Mining's tougher tier-one test

“This was my baby; I didn’t want to do this … it breaks my heart in a lot of ways.” Those were the words of Freeport-McMoRan CEO Richard Adkerson a day after his company sold its 56% stake in the massive Tenke Fungurume copper-cobalt mine in the Democratic Republic of the Congo.
Mining's tougher tier-one test Mining's tougher tier-one test Mining's tougher tier-one test Mining's tougher tier-one test Mining's tougher tier-one test

Search for mining's new tier-one deposits and assets is taking on Holy Grail proportions

Gareth Tredway

“It fitted very well into our previous strategy because it is an asset that has very substantial long-term development potential.”

“Now is not the time to be building new supply for the copper business. We think that will be needed at some point in the future and this will be one of the world’s great mines,” Adkerson told delegates at the Bank of America Merrill Lynch Global Metals, Mining & Steel Conference in Miami.

This deal is unique because, as you can tell from Adkerson’s feelings on the sale, it is the disposal of a high-quality long-life asset from within one of the major mining companies.

Assets like these don’t go on sale very often and new ones seem to be less and less common as time goes on.

They are the ‘tier ones’ of this world. Assets so rich, they stand apart from others, able to destabilise economies, disrupt the overall demand-supply balance and be the springboard for building mighty mining companies.

In recent history, battles over some of these assets have been fierce, extremely tactical and in many cases totally unexpected.

We sit in one of these unique periods where weakness in prices and an over-leveraged sector may force some companies to start offloading these assets. 

Their status within the global mining scene makes them the crown jewels of the mining sector – very difficult to shake loose. On an exploration front, they are akin to the Holy Grail of ore deposits.

Yet even now, for those companies desperate to raise funds and in severe financial difficulty, selling these special assets is not an option despite the ease with which they could offload them owing to the abundance of potential suitors waiting to pounce.

It is not only management teams reluctant to let them go, but also shareholders, who recognise their deeper value and have in the past proven to be a massive barrier in closing any deals.

Since announcing it would consider tapping this particular class of asset as a way of raising funds in January, Freeport has managed to do deals easily, at pretty good prices too.

Adkerson was confident the company had received fair value in the latest transaction, too. “Unlike the rest of our assets, a greater proportion of the value of this asset was in the undeveloped resources,” he said.

“We were able to get a very reasonable value for the future development opportunity, which is going to occur many years out.”

The fact there were a number of different Chinese-based companies that, for a long time, had shown an interest in buying the mine also helped, he said.

“In bulk commodities, to create a new tier-one asset, there would need to be a real belief in sustainable consumption growth, to allow you to make that multi-billion-dollar investment into the infrastructure needed to access a new, high-quality resource base”

Freeport may not be done either, with Adkerson suggesting while the sale of a piece of, or even its entire 53% interest in the Cerro Verde mine in Peru was unlikely, management would consider selling an interest in a group of copper assets in future.

TierOneAntamina

Antamina in Peru

“The idea of selling a minority interest in a package of assets is something that we are looking at.”

What are tier-one assets?

According to a cross-section of mining and finance experts, the consensus seems to be all about quality and assets that generate positive free cash flow throughout the commodity cycle.

Paul Robinson, a director at consultancy CRU, says this general definition can be refined even further depending on particular commodity markets and things like technologies within those markets. 

“We don’t think it is that simple to define a tier one ,” he told Mining Journal.

“Part of the reason for that is your costs in a market that is shrinking, or a market with negative margins can be as low as you like, it makes no difference. And the long life gives you no assistance whatsoever.

“So it is not just about the asset, it is about the market in which that asset operates.”

He gave an example of this by referring to the UK power industry and how a low cost coal-fired power station with flue gas desulphurisation technology, that could last another 40-years, is no longer a tier-one asset because the future of coal-fired power in the country is limited. Indeed this month, for the first time in 100 years, the amount of Great Britain coal generation has fallen to zero.

He also points at the general definition applied to tier-one assets, which refers to their position in the bottom quartile of the cost curve, saying this isn’t a hard and fast rule that can be applied across commodities.

“For instance, we think there are also very good assets further along the copper cost curve, not just in the first quartile.

“The copper market has a number of supportive factors including a scarcity of potential new tier-one mine developments, good medium-term demand prospects and generally speaking, some price protection from assets in the third and fourth quartile that are never going to come down the cost curve, because of the nature of the geology and technology that has to be deployed.”

On the flipside, in aluminium smelting for example, Robinson says the technology used has become completely competitive and available across the board, with the only element keeping any shape in that particular cost curve being the cost of power.

“So you have got a much flatter cost curve and I wouldn’t want to go far up the cost curve and call them tier-one assets,” adds Robinson.

Barriers to entry can also maintain tier-one assets, as is the case with the scale of rail infrastructure that has been built to transport iron in the Pilbara.

At a national level, Canada’s potash industry benefits from a well-developed rail infrastructure that, even though not owned by the mines, creates an advantage.

“In bulk commodities, to create a new tier-one asset, there would need to be a real belief in sustainable consumption growth, to allow you to make that multi-billion-dollar investment into the infrastructure needed to access a new, high-quality resource base,” said Robinson.

Other factors such as a specific company’s country risk tolerance will also result in it regarding assets as tier one  when other companies do not.

Broader definitions also point at large and long-life assets, allowing for multiple expansion opportunities and flexibility.

Size might not necessarily be a required factor in identifying such assets, but a scan of the world’s largest 20 mine’s by revenue (see ‘2014 and 2015 gross revenue, below) reveals many of the well-known tier-one operations of the world.

One could also argue tier one  status can even be tied to a particular district given some of the major mining producing regions of the world are low cost, long-life and expandable on aggregate.

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Kamoa mine box-cut in the Democratic Republic of Congo

Ingo Hofmaier, a director at London-based merchant bank Hannam & Partners, highlights the iron ore province of the Pilbara as worthy of this status. He says under other circumstances those land packages owned by big players and producing half of world supply could easily be in the hands of a larger number of mining companies.

“You could have, for instance, 15 companies who mine the Pilbara today, in reality you have two and a third one as Fortescue [Metals Group] has emerged at a totally different time,” says Hofmaier.

Having secured much of the tenements early on and being able to control the infrastructure means these companies have got vast tracts of land for over 100 years of mining, boosted most recently by a steel hungry China not far away.

“You fly two hours by helicopter over Rio Tinto’s iron ore tenements, several mines, but the aggregation via infrastructure channels makes them tier one ,” adds Hofmaier.

Making a profit throughout the cycle is not just a function of the orebody: in bulks, location and distance to end markets have an influence.

In other commodities, clearly defined orebodies make it easier to define the boundaries of an asset.

“In copper it is usually quite simple because you need particular types of orebodies to achieve scale. To get to tier one  status in many cases one needs porphyry style orebodies. Having said that, the copper belt hosts tier-one assets, but these are mainly sedimentary rock formations,” adds Hofmaier.

There is also an argument, in more modern times, that even if a deposit is identified as having tier-one potential it may not develop into a world-class mine, given the socio-political issues.

Peter Major, head of Cadiz in Cape Town, uses this definition: “In the old days, orebody was probably 80-90% of being tier one . Then once you love the orebody, you say, ‘okay what is the location?’”

He highlights the political, labour, availability of resources and infrastructure as being crucial factors nowadays.

CRU’s Robinson highlights water in Chile as an example of a more modern issue for any potential tier-one deposit.

TierOneTable

Top mining assets by annual sales revenue

“Initially, when the mines were developed, they were accessing existing water courses and were given water rights because water scarcity wasn’t an issue. If you build a copper mine in that region today, the likelihood is you are going to have to build a water desalination plant and pipe that water up to your mine site as part of the cost,” said Robinson.

Time can end up transforming assets either away from this status or into it, through technological advancements, political change, combination of assets or even a structural shift in a particular commodity market, as was the case with many metals with the rise of China.

Billions of dollars were spent by mining companies building assets in the previous boom only for them then to be identified as non-core, and sold off.

As a major, “you can’t justify anything else to your board, even if it turns out not to be tier one, for example like MinasRio (Anglo American’s mine in Brazil),” says Major. “They obviously thought it was tier one otherwise they wouldn’t have put the $14 billion into it. So sometimes you only know if it is a tier-one asset once it is producing.”

In acquiring and developing the asset, Anglo American described MinasRio as a tier-one resource.

However, the massive swing in the iron ore market to one of oversupply pushed the mine down a tier in management’s eyes and CEO Mark Cutifani recently said: “In our view, assets have to have a reasonable likelihood of challenging or certainly being aggressively getting close to tier one .

“At this point in time, with the additional capacity across the board [Minas Rio] probably will struggle.”

Why are they so special?

Besides the obvious financial margin benefit that comes with these assets, there are other unique characteristics that make them so sought-after.

From a financing point of view, owning a tier-one mine can result in more favourable terms with regards to debt.

Neil McKenna, a director at Venmyn Deloitte, tells Mining Journal: “With significant increases in the requirements for debt restructuring and insolvencies among mining companies, banks would consider tier-one assets to have lower risk exposure to market conditions, and their potential for higher margins provides more certainty on debt repayments.”

He adds banks are increasingly focusing on a project’s costs and the ability to control costs.

Mining is among the riskier asset classes and is a long-term investment with often large capital requirements and so, while commodities prices can’t be controlled by miners, banks require comfort that a project can generate free cash flow throughout the cycle.

Having multiple decades of life can also be a real advantage for planning, according to Brad Mills, founder of Plinian Capital and also a former president of BHP Billiton’s base metals division.

From a company’s perspective, it means it is relatively immune to the price cycle over the long term.

This allows management to get an average price across two or three cycles therefore allowing them to calculate the economics on classic mean reversion pricing. Whereas if you have a five-year asset and you start at the high price you might get the bottom of the price cycle and that could be painful.

Mills says even within individual cycles there is a low risk of losing money. He says the 10-year peak-to-trough pricing on copper is circa $3,000 per tonne to about $10,000/t so roughly three times volatility for the commodity price over a 10-year period. A tier-one asset would typically have a cash cost that is below that base case $3,000/t and so could be built or expanded with confidence that it won’t get caught losing money at the bottom of a cycle.

“It may not be very much fun, you may be just trading dollars against your sustaining capital but you are not going to be in a net cash losing situation,” says Mills.

Again, this is commodity specific, with some industries having a large number of assets that would wash their own faces in a trough, while in others like nickel, only Norilsk and a few others currently generate free cash.

“Everybody else, 70% of the industry, is net negative cash flow every day and that’s horrible,” says Mills.

Another benefit, on the reverse side, according to Mills, is when prices turn “your operating margins explode” on a tier-one asset.

There is still of course an element of responsibility required in developing some of these massive deposits: taking on a lot of debt to build them at a massive scale right up front, rather than in smaller phases, can create big problems if there is a sudden and sharp drop in commodity prices.

Even with the lowest cost base, being unable to cover interest payments or having a large debt repayment due can cause problems; though it seems to be debt from constructing non-tier-one assets or expensive acquisitions that usually gives major companies bigger headaches.

At the same Merrill Lynch conference at which Adkerson spoke, Rio’s CFO Chris Lynch told delegates with the “new normal” not yet established in commodity markets and volatility in pricing having increased significantly, being “robust” against a wide range of potential outcomes is critical.

“Robustness is founded in tier-one assets. They generate cash and retain their value and quality at points in the cycle where lower tier assets have to focus more on survival,” said Lynch.

A lot of the time, the expansion decisions or roll-outs on tier-one assets are completely counter-cyclical, as has been the case with the iron ore giants in Brazil and Australia, as well as Rio Tinto’s recent decision to build the $5.8 billion underground project at Oyu Tolgoi in Mongolia.

Why don’t they trade often?

The obvious reason these assets don’t trade very often is based on their quality and so not only resistance by management but shareholders also being unwilling to sell them.

In 2009, Rio Tinto, saddled with a large debt position following its Alcan takeover, proposed the sale of stakes in its underlying assets to Chinalco for a total of $19.5 billion.

Cadiz’s Major says: “That was scary. I remember when they did that deal and shareholders were petrified that they were selling family jewels at the height of panic.”

If it had succeeded, Chinalco would have gained 15% of Escondida, 25% of Kennecott Copper, and 15% of Hamersley Iron, to name a few.

“Even in the depths of the global financial crisis, the shareholders had a clear understanding that you are absolutely throwing away the crown jewels and said we’d rather have a rights issue than sell these assets,” says Mills when recalling the news.

The transaction did not close and Rio later did a rights issue to ease its debt burden.

Another reason they don’t trade often is, like in the recent spell of severe weakness in commodity prices, the window of opportunity remains open for a very limited period and so companies need to be cashed up and ready to take advantage.

Major said: “This price capitulation actually happened quite quickly, it was really just the end of November, December and some of January and then things turned and shot up. So most guys were panicking and looking to sell [but] it just takes so long to close [these deals] – this whole phase was over before you knew it.

“Even if you’re fast on your feet and you have got a lot of cash, just getting the documentation prepared and the right people to sign them – you are lucky to do a deal in two months.”

Plinian’s Mills says competition issues can also be a hurdle as combining such large amounts of production can lead to too much market dominance.

“We saw for instance in the Rio Tinto and BHP deal when they tried to merge, they were trying to put together two large tier-one assets in iron ore, which is where all the synergy is and the world just said: ‘No, you can’t do it, you can’t have 50% of the iron ore market in one basket’.”

Another example of this was when Glencore acquired Xstrata and the Chinese authorities forced them to sell the Las Bambas copper mine in Peru. In that deal, and what tends to happen when these assets are sold, they achieved pretty good values taking much of the undeveloped potential into account.

Not long after the dust had settled on the Rio takeover attempt, BHP was trying again at a tier-one  takeover, this time a hostile approach of Canada’s PotashCorp, a transaction that also hit heavy resistance and regulatory hurdles. It, too, failed to close.

One of the more surprising tier-one asset deals came in 2012 when Anglo received notice Codelco would exercise an option to purchase almost half of the former’s Sur copper division in Chile.

The eventual settlement saw Japan’s Mitsui and Mitsubishi take significant stakes in the asset, valuing them at almost $10 billion.

While these examples reveal a general rule that these assets move around expensively and slowly, there are numerous instances, most often through exploration but also via acquisition, where these assets have been gained for a steal.

Two of the most obvious examples are Escondida and Oyu Tolgoi, which originally changed hands when they were both undeveloped.

In 1994 BHP bought Utah Mining from General Electric in a deal said to be worth over $2 billion. Plinian’s Mills says the primary target was Utah’s Queensland coal assets and that the Escondida asset carried no value in the transaction.

At Oyu Tolgoi, BHP was on the other end of the equation, disposing of the asset for close to nothing.

“BHP Billiton was on the losing end of the Oyu Tolgoi transaction when it sold the asset to Robert Friedland for just $5 million, having not realised the tier- one potential of the asset,” comments Hofmaier.

Resolution copper in the US was a similar story, where a major failed to see the potential of a tier-one asset and earned-out.

The action on tier-one assets does seem to occur more in the junior space when it becomes clear the potential is there.

“This being a function of the large amounts of capital involved in building them. A tier-one asset is best built big to utilise the economics of scale that other assets simply can’t support,” adds Hofmaier.

Where are the deals?

Ivanhoe’s assets: At Ivanhoe Mines, the company Robert Friedland runs, there is a portfolio of assets that could potentially be tier-one mines of the future. In the DRC, China’s Zijin Mining has paid $412 million for almost half of Ivanhoe’s stake in the Kamoa asset, valuing the undeveloped copper deposit at nearly $900 million. Ivanhoe also owns the high-grade Kipushi zinc project in the DRC, as well as the Platreef PGM asset in South Africa.

The streamers: A relatively new area where companies have been able to get hold of some form of interest in tier-one assets, rather than buying them, is in the streaming space. Several deals have allowed these alternative financiers to gain access to the riches these mines hold. The first, announced in September last year saw Royal Gold pay $610 million upfront for a portion of gold and silver production from Barrick Gold’s 60% interest at the Pueblo Viejo mine in the Dominican Republic. Then Teck Resources and Glencore sold silver streams in their respective portions of production at the Antamina copper-zinc mine to Franco-Nevada ($610 million) and Silver Wheaton ($900 million). Glencore didn’t stop there, closing another deal earlier this year that saw it sell a $500 million stream based on production from the Antapaccay mine, also in Peru, to Franco-Nevada.

Major debt forces sales: Besides its Tenke Fungurume sale, earlier in the year Freeport sold 13% of its Morenci mine in Arizona to existing partner Sumitomo for $1 billion. Plus the company still has a number of other quality assets that could find new owners if the price is right.

The multitude of deals reflected here show that, much like their definition, the trading in tier-one assets also does not depend on the mining cycle alone. Rather, picking up a tier-one asset is the result of being opportunistic, exercising financial clout and, in some cases, pure luck.