression: demand and prices tumbled, profits vanished; some high cost mines shut down; and survivors tightened their belts admirably. Some surviving mines were 'high graded', thereby shortening their lives. Except for gold and platinum which recovered rather quickly and prospered, (indeed some of the euphoria of the earlier days appears to have spilled over into gold and platinum mining), very few, new, replacement mines have been brought on stream during this period. Today, finally, all metal markets are generally pretty healthy -- coal and other minerals also show signs of recovery. Although we are not likely to see the euphoria of the 1960s and 1970s return, there is more buoyancy and more new projects are up for funding. But, in that framework, if the investors are to avoid some of the pitfalls of the past, due diligence of mining investments has to take some important, new perspectives. What makes a good minerals investment? The answer appears deceptively simple. Only quality properties should be brought into production. But what is a 'quality' property? Why is it that a Canadian 0.5% Cu ore body is among the lowest cost copper producers in the world while a 5% Cu deposit discovered 25 years ago in Zaire still remains untapped? The difference between a quality and second rate property is not just grade or geology or strip ratio or rock condition or deposit size or metallurgy or labour attitudes or labour availability or labour skills or market timing or demand or competition or terrain or climate or infrastructure needs or political considerations or construction costs or capital availability -- the list could go on for pages. Rather, it is a combination of all the above. If all are satisfactory and fit together you have a quality property. But if even one factor presents too serious a risk, then investor beware -- or at least be aware, and make your decision accordingly.

www.agricolaconsult.com

Page 1

Agricola Consultants
Gold miners have judged the money making potential of their new projects very well these past three or four years. Really, it has been hard to be wrong in gold recently. But what does one do when copper goes from 65[/lb to plus $ 1.00 as it has in recent months? Does it lead to judging new copper opportunities like gold opportunities have been judge of late? We think not! Not yet. But as more and more old copper mines and zinc mines are depleted, and if our economy continues strong, a prolonged period of higher base metal prices may develop. Investors today are looking for that trend. However, the prudent investor who believes (as we do) that better times may be returning will still insist upon an investment analysis or feasibility study to assess investment risks, and base his decision upon the results of that study. But before committing funds the prudent investor will also insist upon an independent due diligence review, not only of accounting and legal functions (which are not the subject of this article) but, of the study's technological, operating and business assumptions. Why due diligence? Why the double protection? Because of certain singular characteristics of the mining business and mining investments. Among these are: Mine investments are large -- even small mines don't come cheap. A mine investment has a certain ultimacy about it. You can't retrofit the grade or (realistically) the mine plan or metallurgy if the mine doesn't live up to expectations. Mining, unusually, involves many kinds of risks. It involves most risks common to all businesses, plus heavy doses of physical, political, climactic and other risks that few other industries must face. You can't see through rock. Mining investments are built on reserves which you can't see and which are seldom homogeneous. To determine reserves precisely is economically not feasible. To approximate them accurately takes a high degree of skill. Every mine is different. Mining is site specific -- you have to put the mine where nature put the ore, and deal with whatever geology, rock conditions, metallurgy, topography, society, politics, etc., is there. Many factors are involved and each mine's risks are different. Risk factors change over time. Due to the length of life of mine investments, the risk profile steadily changes. What begins as a reserves risk may develop into a mining risk or political risk or competitive risk or labour risk. Mining offers unique opportunities to unscrupulous promoters. The investor can't see the reserve through the rocks, can't count the parts per million in the grade, and often can't easily get to the site. Optimism (or perhaps we should say Overoptimism) is one of the greatest risks. Optimism permeates the mining business. Optimism has led to some startling

www.agricolaconsult.com

Page 2

Agricola Consultants
(and sometimes surprising success stories, but overoptimism has been the source of many failed investments. (As Simon Hunt once said, 60% of all mines profess to be in the low cost quartile.) Risks of overoptimism Overoptimism is a risk because many of those in the business have to be optimists in order to do their jobs well. The exploration geologist has to be optimistic to spend his life looking for a good mine. Can you blame him for hoping that the mineralization he does find is a little larger and a little richer than it is? The mine geologist knows that the whole mining operation depends on his finding reserves. Can you blame him for discounting those first hints that the orebody might be playing out, and taking a few risks that may be wrong in the process? The mining engineer developing a new mine must believe in it. Can you really expect him to have the drive and spirit to make a go of the mine and still be clinically objective about its potential risk? (Risks to the engineer are barriers to be overcome, not reasons for stopping.) Similarly, the marketer. The next order is always coming. The price is always going to rise next week. No good marketer could have survived the past few years without some optimism in his heart.

However, overoptimism can lead to unfortunate consequences even in well managed companies. For example, a US mining company well known for its skill in exploration and mining recently reduced a major reserve by 10% with the terse statement, 'Grade recoveries in the deposit were less than had been expected . . . because several high grade intercepts were given too much influence in the reserve calculation.' The consequences: higher costs and a shorter mine life. In these days of slim margins, that hurts.

The consequences of overoptimism can be very large. The molybdenum producers' overly optimistic forecasts of steel production a few years ago cost them hundreds of millions of dollars. Or on an even grander scale, the oil companies' misperception about the mining business cost some of them thousands of millions in mining investment losses. Due diligence in mining Traditional due diligence has been conducted on a functional basis principally in terms of legal due diligence, accounting due diligence, and financial analysis. However essential these are, they are not enough -- for example:

www.agricolaconsult.com

Page 3

Agricola Consultants
The legal review assures the investor that rights to the reserves are secure -absolutely essential to an investor, but of limited import if the deposit is uneconomic. The accounting audit assures the investor that past profits have been accurately stated -- essential but of limited use if those profits were earned in conditions that no longer exist. Financial analysis identifies potential financial returns -- but is of limited use if not solidly grounded in a real understanding of geological, mining, or metallurgical risks.

We believe that the investor should take a business approach to due diligence. What is a business approach to due diligence in mining? Simply stated, it is sitting down and putting all the facts together before you spend a fortune on a new mine. It is often done in six levels of effort: Reserve verification is the initial step. Are the reserves as represented? It is the job of the due diligence consultant to first verify the reserve evaluation process and then identify and quantify the impact of the optimism on the geologist's assessment, (but without being pessimistic either, which would kill every project that comes up for consideration). Level one due diligence hopefully concludes with verification of the reserve estimate. Level two due diligence identifies and seeks to assess all project risks. In addition to reserve risks, these may be metallurgical, mining, infrastructure, environmental, climatic, political, logistical, etc. It concludes with an assessment of whether the project risks in total are manageable. Next on the scale is a forecast of the probability of development and project projections being met -- will the project be completed on time and on budget, and will it produce scheduled tonnages and recovery at projected costs. This necessitates an assessment of management's ability to meet all the present and potential risks to the project -- a critical judgment for the investor. Level four provides competitive assessment of the project or business. Here the due diligence effort moves beyond the project itself to assess its strengths and weaknesses as against the strengths and weaknesses of the competition and concludes with a verification of business viability and risks. Level five consists of an assessment of future markets (1) in general, and (2) as pertinent to the particular project -- will there be sufficient demand and price for its products? Level six is the financial assessment -- what are the cash flows and what are the risks to that cash flow. This is the ultimate objective of the due diligence -- and is what the investor must know before making his investment. But the financial assessment is only as good as the technical, operating and commercial assessments that underlie it.

www.agricolaconsult.com

Page 4

Agricola Consultants
Skills requirements The skills required for due diligence reflect the risks of the business. Geological and mining skills; due diligence starts with assessing the reserves. Thus, geological and mining skills not those on an MBA, are prerequisites. Technical competence in a variety of scientific and engineering deisciplines is required to assess risks to the project as a whole. Operating management skill is needed to make the judgment as to whether risks are manageable and whether management can attain development and operating goals. Political assessment and management skills are necessary, as appropriate to the local environment. Market analysis skills are another very important prerequisite. International skills are needed. Mining is an international business. Minerals, like red wine, travel very well. Due diligence skills must be equally international. Business and commercial competence. Ultimately, the decision to develop or not develop is a business decision and must consider financial, commercial and physical risks.

In conclusion Consider these thoughts on what makes for a good due diligence job: Realism. However valuable modern techniques of geophysics, core drilling, and geostatistical analysis, they can also give a false sense of security. What is needed more is broad experience in studying and interpreting drill data and, because nothing yet can see through rock, a modest amount of scepticism to offset the euphoria that always surrounds new opportunities. Breadth is required. The due diligence team must be able to integrate all the issues into a single conclusion. Objectivity. The due diligence consultant must guard against undue optimism (or pessimism) in his own conclusions as well as in the conclusions of others. And he must not allow his judgment to be swayed by any interest of his clients -except his interest in a fair appraisal.

And finally, age and experience are necessary to put it all together. Due diligence in mining is not a young man's game.

www.agricolaconsult.com

Page 5