Fully funded - mining finance
Emma Jenkins from Cambridge Risk discusses prepays as an alternative form of mining finance.
Financing mining projects is not easy, particularly bearing in mind the present debt climate and economic uncertainty. Mining capital costs are high, especially in remote locations, and the beginning of the payback period may be years away, in which time the market for the product may be in oversupply or its value may have declined, jeopardising the project’s economic viability. Fortunately, commodity prices have been bullish for a decade and demand is high, with China and other BRIC (Brazil, Russia, India, China) countries showing growth rates at levels most western countries envy.
High commodity prices have enabled larger mining companies to build exceptionally large balance sheets. These companies are funding the majority of some exceptionally large projects from cash reserves. For those in the process of developing mines or still in the exploration phase, this luxury is not available and it is necessary to look for cash elsewhere.
Interest in equities usually reflects the wider world economy, and over the past few years there has been a distinct lack of interest in initial public offerings, which fell to virtually zero during 2008–2009 but recovered slowly in 2010 and the first half of 2011, only to be depressed again by the financial crises typified by Greece.
Once a mining company has proven its resources and the route to production, debt finance becomes feasible. When approaching lenders for debt finance proposals, companies are increasingly receiving proposals for prepays as an alternative form of finance. A prepay is a debt instrument combined with a commodity hedge that is presented as a single package. Put simply, it involves the mining company receiving the cash needed to build and commission the mine upfront, with repayments of fixed amounts of the physical mineral being extracted, rather than cash. The company receives US$ upfront in exchange for repaying US$ at intervals over the life of the loan. For simplicity, the loan is illustrated as equal payments over the life, representing principal and interest.
Typically, lenders would seek to reduce the risk of the loan and would require a commodity hedge to be executed in conjunction with the loan, to ensure the loan could be serviced even if the commodity price fell during the repayment period. The mining company would enter into a hedge that would give certainty about the metal or mineral price received over time. The simplest hedge would be comprised of a series of forward contracts. For each forward contract, the mining company would pay a fixed quantity of the commodity and receive a fixed amount of investment. For simplicity, the hedge is illustrated as equal commodity deliveries for equal US$ payments over the life of the hedge.
These amounts are identical to those for prepay. The mining company receives the money upfront and the loan is repaid by commodity deliveries over the life of the loan. So a prepay can be decomposed into a traditional debt instrument and a commodity hedge. This equivalence allows prepays to be assessed against traditional debt finance alternatives in terms of cost, as well as quantum of required hedging. Prepays have been common in gold for a number of years. More recently, the basic technology has been adapted to other commodities, most notably to base metals, coal and iron ore.
The pricing of a prepay is determined by:
- the interest rate on the loan
- the shape of the commodity forward curve at the time of execution of the deal
- the lender’s fees for the loan and the derivative
Once the deal has been executed, the price received for the commodity committed to repaying the loan is set, and the interest rate on the loan component is fixed at an absolute percentage rather than Libor plus a margin. There are several structural variants of the prepay concept. In a full prepay, no cash is received for commodity flows over the facility life and the full present value is paid upfront, less fees. In a partial prepay, some cash is received for the commodities and less cash is received upfront.
Although a full prepay minimises the amount of commodity committed to the financing, the partial prepay is generally preferred by lenders, particularly when the proportion of production committed to the prepay is significant. Lenders will only be fully repaid if the mine operates for the full tenor of the facility and delivers the agreed quantity of the underlying commodity in that time frame. In the real world, it is possible that a mine may experience difficulties for a variety of reasons, such as:
- fluctuating commodity prices
- reduced or delayed production through geological, process or labour problems
- physical catastrophe, such as flooding or a pit-wall failure
When the going gets tough, under a full prepay there is little incentive for the mining company to carry on. The company may choose to close down rather than carry on paying the debt without any return, especially if the proportion of production committed to the prepay is high. Under a partial prepay, if the mining company is receiving at least enough to cover operating costs, it is more likely that operations continue through to the final repayment date.
Further variants are achieved using options instead of forward contracts. If, for example, the mining company wishes to retain the right to participate in increased commodity prices then a collared prepay or capped prepay may be the answer, where the company receives additional payments in a defined price range.
The mining company must be aware that prepay is a contract to deliver the agreed quantity of metal or mineral irrespective of price. If the company is unable to deliver the commodity, then there are two options: pay an equivalent cash settlement or purchase the commodity at market price – an expensive alternative in a rising market. To avoid these potential difficulties, it is important to allow sufficient time to ramp up operations before the first delivery. In the event of a failure to deliver, there may be an ability to roll the delivery forward in time, but that is often subject to negotiation and at the lender’s discretion. Hence it is prudent to leave an adequate reserve-tail in the mine. The obligation to deliver distinguishes prepays from royalties or streaming transactions, which are more equity-like in nature since the counterparty takes performance risk and does not have the right to force delivery on predetermined dates.
It should be noted that the value of the prepay changes as commodity prices move. If commodity prices rise after execution, the miner has pre-sold the commodity at lower prices and the miner would have an additional obligation to the lender if the prepay were terminated. This additional obligation may exceed the initial US$ borrowing if the price rise were substantial.
Prepays are most often applied to smaller projects, often with a single counterparty. This does not preclude larger, syndicated transactions, although the prepay may be re-packaged into a more conventional format to facilitate the syndication process. The documentation requirements are frequently portrayed as being less onerous than a traditional debt facility, but debt-like covenants often do find their way into the finalised terms. The physical delivery aspect of the prepay is appealing from an accounting perspective as it may remove the need to take changes in the mark-to-market value of the prepay through the profit and loss statement.
In summary, prepays are a valid financing options, provided the risks and costs are properly assessed vis-à-vis competing traditional debt proposals.
Emma Jenkins, firstname.lastname@example.org