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1995 Feature Article - Valuing Australia's Natural Resources - Part 1
FIGURE 1. McKELVEY BOX AS ADAPTED BY THE BUREAU OF RESOURCE SCIENCES
Whilst the total stock of Australia's minerals is unknown it is important to note that economic demonstrated resources are a small component of the total resource stock (as shown in Figure 1). EDR is the term used by the BRS, instead of reserves, since the latter term is used by various groups to describe different resource categories. EDR refers to those resources whose geological assurance is demonstrated and for which extraction is expected to be profitable over the life of the mine. It approximates both proven and probable reserves. The ABS has chosen to value EDR rather than just proven reserves as recommended by SNA93 because:
Estimates of EDR and their values may be used for a number of purposes including setting priorities for future mineral exploration and research or assessing the need to find alternative sources of raw materials.
It is difficult to value subsoil assets, as they have not yet entered the production process. SNA93 recommends that, in the absence of market transactions, the value of reserves be determined by the present value of the expected net returns resulting from the commercial exploitation of those assets, although such valuations are subject to uncertainty and revision. Similar studies in the United States and Canada have used the NPV method,<Endnote3> which makes the simplifying assumption that the present price and cost regimes will persist until the resource is exhausted.
Problems with the NPV method
SNA93 recognises that the NPV method is subject to great uncertainty and that the estimated values are subject to considerable revision. The major drawback is the uncertainty surrounding:
The ABS approach and data sources
The approach used by the ABS in calculating the NPV of the EDR was to take the value of gross output during a year and to deduct costs (including a "normal" return on capital) to derive net income. This was taken to be the equivalent to economic rent.<Endnote4> The stream of future net income was calculated for each year, taking into account the size of the resource at year end, average annual production and the average mine life. This future income stream was then discounted to obtain its value in today's dollars.
Most of the data for prices and the volume produced for Australia's resources are readily available from Quarterly Mineral Statistics, published by the Australian Bureau of Agricultural and Resource Economics (ABARE) (one exception was brown coal for which there is only one purchaser). The financial year-end price for the commodity for each year was used here (except in a small number of cases; for example, diamonds where the average of quarterly prices was used (see below) as there was too much volatility during the year).
Physical volume estimates of EDR in Australia are published annually by the BRS in Australia's Identified Mineral Resources.
The estimates for costs were prepared by a private consultancy firm. Cost data cover labour, on-site costs, mining and milling costs and depreciation charges. In addition exploration costs within the mine lease were also included and also a normal return on capital.
The "normal" return on capital used was the Commonwealth government 10-year bond rate which was multiplied by the net capital stock for the mining industry (using the ABS's capital stock estimates). This figure was divided by the average extraction costs. The resulting percentage was used to mark up the extraction costs for each commodity. The 10-year bond rate was chosen as there are insufficient long-term corporate bonds in the Australian market. However, by choosing a riskless investment, the ABS has underestimated the costs of operation (including a "normal" rate of return on capital) and in consequence, overestimated the economic rent. In addition, this approach makes the assumption that the rate of return is the same for all commodities.
Mine lives were calculated by dividing the estimated EDR in each year from 1988-89 to 1991-92 by the average of the annual production in those four years.
The discount rate chosen should represent the cost of the risk in waiting for the cash flow from a project. Risks or uncertainties include, for example, the existence of markets, competition and natural disasters. The longer the lead time, the greater the risk that expected future cash flows will not eventuate. Other factors which must be considered in setting an appropriate discount rate include the weighted average cost of capital, future inflation and the rate of return available from alternative uses of investment funds.
The Securities Exchange Commission in New York requires that mining companies use a 10 per cent rate of discount but the ABS judged that that was too high in the present economic environment. The real discount rate preferred by the ABS is 7.5 per cent, although a 5 per cent and a 10 per cent rate were also applied as points of comparison. Interested parties are invited to comment on the choice of rate.
Discounting an uncertain future flow of income embodies a number of assumptions regarding a "steady state", that is that price, production, interest rates, operating costs and returns to capital will remain unchanged from the year the estimates are made until the resource is exhausted. These assumptions are clearly unrealistic. Moreover, the resource life is unknown until the subsoil asset is fully extracted. However, these assumptions were considered to be more appropriate than attempting to forecast factors such as prices and interest rates well into the future.
Other methods of monetary valuation for the value of subsoil assets examined by the ABS were the net price method<Endnote5> and the user (or replacement) cost method<Endnote6> but both were considered to be inappropriate.
Total subsoil values are shown in Table 1 using the NPV method. At 30 June 1992, the value of Australia's economic demonstrated subsoil assets, using the NPV approach and a discount rate of 7.5 per cent, was estimated to be $145.2 billion. This figure represents 22 per cent of the estimated value of Australia's non-produced assets, 7.8 per cent of Australia's non-financial assets, 7.3 per cent of Australia's total assets, and 8.7 per cent of Australia's estimated net worth at 30 June 1992. Further, over the three years from 30 June 1989 to 30 June 1992, the relative importance of subsoil assets as a percentage of net worth grew by 24 per cent. While these values may seem to be low in view of the perception of the role of minerals for the Australian economy, the mining industry's importance can be better demonstrated by its impact on the balance of payments (23 per cent of gross merchandise exports in 1993-94). Moreover, in the discussion below ("Interpretation of the estimates"), the issue of resource size is explored.
TABLE 1 TOTAL VALUE OF AUSTRALIA'S ECONOMIC DEMONSTRATED RESOURCES, USING YEAR END PRICES,
AS AT 30 JUNE, 1989-1992, (BILLION)
Appendix 1 shows the size and value of the current estimates of EDR of the 33 major mineral commodities in Australia, associated with mineral fields which have been discovered to the end of December for each year. The results suggest that at 30 June 1992, bauxite ($36.6 billion), gems ($27.2 billion), iron ore ($27.2 billion), crude oil ($12.8 billion) and natural gas ($10.7 billion) had the highest value of the major commodities in Australia. While the value of these commodities may be high relative to other commodities, it should be remembered that some of the other commodities make major contributions to our export income, for example, gold ($4.0 billion) and mineral sands ($0.7 billion).
Further, the NPV estimates are subject to considerable variability from one year to the next, due to factors such as changes in price or changes in the costs of extraction. As an example, the NPV of black coal was estimated to be negative from 30 June 1989 to 30 June 1991 (but shown as zero in the table) but by 30 June 1992 black coal was estimated to have a value of $1.9 billion. The turnaround in value was mainly the result of a reduction in extraction costs.
Minerals not included in Appendix 1 are those for which no EDR information is available either because the EDR for the minerals are unknown or because the demonstrated resources of minerals are in almost infinite supply (for example, clay and sand) and hence are not measured.
Interpretation of the estimates
Given the way estimates of the value of subsoil assets are derived, only a very small portion of the total resource is accounted for at any one time; and valuation can give a very misleading impression of the extent of the resource. The argument here is not that valuation should not be attempted but rather that the monetary valuation should be used in conjunction with the physical stocks of the resources. The volatility of the estimates of the value of EDR, as shown in Table 1, could be due to one or more of the following factors:
As shown in Appendix 1, many resources in Australia have very long potential lives at present production levels and present price and cost regimes (for example, bauxite 125 years, black coal over 300 years) mainly because the reserves that have been identified are close to the surface and have not entailed great expense to find. However, for crude oil and gold, the lives average only 10 years, while copper is a steady 21 years, reflecting the far greater cost of finding and proving these resources and the concomitant disinclination of firms to tie up capital. However, the exact size of the economic resource is known only when the well or mine has ceased to produce.
Hence, both the monetary and physical estimates must be viewed with some caution. Monetary estimates are subject to considerable volatility and accordingly can give a deceptively optimistic or pessimistic picture. Physical estimates may offer a very limited view of the resource's full extent. For countries such as Australia, where there are potentially vast resources undiscovered, the physical estimates should be seen more as an indicator than as a definitive statement. Nevertheless, the physical volumes of the resource are at least as useful (in terms of analysis of the resource and the country's overall financial position) as the monetary values. They show that, provided there remain reasonable lives, there should be no undue concern about exhaustion. The "stock" (i.e., the physical resource in the ground on which the valuation on the balance sheet is based) can be expected to remain reasonably close to constant, provided that:
While the physical level of the resource remains fairly constant, it may be interpreted as implying that some sort of "sustainability" is possible. But this concept should not be taken too far because there may be other reasons beside exhaustion of the reserve that could result in a drop in the resource. Changes in the demand for the resource may be caused by changing technology or environmental concerns. Coal, for example, may be regarded as limitless to all intents and purposes but for many countries, coal reserves (as an economic resource) may be disappearing as fast as oil, gas and electricity have replaced it and environmental concerns may have raised the costs of the externalities.
Meanwhile, although monetary valuations will reflect certain economic realities, such as the on-going viability of the resources over the foreseeable future, taking current prices and extraction costs into account, there must be a recognition of the limitations that are embodied in those estimates (such as on prices and interest rates). Valuation of natural resources is still very much in its infancy and interpretation of the results should be made in that context.
This article has discussed the conceptual issues related to the valuation of subsoil assets, including the approach taken by the ABS. Subsoil assets represent a significant part of Australia's assets and export earnings. However, interpretation of the results should be undertaken with care as there are still many conceptual and data issues to be resolved. Readers are invited to provide comment by writing to: Director, National Accounts Research Section, ABS, PO Box 10, Belconnen, ACT 2616.
The second article in this series will discuss critically the methodologies and data sources used in the calculation of the ABS's estimates of the value of land and forests in Australia.
1. The SNA is being widely adopted by government statistical agencies throughout the world, including the ABS, as the conceptual basis for compiling their national accounts.<back>
2. For an asset to be included in the national balance sheets, SNA93 states that it must fulfil certain criteria:
The relationship between prices, costs and rates of return is shown by the following formula for the present discounted value of EDR:
Where PV0 represents the present value of the EDR;
Nt is the net price per unit allowing for financial (e.g. capital costs and depreciation) and operating costs over period t, where these extraction costs also include a normal return on capital;
qt is the quantity of EDR produced over period t;
r is the discount rate; and
T is the expected mine life.
Therefore represents the future income flow generated over the expected life of the asset. Note that by summing from t = 1, the income flow is discounted in the first year.
4. Economic rent is return to the owner of the resource for use of that resource but excludes the costs necessary to replace it. Originally applied to land, it is now generally applied as the return to the owners of any natural resource.<back>
5. The net price method (in relation to subsoil valuation as defined by Landefeld and Hines (1985)), involves calculating the total revenue from extraction, less extraction cost (which should be taken to include a return to produced capital) and dividing this difference by the total quantity extracted in period t. The net price per unit is multiplied by the quantity of remaining resources to obtain a net value. The ABS found estimates derived using the net price approach were inappropriate for valuing future production and they have not been used in the balance sheets. The net price approach results in very high values for subsoil assets, which suggests that the value of future production is being overstated. Although the net price approach has the attraction of simplicity it is the ABS's view that it is unsatisfactory for valuing subsoil assets. In practice, it is not possible to mine all the resource in one year and even if it were possible, the prices for many commodities would be affected by the large supply. In addition, implicit in the net price approach is the assumption that the net economic value of the resource rises each year in line with the rate of interest. There is little evidence to support this assumption.<back>
6. The user cost approach attempts to split the revenue, net of extraction costs, from the sales of a depletable subsoil asset into a capital element (or user cost) and a value added element representing "true income". The capital element represents asset erosion which could be reinvested to generate sufficient future income to maintain the present level of "true income" as the subsoil asset is being depleted and long after the original subsoil asset has been exhausted.<back>
The concept behind the user cost approach is to calculate that part of total receipts attributable to "true income". In practice, a discount rate is applied to the total receipts over the whole life of the resource. This involves calculating the amount of income which would have to be reinvested in each period to maintain the same income in each period while the resource is being used and after it is exhausted. Assumptions have to be made about the life expectancy of the subsoil asset measured in years and the discount rate. The main drawback with the user cost approach is that it does not incorporate unrealised capital gains and losses due to price changes, which is part of the income (See El Serafy 1989).
ABARE, Commodity Statistical Bulletin 1993, Commonwealth Government Printer, Canberra, 1993
Australian Bureau of Statistics, Occasional Paper: National Balance Sheets for Australia: Issues and Experimental Estimates 1989 to 1992,
ABS, (cat. no. 5241.0)
Born, A., Development of Natural Resource Accounts: Physical and Monetary Accounts for Crude Oil and Natural Gas Reserves in Alberta, Statistics Canada Discussion Paper, 1992
Bureau of Resource Sciences, Australia's Identified Mineral Resources, Bureau of Resource Sciences, Canberra, 1992
El Serafy, S., "The Proper Calculation of Income from Depletable Natural Resources", in Y.J. Amed, S. El Serafy and E. Lutz, (eds.), Environmental Accounting for Sustainable Development, Washington, D.C., The World Bank, 1989
Landefeld, J. and Hines, J., "National Accounting for Non-Renewable Natural Resources in the Mining Industries", Review of Income and Wealth, no. 31, 1985
McKelvey, V.E., "Mineral Resource Estimates and Public Policy", American Scientist, vol. 60, 1972
Glossary of terms in the McKelvey Box
Identified resources - specific bodies of mineral-bearing material whose location, quantity and quality are known from specific measurement or estimated from geological evidence. Identified resources include economic and sub-economic components.
Measured resources - for which tonnage is computed from dimensions revealed in outcrops, trenches, working and drill holes and for which the grade is computed from the results of detailed sampling. The sites for inspection, sampling and measurement are spaced so closely and the geological character is so well defined, that size, shape and mineral content are well established.
Indicated resources - for which tonnage and grade are computed from information similar to that used for measured resources but the sites for inspection, sampling and measurement are more widespread. The degree of assurance, although lower than for resources in the measured category, is high enough to assume continuity between points of observation.
Demonstrated resources - a collective term for the sum of measured and indicated resources.
Inferred resources - resources for which quantitative estimates are based largely on broad knowledge of the geological character of the deposit and for which there are few, if any, samples or measurements. The estimates are based on an assumed continuity or repetition, of which there is geological evidence. This evidence may include comparisons with deposits of similar type. Bodies that are completely concealed may be included if there is specific geological evidence of their presence.
Economic feasibility - implies that, at the time of determination, profitable extraction or production under defined investment assumptions has been established, analytically demonstrated or assumed with reasonable certainty.
Sub-economic resources - those resources that do not meet the criteria of economic feasibility.
Para-marginal - sub-economic resources that, at the time of determination, almost satisfy the criteria of economic feasibility. Included are resources that would be able to be produced given postulated changes in economic or technological factors.
Sub-marginal - sub-economic resources that would require a substantially higher commodity price or some major cost-reducing advance in technology to render them economic.
To the right of the EDR in Figure 1 are undiscovered resources which consist of inferred, hypothetical and speculative resources. These are economic resources which have not been found. For many subsoil assets their size is almost certainly larger than the EDR.
APPENDIX 1. VALUE OF AUSTRALIA'S DEMONSTRATED MINERAL RESOURCES, BY COMMODITY, AS AT 30 JUNE EACH YEAR
Feature Article - Valuing Australia's Natural Resources - Part 2 October Issue 1995
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