23/05/2006 - 22:00

Capital costs crunch sure to hit hard

23/05/2006 - 22:00

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Capital costs crunch sure to hit hard

Brisbane motorists got a bit of a shock last month. They discovered that the toll for using a proposed new road tunnel would not be the $2 per trip promised, but $4.

So what, you might ask. If anyone chooses to live in Brisbane rather than Perth they probably deserve to be penalised.

Perhaps that is true, but the Brisbane experience is not confined to that city, nor is it confined to road tunnel tolls. It’s an example of what happens when the capital cost of a project expands beyond the budget, and future operating revenues must rise to service the cost of capital employed.

The Brisbane tunnel is a public/private partnership, with motorists paying a toll to the owners for the next 45 years. The reason the proposed toll has doubled, years before the project opens in 2010, is that the capital cost of building the 4.7-kilometre long tunnel has blown out to around $2 billion.

Is the penny starting to drop?

What we saw in Brisbane with a vehicle tunnel we can also apply to train lines in Perth – or nickel and iron ore mines in the outback.

Trains first, because they’re much more fun. In Perth, we have been watching with great amusement the problems of building a train line linking the city with Mandurah. Apart from the industrial strife, there has been the never-ending round of budget blow-outs, shouting matches between the government and its contractors, and threats of legal action to recover cost increases.

Not even the planning minister, Alannah MacTiernan, can provide a completely accurate final cost of the project; unless, of course, she knows the result of legal actions proposed by Leighton Contractors, which is trying to claw back extra costs it blames on the government.

From where Briefcase sits, the capital cost of the railway and the tunnel under Perth is irrelevant. It wants to look forward and pose a question: what price a ticket on the Perth-to-Mandurah express?

Like the capital cost of the project there is not yet a detailed breakdown of the operating cost of the train service. But one thing is as certain as the Dockers never winning a premiership – the cost of a ticket when the line opens will be more than the cost when the line was being planned.

Briefcase knows for certain (it’s right up there in the death and taxes category of certainties) that you can’t increase a capital cost (capex) without a corresponding increase in operating costs (opex).

Perhaps there ought to be a financial law written about this phenomena, along the lines of capex = opex.

For potential users of the rail there is some comfort in knowing that rising petrol prices are probably making the electric-powered train look more attractive every day. But, that does not diminish the point that what might have been a fare of, say, $8.10 (the current cost of a Transperth ticket crossing eight-to-nine zones, and less with concessions), is heading towards a $10 standard ticket.

Cheap at the price, is what true train believers will say, and perhaps that too is true especially when compared with the cost of driving a car to Perth from Mandurah and then paying for parking.

However, that does not diminish the point being raised; that the longer the train project takes to build, the more legal disputes add to the delays, and threaten to add hundreds of millions of dollars to the final cost – the higher go the fares that will eventually have to be charged to recoup the capital outlay, debt-free or not.

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What we see on the trains, so we see in the outback. Capital costs are exploding on a variety of big-ticket projects, with potentially nasty future repercussions for investors in the less robust projects.

BHP Billiton’s nickel mine at Ravensthorpe is a case study. It has already suffered one cost blow out and the chatter in the market is that more surprises are on the way.

Fortescue Metals Group is also believed to be heading for a shock when it gets down to the detailed number crunching on its proposed iron ore mines in the Pilbara.

Right now, with most commodity prices in the stratosphere, none of this talk about exploding capital cost budgets seems to be worth worrying about. The belief is that high cash flows will wash away any unpleasant increase in the capital cost.

Past experience tells Briefcase this is a bit of a fool’s paradise and that now is, in fact, a very important time to be worrying about costs because of the effect they will have on producing tonnes of nickel and/or iron ore, just as they affect the future price of a train ticket.

While some project operators, and most investors, are not thinking too far into the future, there is a pecking order in the way these capital cost versus operating revenue issues work out. The simple formula is that the company with the fattest profit margin (a) gets the job done fastest, and (b) survives longer when tough times return.

In WA that means that no-one can compete effectively with the oil and gas sector because profits flowing from oil at $US70 a barrel blows everything else out of the water.

Those oil (and gas) profits also mean that when it comes to buying the best contractors, and equipment suppliers, they not only win, but they drive the prices up for everyone else.

There ought to be a warning bell ringing somewhere in the background for projects that might be even slightly marginal at lower commodity prices than we see today.

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 “History repeats itself; that’s one of the problems with history.” Clarence Darrow

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

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