Mining Valuations

Mining valuations: Future commodity prices; the great unknown

Abstract

Commodity prices are a central element to any mining valuation and, due to their variability, are a source of uncertainty.

Whilst a valuer has a number of alternatives from which to select when seeking future commodity prices, the common theme across each of these alternatives is that the actual price will differ from what has been forecast.

Faced with the choice of a number of (imperfect) alternatives, Axiom believes that an analysis of the available options tends to support the adoption of forecast commodity prices that have been drawn from the futures market.

Introduction

As with any business valuation, the valuation of a mining enterprise requires assumptions to be made regarding capital expenditure, operating costs and revenue.

Revenue that is generated in a mining project is dependent principally upon recoveries from the ore body, the grade of ore recovered and the price at which the commodity is sold.

When undertaking a valuation, assumptions regarding ore quantity and quality will generally be a matter for consideration of an expert geologist. Commodity prices, on the other hand, are a matter upon which a valuer can express an opinion.

Alternate sources of future commodity prices

The alternatives that are available when determining the commodity prices to apply in a valuation include:

  • The current price of the commodity (the spot price);
  • Forecasts prepared by investment banks / stockbrokers (‘consensus forecasts’); and
  • Prices derived from the futures market.

Which should be preferred?

Axiom has been involved in a number of mining valuations, both as independent experts in litigation and as consulting valuers, and has observed a divergence of opinion regarding the preferred source for future commodity prices.

Whilst there may be instances in which it is appropriate to adopt either the current spot price or ‘consensus forecasts’, Axiom considers that the forward price curve derived from the futures market will typically be the most defendable source, these being:

  • Factual: representing the prices at which parties are actually transacting in the commodity on a given day;
  • Objective: as they are not influenced by forecaster bias; and
  • Transparent and available: there is a deep, active and long-dated forward market in most major commodities, meaning that futures prices are generally accessible for several years.

Conclusion

Some measure of variation between what actually occurs and what has been forecast is to be expected when preparing any forecast. Recent history has shown that the degree of variation in commodity pricing tends to be greater than that for other integers that are often forecast and included in valuations.

Axiom believes that in many situations, when faced with a choice between a number of alternate bases, the most defendable prices to adopt will typically be those sourced from the futures market. The reason being that these prices are most likely to reflect the markets’ consensus best estimate of the future price of a commodity at a particular point in time.

Axiom’s recent experience with commodity prices

Axiom was retained to act as an expert accountant in a mining dispute where damages were claimed as a result of a delay to the commencement of the project.

In assessing damages, the expert retained for the plaintiff adopted ‘consensus forecasts’. In this case commodity prices were forecast to immediately (and materially) increase before gradually declining over time.

Given that the claim centred on a delay, higher commodity prices were assumed to persist during the period that the mining would have taken place (the ‘no delay’ scenario), whereas the ‘normal’ commodity price was assumed to prevail during the period in which mining would actually occur (the ‘delay’ scenario).

This is illustrated as follows:

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In this case, Axiom’s preferred approach was to rely on the futures market. Unlike the ‘consensus forecasts’, the futures market did not exhibit a rapid price increase or a material variance between the commodity prices applicable in the ‘no delay’ scenario and the ‘delay’ scenario.

The price curve based on the futures market is illustrated as follows:

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The price curve based on the futures market is illustrated as follows:

Axiom’s analysis illustrated that the adoption of commodity prices derived from the ‘consensus forecast’ was, in and of itself, the primary contributor to the calculation of damages claimed to have been suffered, highlighting the sensitivity of the calculation to the source of the commodity price forecast that was adopted.

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