There are many business risks associated with running a mining company. Failure to identify and properly manage these risks can have a material adverse impact on profitability and cashflow.
Retail investors should be mindful of these risks and carry out appropriate due diligence to ensure they understand how their investment could be exposed. This article aims to examine some of the more relevant business risks that mining companies are up against.
1. Estimates used in the Investment Model
The business case for any mining project is built around assumptions and estimates for volumes, commodity prices, operating costs and the capital expenditure needed to deliver the company’s exploration and production project.
Reduced recovery rates or lower market prices combined with increased production costs can seriously impact the investment case and result in making the mineral resources uneconomic to exploit.
For example, the volume and grade of the ore extracted by the company may not conform to forecast expectations and could lead to a downward revision in its mineral reserve estimates.
Development expenses including mine construction costs, transport costs, treatment costs and overheads etc are subject to changes in the underlying assumptions behind the estimates used (owing to unexpected events or issues) and this will also impact on profitability of the project.
2. Hedging risk
Where a mining company fails to utilise a derivative or other hedging instrument to protect against a fall in commodity prices, then operational profitability could be adversely affected by the failure to do so.
To mitigate against the risk of a fall in commodity prices, the company should consider entering into a forward sales agreement such that the price of the underlying commodity is fixed in advance (with the customer) for the sale of its future production.
However, where a company has hedged against the future price movements and the price of a commodity continues to rise the company will not see any financial benefit from that price increase.
3. Risk ratings
Any downgrading of the company’s existing credit rating by an international rating agency could have serious consequences for the company and may adversely impact its ability to raise project financing in the future.
In addition, the interest rates charged and other fees levied will be higher and the commercial terms at which such additional financing may be available will be more demanding.
Ultimately, this would have a negative effect on the mining company’s cashflow and financial performance and in a worst-case scenario could even threaten the continuation of the project.
4. Uninsured risk
A sensible, properly managed company will always conduct a risk management exercise to identify what areas of the business can be insured against financial loss.
There are specific insurances such as Employers Liability which are compulsory and of course the company will ensure that the appropriate cover is in place.
However, it may not be possible to obtain insurance against all risks the company is exposed to, perhaps because the cost associated with the insurance premiums is prohibitive or cover is not provided by the underwriter.
For example, the cost of insuring a mining company against environmental damage or pollution caused by exploration and production may not be available on terms that are commercially acceptable.
In this situation, the company may elect to reduce the amount of cover they would like to have in place because of the impact the cost of policy premium will have on operating profits; although it does mean that the company will not cover the full extent of its potential business risks.
This uninsured risk exposes the company to a financial shortfall should any liability arise in the future; and this of course will have a negative effect on its share price.
5. Litigation risk
While the company in which you are invested may not be exposed to any litigation or other legal disputes, at the time you make your investment, the nature of conducting business in the mining sector means that the possibility of legal action remains ever present.
One of the more common areas of contention, for example, surrounds the rights and obligations associated with mining licences awarded by governments to operators.
In addition, the mining sector also brings its own challenges in respect of safeguarding employee health and safety. Failure by the company to exercise appropriate standards of care could have a material adverse effect on the business.
The possibility of legal action is always a threat. Even if there is no merit to these claims, the costs of defending them through the courts and funding any settlement awarded against the company could have serious financial consequences.
Investing in commodities
If you are thinking of investing in commodities and want to learn more about the commodities sector, please follow the link.
