Current Issues in Mining Projects
By Nabil L. Khodadad
As metal and coal prices surge, lenders are being asked to finance projects with weaker sponsors and in countries with greater political risk. This has created interesting opportunities and challenges.
Prices for precious, base and ferrous metals and coal have increased 50% or more in the last few years. The price of gold is up by more than 50% since 2001 and is now near a 15-year high. Nickel, copper, lead, zinc and tin prices have doubled in the last two years, and aluminum prices have risen by more than 50%. Coal prices have doubled in just the last year. Major steel producers in Japan, China and elsewhere agreed to a more than 71% increase in the price of iron ore in February. Share prices of most mining companies have also soared.
Many analysts believe that the prices for coal and most metals will remain high in the short to medium term. A construction boom in China has helped to push up the price of many commodities, especially copper and iron ore, and surging oil and natural gas prices have boosted demand for coal. Continued instability in Iraq and elsewhere in the Middle East, concerns about global terrorism and a weak US dollar have restored gold as a safe haven in uncertain times.
Surging prices make mining much more attractive to project lenders at the same time that soaring revenues have made the mining majors less reliant on project finance.
The capital markets have become accessible not only to the mining majors, but also to junior mining companies. For example, Sino Gold Limited, a smaller mining company with limited existing production, recently raised $35 million through the issuance of senior unsecured convertible notes due in 2012 to finance development of phase one of the Jinfeng gold mining project in China.
Lenders considering whether to extend financing to a mining project must analyze many types of risks. The following is a “top 10 list” of key risks that apply in a mine financing.
Reserves. Reserves are key in any mining project. Without adequate reserves, a mining project cannot generate enough revenue to service debt. Project lenders are only willing to finance proven reserves and not exploration. To give them a buffer against unanticipated costs, project lenders typically require that a mining project have a “reserve tail” of at least 30%, meaning that at least 30% of the project’s reserves should remain on the final repayment date. Lenders will require the borrower to submit a reserve report prepared by a reputable source, and they also usually retain an independent mining engineer to validate the reserve report and comment on the feasibility study submitted by the mining company.
The importance of verifying reserves was dramatically illustrated by the Bre-X mining scandal in the late 1990s. Bre-X, a Toronto-listed junior mining company with no production, started as a penny stock. Based on reports that its Busang concession contained as much as 200 million ounces of reserves (which would have made it the world’s largest gold deposit), Bre-X’s share price soared to a peak of CDN$286.50, giving the company a market capitalization of over CDN$6 billion. However, an independent audit of Bre-X’s core samples found that they had been salted with outside gold and that the Busang concession did not contain any commercial reserves. After the audit results became known, Bre-X collapsed, and its shares became worthless. As a result of the Bre-X scandal, stock exchanges and regulators in the US, Canada, the UK, Australia and elsewhere have imposed more stringent standards on the reporting of reserves.
Completion Risk. Lenders in a mine project financing are generally unwilling to take completion risk.
They will require the sponsor(s) of the project to provide completion guarantees. Sponsors of mining projects used to be large mining companies with strong balance sheets and substantial non-project assets to support their completion guarantees. However, loans are being made increasingly today to mining companies with weak balance sheets and fewer non-project assets. This has caused project lenders to look for other ways to mitigate completion risk. For example, project lenders have been forced to conduct more due diligence on the project, focus more carefully on the creditworthiness of the contractor and require more robust construction contracts. They are also requiring larger reserves for cost overruns and contingencies and a larger equity buffer for projects with weaker sponsors.
Mining projects are also being undertaken in countries fraught with political risk. It is precisely in such countries that the mining majors are most likely to seek project finance as a means of reducing political risk. There is a perception that a mining project that has been financed by foreign lenders, particularly international financial institutions such as the International Finance Corporation or the European Bank for Reconstruction and Development, has political clout that can mitigate political risk. Sponsors of such projects may seek to obtain a political risk carve-out from their completion guarantees releasing them from liability where the project has failed for “political” and not commercial reasons.
Mining and Processing Risk. Lenders want a borrower to have qualified and experienced management. This is a greater concern where the sponsor is a junior mining company. Lenders are unwilling to take technological risk and will only lend against tried and tested technology rather than new processes that have not yet been proven on a commercial scale. There are a few examples of lenders extending financing to large projects based on new technology that simply did not work, resulting in substantial write-offs.
If the project takes the form of a joint venture (which is often the case in emerging markets), the lenders will want to check that operating decisions are left to the most qualified party.
Supply Risk. The reliable supply of fuel, power and certain reagents (such as cyanide) may be crucial for the success of a mining project. Supply risk may be of particular relevance for projects located in remote areas without access to good transportation links. Moreover, the cost of key supplies can often make or break a project. For example, power costs alone can represent about 40% of the cost of operating an aluminum smelter. Many mining projects are now located in emerging markets that may have insufficient or unreliable generation and transmission infrastructure. Moreover, such countries may be planning to privatize their utilities, which could have an uncertain effect on the price of electricity. Where possible, project lenders will encourage borrowers to enter into long-term power purchase agreements to ensure that the project has reliable access to power at a predictable price.
Market Risk. If the commodity produced by the mine has a restricted number of buyers or if terminal markets such as the London Metals Exchange are not available, then the borrower may be required to enter into a long-term offtake contract with a creditworthy offtaker. For example, in the $230 million loan financing extended by Export Development Canada and about 20 commercial banks to Aber Diamond Corporation to fund its stake in the Diavik mine in Canada, Tiffany agreed to buy from Aber a minimum of $50 million of diamonds per year for 10 years. This was the largest project loan to a Canadian mining company and the largest non-recourse loan for a diamond mine. Without Tiffany’s offtake commitment, the financing would not have been possible.
Price Risk. Lenders must forecast what the price for products will be when the project commences operation in several years time, and not the price at the time they commit to extend financing.
Where feasible, lenders usually insist that the borrower hedge a portion of its production to ensure that the project is protected in case the price of the product declines. However, mining companies are increasingly reluctant to hedge because their shareholders usually want to be exposed to metal and commodity prices. Moreover, with many hedge funds investing in mining companies, shareholders are putting pressure on companies not to hedge. For example, for established gold producers there appears to be a 3-to-1 rule; each 1% increase in the gold price leads to a 3% increase in the producer’s stock price. For this reason, it is probably not surprising that we are currently witnessing the lowest level of hedging since large-scale hedging was introduced in the 1980s.
Both sponsors and lenders have been exploring ways to mitigate price risk in a manner that does not unduly limit the sponsor’s upside. For example, producers are more inclined to purchase put options that protect the producer in the event that metal prices decline, but do not penalize it if metal prices rise. Moreover, if the project has a robust base case after including very conservative assumptions about product prices, then lenders may become more comfortable with price risk. For example, with gold prices so depressed during much of the last decade, most gold mining projects are coming on stream based on a price of $275 to 300 an ounce, even though the current price exceeds $400 an ounce.
Legal and Fiscal Risk. A stable legal environment is an important prerequisite to project finance.
Through legal reform of their mining laws, countries such as Chile, Indonesia and Ghana have attracted substantial foreign investment in their mines. For example, Chile has a model mining regime that encourages investment by granting clear proprietary rights to minerals, minimizing bureaucratic discretion in the awarding of licenses and permits and stabilizing much of the fiscal regime through a foreign investment contract.
Many other developing countries have joined the reform movement in the last decade, with the encouragement and support of the World Bank, by introducing mining codes that create a more transparent, predictable and commercially attractive legal and fiscal regime for mining. In the 1990s, many Latin American countries reformed their mining laws and this explains, in part, why Latin America’s share of global exploration expenditures doubled from 13% to 26% during the period.
In a mining project, the key legal risks relate to the security of tenure, the enforceability of contract rights and security, and the reliability and neutrality of the forum for resolving any disputes. The mining license or concession is the most valuable asset of a mining project. Lenders will want to ensure that it cannot easily be terminated or revoked by the granting authority, and will want an opportunity to cure any breach of the license or concession before any such termination or revocation. In many countries, it is difficult for a lender to obtain a security interest in mining rights. However, a number of countries permit a lender to do so. For example, mining rights in Chile have all the incidents of real property rights and can be mortgaged. They are also protected by the constitution against taking without adequate compensation.
The importance of security of tenure was illustrated by the Maba v. Queensland decision in Australia that recognized indigenous rights in land. This recognition was formalized in the 1993 “Native Title Act.” Mining companies in Australia have had, since 1993, to spend considerable time and money negotiating with claimants and potential claimants, since native title still remains an uncertain area of the law with regards to exploration rights, mining and related uses of land.
In many developing countries, mining companies have been granted mining rights over areas where indigenous miners have been illegally mining for decades. While such small-time miners may lack mining rights under law, they may enjoy such rights in practice. In such cases, foreign mining companies often try to reach an accommodation with such indigenous miners.
Many of the legal and fiscal risks mentioned above can be mitigated through an investment agreement with the host government. Such agreements typically establish a stable fiscal regime for the project, contain a commitment from the government to issue permits and approvals when the appropriate documents have been submitted and provide for international arbitration in the event of a dispute.
Tax Risk. The local regime can break a project by making it unprofitable. The rates of import duties, royalties, withholding taxes and corporate income taxes can have a big effect on the profitability of a project and its ability to service debt. Lenders are particularly concerned about the stability of existing taxes and tax rates in those jurisdictions that do not have a long track record of foreign investment in the mining sector. As already mentioned, in some countries it is possible to obtain an investment agreement that grants exemptions or privileges with respect to certain taxes and stabilizes the rest.
Currency Risk. Currency risk includes the risk of inconvertibility, non-transferability and devaluation. Political risk insurance is usually available to cover convertibility and transferability. While it is generally not possible to obtain political risk insurance against devaluation, it may be possible, depending on the currencies involved, to mitigate currency risk through a currency swap. In recent times, the US dollar’s dramatic depreciation against many currencies has had an adverse effect on many mining companies whose revenues are principally in US dollars, but whose costs are in appreciated local currency. For example, the depreciation of the US dollar relative to the South African rand has had a particularly adverse effect on South African gold producers who have witnessed a substantial rise in the US dollar equivalent of their costs.
Political Risk. Political risk — the risk of expropriation, interference by national or local authorities, revocation of export or mining licenses and political violence — has grown in importance as mining companies have been drawn to developing countries in Africa, Asia and the CIS with large ore bodies but less political stability.
There are a variety of public providers of political risk insurance, such as the Multilateral Investment Guarantee Agency and the Overseas Private Investment Corporation, as well as private insurers.
There is a perception that mining projects that have been financed by multilateral lending agencies like the International Finance Corporation and the European Bank for Reconstruction and Development, have political clout that can mitigate political risk. Indeed, the raison d’etre of such international financial institutions is the mitigation of political risk.
The mining majors are increasingly likely to view project finance as a tool for reducing political risk and, for that reason, are often keen to carve out political risk from their completion guarantees.
Equity investors and lenders in mining projects are also concerned not only with risks, but also with the issue of “sustainable development”.
The term sustainable development was first given wide currency in a report entitled “Our Common Future” issued in 1987 by the World Commission on Environment and Development and known as the “Brundtland report” after its chairperson, Gro Brundtland, the then-prime minister of Norway. The Brundtland report urged the nations of the world to commit themselves to a path of sustainable development and defined sustainable development as “development that meets the ability of future generations to meet their own needs.”
In the context of mining, sustainability is not found in the resource itself, but in the long-term sustainability of the region. Lenders are focusing increasingly on whether the local population will benefit through employment, transfer of skills and infrastructure and on community investment programs and development initiatives carried out by mining companies. While lenders continue to be concerned about the environmental and economic impacts of investment in mining, they are also starting to look at the social impact of investment as well.
In this area, the multilateral financial institutions lead the way. However, even commercial banks no longer operate in a vacuum where financial return is the sole factor in the decision to lend. They are subject to scrutiny from non-governmental organizations and the media, and the concept of corporate citizenship has become a central facet of business credibility. Thus, the tendency is for the standards imposed by the multilaterals to be adopted by the commercial banks. This is best illustrated by the adoption in 2003 of the “Equator principles” by commercial banks representing more than 80% of the project loan market, under which they agreed to abide by the environmental standards of the World Bank for projects costing more than $50 million. The export credit agencies, which, as agencies of governments, are subject to great public scrutiny, are also becoming increasingly sensitive to these issues.
Under the World Bank standards, proposed projects are classified into one of three categories depending on the type, location, sensitivity and scale of the project and the nature and magnitude of its potential environmental and social impacts, with category A projects having the greatest environmental and social impacts and category C projects having the least. Many mining projects fall into category A as projects that are likely to have “significant adverse environmental impacts that are sensitive, diverse, or unprecedented.” A full environmental assessment, normally in the form of an environmental impact study, must be prepared for each category A project examining the project’s potential positive and negative environmental impacts, comparing them with those of feasible alternatives and recommending any measures required to mitigate environmental impacts and improve environmental performance.
For all category A projects and for certain category B projects, an environmental management plan must also be prepared by the borrower or a third-party expert that draws on the conclusions of the environmental assessment and addresses issues such as mitigation, action plans, management of risks and schedules.
In all category A projects, and certain category B projects, the borrower or an independent third-party expert must have consulted “in a structured and culturally-sensitive way” with indigenous peoples and local NGOs. A summary of the environmental assessment must be made available to the public for a reasonable period of time in a culturally appropriate manner and in the local language. The environmental assessment and the environmental management plan must take such consultations into account and, in the case of category A projects, must be subject to review by an independent expert. The borrower must also undertake to comply with the environmental management plan, furnish regular reports on compliance and ultimately decommission the project facilities in accordance with an agreed decommissioning plan.
The importance of addressing environmental issues in mining project is illustrated by the cyanide spill at the Baia Mare gold mine in Romania. The operator of the Baia Mare mine was Aurul S.A., a Romanian company 50% owned by Esmeralda Exploration Ltd. of Australia, 45% owned by the Romanian government and 5% owned by Romanian enterprises. As a result of poor monitoring of the water table and unusually heavy snowfall, on January 30, 2000, the tailings dam for the mine was breached and more than 100,000 cubic meters of liquid and suspended waste containing about 50 to 100 tons of cyanide, as well as heavy metals, were released into the Lupes, Somes and eventually the Tisza and Danube rivers, causing widespread environmental damage. About 2,000 kilometers of the Danube’s water catchment area were adversely affected by the spill. Hungary, the worst affected country, sought more than $100 million from Aurul in compensation. As a result of this disaster, the shareholders lost all of their equity in Aurul and the commercial banks who financed the project were forced to write off their loans. Within two months of the disaster, Esmeralda Exploration Ltd. went into receivership.
A consensus is also emerging that corruption is jeopardizing sustainable development, particularly in the extractive industries (which are important in more than 50 developing countries). The British prime minister, Tony Blair, launched an “extractive industries transparency initiative” at a world summit on sustainable development in Johannesburg in September 2002. The initiative is aimed at increasing transparency of revenues received by host governments from extractive industries. Both companies and host governments are supposed to implement reporting guidelines so that taxes, royalties, signature bonuses and other payments paid to and received by host governments and government-related entities are aggregated and then publicly disclosed. The initiative has been endorsed by Angola, Azerbaijan, the Republic of Congo, Gabon, Ghana, Indonesia, the Kyrgyz Republic, Nigeria, São Tomé e Principe, Timor Leste, Trinidad and Tobago and other countries, and has been widely supported by international mining companies such Anglo American plc, BHP Billiton, De Beers, Newmont and Rio Tinto, as well as industry associations such as the International Council on Mining and Metals. It has also received enthusiastic support from the World Bank, the IMF, the European Bank for Reconstruction and Development and other multilateral organizations.
Increasingly, investors and lenders view a mining company’s ability to address the issue of sustainable development as a proxy for good corporate governance. They are also becoming more cognizant of the reputational risks of being associated with mining companies or projects that have not adequately addressed the issue. For example, one of the banks that financed the infamous Baia Mare gold mining project had to endure headlines from tabloid newspapers in its home country comparing the use of cyanide at the mine to use of cyanide during the Holocaust. As The Economist astutely observed several years ago, “The real value of a corporation increasingly comes not from the assets that it owns, or the employees that it supervises, but from the domain of trust it has established.”