Modelling Mining and Oil Projects & Fiscal Regimes PLA CEMENT TEST PRESENTATION (ADAPTED) Alistair Watson: jualityaw@gmail.com +44(0)787 965 7669
Modelling Mining and Oil Projects & Fiscal Regimes GOOGLE HANGOUT NOVEMBER 2015 SERIES 1 SESSION 1 Alistair Watson: jualityaw@gmail.com +44(0)787 965 7669
Agenda 1. Economic rent: why mining and oil are special 2. What drives commodity prices & why they are volatile Week 1 Week 2 3. Mining Mining project lifecycle Mineral valuation Cost categories for modelling Case study 1: Building an industry costcurve Case study 2: Building a single-period mining model Mining fiscal regimes Case study 3: Adding a fiscal regime to the single-period model Investor decision making: NPV and IRR Case study 4: Building an annualized model Case study 5: building in the fiscal regime Case study 6: Evaluating results 4. Oil & Gas Life cycle of an oil project Oil (and other hydrocarbons) valuation Oil project cost categories Case study 1: Building a single-period model Oil & Gas fiscal regimes Case study 2: Adding a production sharing regime to the single-period model Case study 3: building an annualized model Case study 4: Implementing the production sharing fiscal regime Case study 5: Evaluating results Case study 6: Expected Net Present Value 3
Agenda (continued) 5. Modelling best practices 6. Where to from here? Building fully fledged models Resources available on-line Example models (FARI etc.) Online Excel training AUSIMM and other modelling standards Process for evaluating projects in your country 4
Industry Characteristics 5
Common to mining and oil & gas Projects exploit a finite resource Long, costly exploration periods Significant geological, technical, political, environmental risks Large up-front investments Sophisticated management and specialized technology Prices (mostly) set on international markets; price volatility High costs of abandonment Significant environmental impact & risks High community impact 6
Economic rent Deposits vary in size, location & quality. Each therefore has a different production cost Investors needs to earn at least the production cost plus an acceptable return on investment Prices for most commodities are set on international markets. The price needs to be high enough so that the highest-cost project necessary to meet world demand is made just viable But that means lower cost projects will make super profits this is Economic Rent : the surplus return above the minimum return necessary to induce the investment Economic Rent could (in theory) be captured by the resource owner - not by the extractor without deterring the investment The trouble is, economic rent is (1) Unknown in advance; (2) Uncertain; and (3) Volatile Also, to invest in risky exploration investors need to earn enough profit on successful projects to cover failed exploration So, Economic Rent is a subtle, somewhat subjective concept, but with profound implications for fiscal regime design 7
Exploration process Acquire rights Initial exploration Identify targets Exploration drilling Appraisal drilling Feasibility study Development planning Remote sensing; regional geochemistry; airborne geophysics; seismic surveys Feasibility study: Mineral Resources Development plan: Resources reclassified as Mineral Reserves 8
Costs Production Mining project life cycle Production Phase 3 Production Phase 2 T i m e Production Phase 1 Operating Costs Exploration $5-20MM Appraisal $20 50MM Initial Development $50MM 3.0Bn (?) Further Development phases Reclamation work commences during production period Operating Cost 9
(basic) Cost categories Exploration Appraisal Development costs Operating costs Overheads Sustaining capital Rehabilitation and Decommissioning Searching for deposits Delineating the size and characteristics of a discovered deposit: Evaluating technical and economic viability Building the project Producing the mineral: Fixed versus Variable with production Fixed costs of managing production Replacing equipment periodically. Treated as capital cost for tax purposes Costs of clean up during and after production "Capital versus Operating costs: Capital costs have a benefit beyond a single year, and therefore usually have to be depreciated for tax purposes. Operating costs are recurring costs with no lasting benefit, so are expensed immediately for tax Most economic analysis is done using cashflows where the distinction does not matter, except to calculate tax payments Capital expenditure often referred to as Capex. Operating Expenditure as Opex 10
Modelling Mining and Oil Projects & Fiscal Regimes GOOGLE HANGOUT NOVEMBER 2015 SERIES 1 SESSION 2 Alistair Watson: jualityaw@gmail.com +44(0)787 965 7669
Recap on last week Key extractive industry characteristics Economic Rent concept Lifecycle of a mining project Cost categories 12
This session Drivers of commodity prices Constructing an industry cost curve Mining model case study: single period model Mining model case study: adding a simple fiscal regime 13
Commodity Prices 14
Price Supply and Demand Demand curve Supply curve Gradient a/b = elasticity a b P Equilibrium price Q Quantity 15
Short Term Long term What determines the shape of the Supply and Demand curves Demand Prices and demand curves for end-use products Availability & price of substitutes Cost to switch Supply Flexibility in mine production e.g. putting mines on care and maintenance in price slump Opec (oil) Prices and demand curves for end-use products Availability & price of substitutes Cost to switch Depletion of existing mines Geology: unexploited resources and cost to find and extract Opec Cartel (for oil) Government policy: e.g. Access to resources Fiscal regimes (cost to extract) Carbon reduction policies Nuclear power plant usage Etc. 16
Price Inelastic demand Inelastic Demand Supply curve P1 P Small decrease in supply, large increase in price Q1 Q Quantity 17
Price Inelastic supply Demand Inelastic Supply P 1 P Small increase in demand, large increase in price Q Q 1 Quantity 18
Price Does this help explain recent oil prices? P 1 1 Increase in short term supply (US production; growing inventories) Massive reduction in price required to clear the market 2 Slowing of demand increase from Asian economies P 1 2 Quantity 19
Price The Lower for Longer view on oil Supply curve has flattened due to Shale P 2 P 1 Implies prices may not return to recent highs for quite a while Demand growth resumes Quantity 20
Commodity prices are a function of marginal costs Goldman Sachs paper suggests long dated (futures) prices for oil and copper are set consistent with marginal costs for highest cost producer Source: Goldman Sachs Global Economics Paper No: 194 Commodity Prices and Volatility: Old Answers to New Questions. http://www.goldmansachs.com/korea/ideas/global-growth/commodity-prices-doc.pdf 21
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 US$ Bbl But it's not simple Marginal cost is volatile, depending on the shape of the supply curve For oil, policy decisions by Opec (reducing or increasing supply); US and other governments Commodities increasingly used as investments: Particularly Gold, Oil, Copper Impact of speculators (though much debated ) All of which leads to price volatility 140 120 100 80 60 40 20 0 Brent Crude Oil Axis Title Brent history (monthly averages) Futures ICE 24Sept2015 22
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Real-terms 2014 Commodity Prices 600 500 Real terms 2014 Commodity Price Indices (2005 = 100) Supply response: investment Forecast 400 300 Steep price increase resulting from rapid Asian growth & perceived shortages Prices fall Crude oil Copper Aluminium Iron Ore 200 Declining prices: lack of investment Nickel Zinc Lead 100 Uranium Gold 0 Source: IMF WEO Database Oct 2014. 2005 = 100; adjusted using US CPI 23
Iron ore cost curve example http://www.bing.com/images/search?q=iron+ore+cost+curve&id=ae5391761dc3976d4885155d9b61f418a28b03fc&form=iq FRBA#view=detail&id=AE5391761DC3976D4885155D9B61F418A28B03FC&selectedIndex=0 24
Remember this? 25
Iron ore cost curve example http://www.sec.gov/archives/edgar/data/811809/000119312513400510/g613026tx_pg08.jpg 26
Coal example http://www.iea.org/etp/resourcestoreserves/ 27
Copper example http://www.commodityintelligence.com/7-11feb11.htm 28
Copper example How can costs be negative? Answer: by-products 29
Gold example Note new metric All-in Sustaining Cost discussed later in the course 30
Oil Price today http://www.iea.org/etp/resourcestoreserves/ 31
Oil http://s3.amazonaws.com/zanran_storage/www.sais-jhu.edu/contentpages/137274942.pdf 32
Case study 1 Constructing an industry cost curve 33
Constructing a cost curve Imagine a particular mineral which can be produced by only 10 projects in the world. For simplicity, let s assume these projects are all either in production, or capable of immediate startup The projects have the following production capacity and unit cost. The unit costs include return on investment the projects need to earn Source data Project Production Unit cost A 100 4.00 B 125 3.00 C 10 9.00 D 50 8.00 E 20 10.00 F 200 2.00 G 50 5.20 H 100 2.75 I 150 2.50 J 45 7.00 34
35
Cost curve cast study (questions) 1. If global demand for the mineral is 675 million tonnes, what does the price need to be to ensure production is sufficient? 2. At this price, what profit margins do projects F, make? What profit (as a % of revenue) does project A make? 3. If demand increased to 725 million tonnes, what would that imply for the price? 4. If demand decreased to 575 million tonnes, what would that imply for the price? 5. With demand 675 and price $4.00, what are the implications of Project I expanding production to 250? 36
Of course its not that simple Projects in production need only to cover current (cash) costs Undeveloped projects need a price high enough to cover investment plus return Each therefore has a different concept of break-even (We discuss this later in petroleum case study) Companies will take a short term loss and hope for a price recovery Stockpiles Producers use Hedging to lock in a price different from the current spot price, may enable them to ride out a temporary downturn 37
On the other hand, this is actually happening right now http://www.wsj.com/articles/glencore-production-cuts-bolster-commodity-prices-1444410734 38
Modelling Mining and Oil Projects & Fiscal Regimes GOOGLE HANGOUT NOVEMBER 2015 SERIES 1 SESSION 3 Alistair Watson: jualityaw@gmail.com +44(0)787 965 7669
Recap First two sessions: Characteristics; economic rent; lifecycle of a mining project; cost categories; industry cost curves This session: Mineral valuation for a specific project Single-period mining model Mining Fiscal regimes 40
Valuing minerals for a specific project International market prices are for a specific grade/quality and specific location. These are called Benchmark prices For example Iron ore, Platts IODEX is for 62% Fe, max 2% Alumina, max 4.5% silica, CFR Quindao China /1 For a specific mine valuation must take into account: Location: transportation from the project location to the benchmark location e.g. sea freight & insurance Quality: Iron ore price is a function of Fe content but also relative impurities like silica Point of valuation: is the value to be determined at the port of export versus at the mine gate? For minerals with no actively traded benchmarks other approaches must be developed to determine arm s length valuation. 1/ http://www.platts.com/im.platts.content/methodologyreferences/methodologyspecs/ironore.pdf 41
Mineral valuation: coal example Mining Treatment Rail Port Ship Final Market Fair Market Value FOB (Free on Board) mine Value of coal in final market FMV. FOB Port Coal price benchmark Benchmark price CFR (Cost and Freight) - Shipping costs Shipping benchmark + Other selling costs (insurance etc.) Arm s length charges = Fair Market Vale FOB Port Calculated - Port handling Arm s length charges by port - Rail costs = Fair Market Value FOB Mine Calculated Arm s length charges by rail company or actual costs incurred 42
Mining Model Case Study 1 Building a single-period model 43
Project X Stylized mining project Generic bulk mineral product, measured and sold in Tonnes Mine Railway (3 rd party) Port International Market Significant transport costs Similar to a coal or iron ore project Relatively opex intensive 44
Sale point SOLD IN FINAL MARKET Cost and Freight (CFR) Seller pays for shipping SOLD FOB PORT Free on Board (FOB) Buyer pays for shipping Price in final market $100 - Sea freight $10 = Value FOB Port $90 - Rail freight $20 = Value FOB mine $70 Sale Point Matters for: Determining if taxpayer is reporting arm s length prices Determining base for royalty 45
Project assumptions Project Assumptions Total production M Tonnes 100 11 years Sales price: CFR $T 100 Sea freight $T 10 Sales price: FOB port $T 90 Capital costs (Capex) Operating costs (Opex) Exploration costs: cash $M 50 Operating costs $T 30 Exploration costs: sunk $M - Overheads $M per year 5 Development capital $M 750 Rail transport $T 20 Sustaining capital * $M per year 20 * From yr 2 till 3rd year before production stops Decommissioning costs % DevCapEx 10% Each item here could be broken down further: detailed cost sub-categories etc. Choice depends on modelling objective and access to data Focus in this course is on fiscal regime modelling: even this aggregated level of detail will give us plenty to analyse 46
Mining Case Study 1 User to populate the green cells using formulas that pick up source data to derive pre-tax net cashflows for the project over its whole life Project "X" Single Period Model Pre-tax cashflows $M Revenues MT $T FOB port = - Exploration costs Development costs Sustaining capital $M/yr years - Operating costs $T MT = - Overheads $M/yr years = - Rail transport $T MT = - Decommissioning % DevEx $M DevEx = - Total costs - Net cashflow before tax - 47
Data sources in practice Mining Company: best source Feasibility studies (EDGAR etc.) Technical colleagues: Sector ministry Rules of thumb Analog projects Getting good project data out of companies can be challenging Make it a legal requirement Pre-feasibility; Feasibility; Development plan; Annual updates; Life of Mine Plans Maintain effective working relationship Establish agreed formats/templates Formally acknowledge that things change: Actual Forecast Companies are hesitant to provide data if they will be held to a previous forecast See later discussion on revenue forecasting 48
Is this a good project? It looks pretty good, but What else do we need to know: 1. Fiscal regime: how much does the government take? 2.? 49
Mining fiscal regimes 50
Government fiscal regime objectives Maximize Revenues IMF paper Attract exploration investment Ensure discovered projects go ahead (neutrality) Incentives to maximize production at minimum cost (efficiency) Capture an increasing share from more profitable projects (progressivity) Stability http://www.imf.org/external/np/pp/eng/2012/081512.pdf 51
Fiscal mechanisms Royalty Income tax Resource Rent Tax Import duties Value Added Tax State participation Others A share of the value of production 3-5% pretty common, rates often vary by mineral A share of profit, determined under tax rules 30% rate pretty common Special tax designed to capture a share of economic rent. Uncommon but often recommended by the IMF % of the value of imports % of sales (output VAT) and % of costs (input VAT) Under properly functioning VAT the consumer should bear the cost not the mining company. But in practice Government owned company owns a share in the project Withholding taxes on subcontractors Withholding taxes on dividends and interest 52
Royalties Usually percent of gross revenue (or unit fee) Widely applied Early, dependable income Distorts production and investment decisions Limited rent capture Regressive, not progressive Internationally accepted at modest levels Administratively simple? 53
Production average unit costs/price Royalties reduce the Tax Base P Long term expected price Non viable Royalty Viable R F Mine A Mine B Mine C D E Inventory of mines y x* 54
Profit based fiscal mechanisms Profit = Revenues minus Costs Revenues = valuation of minerals sold (or produced?) Costs = which costs are deductible, and when For example, with income tax Operating costs deductible when incurred Capital costs deductible over time via depreciation So, depreciation rules matter Faster depreciation = income tax paid later Slower depreciation = income tax paid sooner 55
Further detail on mechanisms Income taxes: need for special rules Mineral valuation Ring fencing Depreciation Loss carry forward Decommissioning Resource Rent Taxes Additional tax that applies only to profits (or cashflows) earned in excess of a threshold rate of return Increasingly common in Mining Parameters needed: Threshold rate of return Resource Rent Tax Rate 56
Fiscal Regime A Fiscal Regime is the combination of all of the mechanisms that determine how project benefits are shared between government (resource owner) and the mining company (the extractor) General IMF advice for developing economies: fiscal regimes should include: 1. Modest Royalty: guarantee some revenue 2. Income tax with mining specific rules 3. A progressive mechanism; such as Resource Rent Tax; or Variable Income tax 57
Generic Mining Fiscal regime Recettes Total revenues totales Bénéfices Profit Coûts Costs Redevance Royalty Revenu Taxable imposable income Bénéfice après Impôt Income sur Profit after tax impôt le revenu tax Resource Taxe de Rente Eco Tax (éventuelle) (if any) /1 1/ Assuming the RRT is deductible 58
Case Study 2 BUILDING IN THE FISCAL REGIME 59
Case study 2: building fiscal regime into single period model Add simple fiscal regime to single period model: 5% Royalty 30% Income tax 60
Is This a Good Project? After government fiscal share it still looks pretty good, but How do we know how much net cashflow is enough? Just $1? $100; $1million; $50 million? Simple net cashflow is not enough information Consider 2 projects identical except one produces 100MT over 5 years and another over 10 years. They have the same net cash flow after tax. Would a mining company be indifferent between these? No, they would prefer earning that net cashflow in 5 rather than 10 years. We need a way of taking into account Timing and Risk This is done through Net Present Value calculations 61
Next session NPV and IRR Annualized model 62