Background

The mining industry is highly capital intensive, owing to the complexity and the prolonged period involved in transforming the projects from exploration into production. As such, a significant amount of capital is usually required to sustain the mining operation in that process.

Over the life of mine, commodity markets’ demand often change, as economic growth drive unanticipated growth and technological innovations result in substitution of certain commodities. Although economic models and projections help determine the outlook, demand and supply fluctuations are often influenced by both micro and macro-economic impacts.

Market booms tend to encourage investment in mineral exploration and subsequent development, ultimately leading to the next bust if supply surpasses the demand. In such a scenario, fourth quartile producers are forced out of business as their projects struggle to break-even, let alone operate marginally. The resulting lower profit margin leads to investors deserting the sector, particularly at the smaller, higher-risk end of the market, with funding for further exploration drying up.

This lack of investment and exploration in turn drives the next boom as the industry fails to replace mined resources, the rate of new discoveries falls and demand overtakes supply leading to an increase in commodity prices and a new round of investment.

In recent years, Royalties & Streaming Agreements have become an important source of alternative funding for the mining industry as a result of its’ cyclical market. In the past, both royalties and streams were considered specialist forms of financing, but have become more common leading to greater awareness of the model from resource companies and an increase in the transactions occurring.

Royalties:

A royalty is a contractual agreement under which the royalty company provides a once off upfront payment to the mining company, in exchange for the right to receive a defined percentage of the returns from the mining operation once in production. The percentage of returns is typically charged on the revenue; however, royalties can take several forms. Some of the most common royalties are described below.

• Gross Proceeds Royalty (GPR): A fixed percentage of the total revenue of a resource extraction operation, before any deductions (such as production, operating, and capital costs, taxes and interest).
• Net Profits Interest (NPI) Royalty: A fixed percentage of the gross revenue from a resource extraction operation, after all the costs (such as exploration, development, production, capital costs, and interest) are deducted.
• Net Smelter Return (NSR) Royalty: A fixed percentage of the revenue of a resource extraction operation, after all incidental transportation, insurance, refining and smelting costs are deducted.

Royalties can be structured in different ways:

• They can be designed to cover only a specific commodity or all commodities within the operation. This allows the flexibility to mine operators to raise capital on both the commodity as well as project level.
• Royalties can be limited to certain areas of the mine, allowing the exploration upside to be shared by the operator and the royalty holder.
• They can be designed to account for production challenges such that the operator only pays royalties once a certain amount of production has been achieved.

The value and risks of the royalties varies across the different stages of the project development. Royalties on early stage exploration projects can represent good value owing to potential upside associated with the resource development. However, they also carry a high risk due to uncertainty associated with the resource feasibility and development as there is often a significant time before production. Royalties on projects near production tend to carry more value and less risk as most work has already been carried out to de-risk the project. The most valuable royalties are those signed on already producing projects as they provide access to income straightaway.

Why Royalty

Comparing to direct equity investment, there are a lot of advantages associated with mining royalties:

• For the royalty owner, there are no direct involvements in the project operations or capital expenditure commitments. As such owning a royalty is less management intensive than being directly involved in running the mining project, enabling a focus on portfolio growth.
• Unlike shareholding that can be diluted through equity placings, royalties are normally tied directly to production or revenue and hence they are non-dilutable.
• Because royalties are normally linked to revenue, as long as the mine is producing, royalties get paid while shareholders may not.
• The ability for royalties to be diversified to the project, commodity and country protect the investors from various risks such as commodity, geological and political risks.

Streams:

A stream is an agreement under which the streaming company provides an upfront payment to the mining company in an exchange of the right to purchase a certain percentage of one or more minerals produced from a mining operation at a fixed price, which is below the market price, for the life of the purchase agreement. Typically under a Streaming Agreement, the commodity sold is a by-product of the mining operation, although this is not always the case. The upfront payment can replace or complement other forms of financing such as equity or debt and can be used for exploration, mine construction, development and production.

Streaming agreements tend to be larger than royalty agreements. They also tend to have more flexible terms and conditions, and generally provide both parties with tax advantages.

Benefits