Managing Volatility

Risk in mining
investment decisions

Managing Volatility

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 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 2 4
- Exhibit 3 5
- Exhibit 4 6
• Risks have to and can be managed 7
• Contacts 7

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 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-2009. 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?
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

Since volatility appears to be here amounts to a robot-like categorisation: the impact of

key risk factors is not quantified and there’s a limited

to stay, companies need to factor insight for how to manage for maximum value or how
to mitigate risks.

it into their business practices and Bringing a business case up to date can be achieved
through a review of the underlying assumptions, its
create new ways to work with it. 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,
In this context, it is not surprising that a current approach to accounting for risks (exhibit 1).
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.

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.

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 NPV does not tell the whole story, and robust risk There are equally important project-level factors
analysis provides more valuable insight about how associated with large uncertainties, like technical
to quantify and manage the downside of major success of a novel mining method or understanding
projects. Executives and project managers do not geology of new resource. But how can the project’s
need to become financial risk mathematicians but downside risks and upside opportunities be quantified,
they do need to shift their thinking from discrete and exploited or mitigated?
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.

What are the key risks, their

interactions and interdependencies?
Risk
Revision
framing
Original
business
Sources case
of new
value
Which risks impact value the most?

Re-built Risk
dynamic modelling
business
case
What is the project’s risk profile and
how to mitigate it for maximum value?
Risk
mitigation

Deterministic leg Risk

Probabilistic leg profiling
Feedback loop
Key
4
© 2010 Deloitte Touche Tohmatsu

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.

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 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
Exhibit 2 is an important part of this
process - people don’t think in terms of Bell curves and
are easily fooled by randomness.

Rehab
Ramp up costs
Permits
delays Acid prices /
Adsorption
Technical supply
agent
success Filter
cost
corrosion
Lime / coal
resistance
Reagents prices

Adsorption agent price /supply

loss/ Fowling Manganese
Commodity prices
recovery Recovery COGS / Energy
NPV OpEx prices
IRR
Labour / Cost
Gold Commodity
Revenue other costs escalation
price grade
factors
F/X Reagent road
West
reserves Commodity transport cost
processed Electricity
CapEx
disruptions
East
reserves Commodity Rail
spot $ price Plant capacity
Upfront costs
footprint
investment

Value drivers / Decisions Objectives

risk factors

Key

Exhibit 2:
An illustrative risk factor map for a commodity project.
© 2010 Deloitte Touche Tohmatsu

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 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.

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 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.

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 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) 940 6896
Email: jeguzek@deloitte.co.za

Louis Kruger
Associate Director
Tel: +27 (83) 388 7261
Email: lokruger@deloitte.co.za

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