Why building a mine on budget is so rare

There is an established history of capital-cost overruns in the mining industry stretching back at least 50 years, mining analyst Christopher Haubrich told the Prospectors & Developers Association of Canada (PDAC) conference in Toronto in early March.

In fact, since 1965, capital cost overruns in the sector have averaged between 20% and 60%.

Even so, there has been little investigation into the cause of the problem, Haubrich said.

“Retrospectively looking at capital cost overruns has obviously not helped at all,” Haubrich noted. “We still have a problem — we have for at least 50 years, as I’ve mentioned — and all reports suggest that we will continue having a problem.”

Haubrich, however, came to the PDAC armed with new insight into the cause of capital cost overruns. It’s a topic he researched while interning at Colorado-based Resource Capital Funds (RCF) on a fellowship arranged through the Colorado School of Mines for eight months last year. Haubrich noted that the research he presented belonged to RCF, but that the conclusions were his own.

In a statistical analysis of 50 mines built between 2005 and 2013 that were representative of the industry, Haubrich said that only two of the many factors that are often given for capex overruns — including poor execution or engineering, poor weather, inflation and currency fluctuations — had a statistically significant association with capital cost overruns.

The first factor, commodity market heat, is a measure of the general direction and speed of commodity price changes at the time of construction.

“The hotter the commodity environment that a mine was built into, the higher the average capital cost overrun, industry wide,” Haubrich summarized.

This relationship, he noted, is fairly intuitive.

“As commodity prices rise and the markets heat up, more projects are planned and more projects go into queue, which ultimately drives up the competition for the inputs to build a mine,” Haubrich explained.

In the last decade, when the industry saw a prolonged period of “heat,” Haubrich theorized there were less experienced management teams, engineers, project builders, etc. entering the sector, meaning more mistakes and more capital-cost overruns.

Commodity market heat was measured relative to the commodities’ own recent history.

For example, while today US$1,200 per oz. gold would indicate a cool market, five years ago, it would have indicated a hot market.

The second statistically significant variable was project quality.

“We found that marginally economic projects had higher capital-cost overruns on average than economically robust projects,” Haubrich said.

This was not a relationship that had been identified before, so RCF made sure it was not an anomaly in the data.

To do this, the company measured project quality in two ways — by internal rate of return (IRR) and by the ratio of net present value (NPV) to capex.

“In both cases, we found statistically significant relationships to the 1% level,” Haubrich said. “That’s pretty rare in statistics, not only to be able to measure a variable in two separate ways, but for both of those ways to be statistically significant to the 1% level.”

Haubrich theorized that projects with marginal economics are under more pressure to optimize their plans and reduce capital costs.

“What I think is happening here is that the pressure to optimize those lower-quality projects is resulting in capital-cost estimates that are published in the feasibility studies that have been reduced too far on paper, which results in capital-cost overruns in reality,” he said. “You’re essentially setting a target that is too difficult to hit.”

Haubrich concluded that while most if not all projects can and should be optimized in the feasibility stage, optimizing capital costs should be seen as a high-risk endeavour.

“When capital-cost optimization is done improperly, the cost-reducing efforts become little more than a paper exercise that result in a published capital cost estimate that in reality is nearly impossible to achieve — not because there has been any deliberate lying or manipulation, but because there is simply no room for error left in the estimate. There’s no room to go wrong and that, as we all know, rarely happens.”

Although the industry is in a cooler commodity price environment, Haubrich estimated that mines under construction would still have capex overruns of at least 25–35%.

“The question is not whether or not these risks apply to your project, the question is whether you have identified them and managed them properly.”

— This story originally appeared on www.miningmarkets.ca, The Northern Miner’s sister website.