What are reserve tails and what implications do they have in financial modelling and associated debt sizing?
One practical definition of reserves is ‘the economically mineable part of a measured and / or indicated mineral resource’.
A reserve tail on the other hand is the percentage of reserves banks choose to disregard in their debt sizing and project evaluation.
The reserve tail can be based on several metrics including Payable Metal, Gas Equivalent, Oil Equivalent, Contained Metal, Ore Reserves and other measures.
Debt Sizing using Reserve Tails
Debt can be sized in relation to ratio covenants and a reserve tail to identify the maximum debt a given project is able to service and its associated repayment terms, i.e. debt is maximised over the effective reserve life (excluding the tail). CFADS or CADS (Cashflow Available for Debt Service) is disregarded for debt sizing purposes post the cut-off date.
The chart below illustrates that by 31 December 2011, all debt will have to be repaid and that the remaining 25% of reserves will not be included in the calculation and sizing of debt.
Screenshot #1: Reserves Tail Ratio and the Cut-off Date
The following ratios are predominantly used for debt sizing
- LLCR – Loan Life Coverage Ratio
- DSCR – Debt Service Coverage Ratio
- PLCR – Project Life Coverage Ratio
- RLCR – Reserve Life Coverage Ratio
Example of Debt Sizing using Reserves Tail and Target LLCR
Example below demonstrates debt sizing process based on Minimum Reserves Tail Ratio of 25.00% and Target LLCR of 1.50x.
Step 1 – Calculate Reserves Tail Ratio
Reserves Tail Ratio is calculated as:
Reserves Tail Ratio (%) = Remaining Reserves in the Period / Total Payable Metal during Mine Life
In this example,
Total Payable Metal = 307,438.41 T over the mine life
Remaining Reserves (Jun-09) = Remaining Reserves in previous period (Dec-08) less Payable Metal (Jun-09) = 307,438 – 45,003 = 262,435 T
Reserves Tail Ratio (Jun-09) = 262,435 / 307,438 = 85.36%
Screenshot #1: Reserves Tail Ratio calculation
Step 2 – Determine the Final Repayment Date Based on the Calculated Reserves Tail Ratio
As shown below, all debt is fully repaid by the cut-off date or final repayment date of 31 December 2011. In this example, the Reserves Tail Ratio on 31 December 2011 is 26.18%.
We suggest building binary flags (1,0) for the debt repayment and final maturity as shown in Screenshot #2 below.
Screenshot #2: Determine final maturity date using the Reserves Tail Ratio
Step 3 – Debt Sculpting to Achieve Target LLCR
As we have already known the debt repayment period (i.e. life of the loan), we could begin the debt sculpting process to achieve the Target LLCR which is 1.50 x in this example.
Please note that the CFADS is disregarded for debt sizing purposes post the cut-off date of 31 December 2011, this is done by linking the calculation of CFADS to the binary flag suggested in Step 2.
LLCR = NPV (Cashflow over the life of the loan) / Debt Balance B/f
We can re-arrange this as
Debt Balance = NPV (Cashflows over life of the loan / Target LLCR
Screenshot #3 illustrates the debt sculpting process to achieve Target LLCR.
Application of Reserves Tails
Aggressive companies generally prefer to remain unhedged in a bull market in order to offer price leverage to investors. Senior lenders on the other hand aim to mitigate the risk of not getting repaid due to a sudden shift in demand and price for a given product, hence lowering the company’s ability to service its debt.
Reserves tails (based on P50, P90, P1 or P2) are a commonly found in term sheets of a resource project financing, whether it is mining or oil & gas, and serve to partly offset the inherent risks of fluctuations in a given reserve.
The conclusion is that the inclusion of a reserves tail in the term sheet can offer a compromise between banks and companies due to its ability to partially offset the risk of fluctuating reserves, while retaining maximum price leverage for investors.