Record commodity prices have led to record profits for companies involved in extracting natural resources from the ground, processing them into more refined products, and providing services all along the value chain. Even industries with historically unattractive earnings, such as refiners, steel manufacturers, and engineering and construction companies, are seeing unprecedented returns. At the same time, companies across all sectors have experienced soaring costs for everything from energy to engineers.
Not surprisingly, natural resource companies have sharply increased their investments in new projects to capitalize on high prices. Yet while today's profits look stellar, the business cases for many new projects are not nearly as rosy. Canada's oil sands provide a good example of a worldwide trend: Projects already in operation are earning margins of $50 to $60 a barrel (compared with $10 only a few years ago) while new investments are expected to barely make their 10-per-cent return hurdles. The reasons underlying this surprising dilemma have an impact on companies in every sector, not just natural resources.
Simply put, today's high commodity prices are caused by global resource shortages and business risks not seen in the past. As the world's economies have grown, the pool of experienced engineers, technicians and managers has not kept pace, resulting in increasing talent shortages across sectors.
At the same time, new resource developments have become technically more complex. Unabated demand growth has caused companies to pursue more difficult projects in more remote locations, operating under tighter environmental standards. Shortages ranging from mining truck tires to manufacturing capacity for major project components have brought competition for resources to a fever pitch. The resulting inflation has made returns on new investments precarious despite high commodity prices, and has driven up costs for all industries - and the average consumer.
There are, however, things all companies can do to realize more value from their growth projects - whether they are in commodities-related sectors or simply dependent on large projects for growth.
The first step is to move beyond project management practices developed in the 1980s and 1990s and adopt an approach that recognizes the riskier and more technically complex nature of projects today. Strategies like stage-gate processes, assurance reviews and front-end loading are broadly used in every sector from software development, to aerospace, to mining. These remain important but they miss challenges that many projects now face: Major uncertainties are not addressed early enough in the development process, subteams work in silos with poor tools for sharing information and cultural biases prevent a full range of solutions from being explored (for instance, building a project in stages instead of one big project). Overcoming these organizational challenges from the start consistently yields significant improvements in results.
Second, the development strategy should consider how to optimize the risk profile of the project in a holistic way. For instance, the design should address the technical, operating, commercial, execution and stakeholder risks right from the start. Instead, managers often try to deal with individual risks, like fuel prices, only after the basic design is frozen. The judicious use of partnerships, locking in suppliers or securing a market for the end product can be powerful strategies. Lowering project risks will also improve available financing options.
The final step is to take a hard look at the basic engineering design of the project. For instance, any construction or assembly project should meet four tests: 1) It must be designed for the minimal technical requirements and avoid unnecessary "gold plating"; 2) it must minimize execution and supply chain risks, for example, by shifting as much labour and cost to less-remote, lower-cost locations and facilitating application of "lean" practices throughout; 3) where possible the design must be standardized and modularized to minimize the cost and complexity of sourcing components; 4) and the design must reduce startup risks and enable world-class operation. The application of these tools can yield cost reductions of 25 per cent or more, and decrease the uncertainty in the final cost of the project.
There is no indication that the growth in demand for raw materials by the world's economies is about to abate. Since a response to this rapid demand growth may take many years, the challenges that large capital projects face will likely persist for a long time. It is therefore crucial that companies raise their project execution game quickly to stay competitive.
Jiri Maly is a principal in the
Toronto office of McKinsey & Co.