Metal Prices and the Differences between Forward and Consensus Pricing: Which one is better for use in a DCF Model?

Transcription

1 Metal Prices and the Differences between Forward and Consensus Pricing: Which one is better for use in a DCF Model? Dr. Luis Martinez Tipe ( PTY LTD) Jeames McKibben (SLR Consultants) Shaun Barry (SLR Consultants) Copyright 2016 R&O Analytics Pty Ltd

2 Introduction Metal prices are central to the mineral investment decision Spot metal prices are informed by disequilibrium between international supply & demand Commodity price is one of the most significant & sensitive drivers of project viability & likely value Considerable time & effort is applied by industry to forecasting prices 2

3 Objective & Agenda Objective: Fundamentals & differences between Futures/forward & consensus pricing Appropriateness of each in a DCF model for mine evaluation Agenda Key drivers of metal prices Current industry practice - price forecasting Mine valuation - Futures vs consensus DCF modelling & selection of the appropriate discount rate Valuation Process using Consensus forecasts Valuation Process using Futures/forward prices Using Stochastic Futures/forward prices when valuing mine projects 3

4 Key metal price drivers Numerous factors impact on commodity price behaviour Is commodity an industrial metal (i.e. consumed to support industrial growth) or investment vehicle (i.e. a store of value)? Many pricing models: scarcity(economist model) supply-demand balance (business analyst model) expectations (investment analyst model) inventory levels (commodity analyst model) speculation (financial market analyst model) 4

5 Current industry practice Metal market where community of companies & individuals concerned with producing, trading & consuming commodities gather to purchase or sell a specific metal Needs to be free of arbitrage (i.e., a fair market) implying that assets with equivalent payoffs (i.e., substitutes) will have the same price Predicting metal prices is a critical first step in valuation & not an exact science Several recent surveys into choice of method used to determine commodity prices 5

6 KPMG and PWC surveys - preferred methods, and Author s online poll Table 1 Table 2 Preferred method for commodity pricing 2013 and 2015 surveys - Source KPMG. Method Consensus estimates 31% 51.7% Forward pricing 24% 41.4% Commodity expert 19% 34.5% Spot rate 19% 17.2% Other means 7% 3.4% Preferred method for commodity pricing 2014 and 2015 surveys - Source PWC: For long-term pricing of gold, silver and copper.. Method Gold Silver Copper Year Consensus estimates Internal estimates 33% 48% 19% 50% 47% NR 33% 39% 55% 40% 41% NR Spot rate 9% 9% 6% - - NR Historical averages 13% 4% 16% 10% 6% NR Forward curve 14% - 3% - 6% NR o NR = No Response Figure 1: Author s online poll 6

7 Mine valuation Futures price forecast Assumption: Futures & forward prices are equivalent (collectively known as Futures) Futures price curves assume all transactions in the metal market require: Seller accepts the price received is fair and adequate compensation for forgoing the opportunity to hold the metal in inventory to sell later Buyer accepts the benefit of purchasing the metal now outweighs the benefit of waiting to buy at a later date Accordingly, Futures price embodies an expectation of what prices will be like in the future, facilitating the hedging of risk. 7

8 Mine valuation consensus price forecasts Predictions of the price at specified future dates created by combining together several separate analyst forecasts Typically, a simple average of forecast prices produced by analysts at banks, brokerage companies, research companies, buy-side institutional investors & other price forecasting institutions / corporations Consensus Economics - world's leading international economic survey organisation reportedly polls more than 700 economists & analysts each month 8

9 Futures vs consensus : Advantages/disadvantages Consensus Advantages Widely used & accepted by industry Readily accessible & easily compiled Updated timeously (typically every 2 to 3 months) Disadvantages Market commentators, but not necessarily market participants - hence no skin in the game Forecast methods may vary between firms & analysts Not a true consensus agreed by all participating analysts Black box - no disclosure of key assumptions used by analysts in forming their opinions Date of preparation & forecast period of each analyst may differ & often not disclosed 9

10 Futures vs consensus : Advantages/disadvantages Futures pricing 10

11 Mine valuation - futures vs consensus Which to use? Key points typically relate to: Theoretical & practical basis for the use of Futures / Consensus forecasts when valuing a mine project, and The accuracy of forecasts relative to actual spot prices as at a designated future date. Need to understand: Normally, mining companies do not sell product every day, but may store & accumulate product to be delivered in the future Trading of product is carried out in the metal market, which is an open and unrestricted market at an agreed value 11

12 Estimating the current value of a mine: The DCF model DCF is a widely accepted method used by industry to estimate the value of a mining venture. Net Present Value (NPV) = expected future (multi-period) cash flows (both inflows and outflows) discounted using a risk adjusted rate of return (RADR). 12

13 DCF modelling & selection of appropriate discount rate Determining rate of return is typically a top-down exercise Selection typically fall into two main investor categories: those concerned with financial performance of a project use the OCC, cost of debt, WACC or similar measure those concerned with risk performance of a project incorporate a premium to compensate for any additional risk not included in the cost of capital, thus assume an appropriate hurdle rate. Thus using a single parameter to account for two inherently different variables (i.e. time value of money & risk) weakens investor s ability to correlate a rate of return with a project s given risks 13

14 Valuing mine projects using Consensus Defining Metal quantity : Consensus price: Cash Flow as: 14

15 Valuing mine projects using Consensus Focus should be directed towards estimating the most appropriate RRRR A common technique is the Capital Asset Pricing Model RRRR R = rr ff + PPRPPPPPP mmmmmm σσ R. Time risk Premium risk Time risk Premium risk 15

16 Valuing mine projects using Consensus Approximating RADR : Time risk Market price of risk Then, NPV expressed as: If using consensus, need to provide an estimate of market risk of price not a trivial process The CAPM provides a one-period pricing model & only a one-period risk premium inappropriate for most mineral projects with large LOM 16

17 Valuing mine projects using Futures By definition, futures price is: Current Spot price Market price of risk Then, NPV is: or: 17

18 Valuing mine projects: Futures vs consensus Main difference between Consensus & Futures resides in: If Consensus used, then discount future cash flows at RADR Need to estimate market price of risk not an easy task If Futures used, then discount future cash flows at the risk free rate, instead of the RADR No need to estimate the market price of risk or the project beta. 18

19 When uncertainty intrudes We have neglected measuring the uncertainty of Futures metal prices most metal markets do not have Futures prices extending over more than a few years (1-3 years) As operating life of mine projects typically span decades, must consider: uncertainty in medium to longer term prices and the possibility that Futures incorporate a risk premium 19

20 When uncertainty intrudes Two common methods to forecast price behaviour: Geometric Brownian Model ( GBM ) typically for precious metals Mean Reverting Model ( MRM ) typically for base metals However it is important to consider that both models can also be used to model real prices (spot, consensus, etc.) and Futures prices - or risk neutral prices. 20

21 Modelling metal prices as a stochastic GBM The Geometric Brownian Model ( GBM ) typically for precious metals Real model- uses RADR Risk neutral model - uses risk free The Mean Reverting Model ( MRM ) typically for base metals It is a bit more complex, but there are also the real and risk neutral models. 21

22 Conclusions The valuation technique adopted (DCF or modern asset pricing) dictates the most appropriate price forecast. If using DCF, then use consensus estimates or in-house expert price estimates. However, must also estimate the risk adjusted discount rate (not a trivial process). If using MAPM, then use Futures. However, must also adopt the risk-free rate as the discount rate. It is important to consider the future uncertainty especially for long term periods of time. When using a stochastic price model, such as the GBM or MRM, it is important to consider if the prices modelled are real (e.g., spot, consensus, etc.) or risk neutral (i.e., Futures prices), because. 22

23 Thanks, Questions 23