return to AMPLA 2004 Table of Contents Private (Non-Government) Royalties: Mining Royalties from a Royalty Owner s Perspective Paul Kiley* SUMMARY Financial non-working interests are a familiar feature in the Australian resources Industry. The types of interests granted and their essential conditions differ from time to time and often from project to project. There are also significant differences between the practices adopted in the mining and the petroleum industries. This commentary is a practical examination of this area of Australian mining and petroleum practice and was presented as an instructional session for practitioners who have an interest in mining and petroleum, with a focus on industry practice and usage in royalties. INTRODUCTION Newmont is the largest gold miner in the world, and currently produces about 7 million ounces a year. It has a market capitalisation of US$17 billion, including the old Franco Nevada royalty business which produces a royalty income of US$50 million a year. This paper focuses on Newmont s experience with royalties, and should produce a better understanding of how an operator thinks about royalties and what the needs of the royalty owner are. DIFFERENT TYPES OF ROYALTIES AND HOW TO EVALUATE THEM There are a variety of types of royalty interests each requiring a different set of considerations to assess their suitability in relation to a particular project structure. As the prospective holder of a royalty, the reader is invited to select a royalty or type of royalty in each section of the menu in Figure 1 below. This presentation * Director Merchant Banking, Australia, Newmont Australia Limited. This paper was prepared by Martin Klapper on the basis of Mr Kiley s presentation at the AMPLA conference 2004. 266
MINING ROYALTIES FROM A ROYALTY OWNER S PERSPECTIVE 267 will examine these types of royalties and produce an understanding of which to choose and why, in any particular situation. Figure 1 Menu Entrée 6% Working Interest (WI) 2% Net Smelter Return (NSR) Royalty 6% Net Profit Interest (NPI) Royalty Main Course $30/oz Royalty A$1.00/tonne Royalty 5% Net Cashflow Royalty Dessert Goldstrike Royalty Hancock Royalty Bass Strait Royalty A brief explanation of the terms used in Figure 1: Working interest (WI): a minority interest in the underlying asset, in this case of 6%. Net smelter return (NSR) royalty: this is gross revenue from the project, less refining costs. It is effectively a royalty on revenue. Net profit interest (NPI) royalty: a royalty on profit, that is, revenue less costs. $30 per ounce royalty: a royalty based on the number of ounces produced. $1 per tonne royalty: a royalty based on the number of tonnes mined. 5% net cash flow royalty: a royalty based on the net cash flow of the project, similar to the NPI royalty. The Franco Nevada Royalty Business Can you Build a Royalty Business? Franco Nevada started with the Goldstrike royalty. The Goldstrike royalty was advertised for sale in a Reno, Nevada paper in 1982. A consultant brought the royalty to Franco s attention. At the time there were two royalties: a 5% net smelter return royalty; and a 4% net profit interest royalty, Franco acquired the royalties for US$2 million, equivalent to their net present value based on the resource of 400,000 ounces.
268 AMPLA YEARBOOK 2004 The mining tenement was subsequently bought by Barrack in 1985, which discovered the Post Betze and Miekle deposits. Goldstrike has since produced in the order of 35 million ounces of gold and has paid Franco a royalty of just under US$500,000,000. This became the cash cow of the Franco Nevada business. Overview of Franco Nevada Franco initially began as a junior exploration company. Early in its life it changed course to pursue a new market niche as a mineral royalty company, the impetus for that change being Seymour Schulich and his experience in the oil and gas industry where royalties were much more common than in the mining industry in the 1980s. Between 1982 and 1998, Franco Nevada established a portfolio of over 150 royalties in precious/base metals and oil and gas, it discovered the Midas mine and accumulated a substantial portfolio of cash and equities. By 1998 Franco Nevada was the fourth largest North American listed gold company with a market capitalisation of $US2.3 billion, behind Barrack, Placer and Newmont. Until 1998 it had never mined a single ounce. In 2002 Franco Nevada merged with Normandy Mining and Newmont. At that stage the company had achieved a growth rate of 35% per year. Franco created a minerals royalty market niche and operated in a vacuum without competition for most of its corporate life. Acquisitions and discoveries were timely, the Goldstrike discovery occurred soon after its acquisition by Franco Nevada and the cash cow was created. Franco Nevada s strategy was that of a venture capitalist invest in 10 opportunities, hope one becomes a huge success and the other nine at least break even. Considerable financial strength is needed to allow time for this type of royalty strategy to work. The market today is very competitive with new royalties, investment trusts and yield plays competing for the same royalty assets. How are Royalties Created? For a start, of course, there are government royalties, for example the royalty charged by the Western Australian State government on gold. There are royalties generated through access to land. For example, aboriginal groups often charge royalties to permit access to their land, and freehold landowners in some circumstances can do the same. And then there are asset sales. A junior may have a good asset and wants to sell. A royalty permits that junior to retain an interest in the upside. There are also the old red face clauses, where a substantial explorer or producer has explored a piece of ground, has decided not to develop it and sells it and retains a royalty. There are also other circumstances, for example one we have come across is where the minority interest holder in a joint venture wants to dilute down and take a royalty in lieu of the joint venture interest.
MINING ROYALTIES FROM A ROYALTY OWNER S PERSPECTIVE 269 Advantages of Royalties over Traditional Financing Financing based on a royalty may have considerable advantages over traditional bank financing. Imagine that you are a junior and have just made a discovery. If traditional bank financing is not an option then financing based on a royalty may have advantages: A royalty does not dilute the junior s shareholding. If it has just made the discovery but has not moved towards development the share price would not be that high. Royalty based financing eliminates a need to dilute equity in order to introduce new capital. Payback is based on production only so the junior doesn t have to pay unless they actually produce. Payback is spread over the life of the operation, for the same reason. Debt is moved off the balance sheet, and as a consequence the balance sheet looks a lot better. The operator retains control of production. The operator gets credit for 100% of production and reserves. Gold companies are measured by the number of ounces that are produced. In this case, although the royalty might be paid in kind, that is in ounces of gold delivered to the royalty holder, the junior still gets credit for the number of ounces produced. Closing can be done quickly and at lower transactional costs. The absence of restrictive bank covenants. Many banks will require the junior to hedge, and at the moment, the market gives a premium to companies that don t hedge. Structuring Royalty Financing Royalty financing can be established in a number of different ways, including: Bridge financing a front-end lump-sum payment needed to carry a project forward. Strategic alliances running very low on working capital and needed to buy out the operator on one of its key properties. Seed capital and/or public financing financing of number of junior exploration companies or involved start-up activities. Completion guarantees another area in which royalty financing can be effective is by utilising our balance sheet to underwrite project completion guarantees for lending institutions or environmental letters of credit to governmental agencies.
270 AMPLA YEARBOOK 2004 How Royalties are Assessed The royalty business is a probability game. I would be out there looking for a large or strategic land holding in prospective belts of mineralisation. The more land one has got the better, the larger the chances that a discovery will be made. I would not enter into a royalty agreement just with any junior. It is essential to find someone who is aggressive, has the budget to put the dollars into a ground and a strong track record in exploration. It is also important that there is a good chance a quality operation can be developed at a low cost. It is best to look for a leveraged royalty interest, attached to the land with full rights of audit and inspection. The valuation philosophy is an important element of assessing the royalty. Payment would be due on the basis of reserves and it is best to look for a blue sky premium that might be available on the resource. The royalty business is now more competitive than it was before about 2000 and acquisitions on a reasonable basis are more difficult. There is also now competition from the banking sector, where banks are now taking part in bidding processes for royalties with a view to putting the royalties into funds and building a business from it. Valuing a NSR Royalty vs NPI Royalty vs Working Interest It would be useful now to examine the value of a royalty based on the following assumptions. Our example is a gold mine: 500,000 ounce reserves and 1 million ounce resource; a gold price at A$525 per ounce; cash costs at A$350 per ounce; capital investment of A$50 million required. Contrast the acquisition of a 2% net smelter return (NSR) with the acquisition of a 5% net profit interests (NPI) or a 6% working interest. It becomes apparent when comparing the royalty valuations in Figure 2 below why Newmont prefers a NSR royalty. The NSR royalty is very low risk. Although in absolute valuation terms the midrange of valuations is broadly similar, it is in the range of each of the valuations that is indicative of the strength in valuation terms of the NSR based royalty. What is seen in Figure 2 below is that NSR royalty is very inflexible as price and cost charge, it stays pretty much the same; whereas the NPI royalty and the working interest are all over the place. For all of those scenarios the NSR based royalty will give a return of between $6.3 and $8.1 million. The reason the other two types of investments vary so much is that they are exposed to the cost of the operation. For example, if there is a breakdown of critical equipment at the mine, the valuation of the NPI royalty or the working interest can reduce rapidly.
MINING ROYALTIES FROM A ROYALTY OWNER S PERSPECTIVE 271 Figure 2 Royalty Valuations 2% NSR 6% NPI 6% WI Base Valuation $7.2m $5.0m $5.3m Price $575 $8.1m $7.5m $7.7m Price $475 $6.2m $2.6m $3.1m Cost $300 $7.2m $7.5m $7.7m Cost $440 $7.2m $2.6m $3.1m 575/300 $8.1m $9.9m $10.0m 475/400 $6.3m $0.1m $0.7m Range $6.3 $8.1m $0.1 $9.9m $0.7 $10.0m Comparisons between these types of royalty: The NSR type royalty is: simple to calculate and easy to audit; low risk, the first dollar you spend on the investment is the last dollar you spend, it is not demanding in terms of capital investment; a readily saleable asset and requires minimum leverage. The NPI type royalty: carries cost and operational risks; can be difficult to calculate, disputes are likely as you will know if you have ever tried to audit a NPI based royalty the investment is highly leveraged. The working interest: requires further capital investment because it involves obligations to pay cash calls; can be very difficult to sell; caries with it additional costs of operational risks; the potential for ongoing liability is a major issues these days. Tricks and Traps These are some of the things to be aware of when negotiating a royalty. Don t set the royalty rate too high: if the royalty rate is set too high it can sterilise the ore body because the costs of getting the gold out of the ground are too high, it can even kill a project. Accounting implications: recently Newmont bid on royalties held by a major mining house with two components price and production. A particular problem with the presentation of that royalty was that the price royalty was deemed a derivative for US GAAP. It was mentioned earlier that Newmont does not hedge,
272 AMPLA YEARBOOK 2004 believing that people buy shares in gold companies in order to have exposure to the gold price. The lesson to take away is that the structure of the royalty itself can make it more or less attractive to potential buyers. Start up operation: establish whether the royalty is payable immediately, or only after a hurdle (for example, a minimum return to the operator) has been reached. Also examine the royalty for the consequences if a second discovery is made is the royalty payable on all ounces produced? And is the royalty payable on a particular mineral, or on all production including other minerals? Rules of thumb: a gold project should support a 2 5% NSR, depending on the operating margins; a 1% NSR royalty is equal to a 3 5% working interest/npi royalty. Nature of the royalty: examine the local legal regime as it applies to the recognition, enforcement and protection of the royalty. For example, in the United States the royalty generally attaches to the land and survives changes in control, bankruptcy etc. In Australia, the royalty is generally a contractual right, it does not survive relinquishment of the tenement. Tracking ownerships: royalties and tenements can both change hands frequently. The nature of the mining industry in Australia is quite incestuous; it is unlikely that if one were buying a royalty one would be buying it from the original owner. There is therefore a need to carefully track royalty ownerships, in particular because of the contractual nature of the royalties. That is compounded when companies are taken over or sold. Trying to track the ownership of the royalty over time is one of the major components of the legal due diligence on the acquisition of a royalty. It is the thing that we focus on most. Royalties can be quite complex: they can be made payable on the basis of a sliding scale (either or both of price and production), and they can provide for a production hurdle or a price hurdle, or both. Don t underestimate the cost of registering the agreements: the cost of registering an agreement is about A$80 per tenement, one of our royalty agreement is over more than 500 tenements, which is a cost of around A$40,000. The reverse is also true: when you are negotiating a royalty bear in mind that everything in this paper is true in reverse depending on the side you represent. So, for example, the party negotiating to pay the royalty may begin the negotiation on the basis of the payment of a NPI royalty, and then work back from there. Royalty Agreement Requirements On the basis of our experience we would recommend that a royalty agreement should always address these issues: A statement of how payments will be calculated, preferably supported by an actual calculation by way of example.
MINING ROYALTIES FROM A ROYALTY OWNER S PERSPECTIVE 273 The type of payment to be made and timing for payment. For example, whether the payment is in money and if so in which currency is it denominated; or is it in kind (in ounces). If a London Metals Exchange (LME) rate or price applies then it needs clear definitions. Is the royalty payable on all minerals or is it payable on a particular mineral or minerals? We have seen agreements that specify a royalty but not the minerals to which the royalty applies. Ideally, the royalty will cover all minerals. Timing of payment: are payments to be made monthly, quarterly, yearly or on some other basis; and in each case how long after the balance date? What consequences apply to late payment? We have seen agreements that impose effectively no consequences at all on late payment. The agreement must list the tenements on which the royalty is payable. We have one agreement that lists between 500 and 600 tenements. It is preferable to include an area of interest clause that identifies the area from which the royalty is payable even if the identity of the tenement changes. The royalty agreement should give the royalty holder rights to audit and inspect the records of the royalty grantor. An audit every 12 months is best and you would want the operator to pay the costs of the audit if the audit discloses a discrepancy of 5% or more. Ideally, the operator will be required to provide regular reports and forecasts on the royalty so that his performance can be monitored. Bear in mind that gold companies are ranked by the number of ounces they produce, and they regularly report those ounces to the market. So, in the case of a NSR royalty, if royalties are payable on a quarterly basis and production is noted in the quarterly report it is a simple calculation to check very easily whether or not the correct royalty has been paid. The agreement should require a restriction on the disposal of the mining tenement to which the royalty attaches. If the grantor of the royalty, the holder of the mining tenement, proposes for example to relinquish the tenement it might be obliged to offer the tenement to the royalty holder for $1. The royalty holder is then in a position to evaluate the prospectivity of the area and perhaps to sell it to another party. Corresponding restrictions are also usually placed on the tenement holder on assignment of interests in the tenement, on the exercise of reversionary rights, and similar. The agreement will normally oblige the tenement holder to keep the tenements in good standing. The Window of Opportunity to Buy a Royalty After the first discovery is made the shares in the junior explorer will increase in value and eventually reach a speculative peak, when the market decides that the
274 AMPLA YEARBOOK 2004 discovery might not be worth what was first thought. It can then take three to four years for the development to get under way until production starts. In the interim the explorer will do the feasibility study and prove up the resource. The obvious response is that one would want to buy the royalty in the prediscovery stage or just after the discovery stage. So what are the Royalties Worth? We return now to the chart in Figure 1, but with a valuation added to each type of royalty. Figure 3 Menu Entrée 2% Net Smelter Return (NSR) Royalty = A$6.5m 6% Working Interest (WI) = A$5.1m 6% Net Profit Interest (NPI) Royalty = A$4.7m Main Course $30/oz Royalty = A$18.1m A$1.00/tonne Royalty = A$6.5m 6% Net Cashflow Royalty = A$5.4m Dessert Goldstrike Royalty = A$714m Bass Strait Royalty = A$600m Hancock Royalty = A$250m As appears from Figure 3, the 2% NSR royalty will outperform the 6% working interest return and the 6% net NPI royalty. The $30 per ounce royalty is really a net smelter return royalty in another form, and as appears from Figure 3 it also outperforms the other types of royalties listed. The $1 per tonne royalty is also an NSR type royalty but simply expressed in a different way. The net cash flow royalty is really another version of the NPI. 1 1 The values given for the Bass Strait royalty and the Hancock royalty were obtained from a casual examination of current literature and are not intended as a representative of the precise royalties paid. return to AMPLA 2004 Table of Contents