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POSTED JUNE 2016

Break-even is broken

By Julian Poniewierski FAusIMM(CP), Principal Mining Engineer and Brian Hall FAusIMM(CP),
Principal Mining Engineer, AMC Consultants Pty Ltd (http://www.amcconsultants.com)

Why the use of the break-even cut-off grade is flawed, and how it poses
a fundamental problem for the mining industry

Sometimes what we are taught is not right anymore


(if it ever was)
The lead authors father was taught at school that the nucleus of an atom was the smallest
indivisible piece of matter. It was then an undisputable truth. We now know of course about
quarks, muons and neutrinos. In this article, we invite the reader to reconsider what they were
taught on how break-even grades should be calculated and used, and how cut-off grades are
selected for use in mining studies and ore reserves estimation.
The authors contend that the way the base and precious metals mining industry uses break-
even grades is not consistent with the stated objectives of the mining company, and therefore
if not plainly wrong, is at least deeply flawed and subject to so many sources of error that value
is almost guaranteed to be destroyed.

Like using Newtonian physics in a quantum physics world, we contend that the way that the
majority of the mining industry calculates ore reserves with a break-even equation is no longer
appropriate it is broken. In addition, it is a major contributor to the underlying problems
with the financial returns of the mining industry. As will be shown in the case study in this
article, an error of just 0.1 g/t in the break-even cut-off grade of a large-scale open pit gold
mine can result in 50-60 per cent of the ore reserve having zero value. The authors contend
that it is more common than not that mines have ore reserves with this scale of error.

While the current process that is commonly used to estimate an ore reserve is deeply flawed,
the resulting declared ore reserve is not necessarily invalid. The JORC Code only requires that
the ore reserve is shown to be economically mineable (JORC, 2012) and does not say anything
about an ore reserve having to exclude substantial tonnages that are negative in value and will
lose money. However, it is implied in the JORC Code that the ore reserves quoted are what will
be mined and processed by the mining company.

The purpose of a cut-off grade


Mining companies will generally state their goals, purpose or mission to be something similar
to:

create long-term shareholder value (BHP Billiton, 2015)


deliver strong and sustainable shareholder returns (Rio Tinto, 2015)
deliver superior returns(Newcrest, 2015).

This can only be achieved by a selected combination of share price growth and dividends.

Given that the cut-off grade is the key decision variable determining what is processed in a
mine (and what is not, with ore processing being the main value-generating function of a
mining company), the purpose of the cut-off grade should be to enable the mining company to
achieve its previously stated overall goals (ie creating shareholder value from the mine in
which the cut-off grade is being applied). If the cut-off grade is not doing this, the company
cannot achieve its stated aims.

The break-even grade


The cut-off grade used by most mining companies for the process/do not process decision,
rightly or wrongly, is the break-even cut-off grade.

The break-even grade is defined as the grade at which revenue obtained is equal to the cost of
producing that revenue. The simple break-even formula to determine this is:
Although the formula is simple, many companies spend a lot of time and energy arguing over
what costs shouldbe included.

In addition, what is commonly not recognised, or is dismissed as not being particularly


important, is the fact that the recovery is usually a function of grade and that both the cost
and payability can also be a function of grade.

So, in fact, the simple formula is not so simple after all.

It is also important to note that this definition of the cut-off grade being used for the
estimation of ore reserves and the planning of the mine (the break-even cut-off grade) is not
the same as the stated objective of the mining company to deliver shareholder value. Thus,
the use of a break-even cut-off grade will lead to mine plans that are almost guaranteed to not
deliver the companys stated goals.

This then begs the question: why are companies using a break-even cut-off grade? The
authors suggest that they are simply oblivious to the effects of what they are doing.

The marginal tonnage issue in ore reserves


Although it is not often appreciated, a key feature of many stated ore reserves estimates is that
a significant portion of the ore reserves tonnage is marginal in value.

While this is well-known and understood by mining engineers heavily involved in the
preparation of ore reserve estimates and strategic long-term planning, it has become apparent
to the authors that the vast majority of mining executives do not understand how marginal
much of their companies ore reserves actually are. This is especially the case for executives
from a non-technical background.

Figure 1 presents an example of the distribution of an ore reserve tonnage by value for an
actual open pit copper-gold mine (Mine A). The distribution shown is typical of many
orebodies when a break-even cut-off value (grade) is used to estimate the ore reserves. A
significant portion of the ore reserve tonnage is of low or marginal value.

The distribution of total value for this ore reserves estimate is shown in Figure 2. The grades of
the material have been converted to equivalent net values expressed in dollars per tonne.

In this particular distribution, an interesting symmetry was present. The bottom 27 per cent of
the ore reserve by tonnage held 6 per cent of the value, while the top 27 per cent held 60 per
cent of the value, equating to ten times the value for the same tonnage. In effect, a lot of the
ore reserve was being mined and processed for little more than practice.
The effect of small errors in the break-even cut-off
grade on ore reserve value
Using the cut-off value/tonnage distribution for Mine A, it can be seen that a marginal break-
even cut-off grade for the ore reserves estimate can have a significant downside effect if there
is an error in calculating the break-even cut-off grade. Such an error would result in a
significant portion of the stated ore reserves becoming negative in value.

If the error was equivalent to $5/t in value (be it a cost or revenue error or a combination of
both), the distribution shown in Figure 1 would be modified to the value distribution shown in
Figure 3. In total, 27 per cent of the ore reserve tonnage would then be in the -$5/t to $0/t
value bin and a similar tonnage would be in the $0/t to +$5/t value bin. As a result, a total of
55 per cent of the ore reserve would effectively have zero value.

The $0/t to +$5/t value bin tonnes should be contributing to the capital payback of the
project and adding to the value of the total project. Instead, they are supporting the loss
associated with the -$5/t to $0/t value bin tonnage.

To understand how easy it is to have a $5/t error in the cut-off grade, at a gold price of
A$1640/oz (current at the time of writing), a $5/t error is induced by any error that changes
the calculated cut-off grade by 0.095 g/t (which the authors have rounded up to 0.1 g/t).

So an error of 0.1 g/t in the break-even cut-off grade calculation of a large-scale, low-grade
open pit gold mine (for which the previously discussed value distribution is typical) will result
in 50-60per cent of the ore reserve having zero value. This is quite disturbing to realise and is
generally unappreciated within the industry.

The authors refer to these ore reserves as negative geared. Negative geared ore reserves are
discussed in more detail in a paper written by Poniewierski (2016) for the Project Evaluation
2016 conference.

The two most common errors


The two most common errors that the authors have seen in the calculation of break-even cut-
off grades, which lead to negative geared ore reserves, are:

1. the fixed recovery error


2. the omission of sustaining capital costs.

The fixed recovery error refers to the use of a constant fixed recovery percentage for all head
grades down to the break-even grade. For example, consider a mine with a gold head grade of
2.2 g/t that has been evaluated to have a recovery of 94 per cent at the 2.2 g/t head grade. If
the 94 per cent recovery value is used to determine a break-even grade, it would be 0.4 g/t,
which implies a tails grade of 0.02g/t. This is a tails grade so low that, to the authors
knowledge, no operating gold mine has ever achieved it. At a head grade of 2.2 g/t, a recovery
of 94 per cent implies a tails grade of 0.13 g/t.
If it is recognised that the recovery varies with head grade and a fixed tails grade is used to
assess the recovery instead of a fixed percentage recovery, the same cost and price conditions
that resulted in a break-even cut-off grade of 0.4 g/t for the fixed percentage recovery would
result in a break-even cut-off grade of 0.5 g/t. This is a difference of 0.1 g/t, which is sufficient
to make 50-60 per cent of the ore reserve previously calculated with the fixed percentage
recovery of zero value.

An examination of JORC Table 1 releases shows that the fixed recovery approach is being used
to determine the break-even cut-off grade of a large percentage of ore reserves.

The second item, the omission of sustaining capital costs, can result in a significant
underestimation of the true costs and therefore a significant underestimation of the break-
even cut-off grade.

Hall (2014) discusses the sustaining capital in detail. Sustaining capital is expenditure that
maintains existing capabilities as opposed to project capital that is used to buy capability (or
capacity).

For maintaining existing capital items, there is no conceptual difference between replacing an
oil filter every 50 hours (an operating cost) and replacing a truck engine every 16 000 hours (a
capital cost) or a truck every 50 000 hours (a capital cost). Therefore, sustaining capital is
conceptually a lumpy irregular expense that is classified by accountants as capital rather than
operating costs purely by virtue of the spending pattern, not the underlying nature of the cost.
By capitalising these irregular expenses, accountants are able to use depreciation to more
evenly spread these lumpy costs out over the useful life of the equipment being maintained.
As such, sustaining capital needs to be included in the cut-off grade calculation.

Some examples of sustaining capital costs that should be included are discussed in
Poniewierski (2016) and Hall (2014).

How should break-even be calculated?


The authors contend that the only true method of evaluating a correct break-even cut-off
grade is to undertake a set of scenarios with varying cut-off grades and production rates. If
these scenarios are evaluated in a financial model that accurately reflects the costs of each
scenario and the undiscounted cash flows are graphed as shown in Figure 4 (where, in this
case, the y-axis of increasing value is the project total undiscounted cash flow), the cut-off
grade that results in the largest undiscounted cash flow is the true break-even cut-off grade.
By definition, a cut-off grade less than the identified peak cash flow cut-off grade and that
results in a lower total cash flow must include material that is losing value.

Should we be using break-even at all?


The authors also contend that we should not be using the break-even grade at all. If the time
value of money is recognised, a cut-off grade higher than the calculated break-even grade will
usually be one that maximises net present value (NPV) (for a fixed selected cut-off grade
value), as discussed in Hall and de Vries (2003) and Hall (2014). In this case, for the y-axis
shown in Figure 4, the increasing value is the project total NPV (discounted cash flows).

Further refinement is possible, resulting in a cut-off grade policy of varying cut-off grades over
the life-of-mine that will increase the NPV, as discussed by Lane (1997), Whittle (2015) and King
(2001).

Sub-grading
The authors recognise that there is a perception in the mining industry that increasing the
cut-off grade above the currently used and publicised break-even cut-off grade leads to
accusations of high grading. The term generally has a negative connotation and is always an
accusation that the mined grade is higher than it should be; picking the eyes out of the
resource, sterilising ore and thereby destroying value.
If thats what increasing the cut-off grade is really doing, then it is indeed a bad thing. But this
begs the question of what the grade should be! Presumably, it should be the grade that
delivers on the companys goals providing shareholder returns and value.

Over the course of numerous strategy optimisation studies, the authors have never found an
operation high grading above the grade that maximises cash generation. However, many are
sub-grading, which involves mining and treating grades that are substantially lower than the
cash maximisation grade and using higher-grade ores to subsidise loss-making ore tonnages.

The authors suggest that mining with a properly engineered mine plan at the grade that
delivers the companys goals is right grading. Typical plans are therefore sub-grading, which
should be just as pejorative a term as high grading. To a sub-grader, right grading will look like
high grading. But what right grading has eliminated from the sub-graders mine plan is
material that is actually destroying value, which should not have been in the plan in the first
place. Sterilising value-adding material is not destroying value, which is the feared outcome of
high grading.

Mining is a business, and a business does no one any favours by setting itself up for failure.

Conclusion
The use of the break-even cut-off grade is a fundamental problem that is exacerbating the
poor financial returns of the mining industry. We leave the reader with a final thought that
should be the new mantra on cut-off grades:

Cut-off grade should be an outcome of a mining study that has been undertaken to meet the
companys stated value goals. Cut-off grade should not be a predefined input into such a study,
as this will guarantee that the companys value goals will not be met.

References

BHP Billiton, 2015. Resourcing Global Growth: Annual Report 2015.

Hall B, 2014. Cut-off Grades and Optimising the Strategic Mine Plan, Spectrum Series 20, 311 p
(The Australasian Institute of Mining and Metallurgy: Melbourne).

Hall B E and de Vries J C, 2003. Quantifying the economic risk of suboptimal mine plans and
strategies, in Proceedings Mining Risk Management Conference 2003, pp 191200 (The
Australasian Institute of Mining and Metallurgy: Melbourne).

JORC, 2012. Australasian Code for Reporting of Exploration Results, Mineral Resources and Ore
Reserves (The JORC Code) [online]. Available from: <www.jorc.org> (The Joint Ore Reserves
Committee of The Australasian Institute of Mining and Metallurgy, Australian Institute of
Geoscientists and Minerals Council of Australia).
King B, 2001. Optimal mine scheduling, in Mineral Resource and Ore Reserve Estimation The
AusIMM Guide to Good Practice (ed: A C Edwards), pp 451458 (The Australasian Institute of
Mining and Metallurgy: Melbourne).

Lane K F, 1997. The Economic Definition of Ore, second edition (Mining Journal Books:
London).

Newcrest, 2015. Our values [online]. Available from: <www.newcrest.com.au/careers/work-


with-newcrest/careers-our-values> [Accessed: 19 March 2015].

Poniewierski J, 2016. Negatively geared ore reserves a major peril of the break-even cut-off
grade, in Proceedings Project Evaluation 2016, pp 236247 (The Australasian Institute of Mining
and Metallurgy: Melbourne).

Rio Tinto, 2015. About Rio Tinto [online]. Available from: <www.riotinto.com/aboutus/about-
rio-tinto-5004.aspx> [Accessed: 19 March 2015].

Whittle G, 2015. Whittle Optimisation the money mining methodology and its impact on ore
reserves,
in Mineral Resource and Ore Reserve Estimation
The AusIMM Guide to Good Practice, second edition, Monograph 30, pp 525 528 (The
Australasian Institute of Mining and Metallurgy: Melbourne).

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