Investing: Hope vs. Reality & How to Avoid Repeat Mistakes
We are committed to helping investors come to grips with the resources sector and learn how to interpret news releases made by companies. In these Analyst’s Notes we illustrate how news from companies affects the investment case for the stock, and how it can affect peers as well. The topics are selected based on what the analysts think is both relevant and informative to you, the investor.
Before making comments, please ensure you have read the whole article and the FAQs at the bottom.
This week, we have chosen to focus on Harte Gold as case study for how much it actually costs to run an underground mine.
Action Points and Key Takeaways
Harte Gold is a perfect example of how difficult it is to make an underground mine work well. This brief report reviews Harte’s Sugar Zone Mine through the lens of our recent analysis of cash costs per tonne for Canadian underground mine, and shows how it will always struggle to generate meaningful free cash flow.
If you want to apply lessons from Harte Gold to other companies, then you should do the following three things:
- Watch out for deposits that are narrow and skinny relative to depth extension, unless they are super-high grade. The Vertical Ounces per Metre calculation will always work against you.
- Avoid projects that are being brought into production on the back of a PEA. It only ever works in exceptional circumstances, and normally ends in tears.
- Walk away from starter projects raising capital to scale up production from the “free cash flow” that is forecast to be generated. Forecasts disappoint, free cash flow is not generated, and the sorry saga continues.
On 17 March 2021 we published an Analyst’s Note looking at benchmarks for unit cash costs and the cash generative capacity per tonne treated for Canadian underground mines. Soon after that, on 25 March, Harte Gold announced its actual operational and financial results for 2020. These results plus the recently published feasibility study on expanding production at its Sugar Zone mine means that we can immediately test our observations on a ‘live case’.
The Sugar Zone Mine is exploiting steeply dipping, narrow veins, which make it a perfect candidate to test it against the guidelines defined in our earlier study.
Harte Gold Case Study
Background to the Sugar Zone Mine and Performance to Date
The Sugar Zone mine is located in northern Ontario 30km northeast of the town of White River and 715km northwest of Toronto (see Figure 1).
The deposits being mined are narrow lodes within a deformation zone called the Sugar Deformation Zone (“SDZ”) from which the mine derived its name. The mineralisation is present in several “subzones” that range between 0.2m and 6m in thickness, strike northwest and dip between 65º and 70º to the southwest. Whereas the mineralisation is found over a 3.5km strike length and to a vertical depth of over 1,200m, the resources defined to date cover less strike length. Figure 2 shows the interpreted wireframes of the mineralised veins for the Sugar Zone (in red), the Middle Zone (brown) and Wolf Zone (in yellow).
At the Sugar Zone (not to be confused with the name for the entire project, which is the Sugar Zone Mine), there are three zones of sub-parallel, sub-vertical mineralisation (Upper, Lower and Footwall) from west to east, with each of the three zones separated by 20–30m of waste. Of these zones, the Footwall Zone is best developed with the highest grades.
Moving along strike to Middle Zone a weak Upper zone is developed in addition to the Footwall zone and the northernmost Wolf Zone has only one zone with an upper (or higher) and lower domain (see the two yellow blobs in Figure 2).
The illustration, above, shows the wireframes for the mineralised extent of each zone. Once the modifying factors of stope design, economics, dilution, and the like are incorporated into the calculation of what is actually mineable, the dimensions drop considerably as is shown in Figure 3. This section shows the mine lay-out for the Sugar Zone (split into South and North Zones in the south-southeast) and the Middle Zone.
Keen-eyed readers will spot that the vertical scale has been exaggerated relative to the strike dimension by a factor two (compare the bar scale and the vertical coordinates).
Using the scale bars, we estimate the ore shoots to have a strike dimension of 500-600 m and a vertical dimension of 800-900m. Information on the shoot thickness comes from the recent feasibility study. On page 15-1 the average ore thickness at the Sugar Zone is put at 1.1m, which contains roughly 2/3rds of the ore and 2.2m at the Middle Zone which contains roughly 1/3 of the ore. The designed mining width is 2.0m horizontally, which converts to between 1.5m and 1.9m true mining width, depending on the dip of the veins from respectively “shallow” to 70º. The mining width is therefore usually wider than the deposit, resulting in considerable dilution which will serve to reduce the Run-Of-Mine grade delivered to the mill.
The narrowness of the veins, plus the constrained strike extent means that if Harte Gold wants to increase ore tonnage rates it therefore needs a commensurate acceleration of vertical development. An additional challenge for Harte Gold’s mine is that it has three ramps, and three plunging shoots.
ASIDE: A good way of looking at a deposit is to measure the vertical ounces per metre. This concept is pretty self-explanatory. How many ounces are included in the mine plan for every additional metre of depth that is measured? Clearly, the number of ounces is a function of grade & tonnes in each vertical metre. In narrow deposits of limited strike length, the tonnage per vertical metre will be low which means that the grade needs to be extremely high to give a decent “vertical ounces per metre” figure. Remember that vertical development is expensive, and it is almost always carried out in waste material.
The Sugar Zone Mine is an example of a project having been given the go-ahead on the basis of a preliminary economic assessment (“PEA”). Hmmm. We really do not like seeing mines go into development on the back of a PEA unless it is an extremely simple project (think easy metallurgy, heap leach, low capex, good grade).
Construction started in February 2017 and commercial production declared on 1 January 2019, months later than according to plan. The declaration of commercial production was largely cosmetic, probably to prevent loan covenant breaches, as production during H1/19 fell far short of plan. Total mine production for 2019 was 75,000 tonnes, which is less than half the rate envisaged for 2019 in the PEA.
The original (PEA) business plan called for a staged ramp up, starting at a mill rate of 575 tonne per day (‘tpd”), increasing in Phase 2 to 800tpd and eventually to 1,400tpd in Phase 3. Phase 3 was also supposed to include a leaching circuit for the flotation concentrates, producing gold in doré on site, thereby dispensing with the toll treatment that was being used for Phases 1 and 2. Not wanting to take too dramatic a view, but we analysts tend to see these kinds of phased approach with very low production levels in the initial phases as the kiss-of-death for a project with a mediocre grade.
Small operations are as difficult to run as large operations and the overhead of a listed company is more or less the same whether production is 33,000 ozpa (Harte Gold) or 330,000ozpa. When the annual production of 33,000oz gold or less, the operation is extremely unlikely capable to carry the overheads of a listed company, especially when dealing with lots of narrow development headings, and three ramps, and not many ounces per vertical meter.
We also come into this review of Harte Gold’s recent performance fresh off a study on underground operations. The Analyst’s Notes from 17 March showed that operating cost and capital cost per tonne milled are very sensitive to production levels and that when production rates are low (575-800tpd), then operating costs and sustaining capex can be expected to be very high.
Where we looked at Canadian peers for benchmarks, Harte Gold relied on cost forecasts from a PEA level study which were very low in comparison to the cost at operations run by peer companies in 2019 (Table 1).
Table 1 also includes revised numbers as per a feasibility study from 2 May 2019, but generated by the same consultants responsible for the PEA and these were still too optimistic. The table includes H1/19 numbers and not full year numbers because the company ceased to provide costs for mining, processing and G&A separately thereafter.
# For the cost breakdown the ratios in the technical report for 2017 reserves was used
$ This excludes ‘growth” capital of C$128/t and exploration expenditure of C$60/t milled
^ Possibly not representative, operation in trouble. However, underground development capex alone is C$72/t
A review of the table above shows that the cost estimates in the PEA and in the Feasibility Study were significantly below the actual costs. It is also worthwhile noting that the actual costs were not entirely out of kilter to the real costs of other Canadian underground operations. Yet another argument for relying on benchmark costs, not consultants’ predictions, but that is a whole separate discussion in itself.
The high actual H1-2019 unit costs for Sugar Zone are partially explained by the low production rate with a material fixed cost component in each of the activities, particularly processing and G&A. Ramping up to the target rate of 0.30Mtpa (i.e. 800tpd) in Phase 2 would help reduce cash operating costs and sustaining capital cost per ROM tonne.
The next section will compare the actual 2020 cash cost and forecast cash cost as per expansion feasibility study to what the relationships in the Analyst’s Notes dated 17 March 2021 suggest.
Latest Plan and Forecast Performance
The latest feasibility study is on an expansion plan to increase production from 800tpd to 1,200tpd (approximately 0.44 million tonnes per annum) to improve on economics of the Sugar Zone mine.
Table 2 shows the mineral resources and mineral reserves on which the expansion schedule is based.
Please note that the table shows a conversion of 74% of the gold contained in Indicated Resources to Reserves, but that it comes with a substantial drop in grade (40% lower than in mineral resources). This is due to the substantial dilution resulting from mining the deposits at a minimum horizontal width of 2.0m. With the narrower lodes at Sugar Zone, the grade reduction there is more than half compared to one quarter reduction for Middle Zone resource grade. The resource grade of Wolf is too low to warrant mining.
A metal content of 0.8Moz in reserve amounts to approximately 1,000oz per vertical metre when assuming an average vertical extent of 800m for the 3 shoots. Given 3 ramp structures are required to mining this gold, it places a heavy capital component on mining the Sugar Zone Mine gold as each vertical metre ramp development will access only 335oz. Table 3 shows the forecast cost rates used in the expansion feasibility study.
# These are LOM numbers including 2021 numbers
Figure 4 places the numbers in the table, together with actual 2020 performance, in the context of the relationship between production level and unit operating cost and capital cost expressed in US Dollar for Canadian underground mines as a function of production level as established in the 17 March 2021 Analyst’s Notes.
The Analyst’s Notes gave the relationship as a straight-line relationship as a simplification for the reader not proficient with exponential formula, but the true relationship is exponential as determined purely mathematically from the impact of fixed cost component on total unit cost.
The relationship for Opex (in US$/t) is: US$2,912 x (treatment rate in ‘000t) -0.454
The relationship for Capex (in US$/t) is: US$5,446 x (treatment rate in ‘000t) -0.644
The enlarged black dots indicate the actual 2020 cost rate (the dot on the far left) and forecast rates for Phase 2 and Phase 3 as processing rate is increased. The numbers exclude royalty and treatment expenses and off-mine General and Administrative expenses, which amounted in 2020 to almost 40% on on-site cash production cost. As some of the other peer group costs do include royalties and treatment charges, there is a slight favourable bias in the Sugar Mine numbers. Even so, the Sugar Mine rates fall well within the established relationship for Canadian underground mines and can be considered reasonable.
However, the single large red dot, which indicates sustaining mine development and capital expenditure for the Sugar Zone Mine, is on the low side, especially considering the average treatment rate is lower than the Phase 3 treatment rate used for plotting the unit cost. In addition, the forecast production rate is pushed up by developing three mining centres, which means that economies of scale are lower than being able to push the rate of from a single deposit with good mining width.
Figure 5 shows the cash flow generated in 2020 per tonne treated as function of feed grade (the large black dot) compared to the relationship established in the 17 March 2021 Analyst’s Note.
The reason why the Sugar Zone Mine performance falls well below the correlation line is that the average received gold price was only US$1,446/oz, well below the spot price in 2020 because of hedging transactions. In addition, with the company preparing the mine for production ramp-up a proportion of the “sustaining” capital expenditure can be considered “growth” capital expenditure and will come down in future. Against this any investor must realise the mine pays 4% royalty not reflected in the above rate and needs to cover more than C$10M of corporate overheads, which equates to more than US$80/oz at maximum production. This confirms our view that an underground Canadian mining operation will battle to generate meaningful cash flow at a feed grade of 4g/t Au and that Harte Gold will struggle to give a return to its shareholders without a substantial boost from a much higher gold price.
We draw the following broad-brush conclusions from reviewing the Sugar Mine:
- Developing an underground mine in phases, starting from a very low output rate, is poor strategy leading to bad economics. The fixed cost component of on-mine activities and corporate overheads make it impossible to generate positive cash flow.
- Trying to improve the economics by dramatically scaling up production makes sense on paper, but will always be difficult on narrow structures without bonanza grade due to the need for multiple development headings. At the Sugar Zone Mine, operations are facing this exact challenge, and it will have to be seen whether the very narrow veins and the associated requirement for lots of working stopes at any point in time to support the planned processing rate can be achieved.
- The Sugar mine has very limited contained gold per vertical metre given the very narrow nature of the lodes, limited strike extent, and moderate grade. This is aggravated by having to mine at three centers each requiring its own ramp infrastructure. It will place a relatively high capital cost burden per ounce produced.
- The forecast operating cost numbers for Phase 2 and Phase 3 processing rates at Sugar mine fall well within the established cost relationship and seem therefore reasonable.
- However, the suggested capital investment for mine development and other sustaining capital expenditure seems very low and may in practice prove to be double the suggested rate.
- The reserve grade of 7.2g/t Au is not enough to offset the narrow veins, the dilution, the three ramps, and therefore the economics end up being uncomfortably close to the “4g/t Au feed grade” threshold. As we showed in the 17 March 2021 Analyst’s Note, Canadian underground operations with grades below 4g/t Au will not be able to generate positive cash flow. The grade threshold is for mines with deposits of much larger width than the Sugar Mine deposits.
These Analyst's Notes are not necessarily about the company being discussed. The aim is to share a process for analysis for you the reader & investor to use elsewhere in your investment portfolio. And at the very least to give you an appreciation for the types of questions that you should be asking before you invest. We hope that collectively the Anlayst's Notes can help you feel more confident in your investing and ultimately be even more successful than you already are. Best of luck and happy investing!
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