Relevant Aspects of Mining Project Evaluation - Case Study Example

PETROLEUM ECONOMICS AND ASSET MANAGEMENT Factors considered when selecting a discount rate Generally, the future is inherently uncertain, and this also affects the uncertainties surrounding the mineral exploration and exploration. According to Park and Matunhire (2011, p. 415), there are three main mineral development risks that affect the discount rate applied. First are the technical risks and relate to the mine sites and the mining company’s capability and include the completion risks, production risks and the reserve risks (Park & Matunhire, 2011, p. 774). Second are the economic factors and are presented by the economic volatility and include price risks, foreign/exchange risks, and demand/supply risks. The third risks are the political risks, which are determined by the government unforeseen actions. They include currency convertibility, tax, environmental, and nationalization. Given the prevailing situations, in this case, it would be prudent to adopt the higher regional discount rate of 15% and not the company's 6% weighted average cost of capital. This decision is guided by the fact that the government is not currently offering any form of tax relief for the decommissioning costs. Additionally, there is no certainty about the nature of reserves, but the company hopes not to avoid any early abandonment and the asset production for oil wells will decline at the rate of 22% pa while for gas wells is 8%. Economically, the dollar’s purchasing power will decrease at a rate of 2% pa. Project optimisation Before a decision is made to execute a particular mineral project, there is a need to carry out a valuation analysis. This will give the basis or the selection criteria for the mineral project. Using the managerial and financial resources that your company has, a choice must be made between the available alternatives using some tangible measurement of economic return or value. The measurements must be based on the project’s annual cash flows. In making the economic decision on this project and the alternatives to implement, the time value of money was considered. The annual cash flow calculations for the planned mining period were used to make the final economic analysis. The economic analysis was aimed at establishing the economic viability of the mining project. The number of values and indices used in performing financial analysis of this mining project includes the maximum cash exposure, the internal rate of return, payback period, discounted payback period, and the net present value using the selected discount rate. The uncertainties surrounding this project were associated with the input and the related economic evaluation indicators. When using the net present value, the first criterion for evaluating this project was the net present value itself. For the project to be chosen, it must have been posting positive net present values. However, in this scenario, there was no set standard or a minimum value that your company had determined. After establishing that the net present value of a particular project was positive, these projects had to meet other key criteria. These criteria include: first, the project must be able to recover the initial capital outlay; secondly, the financial returns from s project must be greater than the interest rate; and thirdly, the premium of the mineralisation was to be discounted. The internal rate of return was also considered since it is a special case of the net present value approach. Through this approach, an interest rate that would exactly discount each project's estimated future cash flows to the present value of its initial capital investment. In other words, the rate that would make the project to give zero net present value., a minimum internal rate of return is usually established, under which a project is rejected. In this scenario, your company did not have a minimum acceptable rate of return. Therefore, the cash flows were tested through sensitivity analysis for projects, mineral properties, and mineralisation valuation and ranking before your company goes ahead to develop them. Consideration of the payback period was also considered necessary. It was aimed at determining the time it would each project to produce enough cash flows to cover its initial investment costs. Through this approach, the value of the mining projects was established by ranking them by the time each would take to recover the initial capital outlay from the project's cash flows. Table 1, 2, 3, 4, 5, and 6 below show the various cash flows that are involved in every project. These cash flows include the initial investment costs, additional annual costs, annual incomes, repair costs, and the tax. In addition, the net cash flows of each project were computed. Using the discount rate of 15%, these future cash flows have been discounted to the present value. Table 1 Evaluation of Evaluation of Development Drilling Gas Well G-3 Time Period (Year) 2016 2017 2017 2018 2019 2020 2021 2022 2023 2024 2025 Initial Costs/Investment   -16.68                 Additional Annual Costs     -1.32 -2 -1.4 -0.96 -0.64 -0.4 -0.24 -0.16 -0.08 Annual Income     47.2 74.45 50.94 35.27 23.51 15.67 8.02 4.1 3.74 Non-Annual Maintenance/Repair Costs     -5.96                 Decommissioning Costs/Salvage Value                       Tax     -4.35 -34.54 -31.65 -29.14 -26.67 -24.49 -22.43 -20.55 -18.79 Net Cash Flow (NCF)   -16.68 35.57 37.91 17.89 5.17 -3.8 -9.22 -14.65 -16.61 -15.13 Accumulated NCF   -16.68 18.89 56.8 74.69 79.86 76.06 66.84 52.19 35.58 20.45 Discount Factor   0.8696 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323 0.3759 0.3269 0.2843 Discounted Net Cash Flow (DCF)   -14.5043 30.9304 28.6654 11.7630 2.9560 -1.8893 -3.9861 -5.5075 -5.4298 -4.3009 Accumulated DCF   -14.5043 16.4261 45.0915 56.8545 59.8104 57.9212 53.9351 48.4276 42.9978 38.6969 Table 2 Evaluation of Sidetracks N-7, 8 and S-7, 8, 9 Time Period (Year) 2016 2017 2017 2018 2019 2020 2021 2022 2023 2024 2025 Initial Costs/Investment   -34.2                 Additional Annual Costs     -3.36 -4.2 -1.56 0.76 0.44 0.32 0.32 0.32 0.32 Annual Income     125.22 153.01 58.6 -27.61 -15.67 -11.76 -11.76 -11.76 -11.76 Non-Annual Maintenance/Repair Costs     -1.72 -3.44 -3.44 -3.44 -3.44 -3.44 -3.44 -3.44 -3.44 Decommissioning Costs/Salvage Value                       Tax   -72.19 -122.11 -45.03 25.44 15.69 12.5 12.5 12.5 12.5 Net Cash Flow (NCF)   -34.2 47.95 23.26 8.57 -4.85 -2.98 -2.38 -2.38 -2.38 -2.38 Accumulated NCF   -34.2 13.75 37.01 45.58 40.73 37.75 35.37 32.99 30.61 28.23 Discount Factor   0.8696 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323 0.3759 0.3269 0.2843 Discounted Net Cash Flow (DCF)   -29.7391 41.6957 17.5879 5.6349 -2.7730 -1.4816 -1.0289 -0.8947 -0.7780 -0.6765 Accumulated DCF   -29.7391 11.9565 29.5444 35.1793 32.4063 30.9247 29.8958 29.0011 28.2231 27.5465 Table 3 Evaluation of Corrosion Workovers S-5, 6 Time Period (Year) 2016 2017 2017 2018 2019 2020 2021 2022 2023 2024 2025 Initial Costs/Investment   0                 Additional Annual Costs     -1.32 -2 -1.4 -0.96 -0.64 -0.4 -0.24 -0.16 -0.08 Annual Income     47.2 74.45 50.94 35.27 23.51 15.67 8.02 4.1 3.74 Non-Annual Maintenance/Repair Costs     -5.96 0 0 0 0 0 0 0 0 Decommissioning Costs/Salvage Value                       Tax     -33.53 -60.86 -41.62 -28.82 -19.21 -12.83 -6.53 -3.31 -3.07 Net Cash Flow (NCF)   0 6.39 11.59 7.92 5.49 3.66 2.44 1.25 0.63 0.59 Accumulated NCF   0 6.39 17.98 25.9 31.39 35.05 37.49 38.74 39.37 39.96 Discount Factor   0.8696 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323 0.3759 0.3269 0.2843 Discounted Net Cash Flow (DCF)   0.0000 5.5565 8.7637 5.2075 3.1389 1.8197 1.0549 0.4699 0.2059 0.1677 Accumulated DCF   0.0000 5.5565 14.3202 19.5278 22.6667 24.4863 25.5412 26.0111 26.2171 26.3848 Table 4 Evaluation of Sand Screen Change N-4, 6 Time Period (Year) 2016 2017 2017 2018 2019 2020 2021 2022 2023 2024 2025 Initial Costs/Investment   0                 Additional Annual Costs     -1.28 -1.68 -0.88 -0.32 -0.08 0 0 0 0 Annual Income     47.02 62.52 31.35 11.76 3.74 0 0 0 0 Non-Annual Maintenance/Repair Costs     -3.92 0 0 0 0 0 0 0 0 Decommissioning Costs/Salvage Value                     Tax     -35.13 -51.11 -25.59 -9.61 -3.07 0 0 0 0 Net Cash Flow (NCF)   0 6.69 9.73 4.88 1.83 0.59 0 0 0 0 Accumulated NCF   0 6.69 16.42 21.3 23.13 23.72 23.72 23.72 23.72 23.72 Discount Factor   0.8696 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323 0.3759 0.3269 0.2843 Discounted Net Cash Flow (DCF)   0.0000 5.8174 7.3573 3.2087 1.0463 0.2933 0.0000 0.0000 0.0000 0.0000 Accumulated DCF   0.0000 5.8174 13.1747 16.3833 17.4297 17.7230 17.7230 17.7230 17.7230 17.7230 Table 5 Evaluation of ESPs N-4, N-6, S-5, and S-6 Time Period (Year) 2016 2017 2017 2018 2019 2020 2021 2022 2023 2024 2025 Initial Costs/Investment   -40                 Additional Annual Costs     -0.32 -2.4 -1.44 -0.84 -0.48 -0.28 -0.12 -0.08 -0.09 Annual Income     15.14 84.61 49.34 29.57 17.63 9.8 2.32 1.96 1.96 Non-Annual Maintenance/Repair Costs     -0.04 -0.4 -0.4 -0.4 -0.4 -0.4 -0.4 -0.4 -0.4 Decommissioning Costs/Salvage Value                       Tax     21.25 -68.11 -39.29 -23.19 -13.47 -7.05 -0.9 -0.64 -0.63 Net Cash Flow (NCF)   -40 36.03 13.7 8.21 5.14 3.28 2.07 0.9 0.84 0.84 Accumulated NCF   -40 -3.97 9.73 17.94 23.08 26.36 28.43 29.33 30.17 31.01 Discount Factor   0.8696 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323 0.3759 0.3269 0.2843 Discounted Net Cash Flow (DCF)   -34.7826 31.3304 10.3592 5.3982 2.9388 1.6307 0.8949 0.3383 0.2746 0.2388 Accumulated DCF   -34.7826 -3.4522 6.9070 12.3052 15.2440 16.8748 17.7697 18.1080 18.3826 18.6214 Table 6 Evaluation of Offshore ESPs A-1, B-1 Time Period (Year) 2016 2017 2017 2018 2019 2020 2021 2022 2023 2024 2025 Initial Costs/Investment   -43.84                 Additional Annual Costs     -0.64 -4.32 -3.4 -2.64 -2.04 -1.6 -1.24 -0.96 -0.76 Annual Income     23.16 158.35 123.08 95.65 72.49 56.64 44.71 33.13 25.29 Non-Annual Maintenance/Repair Costs     -11.8 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 Decommissioning Costs/Salvage Value                       Tax     14.04 -63.1 -48.78 -37.6 -28.88 -22.08 -16.78 -12.66 -9.42 Net Cash Flow (NCF)   -43.84 24.76 90.33 70.3 54.81 40.97 32.36 26.09 18.91 14.51 Accumulated NCF   -43.84 -19.08 71.25 141.55 196.36 237.33 269.69 295.78 314.69 329.2 Discount Factor   0.8696 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323 0.3759 0.3269 0.2843 Discounted Net Cash Flow (DCF)   -38.1217 21.5304 68.3025 46.2234 31.3378 20.3693 13.9901 9.8082 6.1817 4.1246 Accumulated DCF   -38.1217 -16.5913 51.7112 97.9345 129.2723 149.6417 163.6318 173.4400 179.6217 183.7463 Table 7 Values and Indices used in Performing Financial Analysis G-3 Sidetrack Corrosion workover Sand screen ESPs Offshore ESPs Maximum Exposure -16.68 -34.2 0 0 -40 -43.84 Net Present Value (NPV) 31.76 20.07 22.94 15.41 11.66 154.81 Profitability Index (PI) 2.904 2.204 2.375 1.924 1.699 10.281 Payback Period 0.46 Years 0.71 Years 0 0 1.29year 1.21year Discounted Payback Period 0.54Years 0.82Years 0 0 1.33Years 1.24Years Internal Rate of Return (IRR) 5.51% 81.41% 0.00% 0.00% 35.85% 110.97% Table 7 above shows the values and indices used in performing financial analysis for all the six projects. These parameters will guide the selection of the most viable on which the $100M for capital expenditure and $20M for operating expenditure would be used. Using the net present value technique, all projects are viable as they have positive net present values. In regard to the Offshore, ESPs has the highest profitability index. In terms of the payback period, project G-3 has the lowest payback period. This paper proposes that projects G-3, Sidetrack, and the offshore ESPs. These projects require a capital investment of $94.72. Their net present values will be $31.76, $20.07 and $154.81 while the payback periods will be 0.46 years, 0.71 years, and 1.21 years for G-3, Sidetrack, and the offshore ESPs respectively. Handling data uncertainties Basically, the approaches used to evaluate the viability of these projects are the discounted cash flow approaches. These approaches have uncertainties in the input parameter values. Such uncertainties surround the prices of wells, commodities, production rate, mining and processing costs. To address these risks, the projects will be managed in a constant manner through a constant discount rate. According to Iloiu and Iloiu (2009, p. 149), the decision tree method will be used to eliminate these disadvantages sine it gives discrete probabilities of these variables occurring. The Monte Carlo Simulation approach can also be used since it employs a probability distribution for input variables. The forecasted net present values from the selected projects will be presented as a histogram. As noted by Iloiu and Iloiu (2009) related to real option, uncertainties are principally linked to the price. In addition, the aforesaid two approaches will be used to flex the management's assertion that the project's life and scenario are constant. Through the Decision tree, the managerial strategies are analysed, and all outcomes of these strategies calculated. The Monte Carlo approach will be used to model the uncertainties associated with input parameters, ignoring managerial strategies. The generated net present value distributions would be a representative of the outcomes of the projects beforehand. Through Real Options, multidimensional dynamic series of the decision will be presented for the manager to be flexible to adopt and correct any available new information to resolve the uncertainty. References Iloiu, M. & Iloiu, S., 2009. Relevant Aspects Of Mining Project Evaluation. Humanitarian Sciences and Economics, 52 (4), pp. 147-50. Park, S.J. & Matunhire, I.I., 2011. Investigation of Factors Influencing the determination of Discount Rate and the Application of Quantitative Methods for Discount Rate using Risk Factors in the Minerals Industry. The Southern African Institute of Mining and Metallurgy, pp. 413-28. Park, S. -J. & Matunhire, I.I., 2011. Investigation of factors influencing the determination of the discount rate in the economic evaluation of mineral development projects. The Journal of The Southern African Institute of Mining and Metallurgy, 111, pp. 773-79. Read More