The Silver Lining to the Price Plunge

By Brian Anstey, Alan Cruickshank and Taylor Milner

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Times are tough right now for miners and energy producers. China’s economy, as well as many others, have slowed and commodity prices are at their lowest level in almost a decade. Once healthy margins are tight or have vanished altogether, projects that met hurdle rates are less attractive or viewed as nonviable, and long-term plans are being questioned.

At times like these it can feel like the sky is falling, but it should not be forgotten that crises also present leaders with unique opportunities to reposition their organizations in the competitive landscape. As Winston Churchill once said: “Never let a good crisis go to waste”.

This crisis will have winners and losers, like every crisis before it.  However, given the increased globalization and competitiveness of the industries, the range of results will be even bigger. The winners will win bigger and the losers will lag for years or decades to come. Based on what has happened in the past, on what we see in the market, and on the available data the winners this time will do two things:

  • Generate cash by significantly improving operating performance of assets.
  • Effectively invest in future growth to capture upside as it emerges.

While this may seem obvious on the surface, we will explain why taking these two paths together is not the typical reaction to a crisis and yet is the best way to survive it and thrive coming out of it.  We will also discuss the magnitude of results that can be driven through each of these paths.

In short, we are already seeing leading players improve the profitability of their operations by up to 50% a year, and seeing businesses pull up to 30% of the cost base out of capital project while maintaining the quality and timeline of the projects. The diverse range of operations and projects in which these results have been achieved lead us to believe that similar gains are possible in any environment and industry.  Below we lay out why we’ve reached this conclusion and some ways to start making this a reality.

Learning from the 2008 financial crisis and the past commodity super-cycle

Companies who flourished coming out of the last crisis did not adopt the typical go-to strategies of a crisis. According to the Harvard Business Review, these three typical strategies did not produce the outcomes one might expect:

  1. Those who cut fastest and hardest were the least likely (21%) to outperform after a downturn.
  2. Those who boldly invested more than their rivals were second least likely (26%) to outperform.
  3. Those already ahead were not necessarily likely to stay so. Only 15% stayed ahead.

Because of this “only a small number of companies – approximately 9% of our sample – flourished after a slowdown … outperforming rivals in the industry by at least 10% in terms of sales and profit growth.” So, if the companies that thrived were not those that cut faster, cut deeper, invested more during the recession or were already the leaders, what did they do?

According to the research, “companies that master the delicate balance between cutting costs to survive today and investing to grow tomorrow” are the ones that flourish. In fact, the businesses that were most likely to succeed (37%) were those that deployed a specific set of strategies:

  1. Reduced costs to endure the downturn: Not by swiftly reducing headcount or shuttering operations, but by focusing on operational efficiency improvements of a magnitude that exceeds that of their rivals, developing greater capability and positioning themselves to scale quickly
  2. Invested comprehensively in the future: Ensuring future growth through the delivery of high-value ventures and expansions

These may seem like obvious winning strategies, but they are challenging to achieve as they are not about superficial changes like cutting non-essential travel or employee pay raises, or rationing to survive the storm in order to return to “business as usual” when it subsides. Those who wish to thrive through this period must make fundamental changes to their operating model, not batten down the hatches and hope.  To continue the analogy, they must roll out the sails and use the headwinds to sail faster and further away from the pack in a new direction.

We acknowledge that this is not easy.  Most in the industry have already made productivity improvements over the last few years and if they knew where further large improvements could be realized, they would already be working to realize them and enjoying healthier margins. How to go about this strategy is what we will address in the following section.  Given that comprehensive investment in the future requires cash, we will start with how to address the productivity of assets to weather the storm.

Weathering the Storm

Faced with commodity price pressures for the past two years, many have already made significant strides in productivity.  This has led to the belief that most of the fruit (not just the low hanging pieces), has been harvested and only incremental opportunity to improve remains. Our experience in these industries and the results by others in the sector disprove this assumption.  PwC’s 2014 study entitled “Mining for Efficiency” revealed the magnitude of opportunity they saw through benchmarking and reached two powerful conclusions:

  1. There is an over-reliance on capital in mining: Research suggests that a better-rated piece of equipment may yield a 5-10% output improvement while requiring additional capital but in their experience and ours, changes in operating approach can yield 20%+ gains with no capital.
  2. The difference between median performance and best practice output by equipment category can be over 100%.

Furthermore, the data that we have collected suggest that mining operations have five to seven more times the opportunity to improve than is currently recognized by the organization.  Even best-in-class operators have the potential to improve cost performance by 20% rapidly. The way we are seeing this opportunity uncovered most effectively begins with the assessment of the performance of assets against their theoretical capability.  We all know the benchmarks with our competitors, but simply aiming to be as good as they are is not going to help us win in this challenging industry environment.

Instead, examining your operations versus theoretical performance allows you to see all opportunities available to you for the lifetime of your asset, and prioritise the levers of disproportionate value. By doing this you can begin to build the capabilities and operational efficiency required to reduce cost currently, and use this same capability to scale when market conditions improve.

Investing in the Future

By doing the above you will generate more cash from operations.  How do you best deploy this now scarce resource most effectively?

We are seeing a growing number of capital project portfolios (ranging from a few hundred million US$ to more than US$10 billion) where 30% of the cost base is being reduced while maintaining the scope and timeline of the overall portfolio. In fact, confidence in both of these factors is often improving alongside the cost reduction.  The project leaders that are succeeding at challenging their costs while maintaining or improving their scope and timeline are breaking the constraint that those three factors cannot all be improved together.  This is the so called “iron triangle.”  Conventional wisdom says that trade-offs must be made between the three.

Breaking this belief is powerful, because it allows three advantages in the marketplace:

  1. Businesses can continue to invest and secure supply, even with reduced cash flow.
  2. Marginal projects can move toward sanctioning, even with more stringent requirements
  3. “Underwater” projects can be acquired at a significant discount from struggling operators desperate for cash.

Healthy projects also afford a substantial benefit when conditions improve. Coming out of the last commodity super cycle, BCG research showed that 80% of the value gains were attributable to volume and commodity price increases. For this reason and those that follow, this crisis may actually be the best time to progress projects:

  1. A downturn is the most cost efficient time to invest in a project – softened demand will inevitably reduce contracting and procurement costs
  2. A well-executed project will be positioned to take advantage of more favourable market conditions in the future.
  3. Market pressure can be the driving force to review projects under a more critical lens.  This closer look can be the difference between the execution of a project that is “good enough” in favourable times and an outstanding project sanctioned in defiance of a harsh outlook.

The question then becomes: how do you achieve the improvements in project execution to support this strategy?

The sheer number of projects tackled in recent years has led to large amounts of process standardization.  This systemization, while succeeding at driving the necessary scale, has built in constraints, such as the project triangle, that have hidden the value which could be realised to achieve the current hurdle rate.  Those leaders challenging this perception are doing something similar to what the leaders at Toyota did and now others in the auto industry are doing. Just as Toyota audaciously challenged a once-sacred industry premise, that longer production runs were the key to low costs, these leaders are challenging similarly outdated premises and proving that large natural resource projects can be executed with dramatically reduced capital expenditure and enhanced schedule and scope.

Conclusions

The scale of the results that are being achieved, appear large and perhaps unattainable for some. This is because they are the leading indicators of a new direction businesses are taking to be truly successful in the current market and prepare themselves to thrive in the future. The current crisis will accentuate the difference between the winners and the losers, with the winners enjoying even greater returns, and the losers enduring a very painful lag. As with previous crises, the winners will not be those that simply react to endure and then return to normal, but those who take this opportunity to fundamentally change the way they operate for the better. This fundamental change is not only in operations, but also on the investment side to position future operations for success. Never let a good crisis go to waste.

 

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