Mineral and Petroleum Economics

1. Key economic features of mining and petroleum projects

There are a number of features which make mining and oil and gas different from other economic activities. The following is a list of characteristics which influence the investment of trillions of dollars in the extractive industries.

Projects exploit a finite resource

Sub-soil resources are “one offs”. There is a certain amount of oil, or gold, or copper, under the ground and once you dig it out, refine it and sell it, it is gone. It is, in other words, depletable. This makes it fundamentally different from, say, agriculture, where the same crops can be grown year after year, or even manufacturing where, even if it relies on these same raw materials as inputs, most of the business model is in the value added of industrial processes that are not depletable in the same way. Considered economically, that puts any resource owner in a position of producing out natural “capital”, rather than earning revenues with replaceable inputs like labour. For a company, that then brings considerations of how to control the rate of production to maximize profit. The more you produce, the less you have left – unless you find new fields.

For governments it poses the challenge of how to manage what is called “intergenerational justice”. Are you cashing in today at the expense of your children tomorrow? And then again, this important theoretical concept – that natural resources are depletable – needs to be tempered by what actually happens under market conditions. Geological depletion suggests an absolute amount of raw materials on the planet. But technology constantly improves, especially when driven by the incentive of higher prices and greater profits. Oil can be sucked out from places where it could not even be detected a generation ago. Miners who 30 years ago would have had to dig a deep vertical shaft to reach a few limited veins of gold these days can bring in diggers to remove – economically – tens of millions of tonnes of “overburden” and create a massive open mine, reaching far more of the resource.

Long, costly exploration periods

While the lore and popular image of extractive industries is steeped in booms and get-rich-quick movements, from the Klondike in 1849 to gold rushes across Africa today, the reality of industrial level production is somewhat different. Thorough exploration often takes years and costs millions, sometimes billions, of dollars before a prospect is declared commercial and real development begins. A single deep sea exploratory oil well can cost $100 million. And always with the risk of total failure. In economic terms, this creates what is sometimes called a “hurdle” before a decision to invest is taken. A prospect needs not just to contain copper, but enough copper, extractable at low enough cost, to be declared commercial.

Large up-front investments

Exploration costs pale in comparison to the money needed at the next stage. Developing a huge project takes billions of dollars, and the trend in both oil and mining in the last couple of decades has been towards more and more “megaprojects” – single concession areas which require more than a billion dollars up front investment. Moreover the structure of extractives is generally that that investment is needed “up front”, at the start of a project, whereas production, revenues and profit lie years, sometimes even decades, down the track. For investors, time is money in a very real sense. The potential returns need to be that much greater the further in the future they lie, compared to investment outlay now. This relationship is factored into all investor metrics, as we shall see in the later sections.

Significant geological, political, environmental risks

Extractive industries are controversial because, when so many different things can go wrong, there will always be projects where they do go wrong. Analysts often talk in terms of “below ground” risk and “above ground” risk. Below ground risk means, even after all that exploration, there could be less resource, or it is more difficult to get at, than anticipated. In the past few years there have been several spectacular cases of such misjudgement. Rio Tinto had to write off billions of dollars, in a case which led to the resignation of its then CEO, when coal reserves in Mozambique turned out to be much lower grade than expected. The British oil company Genel wrote off half a billion dollars in a single oil field in northern Iraq in 2015 after it was forced to conclude it had overestimated the amount of oil and gone about drilling for it in the wrong way (reservoir management). Above ground risk is everything else, ranging from a coup d’etat – or an election – changing the government who signed a deal, and with it the political will to keep to the original terms, changes in law, lack of manpower or changes in global markets.

Sophisticated management and specialized technology

The constant evolution of technology may make more possible. But it also massively increases complexity. More things can go wrong. For example, gas can be brought to market globally if it is liquefied. But that means cooling it to minus 180 degrees and keeping it at that temperature on huge tankers running trans-continental voyages. Lower and lower grades of gold can be mined out – many operations now mine out ores with less than a gram of gold per tonne of ore – but only if all the many processes needed work well by themselves and interact with each other smoothly.

Prices (mostly) set on international markets; price volatility

Costs may be hard to predict accurately. Prices are impossible. The last few years have given ample demonstration of massive volatility in commodity prices, as what was touted as a supercycle boom in the years after 2000 culminated in a mid-2014 price crash of historic proportions. Moreover, experts do not agree on future forecasting, or even the reasons for price movements in the past.

High costs of abandonment

Large extractive projects not only cost a lot of money to set up. They cost another lot of money to leave in any kind of responsible way. “Abandonment”, or decommissioning a mine or oil field, can take years and cost millions, and those costs have to be factored into investment decisions from the beginning.

Significant environmental impact & risks

The Deepwater Horizon blow out in the Gulf of Mexico in mid-2010 has so far cost BP, the operating company, at least $20 billion. The Paris climate change agreement of 2015 aims to factor in the impact of fossil fuels on global warming. But costs under business-as-usual scenarios are incalculable. In mining, too, tailings piles can subside, toxic chemicals used for processing can leak, dams can collapse, or the project can end up competing for water in the long term with the growing needs of communities in the region.

High community impact

The phrase “Resource Curse” is contentious. Experts disagree about what causes it, or even if it exists at all. But its mere presence points to one indisputable fact: the powerful impact extractive industries have. This impact can make itself felt at national level, as with the so-called “petrostates”, and even more intensively at the level of local communities. Single projects can trigger, or at least play into, tensions within communities, between them and outsiders brought in to operate mines and fields. They can be a region’s largest employer and most visible connection to the global economy. They can run a region’s major infrastructure and use huge amounts of its other resources such as land and water. It is little wonder that companies spend a lot of time and money in “corporate social responsibility”, trying to win support at all levels of the societies they operate in. And, conversely, the last few years have seen numerous disputes between companies and communities, in Zambia, Peru, Indonesia, Thailand, South Africa, Greece, Afghanistan, the United States, the United Kingdom, Nigeria, and many other countries.

There are three general observations to be made about this list.

First, the fact that these are specific characteristics of the oil and mining industries is not supposed to mean that each one is unique to those industries. Many other economic sectors can be characterised by one or more of these attributes. Commercial real estate development, for example, can require comparable amounts of up-front investment. IT deals with similar technical complexity. Agriculture faces great volatility on world markets. It is the combination of all these elements together, and their intensity, which is unique to extractive industries. Like a fingerprint, as it were.

Second, some of these components are not directly financial, or at least quantifiable. But they all have financial implications for the management of extractives projects. Labour unrest, a change of government, or community tensions can all lead to stoppages, which are directly mapable as lost production and revenues. All of these variables are factored into the agreements which investors strike with governments, and integrated into contract terms and liabilities. One way or another, each of these factors ends up as a number, or part of a number.

Lastly, although at a media or policy level, there is much talk of the oil or mining industry, either globally or at a national level, in terms of economics it is the project which predominates and is the natural unit of analysis. A single “project” could encompass hundreds of wells, or seams, and combine many differently acquired concessions or license areas. But, generally speaking, it has its own business model, physical infrastructure, tax treatment, incorporation structures and finance mechanisms. Large multinational producers may operate scores of major projects in as many countries. But they are constantly seeking to match their forecast of global demand against a supply driven by the specifics, and resource bases, of all of their projects.

And each project is highly specific. The geology of one field may be significantly easier or harder than its neighbour. The same geology could spread across two or more jurisdictions with radically different “above ground” risk. Consider, for example, that the Eagleford shale formation of Texas extends hundreds of kilometres beyond the US border into Mexico. On one side of the border there are thousands of wells. On the other side, none.

The global portfolio of one company can be radically different to another, based on different competitive advantages, or indeed different views of the market. Shale gas in the United States was pioneered in the 2000s by then unheard of companies like Devvon Energy and Chesapeake Resources because the existing supermajors like ExxonMobil and Chevron initially saw less margin in it for them. Vertically integrated oil companies like BP and Total may be more likely to retain operations at all stages in the value chain, from the well head through to the petrol station, even through downturns in one or another stage in that chain, such as refining, than other companies which have never had that history or business model. Which is radically different to explorer companies, which routinely “flip” assets once they have made major discoveries, and stay resolutely out of major production themselves. Or Chinese companies owned or strongly influenced by the Chinese state, which will integrate factors such as security of access to resources into their thinking in a way a Western company never will. Newmont Mining can explain its decision (in mid-2016) to sell a mine in Indonesia to investors as a bid to concentrate purely on the production of gold, in this case divesting from major copper production, in the same market that its competitor Rio Tinto doubles down on copper production by moving ahead with an extended investment in Mongolia.

Each of these global portfolios is different. But each of them carries the same relationship to the project level. In supply terms, the portfolio is simply the sum of the parts - the projects. The project is the natural unit of analysis of economics.