Document Sample
MINE ECONOMICS Powered By Docstoc
					Mine Economics                                                               2005



All new mining industry projects require financing and, in most cases, that finance
will be required for several years before the project achieves payback. Determining
the financial structure of a project is a very important part of the assessment of the
economic viability of the project. Such financial analysis takes account of the
feasibility study of the project but looks at it from a perspective different from that of
the project sponsors. Sponsors are concerned with the likely range of returns on
investment. There is no limit on the amount of upside potential they can receive and
they tend to concentrate more on that upside potential than on the risk of insolvency.
The lender’s perspective is totally different. The best the lender can achieve is to
receive interest and principal back on time and in full. There is no upside potential
for the lender.     Hence, the lender must assess the project very conservatively to
ensure that there is no, or very little, downside risk. Typically, lenders are very
highly leveraged themselves and cannot afford to take any significant risk.

The sponsor’s perspective usually leads to concentration in the feasibility study on the
technical issues involved in converting a resource in the ground into salable product at
the lowest possible cost. Less attention may be paid to the market situation, product
prices, political and environmental risks, exchange rate risks, management capability
and the like. The sponsor is likely to err on the side of optimism. The lender cannot
afford that luxury. Lenders must be concerned with downside possibilities, in order
to establish certainty of repayment. Since the sponsor’s capital investment is more at
risk than the lender’s loan funds, the cavalier attitude of sponsors to project risk may
appear surprising. However, for sponsors with a single project, most of the sponsor’s
capital may already be invested by the time exploration and feasibility study is
completed. The only hope the sponsor has of recovering his capital, and possibly
making a profit, is to bring the project into production.

Substantial companies, faced with many investment opportunities, will be as rigorous
as any lender in determining the viability of project developments.         Viewing the
project from a lender’s perspective is a good discipline to achieve that end.

Equity and debt are the two main types of funding available for project finance.
Equity can consist of new issues of shares, options or units, receipts from asset sales,
retained earnings or any mixture of those. Debt can consist of project finance, with
or without recourse, corporate loans, securities, commodity loans and equipment
leases. Debt/equity hybrids include convertible notes and preference shares. There
are many sources of both equity and debt. Equity can be raised from existing
shareholders, institutions and the general public. Debt is generally raised from banks
or other financial institutions, though securities can be issued to the general public, as
can convertible notes and preference shares. Commodity loans are arranged by
specialist banks and equipment leases either by the supplier or specialist

Mine Economics                    Project Financing                                     1
Mine Economics                                                             2005

The financial structure of the project is determined by the technical components of the
project, the economic environment, market constraints, the tax regime and the finance
environment. These all interact in the financial model leading to the determination of
the financial structure.    The first component of that structure is the amount of debt
that the project is capable of reliably supporting.      This is based on the downside
case rather than the base case and takes account of risk analysis, sensitivity analysis
and the coverage ratios generated by the downside case. Market issues, such as the
availability of capital and the terms available, including interest rates, security and
ratios, will also affect the debt capacity of the project.       The debt/equity mix is
determined by the asset type, the risk involved, the reliably expected rates of return,
capital availability and cost, ownership structures and shareholder attitudes, and
government regulations within the constraints of debt capacity.

Lenders will pay particular attention to the life of the project, the difficulties of
achieving technical success, management capability, country risk, marketing and
security of title. Under the heading of risk analysis, the reliability of the resource
estimate and of the reserves based on those resources will be scrutinised carefully.
Until recently, banks would only lend on the basis of proved reserves. In the bullish
80’s, they lent on proved plus probable reserves and sometimes on the reserves which
might exist if inferred resources could be upgraded. In the current conservative
climate, banks will lend on proved plus probable reserves but with a large reserve tail
beyond the loan life reserve. Banks need to reassure themselves that the project life
will be great enough to service the loan.

Other topics of risk analysis include:
        the likelihood that the project will be completed on time, on budget and able to
operate to specification;
        the likelihood that the project will be able to operate as planned in terms of
operating costs, throughput and product quality;
        environmental risks, including the effects of changing standards;
        political risks;
        country risk;
        the technological risks involved in the project;
        has project management the capability of managing the operation efficiently
and of coping with the unexpected difficulties which will occur;
        are there any market constraints or marketing problems ?;
        are there any foreign exchange risks ?;
        will the Force Majeure clauses pose any risks ?;
        any risks in relation to calculation of the effective interest rate;
        any legal risks, including security of title, ownership complications and the

Project financiers look to the cash flows of the particular project to repay the money
advanced. They test the viability of the project by constructing an array of cover
ratios, including Debt Cover Ratio, Loan Life Ratio and Reserve Life Cover. The
Debt Cover Ratio (DCR) is the net cash flow for the period divided by the principal
plus interest due for payment in that period. Interest actually paid in that period has
to be added back to net cash flow for the purpose of this calculation. A Minimum
DCR of about 1.5 is required at the moment but lower or higher values may be
sought, depending on the economic environment at the time.

Mine Economics                   Project Financing                                    2
Mine Economics                                                                  2005

The Loan Life Ratio (LLR) is the cumulative value of net cash flow from time of
calculation until loan maturity divided by the outstanding loan. A minimum LLR of
1.5 to 2 is usually required.

The Reserve Life Cover (RLC) is the cumulative value of net cash flow from time of
calculation until cash flow ceases (exhaustion of economically recoverable reserves)
divided by the outstanding loan. A minimum RLC of 2 is usually required. A
Reserve Tail is a similar concept and refers to the proportion of reserves left after the
loan has been repaid.

In order to achieve project financing on the best possible terms, the project sponsors
must anticipate the needs of potential financiers and carry out their own financing
analysis. The first step is to plan the project carefully, testing the reliability of all the
project parameters and creating a reliable, defensible technical/financial model. On
the basis of this model, the investment merits of the project can be assessed and a
financing plan developed.         Once the financing plan has been developed and
rigorously tested, the sponsor is ready to approach the market.          It is important to
have a clear plan to present to the market and to have anticipated the concerns of
potential lenders or investors, so that convincing answers are ready for all questions.
In this respect, prior experience in project financing is probably essential.. In the
process of negotiation, it is necessary to keep negotiating with all potential lenders or
investors until an acceptable, firm and specific offer has been received and agreed.
The details of the financing plan are bound to vary in the negotiating process but the
project sponsors can ensure that the changes are not damaging. Once the financing
plan has been agreed, the legal documentation will be extremely voluminous. All of
this documentation has to be scrutinised carefully by the project sponsors to ensure
that nothing unacceptable is hidden in the fine print.

Project Finance

Assuming the economic fundamentals of the project are sound, the sponsors have an
array of financing alternatives including corporate debt, project finance and equity.
Project finance has been and remains the preferred option for funding mining projects
in Australia . Project finance is money lent for the purpose of developing a project;
the loan is secured against the assets and cash flows of the project and is repayable
from the cash flows of the project; in most cases, the lenders have limited or no
recourse to other assets of the owners of the project. The limited or non recourse to
other assets of the owners is an important aspect of project finance.       In effect, it
represents a sharing of the project risk between owners and lenders. The lenders will
not normally accept completion risk which has to be borne by the sponsors. Hence,
the loan will initially have full recourse to the sponsors’ assets until the project has
successfully passed specified completion tests, after which the loan will become “non-

The loan documentation will define the completion tests and will specify the degree
of recourse after completion.         Project finance documents normally impose
restrictions on disbursements of project cash flow. Revenues are usually captured
into an escrow account where a minimum balance has to be maintained as a debt
service reserve. Subject to the reserve, excess cash in the escrow account is used to

Mine Economics                     Project Financing                                       3
Mine Economics                                                                   2005

cover costs, taxes, debt service and returns to equity, in that order. Project finance
may be non-recourse to the sponsors’ other assets but it requires a very tight security
package over the project itself. The lenders typically require charges over fixed
assets, over the sponsor’s shares in the project and over the project’s bank accounts
and a security interest in all the project’s agreements and contracts. This is so that, if
the borrower defaults, the lender is able to replace the sponsors and run the project as
its own.


Joint ventures have many advantages over alternative vehicles for exploration,
development and mining. These include the sharing of risk, the pooling of resources,
the pooling of expertise leading to technical efficiency in operations and the ability to
finance larger projects than a single participant could finance alone. There may also
be other advantages depending on the circumstances of particular projects. A typical
one is the inclusion of a potential customer as a participant in order to guarantee a
market for at least part of the production.

The unincorporated joint venture is by far the most common form of association for
major resource development in Australia, so much so that an unincorporated joint
venture is generally called a joint venture.      Other forms of association for the
ownership and exploitation of resources include incorporated joint ventures, unit
trusts and partnerships but these are rarely used in the Australian mining industry at
the present time.

The unincorporated joint venture is an association of separate parties formed to
undertake a particular commecial project or a conditional sequence of commercial
projects. It is neither a separate corporate entity nor a partnership for income tax
purposes and is not required to lodge an income tax form. Each individual member
has the right to take in kind and sparately dispose of its share of production. Each
member would reflect in its accounts and tax return its share of income, expenses,
asseets and liabilities and would have the flexibility to take advantage of taxation act
depreciation schedules to suit its own situation. Each member’s share of any income
tax losses of the project or of any exploration expenditure are available to be set off
against income from other business and mining activities of the member.

The main characteristics of the unincorporated joint venture will usually include the
each participant will own an undivided interest as tenant in common in all of the
assets of the joint venture:
each participant will normally contribute funds for the purposes of the joint venture in
proportion to its participating interest, though this is frequently varied in the early
stages of “farm-in” type joint ventures;
each participant will be entitled to take in kind and separately dispose of its share of
the product of the joint venture in proportion to its participating interest (this is critical
to avoid the structure being classified as a partnership);
the activities of the joint venture will be conducted by one of the participants alone,
by a special purpose company set up and jointly owned by the participants or by an
independent third party, under terms set out in the joint venture agreement or in a
separate management agreement;

Mine Economics                      Project Financing                                      4
Mine Economics                                                                  2005

no participant will be the agent of another participant or be authorised to bind another
participant, except as operator of the joint venture to the extent permitted by the joint
venture or management agreements;
commonly, the participants will enter into a separate marketing agreement for the
joint disposal of the separate shares of the product of the venture.

The nature and intent of the unincorporated joint venture structure focuses attention
on a number of issues which must be defined carefully in the joint venture
agreements. These include the proprietary interests of joint venture participants, the
transfer of those interests, the taking of security over a joint venture participant’s
interests, default by participants, the external liability of participants and inter-
participant relations.

Proprietary interests

Each participant will normally have a proprietary interest in each of the joint venture
assets as a tenant in common. This is different from the beneficial interest of a
partner in partnership assets which constitutes a right to a proportion of the surplus
remaining after sale of all partnership assets and payment of all partnership liabilities
after dissolution of the partnership. Theoretically, a tenant in common could apply
for partitioning of an asset. This could jeopardise the joint venture. Therefore, it is
essential that the participants covenant in the joint venture agreement not to partition
or seek to partition any of the jointly owned assets.

Transfer of Interests

The difficulty in assigning joint venture interests is that they would usually consist of
an indivisible package of proprietary interests, contractual rights and contractual
obligations. Assigning of contractual obligations is particularly difficult. The joint
venture agreement will generally include provisions for the assignment of a
participant’s interests, subject to the prior approval of the other participants and for
the other participants to have a right of first refusal to purchase the interest of a selling
participant. Stamp duty considerations will impact on any transfer of participant

Charges over Interests

A joint venture participant may need to charge its respective interest in the joint
venture assets to a lender in order to raise finance. This may be an acceptable
security to a lender provided that on default the lender is able to obtain control of the
participant’s share of product from the joint venture and hence the income flow which
can be derived from that share of product. The lender would need to do due diligence
on the nature of the joint venture project, the joint venture and ancillary agreements,
the existing security arrangements and the respective rights and obligations of the
participants. The joint venture agreement must be carefully constructed so as to
minimise the conflicts which may occur, in the event of one participant defaulting on
a loan, between the lender to the defaulting participant and the other participants.

Both transferring interests and pledging interests as collateral for debt finance are
more easily achieved with the incorporated joint venture and the unit trust structures.

Mine Economics                     Project Financing                                       5
Mine Economics                                                                 2005


Participants must generally rely on contractual remedies against a defaulting co-
venturer. Such remedies must be carefully defined in the joint venture agreement/s
and can range from loss of information and voting rights to dilution, compulsory sale
to non-defaulting participants or forfeiture of the defaulter’s entire interest. The
relevant provisions in the agreement should be drafted so as to allow the operations of
the joint venture to proceed irrespective of the default with the non-defaulting
participants contributing their proportionate shares of the defaulter’s obligations.

External Liabilities

In general, joint venture participants will be jointly liable, both in contract and in tort,
for all acts of the joint venture operator on the basis that the operator has explicit or
implied authority to act on behalf of the participants. Such joint liability will extend
to all subordinate acts which are necessarily or ordinarily incidental to the express
authority of the operator, so long as those acts are not outside the ordinary course of
the venture. Careful wording of the joint venture agreements may limit the extent of
third party liability of the participants but can probably not remove it altogether.
The risk of third party liability is much less to the participants in an unincorporated
joint venture than to the members of a partnership. It is somewhat more than to the
participants in incorporated joint ventures or unit trusts.

Inter-participant Relations

The participants in an unincorporated joint venture have a contractual relationship to
one another. The contractual relationship between the participants means that each
participant agrees, by implication, to do all such things as are necessary on its part to
enable the other participant/s to have the benefit of the contract. The agreements are
generally worded so as to exclude any possibility of a fiduciary relationship.
Notwithstanding the express wording of the agreement, some aspects of the
relationship may be fiduciary in character.          However, the rigorous standards
applicable to the fiduciary duties of a trustee would not apply to the incidental
fiduciary relationship which might affect participants, particularly as they are
permitted by contract, as expressed in the agreements, to pursue their own interests.

Deed of Cross Charges

Such a deed is commonly part of the extensive documentation of an unincorporated
joint venture. The contractual obligations, especially financial obligations, of each
participant to the project as a whole throughout its life are extremely important.
Thus, it is common for participants to secure such obligations by granting cross
charges to each other. Such cross charges are usually granted over their respective
entitlements to the production of the project or to revenues arising from that share of
production. The cross charges may be granted over the participants’ respective
interest in the joint venture assets but this would preclude the joint venture assets from
being available as security for third party lenders.


Mine Economics                     Project Financing                                      6
Mine Economics                                                          2005

Financing arranged by Delta Gold N L for its share of the Granny Smith project and
its share of the various stages in the development of the Kanowna Belle project will
be reviewed as examples of how the economic and financial environments, the
situation of the borrowing company and the attitudes of company shareholders can
affect financing arrangements.

Mine Economics                  Project Financing                                 7