Royalties and Costs. David Davis Mining Investment Analyst, Andisa Securities

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1 Mining Investment Analyst, Andisa Securities The new draft of the proposed ral and Petroleum Bill should be tabled in Parliament in Royalty payments are set to begin in The first version of the Bill proposed taxing miners and oil producers between % and 8% of revenue, depending on their specific commodity. In this (the first version) Bill, the royalty rates for gold, platinum group metals and diamonds were set at 3%, 4% and 8% respectively. Mining companies have contested these rates as too high. They insist that profit, rather than revenue, would be a more appropriate base on which to impose royalties. However, the Finance Minister has rejected mining companies proposal to charge royalties based on profits. According to Finance Minister Trevor Manuel, the re-drafting of the Bill is in progress, and the document is undergoing substantial refinements in view of comments received, industry financial data analysis, and new cross-country royalty comparisons. The Bill is being re-drafted to accommodate key concerns relating to mineral beneficiation and small-scale mining. The Bill forms part of an overall review of taxes on mining companies, including an assessment of their tax allowances and deferred tax benefits. The South African Revenue Services (SARS) has indicated it intends to update the tax formula currently used for gold mining companies. This tax formula has served the industry well for the past 79 years. It enables gold producers to offset losses and/or capital investments. The formula also provides for a sliding tax scale, so that when times are lean, taxes are minimized, giving relief to the industry, thereby preserving value and jobs; and in times of plenty, the industry can pay up to 46% mining tax. The effect of this sliding tax scale has been demonstrated over recent years. Gold mining companies were making significant profits and paying taxes at the maximum rate at the beginning of 2000 through to These profits were propelled mainly by a 22% depreciation of the rand against the US dollar and an upswing in the gold price US$/oz. Thereafter, revenues and profits declined significantly as the rand appreciated by up to 28% against the US dollar. And so revenues and taxes declined, and the mining sector s contribution to total South African revenues plummeted from 5% in 2000/0 to % in 2003/04 to just 4% in the latest tax year 2004/2005. The underlying value of the gold mining industry will decrease should a 3% royalty tax be applied without tax reform. We have calculated that the market capital of the gold mining industry could be reduced by around 6%. The loss in EPS (five years out) is even more significant, at around 0-5%, which in turn will have an effect on dividend yields. Government will need to review tax reforms with care. It must provide the necessary balance so that reforms are not counter-productive, especially at this time, as the gold mining industry is fast approaching a crossroads with regard to dwindling reserves in South Africa. The industry is capital-intensive, and will require huge capital inputs to replace reserves, which in turn will necessitate tax breaks. The LBMA Precious Metals Conference 2005, Johannesburg Page 33

2 Life of mine of gold recovered for the large South African gold mining companies without reserves Life of of gold recovered tonnes AngloGold Harmony Durban Deep Gold Fields Western Areas years A new large mine will require 0 to 5 years to develop, at a capital cost of least R5bn Events surrounding the legislation of the ral and Petroleum Royalty Bill Date Status 2002/0/3 Bill introduced. 2002/0/3 Announcement was made that the Bill was expected to be tabled in H /03/20 On 9 March 2003, Cabinet approved the release for public comment of the Bill. Four weeks was allowed for comments from stakeholders before Cabinet finalized the Bill for submission to Parliament. 2003/04/22 Deadline for comment was extended to 30 April /09/8 Minister announced 7 September that introduction to Parliament would be delayed until after the 2004 Budget. 2004/02/ Minister announced that an update would be given when he presented his Budget on 8 February /02/9 Government announced its plans again to introduce a sales-based revenue royalty charge. However, this would only take effect in 2009, ensuring that the change in tax regime did not interfere with conversion to new-order mineral rights in terms of the ral and Resources Development Act. 2004/02/25 Extract from slides used in briefing by SARS to PC on Finance 22 February 2004: "Econometric works suggest that economic consequences are limited; Severity of revenue based tax versus profit tax overstated; Relative royalty rates have to reflect differentiated economic impact and market structures; Final rates based on analysis of tax incidence; Marginal mines and potential double royalties need to be addressed; ral Royalty Bill necessitates a holistic reassessment of current fiscal regime for mining sectors, including additional allowance; ring-fencing provision; rate differentiation for diverse mineral sectors; gold mining tax formula; STC exemption, etc; Gold mining tax formula provides for: Income tax exemption and STC relief ; Tax preference more appropriate for a royalty regime than the corporate profit tax; Propose review of 40 per cent rate for oil extracting companies; Review aimed at attracting investment in oil and gas industry". 2004/0/27 Revised Bill to be submitted to Parliament in Will be preceded by further consultations with industry. Remains Government's view that the royalty (to be implemented in 2009) should be imposed on a gross ad valorem basis, but a number of critical issues have still to be addressed. 2005/02/23 Finance Minister Trevor Manuel said in his budget speech that the 2 nd draft of the Bill would be referred to the public for comment in H05. The Finance Minister has rejected mining companies proposal to charge royalties based on profits. 2005/09/9 Both the minerals and Energy Minister Lindiwe Hendricks and the South African Revenue Services (SARS) Commissioner Pravin Gordhan confirmed that the Bill will not be finalized until 2006.The review of South African mining companies would also not be finalized in The new law forms part of an overall review of taxes on mining companies including an assessment of their tax allowances and deferred tax benefits. The LBMA Precious Metals Conference 2005, Johannesburg Page 34

3 Substance classification and royalty rates (as they are currently proposed) Group Substance Royalty Rates % Salt, sand, stone, sandstone, late, gravel, clay, concrete, mortar, plastar, brick, dolorite, limestone, shale, gypsum, limestone, perlite, and phosphate rock extracted by a mineral extractor outside of the exemption described under section 2 2 Oil and gas: natural gas and natural gas condensate petroleum crude offshore production where the water depths are deeper than 500 meters 3 Alumino-silicates (andalusite, sillimanite, kyanite), asbestos, ammonium sulphate, barytes, zirconium oxide uranium oxide, kaolin, talk, magnesite, mica, silica, sulphur, sodium sulphite, mineral pigment, pyrophylite, dimension stone (granite norite), and perlite 4 Anthracite and bituminous coal (low ash and steam) 2 5 Antimony, copper, iron, manganese, lead, zinc, cobalt, nickel, silicon, tin, and vermiculite 6 Oil and gas: natural gas and natural gas condensate petroleum crude onshore and offshore production where the water depths are shallower than 500 metres Gold, silver, vanadium, chromite, and titanium dioxide (Ilmenite, rutile) 3 8 Platinum group metals: platinum, palladium, rhodium, iridium, ruthenium, and osmium 4 9 Amethyst, quartz (smoky quartz, citrine, rose quartz), cryptocrystalline quartz (jasper, opal), or chalcedony (blue lace agate, moss agate, onyx, rainbow chalcedony), tigers eye, blue asbestos (crocidolite), beryl, (emeralds, aquamarine, morganite, heliodor), chrysoberyl (cat s eye, alexandrite), corundum (rubies, sapphires), garnet (jade, hydrogrossular, spessartine), lolite, kyanite, sodalite, sugilite (royal lavulite or royal azel), tourmaline, verdite (serpentine), and topaz 5 0 Unpolished natural diamonds 8 Costs Global industry 0-year cost trends Between 996 and 200, global producer total costs declined 24% from around US$37/oz to US$240/oz. Over the same period, the gold price decreased 30% from US$388/oz to US$272/oz, and the US dollar strengthened by around 40% against the euro. Global total costs and gold price Global production total cash costs US$/oz strengthening US dollar enviroment Gold Price US$/oz w eakening US dollar enviroment US$/oz% Source: GFMS, Andisa Securities Between 2002 and 2004, global producer total costs increased 37%, from around US$228/oz to US$33/oz. Over the same period, the gold price increased 32%, from US$30/oz to US$409/oz, The LBMA Precious Metals Conference 2005, Johannesburg Page 35

4 and the US$ weakened against the euro by around 55% against the euro. Given the strong relationship between the US dollar strength and the gold price as well as costs, we believe the significant decrease in costs between 996 and 200 was driven most likely by currency valuation and inflation rate differentials against the US dollar, not by industry cost savings (as many of the large producers have claimed). Between 2002 and 2004, Newmont s costs rose 22%, whereas South Africa s gold industry costs increased by 00% in US$ terms. Gold price US$/oz, R/kg and USD/ZAR exchange rate Date USD/ZAR USD/ZAR Gold price Gold price Gold price Gold price Gold price % change US$/oz US$/oz R/kg R/kg R/kg %change change %change 20/2/ high 29/2/ low /0/ present 23 Over the same period, the global industry has had to contend not only with a much weakened US$ but also significant increases in commodity prices, consumables, and equipment. South African industry cost trends Over the last three years, the South African gold mining industry has had to contend with a 37% decline in the gold price in local currency terms R/kg, mainly as a result of (a) the appreciation of the rand against the US dollar and (b) an increase in the gold price US$/oz. Source: I-Net; Andisa Securities Over the same period, the industry has had to contend with significant cost pressures, most of which fall outside the control of the mining companies. Since 2000, water, steel prices and explosives have risen 56%, 62%, and 40% respectively, compared to SA PPI of 25% and CPI of 27%. Labour costs, which comprise some 50% of cash costs, have increased substantially more than the inflation rate (around 3% p.a.) in 2003 and Commodity annual growth from 2000 Explosives Explosives 2 Fuel Timber Steel Steel 2 lime HCL caustic soda cynaide Power Water SA PPI SA CPI * Commodity, SA PPI and SA CPI growth from 2000 Source: GFI; Andisa Securities *to date The net result (of the dual impact of the fall in revenues and the upward spiral in costs over the last three years) has been a significant fall in margins and profits for gold mining companies. Many of the marginal mines have become lossmaking, and have had to be mothballed/closed. Further complicating matters, the industry has had to contend with declining grades, which has compounded the decline in margins and profits and has resulted in a decline in South African gold production from 427 tonnes in 2000 to a projected level of around 300 tonnes for South Africa last produced at this level 80 years ago (925)! When the gold price was at its lowest level (R76 700/kg), around 70% of South African gold production was loss-making based on cost of sales and 50% was loss-making based on cash costs. At current prices of around R00 000R/kg, only 0-5% of South African gold production is marginal/loss-making. These loss-making operations are likely to return to profitability in the near future, thanks to ongoing cost-saving initiatives. The LBMA Precious Metals Conference 2005, Johannesburg Page 36

5 AngloGold Ashanti Gold Fields, Western Areas and Harmony cost of sales (June 2005) R/kg Cost-gold price (revenue) squeeze HAR cash costs ANG cash costs GFI cash costs Gold price R/kg Sep-00 Dec-00 Mar-0 Jun-0 Sep-0 Dec-0 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 AngloGold Ashanti Gold Fields, Western Areas and Harmony cash costs (June 2005) R/kg Cash costs Cumulative production % ANG Tau Tona ANG Great Noligwa ANG Mponeng ANG Kopanang GFI Driefontein U/G HAR Kalgold +Surface GFI Kloof U/G HAR Quality Ounces U/G ANG Tau Lekoa GFI Betrix U/G WAR South Deep ANG Savuka HAR Growth Projects HAR Leaveraged ounces Source: Company reports; Andisa Securities Despite the upward spiral of costs, declining revenues and falling profits, the South African gold mining industry has consistently focused on improving productivity and reducing costs. Almost all of the mines have undergone restructuring and reengineering, in some cases leading to shaft closures. The industry has also concentrated on effective ore body management, supply chain management, outsourcing, the introduction of continuous operations (CONOPS), asset consolidation, and downsizing all in an effort to reduce costs and improve efficiencies. Many of these initiatives have, and are continuing, been effective in controlling costs. Unfortunately, the process of restructuring has led to some 40,000 to 50,000 job losses in the industry since The cost-gold price revenue squeeze experienced by AngloGold Ashanti Gold Fields and Harmony is illustrated in the next graph. It shows the quarter-on-quarter costs for each of these companies since December 2000 to June 2005, compared to the gold price received. All these companies began to show, to a greater or lesser extent, the effect of their cost-saving initiatives around March Harmony completed its restructuring in November 2004 after protracted negotiations with labour unions. The effect of this exercise will likely become apparent in the December quarter. Cost-gold price (revenue) squeeze: AngloGold Ashanti Gold Fields, and Harmony quarterly cash costs compared to gold price received R/k R/kg Cost of Sales ANG Great Noligwa ANG Kopanang ANG Mponeng ANG Tau Tona GFI Driefontein U/G HAR Kalgold +Surface GFI Kloof U/G HAR Quality Ounces U/G ANG Tau Lekoa GFI Betrix U/G WAR South Deep ANG Savuka HAR Growth Projects HAR Leaveraged ounces Cumulative production % Source: Company reports; Andisa Securities The LBMA Precious Metals Conference 2005, Johannesburg Page 37

6 There has been a significant shift in the composition of cash costs (R/Kg) in the mining industry as a result of the process of restructuring since 2000 through to The pie diagrams below illustrate this shift.. The increase in service costs is significant. However, despite the reduction in mine labour and contractor costs, both service and mine labour costs still comprise over 60% of the cash costs. Composition of cash costs R/kg for 2000 Composition of cash costs R/kg for 2004 Electricity R 9% Water R % Consumables R 24% Services R 9% Labour R 57% Electricity R 8% Water R % Services R 9% Labour R 45% Consumables R 27% Conclusion The South African gold mining industry is a mature one and has proven its resilience; we believe it will adapt and change. The LBMA Precious Metals Conference 2005, Johannesburg Page 38