LandKeepers News Archive
Feasibility studies: Can’t take them at face value
December 01 2007 | News Articles | Peter Koven, Financial Post
As far as mining consultant Terry Ortslan can tell, there is not a single cost in the industry that isn’t going up fast.
“I just met with a mining company that told me the cost of the reagents in their mill have increased 40% to 60%. The reagents!” says Mr. Ortslan, sounding exasperated. “This is hyperinflation.”
In the past few years, cost overruns on mining projects have become so commonplace that the real surprise is when they come in on budget. In particular, the labour and equipment costs are often far ahead of what the feasibility studies predict.
“You always assume it’s going to cost more, always assume it’s going to take longer. You just can’t take [feasibility studies] at face value,” says Dennis da Silva, a resource fund manager at Middlefield Capital.
For the most part, investors have been fairly understanding as one mining project after another is built well above budget.
But they were not in a forgiving mood on Monday after Teck Cominco Ltd. and Nova-Gold Resources Inc. suspended the huge Galore Creek Project in British Columbia. They decided to shutter it after discovering that the capital cost had increased 127% over the feasibility study to about $5-billion. That study was completed just last year by engineering firm Hatch Group. NovaGold shares quickly lost more than half their value.
Galore Creek may be an extreme example, but the debacle put a spotlight on the feasibility study and its tendency to underestimate costs.
Industry experts believe Galore Creek could be a wake-up call that leads to more conservative feasibility studies, and the result could be more shuttered projects and high prices in the long term.
The bankable feasibility study is a crucial step on the way to constructing a mine. It is conducted by independent engineers who confirm the size of the resource and lay out the economics of the project. It provides important guidelines for bank financing and the investment community.
The problem is that feasibility studies have a history of often being wrong.
Even in the 1980s and 1990s, when mining costs were much less volatile, feasibilities frequently came in too low. A study of 60 Western Hemisphere projects between 1980 and 2002 in the Engineering and Mining Journal found that they overran the feasibilities by an average of 22%.
There have also been a few high-profile disasters along the lines of Galore Creek. The most notable is CVRD Inco’s Goro Project in New Caledonia, in which construction costs have soared from $1.4-billion to $3-billion. Goro has undergone multiple delays and is still not in production. The numerous oilsands projects in Western Canada have also had some large cost overruns.
In the past few years, labour, equipment, steel and electricity costs have gone through the roof. It means that costs in feasibility studies are harder to judge and are underestimated more than ever.
“It takes 18 months to put together a feasibility study for an intermediate to large-size project,” says John Hughes, an analyst at Desjardins Securities. “Over the time frame you’re putting the study together, the economics totally change.”
A big difference between today and the 1990s is the oilsands, which is sucking away much of the labour pool and raising the labour costs for everyone else. And there are other factors that few people predicted, such as the price of oil soaring to nearly US$100 a barrel.
But perhaps the biggest reason for cost overruns relates to the projects themselves. In Canada and other Western countries, many of the deposits being developed are the “tier two” assets that were shelved back in the 1980s and 1990s. They tend to be more remote, have major infrastructure challenges and be lower grade. Galore Creek is one example. NovaGold’s other major deposit, Donlin Creek in Alaska, is another.
Since there are a lot of challenges and few precedents in developing these remote projects, estimating the costs is difficult and they have a greater tendency to spiral out of control if something goes wrong.
“We’re finding in an environment where costs are rising exponentially that projects that were not feasible in the previous cycle remain unfeasible today, despite the increase in commodity prices,” Mr. Hughes says.
But the question still remains: Why are feasibility studies consistently coming in too low when everyone knows that projects are unpredictable and costs are rising so fast?
According to experts, it is partly a function of how the feasibilities are created.
The mining companies want to build the mine as efficiently as possible, and will sometimes pressure the independent engineers to find ways to do it cheaply. They can also be emotionally tied to the project and try to push it ahead too aggressively. That is particularly true of junior companies with only one deposit.
The engineers, on the other hand, have no motivation to offer up a cheap budget. But if their cost estimates are too high, they risk killing a lot of quality mines before they get off the ground. And ultimately, the engineers have to put together feasibility studies according to parameters laid out by the mining companies.
“These things are war zones when you deal with the engineer and the owner,” says Hugh Snyder, a longtime mining consultant and co-founder of Frontera Copper Corp. “If you get experienced people who respect each other, you get a good outcome. [But] if you’ve got a strong owner and a weak engineer, you’ve got an under-engineered project that will probably overrun.”
While the market has accepted overruns as a reality, feasibility studies are finally starting to leave more room for cost inflation. “You’ve gone from idealism into realism, and we’re going to start entering perfectionism,” Mr. Ortslan, the consultant says.
That could mean a profound change in the mining industry. If the next generation of feasibility studies are more conservative on costs, a lot of the “tier two” projects will look a lot less profitable. Experts say many of them could end up like Galore Creek, meaning they are either pushed back or developed under much smaller terms.
Xstrata PLC’s Koniambo Project in New Caledonia (near the Goro mess) is one potential example cited by experts. They also point to many of the deposits in the Far North, where location and infrastructure are big challenges.
If more of these projects do not come to fruition, it means high commodity prices could be here for a long time.
Today, the run in commodities is being driven largely by demand from developing countries like India and China. But if more projects like Galore Creek can’t go forward because of escalating costs, then the next crunch could come on the supply side.
“Unless the Chinese and Indian economies totally implode, who says we’re going back to US$1.50 copper?” says Will Bawden, director of the University of Toronto’s mineral engineering program. “If we can’t bring projects like Galore Creek on, chances are we’re not going back. Because the supply isn’t going to be there.”
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