Mining is mostly about how a company develops resources that have already been discovered, sometimes very long ago.
1. Metals orebodies can vary considerably from one part ot the next in the proportion of valuable minerals they hold. Standard practice is to mine the highest-grade ore when prices are low, and the lowest-grade when prices are high.
Not a lot of operating leverage this way. But the idea is to enable the mine to stay open even during the inevitable cyclical downturns. Doing the opposite, which will likely boost the stock price in good times, can lead to disaster during the bad. There’s no easy way for an outsider to tell, except by the reputation of company management. In the case of gold, we may find out who’s been prudent and who’s been reckless when the 2013 financials are published.
2. Same thing with site preparation. Standard, and prudent, practice is to routinely spend money on things like removing overburden (layers of dirt covering the ore) in places where the company is not mining today, but plans to in the near future. This activity can be quite expensive. But it’s necessary. On the other hand, a firm can make short-term profits look considerably better by not doing so.
oil and gas
Oil and gas is much more involved with finding new deposits, and how to account for those costs, than metals mining.
1. Companies have two ways to account for the costs of buying mineral rights and doing exploratory drilling. They are:
–successful efforts, where, as the name suggests, only successful fields are put on the balance sheet and gradually written of as oil and gas is produced. The costs of unproductive areas are written off as expense as soon as they’re incurred.
–full cost, where all exploration costs, both for productive and non-productive projects, are capitalized and written off against production.
Successful efforts is more conservative, but normally results in lower earnings.
2. Accumulated costs are written off pro rata as each unit of oil or gas is produced. The amount expensed against the revenue from each unit is its proportionate share of the total cost of finding and developing all oil and gas (it’s a little more complicated than this, but this is basically what you need to know). That proportion, in turn, is calculated based on periodic estimates by petroleum geologists’ of the total size of reserves.
Big oil companies use their own geologists; smaller ones hire outside consultants. The important point is that this estimate–and therefore the amount of cost written off per unit produced–can vary a lot, depending on the particular consultant hired. It may also depend on the tone, conservative or aggressive, company management sets.
Just as important, as I mentioned yesterday, oil and gas price changes can alter the size of total reserves. The cost of recovery doesn’t change, but the amounts of hydrocarbons that can be brought to the surface at a profit can be. Lower selling prices can raise the per unit amount expensed; higher selling prices can lower the unit amount. Potentially, lots of operating leverage–that’s completely out of management’s control.
3. A minor clarification of #2: subject to some limits, the company decides how to group reserves and associated costs into different “cost pools” for figuring out depreciation and depletion. Artful grouping of these pools can help disguise an extended run of bad drilling luck. Not usually a worry, except with small firms with limited history.
4. As with any other capital construction project, when oil and gas companies explore and develop with borrowed money, they can capitalize (that is, put on the balance sheet rather than expense immediately) the interest expense on that borrowing. The interest expanse becomes part of the general costs that are written off against oil and gas production. For smaller companies with an ambitious drilling program, this can sometimes create the peculiar (and potentially disastrous) result that it shows positive earnings while it is suffering cash outflows. This is because interest is being paid to creditors but these payments basically don’t show up on the income statement. Check the cash flow statement!!
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