It was announced late yesterday by Kinross (NYSE: KGC; TSX: K) that after years of wrangling the Ecuadorean government headed by Rafael “Hugo-Lite” Correa is finally almost ready to conclude negotiations on the very first mining license since the passage of the Mining Law in early 2009. Fortunately, the “non-binding agreement in principle” goes a long way in revealing the frame of mind of the Ecuadorean government. Unfortunately, it is not very healthy for the business of mining. The windfall tax of 70% begins right at the current spot price of gold and creates unacceptable risk to a for-profit, privately-financed mining enterprise under a number of market circumstances as we explain here.
Correa-types are not going to understand it simply because they don’t understand how business works, but suffice it to say that the combination of the windfall profits tax at such a low trigger price and a minimum 5% net smelter return (NSR) royalty — increasing to 8% above $2,000 gold! — is a double whammy of unnecessary harshness and unwise greed on the part of Mr. Correa’s bureaucracy. In fact the windfall tax and NSR, taken right off the top, represent one of the most oppressive tax regimes devised in the history of mining.
Kinross is trying to spin the preliminary agreement as a win because it would still technically allow the world-class Fruta del Norte gold deposit to be developed as a profitable mine under reasonable gold price and cost assumptions, and the stability agreement would call for dispute arbitration in Chilean courts, but it doesn’t take much real estate on the back of a napkin to figure out that the financial math is going to be brutal all around. Simply put, the odds of obtaining an attractive mine financing under this structure are poor. Meanwhile Kinross would be a masochist if it were to attempt self-funding the project using only equity. A deal this bad for the miner needs to have at least some ray of sunshine — a tax holiday during the first few years while capital costs are recovered or the government sharing in the financing burden — but here the parting of clouds merely exposes a dark night sky.
The thing is that Fruta del Norte (FDN) is a world-class deposit with few peers and it probably will be developed even if the upside for Kinross is only moderately worth the effort. Several other projects waiting for their turn on the butcher’s block, however, are not so highly endowed by the ore-making gods. One wonders if their relative inferiority compared to FDN will be taken into account as those mining agreements are negotiated. In particular, the Rio Blanco and Gaby projects of International Minerals (TSX: IMZ; Pink Sheets: IMZLF) come to mind. These projects, while inherently valuable, currently receive very little shrift in the market as a result of the uncertainties regarding terms of the mining licenses … and based on the Kinross deal we predict the situation to remain as such. In particular, we find the prospects of a Chinese or other partner happily partnering on these projects to be pretty much an untenable scenario based on the Ginsu knife deal that Kinross just got. Death by a thousand cuts is one thing but here we are looking at death by a few large slices. We’ll need to re-evaluate our stance on International Minerals as a silver producer (a report analyzing the top 20 silver miners is currently being prepared for subscribers) given the likelihood of minimal near-term value to be had from its Ecuadorean gold projects.
Another company that has its fate largely tied to the negotiation of mining agreements with a government hell-bent on confounding foreign direct investment is Dynasty Metals and Mining (TSX: DMM; Pink Sheets: DMMIF). Currently in ramp-up stage, Dynasty has been waiting for a sign as to what approach to take on its Zaruma gold project; now it seems clear that the best chance of squeezing blood from the proverbial turnip is to apply for a small miner exemption that might still allow the mine to operate at a decent rate of output (say 1,000 tpd or even 1,500) capable of enjoying some economies of scale. Although extremely cheap, Dynasty may not get much of a rally until the market understands precisely what the economics at Zaruma as well as the Jerusalem and Dynasty Goldfield projects will look like under this oppressive regime. The Kinross preliminary deal is not particularly helpful in elucidating the positive possibilities. Instead, the main question is what size of exemption the company can finagle and whether that exemption would be applied on a project-by-project basis or company-wide. The prudent course of action as sideline observers at this point would be to wait for the answer instead of trying to guess.
Finally we have Salazar Resources (TSX-V: SRL; Pink Sheets: SRLZF), a company that we’ve had in some of our portfolios for a while. Unfortunately these latest developments now simply merit an unequivocal wave goodbye (with perhaps some remnant hope that we’ll meet again). We recently discussed with subscribers our plan to exit our smallish position and we’ll now be looking for that opportunity even more closely.
We really like the Curipamba project and how the El Domo ore body is growing under Fredy Salazar’s commitment to advancing the project. Moreover, our recent inquiries at the SF Hard Asset Show revealed that concerns about local opposition to mining may be overdone. Mr. Salazar was gracious in explaining that basically the nearby town of Las Neves and Curi Mining, the Ecuadorean subsidiary of Salazar, have cooperated very successfully while the remote anti-mining community of Salinas periodically stages fervent anti-mining marches that amount to local spectacles. This apparently for not just the usual noble reason but fear that tourism up the mountain could be affected. The Las Neves soccer team, however, has reached national fame and proudly wears the logo of its sponsor Curi Mining. Even the folks from Salinas begrudgingly root for them. In addition, a number of positive media reports have appeared on local and regional radio and television focused on the positive socio-economic impact that the company has made in the area of Las Neves. Last but not least, Salazar plans to release an updated resource estimates on the El Domo deposit before year end.
Be that as it may, there now stands many more months before we find out if Mr. Correa plans to ruin the nascent mining industry in Ecuador on a wholesale basis or just selectively. And the simple truth is that Salazar’s Curipamba project is no FDN and therefore a deal like the one Kinross is being forced to accept would leave little upside for Salazar. Maybe the deposit will keep getting better and better (thus able to withstand a Ginsu attack) or perhaps Salazar will find a way to get a small miner exemption, but for now these shall remain possibilities for future consideration and not a present worry.
Disclaimer: We own a small position in Salazar and will be looking for an opportunity to exit in the near term. We do not own any other companies mentioned herein and we have not been compensated by any party for this commentary. This is not investment advice, which you should obtain from a licensed investment professional.
@ Silverax,
“Correa-types are not going to understand it simply because they don’t understand how business works”. Are you sure about that? I would like to see more agreements before I’d agree to that.
The problem for Kinross might be just the opposite, that Correa understands exactly how business works. They already spent lots of money acquiring FDN, and it’s a world class project, so eventually they’ll give up a large portion of their margins, since even a small part is attractive enough. Since these profits are a onetime gift from the Ecuadorian earth I can’t even blame Correa for this.
We’ll need other existing project to see how smart Ecuador is in handling this.
@Tweetie
Maybe! Correa is an economist and most of them have little clue about business or common sense in the microsphere. I do think many of his macro policies have been pretty good but the problem here isn’t the extraction of the last drop of blood in a shrewd business deal, it is the message that Ecuador has just send to international mining — which is a big F you. Not willing to share ANY of the risk at all while being entitled to virtually all of the upside does NOT make a good business partner, which is in effect what the government is to mining companies. Compare the recent deal between Guyana and Sandspring for the kind of give and take that says, “open for mining” (that is a decent deal with some windfall profits accruing to the government).
Have done quite a few models using Dynasty. The terms are complex and the Kinross press release not totally clear.
Here is my 4th model whereby I plug in Minimum Tax so that Ecuador total profit % divided by DMM profit % equals 1.083% (52%/48% = 1.083). When Ecuador gets over 52%, then no minimum tax and Ecuador keeps it all (but how does cumulative cash flow work…, would this reduce future year minimum tax?).
4th Model
http://www.box.com/s/5fa8nhgraxugsp52e0fm
This 4th model is likely materially accurate. Ecuador always paid 52% or more compared to DMM.
Questions:
1) How does cash cost factor into the 52% share to Ecuador?
An obligation to maintain the government’s share of project economic benefits at a minimum of 52%.
Project economic benefits are defined as the cumulative sum of the Government’s share (comprised of
the royalty, corporate income tax, the state portion of the profit sharing contribution, and windfall profit tax,
as described below, plus a 12% value added tax applied to customary project expenditures) and Kinross’
share (comprised of the after tax free cash flows of the project), calculated annually;
2) How does one calculate the Minimum Tax…? And how does cumulative sum work? And does after tax free cash flow include cash costs, and if so, how does that fit in…
@amarkscpa
Wow, love your gold prices! These are all good questions and from the looks of it the spreadsheet seems to be coming up with the right numbers. I’m fairly certain though that DMM does NOT want a mining “Ginsu deal” and will fight hard for an increased small miner exemption. Currently this is 500tpd under the mining law and if they can’t increase it then they may remain at that rate until 2013 elections, biding their time. It has already been 2 years, what’s another 2 between friends?
@silverax
Yes, gold a volatile asset in this model… As you may have surmised, the wide range of gold prices were used to stress test the model…
Amazing. I went out for a walk to muse about what I would write about this Kinross/Ecuador NR, with my theme being ‘it ain’t so bad!’.
Back now and reading your article, I see that I have a formidable opposing viewpoint – and, two intervening comments in response.
Well, silverax, given your admission to heightened awareness about unified field theory, I am hopeful that you and others commenting will entertain a groupthink outcast and not whack/humiliate me too badly as I try to score a few points.
More later. I must fortify myself with a few beer.
A point of interest regarding Dynasty Mining (Dmm.to): Last month, I went to the Toronto presentation of the Ecuador Minister of Mines and he briefly mentioned the ancillary small miners’ legislation for operations up to 1500tpd; he said it would be enacted in Q1fy12. My take is that the legislation has been ‘tabled’ and is being circulated. After the presentations, I spoke with a private sector lawyer from Ecuador, whereupon I formed the view that while it is theoretically possible that this legislation will be ‘good to go’ in Q1, I will not be holding my breath (as I would likely die from oxygen deprivation).
Then, looking again at DMM (of which I own some underwater shares), I was dubious about their being a small miner candidate. I spoke by phone with IR rep. Murray Oliver; and I now believe that is the path they’ll take. So, my opinion: it’ll be a while before commercial production from those guys, because it could be a while before the operative legislation is in place.
Concluding, I hope readers accept that I am loathe to substantiate my conclusions with quotes from sources who were kind enough to indulge my questioning in exchanges which they would not foresee would lead to my publicly quoting them.
@joey
So, I’m reneging on my threat to try to score some points. As I was inching along in my writing, Zurbo did an NR review. And what did he write?
” In the current gold price environment the minimum 52% would be triggered and the total tax burden ends up being not so bad and probably largely in line with many other countries considering that the 52% includes everything.”
I’ll leave it at that.
Now that I’m back to the sub’s thread, I’ll share my theory. Tye Burt doesn’t care about the terms of this ‘git ‘er done’ agreement and get on to exploiting. He’s planning to short $1650 calls. I saw nothing in this putative agreement attracting windfall tax on option premiums.
COE Burt, calls this a milestone agreement or did he mean millstone…I call it the Correa Shaft…Kingross, needs to seek relief in the courts or walk away!
This is an unmitigated disaster..
If I remember correctly, similar extractions was done to the foreign oil and gas industry earlier…
For those that known their Middle East history, the Akbar Arabs did the same to the western oil companies, increasing their cut each and every time, until nationalization set in..
“Ecuador’s new mining regulations–outlined in executive orders signed by President Rafael Correa–give the government a 50% participation in mining companies operation. The orders enact a general mining law, implement laws on the development of small-scale mining, and impose environmental regulations for operations. Several documents create the ENM national mining company”
Quito (does the capital give any hints) has set a very bad precedence; established it’s own national mining company; and demands half ownership in production!!
Economists, by and large are leftests and Correa fits the mold very well…Not only this, the President also want pre-production payment from $100 to $200 million dollars from miners…
There are only three nations we would invest in SA and Ecuadoor is not one of them and those that do, do so at their own economic peril…
This is what Democracy looks like. The Kinross gringos are truly privileged that the Ecuadorian gubment croni.., er I mean people, allow them to receive a net 3% return from the exploitation of this rich national treasure.
@Hans
Good points, there is always the possibility of creeping nationalization. It is one of many risks that a mining company will face but there are many others as well, including high inflation (now a major problem for mining companies in Brazil and Argentina, and could become one in other SA countries as well) and shifting political tides (violent internal conflicts in Chile, Peru and Colombia aren’t so far in the past that they might not return with a vengeance especially if the “Chavez axis” decides to really stir up some trouble in the region).
@forwill
If the government and people got 50% of the economic value through taxes and various other means that would not be a problem at all and entirely fair. Part of the problem is that in reality the local area should get most of that 50% share (at least 25%) but that rarely if ever happens. Instead the government puts the money in its general budget. Negative impacts on the surrounding area are not properly compensated for and so small wonder why mining can be so unpopular. Out of all the maddening things about this Correa approach to mining is the self-serving claim that somehow it is being done for the “people” — which people? (the mining companies have probably done more to help locals than the government ever has…)
@joey
The problem with writing 1650 call options of course is that you don’t know yet WHEN gold will be mined and by the time you do the price might not be 1650 but a lot higher and already subject to oppressive windfall tax.