Managing Volatility. Risk in mining investment decisions. Managing Volatility

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1 Managing Volatility Risk in mining investment decisions Managing Volatility Previous page Contents page Next page

2 Contents Managing volatility risk in mining investment decisions Introduction 2 Can your business case effectively respond to the speed of change 2 - Exhibit 1 3 Building a dynamic business case - three steps 4 - Exhibit Exhibit Exhibit 4 6 Risks have to and can be managed 7 Contacts 7 1 Contents page

3 Managing volatility risk in mining investment decisions After reaching record highs in the first half of 2008, commodity and metal prices, collapsed spectacularly in the wake of the global financial crisis, losing nearly 50% by mid However, the effects of the huge stimulus packages co-ordinated by the developed world governments, and the growth needs of the developing nations led by China and India, brought the demand for commodities and profitability back to the mining sector. The industry has since recovered many of its earlier losses and, in certain cases, achieved impressive gains. But how long will this buoyancy last and does it have to end in yet another bust cycle? Since volatility appears to be here to stay, companies need to factor it into their business practices and create new ways to work with it. In this context, it is not surprising that a current analysis of the main trends and business risks facing the mining and metals industry ( Tracking the trends 2010, A look at the 10 of the top issues mining companies will face, Deloitte Energy & Resources, 2009) indicates that capital allocation emerges as the number one strategic risk for the industry in 2010 and, conceivably, well beyond. The decision on how to allocate capital in mining has always been complex, but the unpredictability of the markets and the unprecedented level of volatility they have displayed recently makes mining investment decision-making even more difficult and increasingly multifaceted. Analysts and industry insiders agree that the next 10 years business cycle won t be normal and the environment will be volatile within the uplifted demand circumstance. Can your business case effectively respond to the speed of change? Capital project planning usually extends over a considerable span of time and it is largely about building value over the long term. Thus large capital projects have to navigate market cycles well beyond the annual budgeting cycle. But the robustness of many capital business cases is weak in terms of their ability to respond to changing business risks. Many business cases are dated, which reflects a lengthy approval process, due to a project being taken through various authorisation gates. Average business cases are also quite static, encapsulated in a few NPV numbers corresponding to a set of typical scenarios: high, low and base case. A straight line sensitivity analysis offers no insight (or very limited insight) into the likelihood of each scenario. Risk assessment often amounts to a robot-like categorisation: the impact of key risk factors is not quantified and there s a limited insight for how to manage for maximum value or how to mitigate risks. Bringing a business case up to date can be achieved through a review of the underlying assumptions, its construction logic and methodology, and the current revision of the financial and economic parameters, through a rigorous deterministic process. However, making it dynamic requires a fresh, probabilistic, approach to accounting for risks (exhibit 1). How can this volatility risk be managed in mining investment decisions? Since volatility appears to be here to stay, companies need to factor it into their business practices and create new ways to work with it. Deloitte s dynamic approach to capital efficiency can provide some answers. 2 Contents page

4 NPV does not tell the whole story, and robust risk analysis provides more valuable insight about how to quantify and manage the downside of major projects. Executives and project managers do not need to become financial risk mathematicians but they do need to shift their thinking from discrete and finite numbers into thinking in terms of uncertainties, likelihoods and expected returns. Uncertainties are associated with every aspect of the economy, business and finance. The political environment for doing business, commodity prices and exchange rates are a few examples of global factors that are characterised by uncertainties, particularly in the present volatile circumstances. There are equally important project-level factors associated with large uncertainties, like technical success of a novel mining method or understanding geology of new resource. But how can the project s downside risks and upside opportunities be quantified, exploited or mitigated? Exhibit 1 The Deloitte approach to capital efficiency to turn a dated and static capital project business case into a dynamic one. The probabilistic leg helps manage volatility risk actively and quantitatively. 3 Contents page

5 Building a dynamic business case - three steps In our experience, people open a spreadsheet too soon. The first challenge in dealing with a project s risks is to accurately identify them. Risks often arise from the complex interactions and interdependencies between various factors, which are not immediately self evident. Deloitte s risk framing process provides the structure to navigate such complexity, bringing to the surface threats that may destroy value, as well as opportunities that may enhance value. The final outcome of this first step is a risk factor map: a diagram of important drivers of uncertainty, flexibility and value metrics, with the emphasis on how the key drivers interact (exhibit 2). The next step is to estimate and assign probabilities to events and, ultimately, the impact of each of these on the project. Getting used to thinking about risk in terms of probabilities is an important part of this process - people don t think in terms of Bell curves and are easily fooled by randomness. Exhibit 2: An illustrative risk factor map for a commodity project. 4 Contents page

6 Events of low probability but large impact are often ignored and are deemed too unlikely, but they can potentially inflict irreparable damage on a project. There s no database where uncertainty figures can be obtained, but sources of uncertainty assumptions abound. When risks are priced in the capital markets, price and volatility data show how the markets quantify uncertainty - empirical data can supply a wealth of information to provide uncertainty assumptions. Uncertainties can also be effectively worked out from the knowledge and experience of technical specialists and Deloitte subject matter experts. One of the typical outcomes of this step is a tornado diagram, which shows which risk factors impact value the most (exhibit 3). Exhibit 3: An illustrative tornado diagram for a commodity project. 5 Contents page

7 Finally, rather than constructing project high- and low-road scenarios, expected value curves or risk profiles are generated which represent all possible scenarios. All identified risk factors and their uncertainty ranges are used to construct the curves (exhibit 4). This is accomplished by using the Decision Programming Language (DPL) software, which applies either decision tree analysis or Monte Carlo simulation, depending on specific considerations for each particular project or problem. Exhibit 4: Illustrative risk profiles for different project strategies. A risk profile, such as the one illustrated by a Strategy-1 curve in exhibit 6, can be interpreted in terms of likelihood as follows: for (100-X)% of all possible scenarios, the NPV value for the project is no less than Y-dollars. This is a much more powerful and quantitatively precise statement than saying: if a low road scenario materialises, then the NPV of the project will be Y, where the likelihood of the scenario is not quantified. Moreover, expressing project outcomes in terms of the risk profile enables one to modify that profile in such a way as to maximise the outcome: enter quantitative risk management. 6 Contents page

8 Risks have to and can be managed Risk analysis informs one s strategy and a dynamic road map can capture the impact of uncertainties faced by the project, what milestones and thresholds need to be monitored and what mitigating actions are available at each point. One would ideally like to make the risk profile steeper (less NPV variation in a larger range of probability) and move it towards higher NPV values, as illustrated by Strategy-2 curve in exhibit 6. Managing a project with strategic flexibility entails contingency planning for future decisions. One may decide to hedge a certain portion of the foreign currency exposure in order to ensure financial certainty at the critical point of the capital schedule, or to sell forward some of the future output in the event that the commodity price is expected to turn against the project at some point. Either way, one s modified risk profile will provide a quantitative assessment of the resulting value, at an instant, without the necessity of a laborious re-construction of discrete scenarios together with the project s responses to each. Deloitte s dynamic approach to capital efficiency enables active and quantitative risk mitigation and managing the project to maximum value by helping to discover hidden value, improve business practices and identify innovative strategies. It blunts the edge of volatility on investment decisions. Contacts Jacek Guzek Executive Lead Tel: +27 (82) jeguzek@deloitte.co.za Louis Kruger Associate Director Tel: +27 (83) lokruger@deloitte.co.za 7 Contents page

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