Managing financial risk in mining

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 ABC’s operations.

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 costs.

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 ABC’s problems were in the administrative offices and not in the operations.

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 ABC’s products were increasing. Yet the financial issues persisted.

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 became problematic.

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 challenges.

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 mine’s reputation.

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 employed.

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 price.

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 mitigated.

In this light, each of ABC’s 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 tests.

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 financiers.

In ABC’s 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 mine’s 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 ABC’s experience are:

• Match the project financing time frame to the project time frame.
• 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 ABC’s 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 early on.

Question your assumptions, even operating assumptions

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’s”.

If things start to go wrong, question the recovery plans. In ABC’s 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 unrealistic.

Build flexibility into financing plans

More financing flexibility will allow a company to handle more variability in a project’s 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 project’s 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

Conclusion

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 definition.

In reality, financing is essential to generating a profit and even survival, and it will come after technical definition, but still requires a risk assessment.

In ABC’s 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 efforts.

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 and bankruptcy.

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 advisor.