Balancing Risk and Scale in Project Development
Until the last third of the twentieth century, most mine developers did not have ready access to project capital and so they had to develop projects using a combination of new shareholders’ funds and retained earnings. Available capital was a key consideration in sizing a new project. More recently there has been an assumption that any scale of project will attract project finance if it satisfies the hurdles set by bankers, so capital constraints are not commonly included in the project optimization process. Bigger projects are generally thought to be better. In reality, the interests of existing shareholder owners of a mineral deposit may be best served by a modest scale of development, with restricted use of external capital. The value of a smaller project as measured by Net Present Value may be lower, but the risk-adjusted value to shareholders may be greater.
The uncertainties in mining investment are many. Mineral prices are cyclical and to a large extent unpredictable. Over the life of a mine, these prices are falling in real terms. The mineral resources being mined are finite and can be highly variable in both size and quality, while ground conditions can vary significantly with depth and location. Costs are difficult to predict and subject to periods of rapid escalation.
The need to manage risk was well understood in the past. A small project was built, often with second-hand plant, and then cash flow from the operation, or equity funding from the now-reassured investors, was used for a series of expansions and optimizations. If there was a problem with the initial ore reserve or cost estimates, the exposure of shareholders to this problem was minimized and managed. The history of Mount Morgan is one of gradual expansion and evolution of processing technology that gave fabulous returns to the early investors. In a modern development this opportunity would have been subsumed in building a much larger project from the outset. The gold cap on the copper orebody might today be seen as a sweetener or as an obstacle to be sluiced away in pre-stripping the “optimized” pit, both options having been taken in Papua New Guinea in recent memory.
The risk of large-scale development applies to the project overall and to the production units employed. At Bougainville Copper Limited, flexibility and selectivity were built into the initial pit operations by the technological limitations of the day, which included 100 t trucks and 13 m3 shovels. Similarly, the processing plant began with nine ball mills. Mining capacity was never a constraint on mill throughput, so an increase in milling rate (at constant grind) or a finer grind (at constant milling rate) translated directly to increased production.
As the head grade gradually declined, the throughput was gradually increased to offset it. Had the plant started life with a single SAG circuit this would not have been possible. It would have been necessary to install pebble crushing as the first increment, then perhaps pre-crushing, then the large increment of another mill. Another key advantage of multiple parallel circuits is that production volatility, or day-on-day variation, is minimized, allowing the production plan to be delivered consistently. The modern alternative is to build very large expansions (e.g. Kennecott) or new concentrators (e.g. Escondida, Grasberg), which involves major changes in workforce numbers and retraining.
A company may develop a project in a variety of ways. One option might involve mining only the central, very high-grade part of the resource using second-hand plant including a small ball mill. It may be expanded later, but will have a relatively high operating cost unless a major investment in new plant is made. At the other extreme, a large project has the highest NPV and hits an important “ounces per year” milestone that may enhance the share price. It also uses a low cut-off grade, so it maximizes the reportable ounces in resources. The first option is low risk, the second may be high risk, particularly if it exposes the capital base of the company to a larger one-off project risk.
Project risk includes production performance but also the timing and cost of project delivery. In a small company, if there is an overrun in a large initial capital cost, shareholders may suffer from massive dilution in value by the need to raise additional funds in a time of adverse publicity, or they may even lose control of the project entirely. Even in large companies, poor delivery of a large project will be reflected in the share market.
Value at Risk
The Value at Risk approach is widely used in the financial sector. Value at Risk (VaR) is the maximum loss not exceeded with a given probability defined as the confidence level, over a given period of time. It is commonly used by security houses or investment banks to measure the market risk of their asset portfolios (market value at risk), over time periods of one day to a few days. However VaR is a very general concept that has broad applications. For example, a Monte Carlo approach to modelling net cash flow outcomes for a particular project development option might show that 95% of outcomes have a net cash result better than minus US$ 50 million. In other words, the cash loss is expected to be greater than US$ 50 million only 5% of the time. This approach must have a constrained time period applied, such as the time to project payback or a fixed number of years. The various project development options can be modelled and a decision made based on both the expected NPV and the VaR for each development option.
The Value at Risk approach is one way of quantifying the downside when considering alternative project scales and development paths. Its use, in combination with tradition NPV analysis, provides a more complete picture of the options available to a company when it sets out to develop an ore body.
AMC Consultants is a leading independent mining consultancy, providing services exclusively to the minerals sector. This article first appeared in the August 2013 issue of Digging Deeper, AMC’s quarterly newsletter.
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Written by AMC Consultants
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