Does the mining industry know the price of risk?

Odey Asset Management portfolio manager Henry Steel, who leads the firm’s Concentrated Natural Resources Fund, has argued that mining companies are failing to properly price and allocate risk. Yoana Cholteeva spoke to Steel to find out how firms could improve their balance sheets.

Henry Steel, portfolio manager at Odey Asset Management. Image: Henry Steel

Observations of company annual reports and conversations with management have prompted Odey Asset Management’s Henry Steel to identify the lack of correct risk allocation and pricing, problems which are neither company nor commodity specific.

While mining operators tend to sell low-risk existing assets and buy high-risk greenfield projects, this impedes growth and makes them lose value, according to Steel. Instead, he encourages companies to recognise their own core competencies and be clear about what risks they do and don’t want to take on.

As identifying, pricing, and allocating risks is critical to the efficient allocation of capital, a better approach will also result in a balanced commodity supply and demand environment.

More than half of the country’s coal mines are managed by pro-Russian separatist militia.Credit: DmyTo/Shutterstock.

Yoana Cholteeva: Could you tell me a bit more about risk management in the mining industry?

Henry Steel:

What I really want to get across is the importance of identifying all the risks, pricing those risks and then allocating them correctly to the right people who should be taking them. We are talking about different types of risk such as construction risk, geological risk, operating risk, technical risk, etc. In particular, where mining companies have failed in the last 10-15 years is construction risk.

When miners allocate away that risk in terms of getting the construction contracts to engineering, procurement and construction companies (EPC) [a prominent form of contracting agreement in the construction industry], EPC then do these construction projects on behalf of mining companies, but they don't have the kind of turnkey guarantees, which are very common in other industries like the oil and gas industry.

This is evidence that the oil and gas industry is very far ahead of the mining industry. Because they've had so much risk there historically, typically on the construction risk, they had to focus on good management and therefore, they're leaps and bounds ahead of miners. I think it’s time that the mining industry becomes reflective of this rather than just regarding risk as one whole thing and not really understanding how to identify price and allocate it correctly.

What circumstances or decisions have led to improper allocation of risk in the industry?

[Mining companies] are often taking on all the risks themselves and not understanding why one should allocate away certain risks in order for other parties to manage them in a more efficient manner.

With regards to the construction risk, if we can use the Turquoise Hill company example, without an investment grade balance sheet, Turquoise Hill was never going to be able to raise finance from lending parties for the construction of its last mine. The company therefore needed to have a recourse to an investment grade balance sheet in the form of someone like Rio Tinto.

So, a lot of these juniors out there with big projects have the issue of not being able to get funding, because banks don't want to be taking this construction risk as they only have a recourse to the projects if anything goes wrong. Sirius minerals couldn't get access to finance for the same reason but there's no need for large corporates to buy into the equity of subsidiaries.

Instead, they can take on the construction themselves and control it, but appoint an EPC company, such as Fluor or Bechtel, to do the job on their behalf. If there is an issue – more funding is needed, or the original model doesn't work - according to the agreement with the junior, majors would have onerous step-in rights, including an ability to force a rights issue if construction begins to be delayed or goes over budget.

What would you say companies should be particularly aware of when making risk asset decisions?

When they make the original investment decision, they should map out all the different types of risks that exist. When identifying the risks, they should decide if it is in their core competency to take it on. Mining companies should not be taking on construction risk, they should be taking on operating and geological risks. So, it's about identifying, allocating, and before you allocate, pricing these risks.

For example, being aware of how much it would cost me to allocate away certain risks that I've identified. If I don't want to take on construction risk, how much would it cost me to allocate it away? And how would I do that? After I've allocated all these different types of risk, I might look and say this is just too expensive for me and I wouldn't build this project, it’s not about building projects anyway. Price the cash flows correctly, and then understand whether this will work out in reality.

Is there a set of measures that miners can take now to improve their asset risk strategy in the long run?

They need to revamp their investment committees because committees usually use an excel model where they simply rely on expected numbers and best estimate of cash flow, opex, capex, etc. They run these hopeful numbers, discounted at the group discount rate, breaking down the different cash flows in and out of the company and the risk behind those cash flows. There must be a complete change in the way that these miners think about their risk, cash flow, and the way they allocate them.

Overall, this model I’ve described highlights the importance of identification, pricing, and allocating risk in particular ways to juniors, while still having the power to step in if necessary.

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02/17/2024 05:23:05