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The tricky business of reserve estimation

Few in the mining industry can forget the devastating market collapse that occurred in the aftermath of the Bre-X scandal in 1997. An independent mining consultant concluded that the Calgary-based Bre-X had salted its gold samples, overstating the value of the Busang deposit in Indonesia from a mere 3 million ounces to more than 70 million ounces. Thousands of investors lost billions of dollars in this elaborate gold hoax that ultimately collapsed Bre-X. Shares once valued at more than $6 billion on the stock market became worthless.

The bust also led to the drying up of high-risk exploration funds for the companies that make many of the new discoveries. The mining and metals sector of the market has only recently turned up from the lows it experienced after the Bre-X crash, which resulted in tighter regulations regarding mining disclosures in Canada and around the world.

The Bre-X scandal is finding new relevance in light of the recent corporate accounting scandals that began with the downfall of Enron last year. Like Bre-X in 1996, when it discovered the fabled Busang property, Enron seemed an unstoppable force in the stock market. Both companies’ deceptions left investors in the cold, wondering when the next fraud would surface.

At the same time, in the mining industry, Bre-X represents a unique case of geological fraud. Experts warn that while future reserve busts are possible, they would probably come not from data tampering, but rather from errors in the collection, processing and interpretation of the scientific data.

In his 21 years as a geologist at the U.S. Securities and Exchange Commission, David M. Abbott Jr. saw few cases of intentional fraud by mining industry professionals. “Enron and the other accounting fraud cases that I know of involved people with knowledge of the accounting systems and knowledge of the auditing systems, who were able to deliberately defeat those systems,” says Abbott, now a consulting geologist in Denver. “In the mining busts, however, with rare exceptions such as Bre-X, the errors occur, the busts occur, but they were not intentional errors.”

The problem for a mining company is that its inventory is its reserves, Abbott says. But a reserve is only an estimate of the amount of ore in a mineralized deposit that can be mined legally and at profit. “Inherently, that requires looking into the future. Accounting is based on the 20/20 hindsight principle. The reserve estimates are not part of the financial statements for mining companies,” he says.

Although investors should be aware of the reserve estimates because they appear in company annual reports, the numbers are often buried on the last page, and investors are largely unaware of the many steps that go into calculating a reserve estimate. By the time these numbers reach investors in the stock market, the detailed geological, engineering and economic processes that provide the technical basis for the estimates become lost in the abyss of corporate summarizations and disclosure practices, Abbott says.

“The reasons that estimates are blown come from errors in sampling, errors in density measurement, errors in geological modeling and they come from errors in the execution of the mining plan or the processing,” Abbott explains. While the likelihood of error varies widely depending on the type of deposit, all estimates depend on good geology, he adds.

That geology is often complex and uncertain, says Henrik Thalenhorst, a consulting geologist for Strathcona Minerals in Toronto who participated in the audit of the Busang deposit in 1997. Gold grades (the amount of gold in any deposit), for example, are unevenly distributed — making it extremely difficult to extrapolate sample grades over a wider area. Porphyry copper deposits, however, are much easier to model because the metal grades are more predictably distributed. The reserve estimates for all deposits, however, face some uncertainty.

Charles Tatman, a consulting mining engineer in Portland, Ore., says that large variances between reserve estimation and actual production are all too common. In his study that examines the reserve grades of 41 underground North American gold mines over the past 15 years, “25 of the mines had less production grade than reserve grade, some of them by 200 to 300 percent less grade,” Tatman says. Seventy-five percent of these mines erroneously sampled deposits, while the other 25 percent incorrectly modeled the geology. The other 16 of the 41 mines ended up with better grades than the original reserve grade.

Thalenhorst says that these errors are to be expected. “We’re only ever estimating, never determining. There’s always a variance with reality and the key is to keep it small and to err on the side of caution.”

Another part of the problem, Thalenhorst says, is that companies are often unwilling to spend the money necessary to do enough drilling and sampling. “Some people feel pressured by management to cut corners.” Up until recently, geologists have not had a universally strong enough role in that process to advocate sounder methodology, he says.

In the years since Bre-X, Canada has adopted new regulations that require geoscientists involved in mining and exploration to be a “qualified person,” a designation for someone who belongs to a self-regulating professional organization and has a minimum of five years of practical experience. “We have strengthened the role of the geoscientist in general,” Thalenhorst says. “That concept enables us collectively as geologists to put our foot down and say ‘look this is the way it is.’ And therefore we cannot be manipulated by management.” The new regulations mirror those of Europe, Australia and South Africa.

Thalenhorst thinks the role of geology could go a step further — to the global stock markets, where he says more detailed technical data should become part of a company’s annual report. He suggests that operating mines be forced to report on the process of reconciliation between what they have actually produced and what was predicted by the reserve model. “You know what came out of the mine and you should track that back into your reserve model,” Thalenhorst says. “That’s the single most important aspect of tracking how you are doing on this whole estimation process.”

Many companies, however, are not going through that back-tracking process, or at least are not reporting it. Companies are not required to report such comparison in their annual reports, press releases and other materials that go to investors, Thalenhorst says. Perhaps a little bit of geology in such documents could go a long way in preventing future reserve busts.

Lisa M. Pinsker


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