Moatize: Project Solution

The main questions that must be answered are whether or not CVRD should bid for the right to explore the Moatize coal mines, and if so, how much they should bid. To address whether to pursue the bid for the Moatize coal reserves CVRD must evaluate various factors discussed in the case. Our recommendation is for CVRD to pursue the bid because in analyzing the project under different dimensions, the benefits of participating in the bid process significantly outweigh the benefits of staying out of the process. To reach this conclusion we analyzed the following factors:

  • The evaluation of profitability potential,
  • company strategy,
  • competitive landscape,
  • government stability/risks faced in investing in Moatize
  • participation of multilateral agencies, and
  • likelihood of infrastructure improvements.

Profitability Potential

The profitability potential is illustrated in the attached valuation of the coal reserves. It demonstrates that this is a positive NPV project, even with conservative projections for the volatile metallurgical coal prices and also underestimating the size of the coal reserves. Winning the bid process to explore the Moatize coal reserves will provide CVRD with real options that will not only mitigate the downside of the investment but willalso provide flexibility to capitalize on the upside, based on changes in market demand. We will further discuss such real options later in this document.

Company Strategy/Competitive Landscape

Participation in this project is also aligned with CVRD’s corporate strategy to pursue opportunities in international markets and to diversify its portfolio of products to its customers in the steal industry. It is also a chance to reduce costs by vertically integrating. There is a valid concern that CVRD’s lack of experience in coal mining may cause it to lose another international bid for natural resources, however, the company has allied itself with AMCI to provide coal mining credibility to its offer. Perhaps due to this lack of expertise, CVRD may have to bid aggressively to win, but we contend that CVRD should provide a competitive bid without overpaying (based on its valuation). BHP Billiton has significant investments in Mozambique, including control over the Mozal aluminum smelter. To avoid an over-reliance of the country’s economy on the decisions of one corporation, the Mozambican government would be reluctant to award the coal mining concession to BHP. For BHP, on the other hand, this would be a great opportunity to vertically integrate. If CVRD chooses to forgo this opportunity, it may not be able to gain access to Sub-Saharan Africa in the future, due to the strength of its competitors in the region.

Government Stability

The success of the Mozal project has served to portray a stable economic and political environment in Mozambique which attracts foreign direct investments. Even though the haste of the bid process to conclude prior to the presidential elections is certainly disconcerting, however, the Mozambican government has successfully signaled to the investment community that it is committed to a path of economic development and stability. The presence of multi lateral agencies in other projects in the country and their willingness to be active participants in such development also make the Moatize Coal reserves an attractive project for CVRD. Finally, since the infrastructure investments, particularly in the power, rail and port areas, are critical to the success of the Moatize coal mining efforts, the support of both the Mozambican government and the MLA’s provide additional assurance that the resources from the Moatize will be extracted at a reasonable cost. The cost of capital worksheet for Moatize is attached in the solution spreadsheet.

Real Options

There are four main options that shall be considered when evaluating the Moatize project: the output mix, the option to expand, the option to abandon, and the interproject option.

Output Mix Option

The output mix option allows the project to shift production from thermal coal to metallurgical coal depending on shifts in market demand and prices. Since 2004 metallurgical coal prices are more than double thermal coal prices, given a similar cost structure and without demand constraints, it would be more profitable to only produce metallurgical coal. As demand shifts,metallurgical coal prices drop, and the cost structures vary, having the option to optimize the output mix provides added value to the project.

The Expansion Option

The expansion option is an opportunity to capitalize on an upswing in the market. Since the valuation is based on standard production levels, the Moatize coal mine is large enough to allow production capacity to expand if the market can accommodate it. The figure below illustrates the value of the option to expand as follows: option to expand = p1 ((GG’ – GG) + (GB’-GB))

The value of the option to expand can be quantified based on an NPV valuation that has been done. Based on the author’s assumptions, the following values were obtained:

GG’ = 21 million tons/year = NPV of $4.302 Billion

GG = GB’= 9 million tons/year = NPV of $1.334 Billion

GB = 5 million tons/year = NPV of $0.345 Billion

By assuming p1=0.5, the value of the option turns out to be

0.5*[(4.302-1.334) + (1.334-.345)] = $ 1.979 Billion

Abandonment Options

Contrary to the option to expand, the option to abandon the project limits the investor’s downside risk. If at any point of the project’s duration, the present value of the asset (the coal mine) is greater than the NPV of the cash flows that it can generate, then the project management group can choose to exercise the option of abandoning the project and liquidate the assets.

Interproject Options

Finally, since the Moatize project is interdependent with other projects such as the railway project, the port expansion north of Beira, and the energy gridline expansion to major economic centers of the country, interproject options should also be evaluated in the value of the Moatize coal mines. As these projects are completed, the value of the Moatize automatically increases, this interdependence is part of the reason why the Mozambican government only decided to sell the concession to explore the Moatize after a plan for the rehabilitation of the railway leading to the Beira port had been established.

Bid Value

To evaluate CVRD’s bid value for the concession, we have created a decision tree that arrives at a maximum bid value of US$176 million based on the following assumptions: probability of winning the bid (25%), feasibility of the project (75%), production level of 9 million tons per year of saleable coal, 50% output mix between thermal and metallurgical coal, and 28% cost of capital. To arrive at the US$122.8 M that CVRD is planning to offer, we may shift many of these levers concurrently, but if we limit ourselves to shifting just one lever while holding the others constant we can arrive at the $122.8 M figure by either reducing the probability of winning to 17.75% or reducing the production levels to 7.6 million dons per year, amongst other options. This decision tree further supports not only that this is a positive NPV project but also that the current bid CVRD is planning to put forth is reasonable, considering the uncertainty and the various dependencies embedded in the project.

It should be noted that the figures used in this solution are based on assumptions that were made by the authors and may be different, depending on assumptions ofreaders analyzing the case.