Commentary: Capital cost overruns, part III: Where are the owners in all this?

TEXT SIZE

By: Jay Collins, special to The Northern Miner
2013-02-18

Mining has always been a very risky but high reward industry. But times have certainly changed to today, when shareholders tend to ignore the high risks and expect grandiose success regardless. But, despite the risk that won’t go away, shareholders do deserve some better assurances. After all, it’s the shareholders that keep most of us working.

I recall one well-respected mine development company that managed shareholders’ expectations by always coming in under-budget and ahead of schedule. Always. But then they always added a substantial buffer on the estimated costs, and six months to the project schedule. That is certainly one remedy and let’s face it, in these days of high commodity prices and an apparent acceptance of ridiculously high capital costs, the market could take that approach.

Is that the real answer? I don’t think so. It may have passed the smell test in the days when global costs were sustainable for at least the duration of the project and overruns were manageable. These days, when they are not, we need to sharpen our understanding of those things we really should know and be more studious of those we don't.

As an industry, we need to regain market confidence by establishing project viability within a reasonable band of accuracy — just like we used to do — without resorting to guesstimating.

Otherwise we may as well redefine the matrix of what constitutes accuracy levels for varying degrees of study, because at this point they don't hold water. It speaks for itself when financiers ignore the accuracy levels stated and add their own 25% or more to their optics on capital costs because they lack the confidence that industry can establish consistently realistic estimates.

Let's look first at the study phase when everyone is focusing on whether the project makes long-term economic sense. (Managing the actual development phase of what the studies tell us is a viable project is a whole other matter, and a subject for future commentaries.)

Perhaps the better alternative these days to simply inflating costs through arbitrary and fictitious slush funding would be to first improve the quality of the estimate and schedule by improving the determination of the details that go into the project.

That means more effort, cash and improved leadership. We can no longer go through the same motions in our studies as we did in years past. Things have changed, and are continuing to do so: materials, equipment, labour, productivity, inexperience, degrees of difficulty and modernization. And there are more complex systems, procedures and methods that sink us with out-dated information, plus integrated management systems that have taken on an overblown importance as though without one there can only be failure. Add to that the fact that what have gradually disintegrated with time are our baselines, rules of thumb, good orders-of-magnitude, reliable material and equipment markets and the comparability between the old and the new.

It’s all making it increasingly difficult to estimate and control. Things are not what they used to be and we have to rise, as an industry, to the challenges of making sense of it all without the help we used to have.

Where do we go from here? Let’s start at the top.

Can the owners help us with controlling costs and schedule? Yes, of course. In fact the owners are the linchpin of improvement as we move forward, as it’s the owners who drive the bus for the stakeholders. The owners need to know where estimated costs and timelines are trending and consequently the degree of certainty, or risk.

By default, the owner are the only ones that can insist on control — by drilling deeper, asking questions and paying for the answers.

Too often the owners are falsely comforted by misguided information and advice, after relying on those who may not own up to their own ignorance. Second, and even third, opinions are inexpensive, so why not take advantage of them? I say, take the time and let the market make of it what it will while you drive the bus to a successful terminus. Or better still, establish a timeline with a contingency in the first place. Then manage it.

Some industry leaders have already taken some initiative. In a recent CIM Magazine article entitled “Measure twice, build once” it was noted that Detour Gold delayed the publication of its Detour Lake feasibility study and brought in eight “world-class experts” to review each major aspect of the development, who were each given two months to find holes in it.

You have to take your hat off to the study leaders who conceded that if they had to “bruise our egos a little in the process, it is worth it.” That’s class. Now for the rest.

Some of us still in the industry were raised during times when developers essentially knew what they wanted and just needed help putting it all together. Those were the days when companies were driven by miners, metallurgists and plant operators. I fear those days have been diluted by the financial, legal and opportunist communities enticed more by the potential for reward than by the balance of risk and reward.

In my experience most of the owners’ key people on new project developments are not people who really know how to build a project. They often think they do, especially during the study stages.

There are those in our industry that have a good sense of development but it is rare to see them in senior roles leading the development team through the design and construction phases.

So how does one expect to realize capital costs that are meaningful and real?

As one blustering mining company president blurted out at me over her desk a number of years ago, when confronted with dramatically rising capital costs on her flag ship project: “What else don't you know that you haven't told me?”

It certainly set me back some at the time. But I have come to realize that while she may not have realized what she was asking, there was some sense in the question. After all, what I didn’t know most about at the time were things related to the wills and whims of the owner. In the case above, they were huge.

Here we had a project that went from prefeasibility directly to detailed design, in a panic mode that essentially ignored the basis of the study engineer’s two-year old estimate, and added all kinds of bells and whistles and dramatically increased operator flexibility by paralleling the grinding circuit as well as duplicating a lengthy tailings line while juxtaposing the facilities to pump the tailings uphill. And still the expectation was that costs would under-run the outdated estimate!

Few seem to acknowledge that the estimated margin of accuracy associated with a capital cost estimate is a reasonable (I hesitate to suggest accurate) thing to include, and more so when it comes to widening the margin of accuracy on the “plus” side.

Let’s face it: it is one thing to estimate the known entities, but it is quite different to try to estimate what cannot be reasonably assessed through lack of information and investigation.

Also, times have changed dramatically from where they were even ten years ago. Today we ride in rollercoaster world of prices, resources, labour costs and productivities, labour sources, more and more remote and difficult locations, commodity values and world economics. It is almost impossible to keep up.

Let’s be sensible about this: the estimate is in today’s dollars and that is all we know. The developers and financiers have to take the risk on currency, escalation and on all those factors that we cannot predict or control — but we have to get our baselines correct.

Frankly I have never understood why post-feasibility study press releases don’t simply provide a caveat concerning current costs and the estimated accuracy of cost margins instead of the mid-number that has everyone believing it is a definitive cost. It isn’t, and was never intended to be. The $1-billion project coming out of feasibility is likely going to the upper end of the stated accuracy — i.e. more like $1.15 billion if there is a 15% accuracy estimated. Let’s face that and, regardless of contingency, base our financial model on that upper limit. Then tell it like it will most likely be: $1 billion +15%, -0%. Leave contingency for project components that may have been missed, and accuracy for costs that may increase.

A trustworthy estimate is only as good as the effort, know-how and experience that go into it. Sure it costs, but that cost is dwarfed by the rewards. There should be little that is new cost or scheduling territory with the processing and material-handling components of a project.

But the infrastructure — well that’s a different matter and something that needs better attending to than we have seen on many projects. That is where most of the cost risk lurks and it is in these areas where the details are often lacking.

In some of the larger mining groups, governance by committee bogs them down, systems and procedures fatten their costs as well as add layer on layer of “indirects” — or those that don’t directly contribute — and projects never seem to come in on time, under budget and are generally yet another dismal execution failure.

In fact, I would speculate that with capital costs becoming more and more the sensitive cost portion of the analysis, some projects would never have been started had the owners known where things were really going to end up.

I have witnessed great project leadership in these situations wasted by promotion into the ranks of senior administration. Don’t do that. Compensate, encourage, and attend to comfort but don’t promote from a position of usefulness.

There are always exceptions. In fact there are many, and I have been very fortunate to work with some. They have “been there and done that” and are truly a pleasure to work with. They know what they need and how to achieve it in a well-rounded sense.

But many don’t and it is those, even if well intentioned, that are contributing heavily to the project performance disasters that are plaguing the industry in these times and inadvertently taking advantage of high commodity prices to hide the ravages of capital cost failures.

They often rush into projects without a real understanding of where costs or schedules are going and raise the bar of capital cost expectation while severely crippling those who know they could do it for less, but can’t get the financing because of industry suspicion.

On colleague recently said to me: “One of the things I have noticed when working with junior firms is their reluctance to hear the truth.” It’s an interesting word choice: hear, or listen? It is hard to listen to what one may not want to hear, but I don’t think it only applies to juniors.

In a similar vein is a comment I recently overheard an owner say about cost risk to a member of the project team: “I already have an opinion so I don’t need yours!”

It’s one of those statements that makes you sit back and wonder about the state of things.

But, on the basis that without data your opinion is just that, somehow it starts to make sense why things can get so out-of-control. There are a lot of opinions out there. I think more than there ever were, as we have the ability to find out a lot more through the internet. In my opinion, most are not based on fact but on hearsay – but, then, I have no data to back that up so even my opinion is meaningless on this issue.

I do think that fact is useful and that can only result from drilling for information to substantiate results. And none of this by guess and by golly, with a percentage here and a plugged number there.

It does make one think especially when it comes to projects that are treading on new ground in far-off, strange and testy environments, where governments, NGOs, native populations are all new to us, and there really is no solid data to consider.

You can do all the Monte Carlo simulations you like but, in the end, who is really going to accept the risk based on that kind of assessment in these times of so much uncertainty?

Today’s assessment will not have the same results as the assessment of tomorrow. The better way to do it is to spend the time, with the right people asking the right questions, and coming up with whatever is needed to avoid the pitfalls of plug-pricing, over-simplification and going for the drop-dead issue date.

What can we conclude from all this?

We know that the world has changed from those days when material and equipment prices were stable for years, labour around the world was predictable and even productivity was measurable and even. Fewer projects were being developed in far-flung, obscure locations. Politics were simpler, safety and environmental concerns were no where near the high awareness levels we see these days, and we could rely on trained trades with an adequate supply of apprentices.

All of that has changed, and yet we continue to perform our studies in the same way as we always did. We can’t do that when so much has not only changed, but is also dynamic: Now we can’t easily predict the copper price for electrical cables, or the effects of fluctuating worldwide structural steel demands; now we are forced to use local labour when we have no idea of their level of understanding or productivity; now we don’t know when governments will demand even more studies, or when environmental impact statements will be turned back without solid and understandable causes.

Albert Einstein defined insanity as, “doing the same thing over and over again and expecting different results.” Let’s stop the insanity!

We need leadership. I think it is incumbent on the owners, by default, to provide that leadership through their selection processes, project definition, communications and understanding of how to manage a project for success. Owners must be inventive, think outside the box, get second and third opinions and manage the process closely with well-qualified and experienced people in the business of project development.

— Jay Collins is a professional engineer and president of Vancouver-based Merit Consultants International, online at www.meritconsultants.net.

At the Prospectors and Developers Association of Canada convention in Toronto, he will be a “Technical Session” presenter during the morning of March 4 on the topic of “Cost over-runs on capital development.” Merit Consultants will also be present at Booth #1700 during the entire conference.

Parts 1 and 2 of Jay Collins’s commentary on cost overruns are in our June 11-17/12 and July 2-8/12 edition