Finding a Balance: Government Policy and the Competition for

International Mineral Sector Investment

Embassy of Canada

Belgrade, Serbia

March 23, 2015

Michael DoggettMichael Doggett & Associates

• Mineral policy in the context of the mineral supply process

• Exploration stage policy aspects

• Discovery risk and market risk

• Development/production stage policy aspects

• Market risk and realization risk

• Taxes and Royalties

• The value chain of mineral supply

• Following the money

• Recognizing variability

• Managing the trade-offs

• Conclusions

Overview

The Mineral Supply Process

Exploration Phase of Mineral Supply

• In order to successfully replenish and grow the pipeline of economic mineral deposits, exploration needs to overcome two main risks: – Discovery risk – the low probability that any given mineral

occurrence will be of sufficient size and quality to become a mine;– Market risk – the fluctuations in commodity prices that interrupt the

systematic long-term process of identifying, testing and screening mineral occurrences.

Discovery Risk in Exploration• The chance of success is influenced by a number of factors: the

underlying geological endowment; the level of exploration maturity; and the minimum economic size and return criteria established by individual companies.

• In even the best of cases, the most likely outcome of an exploration program is failure – no new mine; no return to investors and no tax revenue for the state.

• To overcome the high chance of failure, exploration groups must be prepared to commit sufficient capital, time and human resources.

• Government policy must encourage companies to take on the challenges and make the commitments required to overcome this discovery risk.

Market Risk in Exploration

• The second significant challenge to the systematic approach to exploration is the volatility in prices and exchange rates and the resultant fluctuations in availability and cost of exploration capital.

• For larger companies with operating mines (senior companies) exploration funding reflects profit levels which fluctuate with commodity prices. For smaller exploration focused companies (junior companies), exploration capital is linked to the appetite of investors for the high risk high return nature of exploration. The amount of high risk capital invested is also closely linked to current and anticipated commodity prices.

Market Risk and Exploration

• Effective government policy must recognize that market risk is an inevitable and largely uncontrollable factor in exploration decisions taken by large and small exploration groups.

• The evidence of market risk in exploration is clearly shown in the following examples.

Exploration Expenditure Trends for Gold and Copper

Source: SNL Metals and Mining

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 -

2,000.0

4,000.0

6,000.0

8,000.0

10,000.0

12,000.0

14,000.0

Gold Copper

Expl

orati

on ($

US

Mill

ion)

Exploration Expenditure vs Gold Price

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000

$10,000

$300

$500

$700

$900

$1,100

$1,300

$1,500

$1,700

$1,900

Go

ld E

xp

lora

ito

n E

xp

en

dit

ure

s

($2

01

4 m

illio

n)

Go

ld P

ric

e (

$U

S 2

01

4/o

z)

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

Value of Junior Company FinancingsExploration Stage Companies

Proposed/Arranged($millions)

Debt Financing (mil$) Flow-Thru Financing (mil$) Equity (non-FT) Financing (mil$)

Year

Val

ue

of

Fin

anci

ng

s ($

mil

lio

ns)

Government Policy Considerations for Exploration

• If government policy is to support companies in their challenges to overcoming exploration risks, the focus must necessarily be on managing access to prospective ground for exploration.

• Key aspects of managing this process include:– Providing clear and fair rules for obtaining valid exploration licences

on prospective ground for domestic and foreign companies;– Security of tenure and exclusivity of exploration licences;– Providing timely access to government geological data at a

reasonable cost;– Determining expenditure requirements and holding periods for

maintaining; reducing or converting exploration licences;– Guaranteed exclusivity for application and conversion of exploration

licences into exploitation licences; and– A stable regulatory environment to provide the confidence for

explorers to plan exploration programs over periods of years.

Government Policy Considerations for Exploration

• A series of key questions can be used to frame the exploration policy debate:– What is a reasonable timeframe for advancing exploration projects? – Should companies be able to keep licences in perpetuity so long as they meet

minimum expenditure and holding costs?– Should the size of land holdings under licence be reduced each time that a

licence is renewed?

• Given the risks involved, too short a period for holding licences is a major disincentive to begin exploration.

• Prohibitively high holding costs also create a disincentive to explore, as do unrealistic expenditure commitments. (e.g. recent changes in China)

• Smaller countries may have more incentive to turnover licence holders than larger countries (e.g. Serbia vs Canada).

Development/Production Phase of Mineral Supply• Here emphasis shifts from finding deposits to assessing and

realizing the potential value of discoveries. – Can we convert the deposit into a viable mine that makes profit for the

company and returns for its shareholders, generates tax revenue and produces economic spinoffs and employment?

• For companies, realization risks encompass technical, locational, and capital factors that influence the confidence in their ability to generate a reasonable return on their investment.

• Government policy can lower the jurisdictional specific realization risks by increasing the level of confidence that companies, investors, and lenders have in the mining code and general political stability.

Development/Production Phase of Mineral Supply

• As always, time provides an added dimension to understanding and mitigating risks.

• Experience shows that many prospective mining projects do overcome realization risk and are brought into production – eventually. In many cases, however, both companies and governments underestimate the time required for this to happen.

Realization Risk and the Copper Industry

Discovery to Production Time Lapse

*includes deposits for which a production announcement has been made as of 01/01/2015Source: Rich Leveille, FCX

N = 136 Cu deposits developed 1989-2017*Mean = 26Median=21

Realization Risk and the Copper Industry

Predicted Copper Supply

From International Cu Study Group 2009

Government Policy Implications for Realization Risk• Most policy factors influencing realization risk in mining projects

relate to broader the foreign investment climate and include aspects of:– transparency; currency exchange and movement; access to arbitration;

guaranteed title; general safety and security; and force majeure.

• Less explicit yet equally important is the confidence of investors in the stability of the country and its mineral policy. Stability or grandfathering agreements can be beneficial to mitigate this aspect of realization risk.

• An effective policy framework should also enhance the interaction of companies with local communities to obtain a social licence to operate.

• And, of course, realization risk for both companies and government often hinges on the impact of the royalty and tax system on project economics.

Royalty and Tax Policy Considerations• Taxes on mining operations usually take one or more of three forms:

– tax on physical production such as $1 per tonne of coal;– tax on revenue (ad valorem royalty) either a gross revenue or some type of net

revenue; – tax on income or profit.

• Creating tax policy to capture a fair share of the overall value of mineral projects for the state is challenging in light of the market risks inherent in the industry and the high degree of variability of size and quality of mineral deposits.

• A purely revenue based royalty has the positive impact for governments of guaranteeing a minimum stream of tax but can be regressive by collecting fees when a project does not generate profit in any given period.

• A straight profit tax collects lots of revenue during high profit periods and low to none in years of poor to no profit.

Royalty and Tax Policy Considerations

• It is in no one`s best interest to have a regressive tax system that converts economic projects into uneconomic projects. Mining projects create jobs and economic spinoff activities that can greatly enhance overall benefits to government.

• Similarly, it is not in the long-term interest of either governments or companies to have mining projects that do not collect a reasonable amount of tax for the benefit of the people and the sustainability of the physical and governmental infrastructure that underpins the industry.

• What does a reasonable mining royalty and tax structure look like?

• Consider this question in the context of the value chain associated with the mineral supply process as we move from mineralization to resources to reserves and finally to production.

The Value Chain in the Mineral Supply Process

• As a starting point for policy makers tasked with creating tax and royalty schemes that capture a fair share of the wealth generated from mining operations, we can review the changing magnitude of values as we move through the mineral supply process.

• We will consider two case studies:– Case Study 1 – Smaller and Higher Grade

• Measured and Indicated Resource of 300 Mt with average grade of 0.80% copper and 0.31 g/t gold.

• Near surface amendable to open pit mining• Feasibility work underway.

– Case Study 2 – Larger and Lower Grade• Measured and Indicated Resource of 800 Mt with average grade of 0.52%

copper and 0.25 g/t gold.• Near surface amendable to open pit mining• Feasibility work underway.

Case Study 1: Gross In-situ Value to Net Smelter Revenue

  Measured and Indicated Resources (300 Mt)              

  Cu Au Total  

  Grade 0.8 % 0.31 g/t  

  Contained Metal 2.4 Mt 93 t  

  Price 6000 $/t 1,200 $/oz  

  Gross In-Situ Value 14,400 $M 3,600 $M 18,000 $M  

                 

  Conversion to Proven and Probable Reserves within Pit Shell (250 Mt)        

  Cu Au Total  

  Grade (incorporating 5% dilution) 0.75 % 0.28 g/t  

  Contained Metal 1.9 Mt 71 t  

  Price 6000 $/t 1200 $/oz  

  In-pit Value 11,280 $M 2,720 $M 14,000 $M  

                 

  Application of Processing Recoveries              

  Cu Au Total  

  Metallurgical Recoveries 87 % 71 %  

  Recovered Metal in Concentrate 1.6 Mt 50 t  

  Price 6000 $/t 1,200 $/oz  

  Gross Value of Metal in Concentrate 9,814 $M 1,937 $M 11,750 $M  

                 

  Deduction of Downstream Costs of Smelting and Refining            

  Cu Au Total  

  Treatment Charges

590 $M

- $M  

  Payment Deductions 500 $M 290 $M  

  Refining Charge 360 $M 10 $M  

  Transport Charge 300 $M -

$M  

  Net Smelter Value 8,064 $M 1,636 $M 9,700 $M  

                 

Case Study 2: Gross In-situ Value to Net Smelter Revenue

  Measured and Indicated Resources (800 Mt)              

  Cu Au Total  

  Grade 0.52 % 0.25 g/t  

  Contained Metal 4.2 Mt 200 t  

  Price 6000 $/t 1,200 $/oz  

  Gross In-Situ Value 24,960 $M 7,716 $M 32,676 $M  

                 

  Conversion to Proven and Probable Reserves within Pit Shell (700 Mt)        

  Cu Au Total  

  Grade (incorporating 5% dilution) 0.48 % 0.22 g/t  

  Contained Metal 3.4 Mt 154 t  

  Price 6000 $/t 1200 $/oz  

  In-pit Value 20,160 $M 5,941 $M 26,100 $M  

                 

  Application of Processing Recoveries              

  Cu Au Total  

  Metallurgical Recoveries 87 % 65 %  

  Recovered Metal in Concentrate 2.9 Mt 100 t  

  Price 6000 $/t 1,200 $/oz  

  Gross Value of Metal in Concentrate 17,539 $M 3,862 $M 21,400 $M  

                 

  Deduction of Downstream Costs of Smelting and Refining            

  Cu Au Total  

  Treatment Charges 1,130 $M -

$M  

  Payment Deductions 900 $M 579 $M  

  Refining Charge 625 $M 10 $M  

  Transport Charge 565 $M -

$M  

  Net Smelter Value 14, 319 $M 3273 $M 17,592 $M                   

• In Case Study 1, $18 billion of gross value has been converted to a net smelter value of $9.7 billion dollars. In other words, as we move through the value chain represented by the mineral supply process, the value we receive for sale of metals is 54% of the value of the metals in the ground.

• In Case Study 2, although the values are larger for each step in the analysis, the percentage of value we receive for the metals is the same at about 54%.

• Remember that these net smelter values represent the top line in our economic analyses – we have yet to deduct operating costs, capital expenditures, financing costs, royalties and taxes.

• This net smelter value over the life of the project is in many cases the base for government and private royalties (net smelter royalties). In Serbia this would be the base for the 5% mining royalty.

Case Studies: Gross In-situ Value to Net Smelter Revenue

Case Study 1: Net Smelter Revenue to Discounted Cash Flow

Economic Analysis Before Royalties and TaxesLife of Mine Net Smelter Revenue 9,700 $MLife of Mine Operating Costs 3,905 $MLife of Mine Capital Expenditures 1,300 $MLife of Mine Cash Flow 4,495 $MCost of Capital (10% discount)Net Present Value 968 $MInternal Rate of Return 21 %

Economic Analysis After Royalties and TaxesLife of Mine Net Smelter Revenue 9,700 $MLife Mine of Royalty Payments 485 $MLife of Mine Operating Costs 3,905 $MLife of Mine Capital Expenditures 1,300 $MLife of Mine Corporate Taxes 600 $MLife of Mine Cash Flow 3,410 $MCost of Capital (10% discount) $MNet Present Value 640 $MInternal Rate of Return 18 %

Case Study 2: Net Smelter Revenue to Discounted Cash Flow

Economic Analysis Before Royalties and TaxesLife of Mine Net Smelter Revenue 17,592 $MLife of Mine Operating Costs 8,820 $MLife of Mine Capital Expenditures 2,578 $MLife of Mine Cash Flow 6,194 $MCost of Capital (10% discount)Net Present Value 698 $MInternal Rate of Return 14 %

Economic Analysis After Royalties and TaxesLife of Mine Net Smelter Revenue 17,592 $MLife Mine of Royalty Payments 880 $M

Life of Mine Operating Costs 8,820 $M

Life of Mine Capital Expenditures 2,578 $M

Life of Mine Corporate Taxes 795 $M

Life of Mine Cash Flow 4,518 $M

Cost of Capital (10% discount) $MNet Present Value 267 $MInternal Rate of Return 12 %

Average Effective Rate of Taxation• The average effective rate of taxation is a comparison of the tax

collected as a percentage of the overall value of the deposit – on either a cash flow or discounted cash flow basis.

• In Case Study 1, the average effective rate of tax on the basis of: – Cash flow: is determined as total tax and royalty collected divided by total before tax cash

flow. ($485 + $600) / $4495 = 24%– Discounted cash flow ($166 + $162) / $968 = 34%

• In Case Study 2, the average effective rate of tax on the basis of: – Cash flow: is determined as total tax and royalty collected divided by total before tax cash

flow. ($880 + $795) / $6194 = 27%– Discounted cash flow ($265 + $163) / $698 = 61%

• The tax system is clearly more onerous in the less profitable Case 2 particularly with respect to discounted cash flow measures typically used in making development decisions.

• As shown in an international tax comparison this reflects the regressive nature of revenue based royalties.

Government Policy Implications of Market Risks

International Mining Tax Comparisons

Source: NRCan - Taxation of Mineral Income 2012 – How Canada Compares

Government Policy Implications of Taxes and Royalties

• Serbia’s tax system appears competitive with major international systems in terms of average effective rate of taxation.

• On the down side, the high royalty rate results in a very high discounted average effective rate of tax for projects which are less profitable. Under these circumstances a high revenue-based royalty can restrict the number of projects that get approved for development by shareholders and investors.

• As a result, it is likely that any further increases in the royalty rate would begin to alter Serbia’s competitive position in terms of attracting foreign investment for mining projects.

• A recent extreme example of increasing royalty rates and destroying competitive position for investment has occurred in Zambia where the gross royalty for open pit mines was increased from 6% to 20%.

Conclusions

• A balanced mineral policy should capture a fair share of mineral wealth for the state while providing sufficient incentive for corporations to take on the risks associated with the long-term growth and sustainability of mineral supply.

• There is no perfect combination of mineral policies which finds this balance – it needs to reflect the specific circumstances of the country or region and occasionally the specific deposit or investment.

• In all cases however an effective mineral policy must recognize and address the various stages of the mineral supply process from early stage exploration through delineation to development, production and closure.

• A modern mining code helps provide confidence in all aspects of the investment climate: transparency; currency exchange and movement; access to arbitration; guaranteed title; general safety and security; and force majeure.

Conclusions

• Serbia is in the advantageous position of having good geological endowment and an established state mining industry.

• As a relative new player in the competition for private sector investment in the mineral sector, Serbia has an opportunity to grow the industry, create employment and generate benefits for both investors and the people of Serbia.

• The key thing that investors want to see is that the government of Serbia is committed to providing long-term stability in their mining code, tax sharing and foreign investment rules. This will provide the confidence to explorers and developers that they can maintain a reasonable cost-risk-return balance on their activities in the country.