ABC Minerals International Ltd is a fictitious mining company,
but the following account of the challenges it faced with an
expansion project is based on a real case that impacted a major
ABC began life as an open cast
miner with a long history of success. But, after forty years,
the end of operations were in sight. Since the ore body
extended well beyond the parameters of the current design, a
project took shape to expand the footprint and continue
The project, however, was
challenging. The plan called for a half billion dollar
investment and the design essentially meant creating an
entirely new mining area with significant development
So in order to ensure mining
continuity, construction of the new mine would have to match
the decline in old operations.
Shareholders approved the project
and six years later the expansion was both ramping up and on
the verge of bankruptcy. The project was over budget and behind
schedule putting the mine in the position of being unable to
make payments on loans that were coming due.
From the outside, things seemed to
be coming apart for the mine. In reality, most of ABCs
problems were in the administrative offices and not in the
Annual reports and the press blamed
a slow ramp up and new technology for the financial failings.
However, the ramp up was fast compared to similar mines, and
while the technology was advanced, it was also working.
The project was over budget, but
not severely so, and meanwhile the prices for all of ABCs
products were increasing. Yet the financial issues
Financing the project
The original financing plan for the expansion project called
for the mine to fund it out of retained earnings with some
project finance later in the project life.
In the initial phases this worked
fine - not only was ABC able to meet its project
obligations, but the company was also able to continue to pay
dividends to shareholders.
The problems started six years into
the project when the mine had $100m. in debt coming due and no
money to make the payments. The old mining operations were
winding down and the project was behind schedule. As a result,
the mine found itself with a cash flow gap.
In order to meet its obligations,
the mine took out a new short term loan, allowing it to pay off
the first loan and inject needed cash into the project. But
this loan also came due before the mine was producing cash.
This led to a series of short term
loans, mainly from shareholders, and stop gap measures which
bound the mine up in a knot of finance.
Operational issues compounded the
financial ones. Specifically, the production ramp up schedule
The original ramp up schedule was
an aggressive one for the type, location and complexity of this
project. But as the project fell behind schedule the financing
and cash flow plans were based on even more aggressive ramp up
schedules as managers tried to work harder to meet their
original goals. In reality though, this just shifted an
aggressive plan to an impossible one.
ABC was stuck with both trying to
pay back its loans and invest in ramping up production with
very little cash coming in. The mine found itself unable to
deliver on its impossible ramp up plans and its lenders, both
banks and shareholders began to lose faith in the project.
The project was now out of options.
It needed some sort of financing in order to meet its
obligations and found itself in a weak position as a result of
its recent history.
The saving grace was commodity
prices. They were on the rise as unprecedented demand for
metals and industrial minerals out of Asia drove up prices for
all of the mines products to highs not seen in years,
even decades. Improving prices made the project much more
attractive than before, even with the delays and
But lenders remained wary, high
prices are nice, but only if there is eventually product to
sell. So, to provide financing on the back of that new value
they required security.
The only way to satisfy the banks
was to guarantee the price by locking in the higher prices with
forward contracts and provide production guarantees with
clearly defined production targets. The new financing
arrangements left ABC with a significant amount of their
production sold forward and with strict loan covenants.
This final action saved the project
and gave the expansion project time to finally reach full
production. At this point, the project was over two years
behind schedule. But the financial experiences left ABC saddled
with a history of not meeting its obligations. And, as the
sales prices increased beyond the forward prices they began to
record paper losses, further impacting the mines
The mine expansion project did not
have a great reputation. Objectively, however, it was a runaway
success. The production ramp up took just over three years for
full production. While this was double the original projection,
it was fast for this type of mine and with the technology
Once the mine was running smoothly
the company was able to exceed production expectations,
routinely exceed nameplate capacity, and take advantage of
product prices that were three and a half times those in the
original project plan, and over twice the forward sale
Assessing financial decisions
The reality of life and business is that we do not have perfect
information about the future. In fact, we have no information
about the future. So looking back and calling decisions into
question based on subsequent events is useless.
Managers must make decisions today
based on the information available today. Rather than going
back and assessing the financing decisions in light of perfect
information we can look at decisions in light of the
information available and ask whether they were reasonable.
Even with imperfect information,
management must think through the risks associated with each
decision and make efforts to mitigate them. So, we can also
reasonably ask if risks were identified and properly
In this light, each of ABCs
financing decisions was reasonable based on the
expected cash flows. Each round of finance came due
as production and cash flows were expected to increase.
However, as time progressed and the
project fell behind schedule the expected cash
flows became unrealistic. In order to continue to meet the
financial obligations management had to believe and justify
ever faster ramp up scenarios. The ramp up expectations were
very aggressive to begin with, believing that these could be
made even faster was unreasonable.
The financing of major projects is
both critical and tricky. They often run over budget or take
longer than expected and if the financing agreements do not
allow the flexibility to handle the unexpected these can lead
to default. So the real mistake is to rely too heavily on
internal forecasts without subjecting them to external
These internal forecasts depend
heavily on operational assumptions and financial managers are
typically not operational experts. Financial managers do,
however, have the responsibility to review operational plans
and assess, or at least question, the reasonableness of the
cash flows that will eventually be required to pay the
In ABCs case, questions could
have been raised about the aggressiveness of the original ramp
up schedule. But certainly, as the project fell behind schedule
somebody should have questioned the cash flow expectations.
The final financial question is the
forward sale: was selling production forward a bad idea?
Forward selling or long term
contracts with hindsight always look like terrible moves if the
price subsequently increases, or a smart move if the price
subsequently decreases. But again, assessing the decision based
on hindsight means nothing. The question is: did hedging make
sense at the time?
When the forward contracts were
written, commodity prices were coming off long term lows and
had just bounced back considerably. At that time, the forward
prices looked very good, better than when the project was
originally proposed, and much better than where they had been
for the intervening years.
Importantly, the mine also made
money at the forward price. So the price was both historically
good and well above the cost of production.
The higher price meant a better net
present value and meant that ABC could secure financing. But it
could do this only if the company could lock in the high price
of the day. Without the higher valuation the extension project
was likely worthless and may never have been finished.
Forward selling allowed ABC to
complete the project and eventually generate cash. Since only a
portion of the production was sold forward, the remainder sold
at higher spot prices, reaching nearly five times the price in
the original valuation.
Every year as commodity prices
increased, the mines annual reports showed a paper cost
of the hedge in the millions of dollars, leaving analysts and
management shaking their heads.
Certainly, if the mine had been
able to complete the project without selling product forward it
would have made more money. But the mine did not have that
option. In the end, the value of completing the project was
much greater than the cost of the hedge.
Managing financial risk
When planning project finance we recommend treating financial
risk like any other. Draw up a risk register and brainstorm
anything that could happen to cause financial distress.
Risks can be financial risks
associated with markets and prices, but can also be
operational/project issues. Delays are common in major capital
projects and testing financing arrangements against possible
delays and alternative schedules can be revealing.
Those risks that are both
significant and probable need mitigation plans and require
contingencies. Some specific suggestions highlighted by
ABCs experience are:
Match the project financing time frame to the project
Short and medium term financing should never be used for
long term projects. This will always lead to a situation
in which payments are due before cash is available.
In ABCs case the timeframes
of the original financing decisions were closely matched to the
cash flows. But, as the management team found themselves with
debt due before the project was complete they began using short
term instruments. Since the problems continued they ended up
needing a series of short term loans to cover longer term
issues and this led to a downward spiral.
A frank reassessment of the
situation before engaging in stop gap measures might have
helped the mine put together a more realistic financing package
Question your assumptions, even operating
The biggest issue that ABC faced, and one that we see often, is
putting too much faith in internal projections and assumptions.
These assumptions may be right. But setting up a financing
structure on the assumptions means that the future of the
company depends on their accuracy. In assessing project plans
review them rigorously and think about the what
If things start to go wrong,
question the recovery plans. In ABCs case the project
started to run late but the full production date did not keep
up with the delays, making an already aggressive ramp up plan
even more aggressive. They did this with the best intentions of
making up for delays but in the end this was just
Build flexibility into financing plans
More financing flexibility will allow a company to handle more
variability in a projects development. ABC continued to
pay dividends to its shareholders even as the project schedule
began to slip. Reducing dividend payments and building some
additional retained earnings may prove less costly than
emergency finance arranged when options are limited.
Be wary of long term contracts
Avoid it, but enter into long term contracts or forward
contracts if you must.
Forward selling can be a dangerous
game - but it can also be a requirement to secure
financing. If you have to hedge to make the project work, do
it. Even if you expect the price of a commodity to increase
dramatically a forward sale may be the only way to convince
lenders of the projects viability.
Keep a portion of production
exposed to the market, however, so that you can take advantage
of pricing opportunities.
Arrange financing early, not last minute
Emergency finance can be very costly. If lenders know that you
are out of options they have all of the power and are likely to
use it. Keeping an eye on the financial situation can give you
the opportunity to act before a crisis occurs
With all of the complexity of building a mine, finance can seem
like a triviality. Arranging financing for quality projects is
not hard, and it comes well after the hard work of technical
In reality, financing is essential
to generating a profit and even survival, and it will come
after technical definition, but still requires a risk
In ABCs case, a good result
could have been better. If financial managers had retained more
earnings and given themselves some financial flexibility, they
could have avoided the cash crunch that began their financial
distress even in the face of delays and over runs.
Recognising earlier the
aggressiveness of the mine ramp up and therefore planning for
longer time frames would have allowed them to better match
their financing needs to realistic time frames. Longer term
financing would have kept creditors on the side lines while the
miners worked out technical issues. And, this would have
avoided the final refinancing that eventually tied them in to
the forward contracts and restrictive covenants.
Selling product forward was
necessary for the mine to complete the project and ensured that
the mine was operating and able to sell at least a portion of
its production at record breaking commodity prices.
If, however, the financial
situation had allowed them to avoid hedging production, the
mine could have generated over $100m. in additional earnings.
This would have been a good return on risk management
Hindsight makes all decisions easy
and ABC management did not have its benefit. The mine has been
successful for decades and continues to produce tonnages today
that are well beyond the intended capacity of the mine. The
extension project itself has generated significant returns for
shareholders and is an exemplary mine in many ways.
But financial managers can learn
from the ABC experience critical lessons in improving financial
risk management. In some cases this will improve the bottom
line, in others it can be the difference between profitability
Contributor: Jeff Loehr, managing director
Americas, Virtual Consulting International, a leading resources
strategy consulting firm. Loehr joined VCI from a leading
global mining company where he headed business development
efforts for the company and acted as a transaction/investment