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Freeport-McMoRan (NYSE:FCX) Grasberg mine in the Papua province of Indonesia reported impressive performance in the fourth quarter of 2013.

Parameter

First half 2013

Third quarter 2013

Fourth quarter 2013

Copper grades (in per cent)

0.69

0.74

0.87

Gold grades (grams/tonne)

0.53

0.65

0.99

Net cash cost (per lb)

$1.95

$0.99

$0.21

The Grasberg operations reported improving productivity throughout 2013 and even posted better performance compared to Freeport's consolidated performance. The company's Indonesian operations reported an annual net cash cost of $1.12 per pound of copper, compared to the company's consolidated net cash cost of $1.49 per pound. Moreover, the Indonesian business contributed 21% and 91% to the company's 2013 copper and gold sales, respectively. Considering these numbers and the Grasberg mine improving grades and lower costs, the Indonesian business will play a vital role in the company's success.

However, the company's Indonesian operations are already being affected by the ongoing mineral-ore export ban. To improve the domestic processing industry, the Indonesian president approved a ban on the export of mineral ores earlier in January. As a result, mineral export companies are now required to process ore concentrates domestically. Even though the government has allowed the export of copper concentrates until 2017, Freeport's gold production will be affected by the ban. Moreover, the export of copper concentrates will be taxed with an export duty of 25% in 2014, rising to 60% by mid-2016.

Currently, there's only one copper smelter in Indonesia, PT Smelting, to which Freeport allocates 40% of its production while the rest is exported to international smelters under long-term agreements. In such a scenario, Freeport will have to either pay higher taxes or cut down its copper production, since processing its entire copper domestically does not look feasible. The company could pay $5 billion of additional taxes in the next three years. However, these tax provisions do not honor the contract of work, or CoW, which Freeport had signed with the Indonesian government. As per the CoW signed in 1991, Freeport would not have to pay any new taxes, duties, or fees. The company seems optimistic about the issue being resolved soon. Until then, Freeport has deferred its production, which quantifies to 40 million pounds of copper and 80,000 ounces of gold per month.

Freeport's copper business in Indonesia accounts for 19% of its total revenue, and out of the company's total gold reserves of 31.3 million ounces, 29.8 million ounces are in Indonesia. The company's earnings and cash flows may take a hit, until and unless there is a change in the government's stance.

Apart from Freeport, Newmont Mining (NYSE:NEM) will also be affected by the ban. Newmont accounts for 24% of Indonesia's copper production and exports concentrate from its Batu Hijau mine. Compared to Freeport, Newmont will be less affected by the ban, as the Batu Hijau mine contributes around 6.8% of Newmont's revenue. However, Newmont is considering legal action against the export tax, as it breaches the CoW the company signed with the government. As per the signed CoW, Newmont is required to pay a corporate income tax of 35%, and is not subject to pay any other taxes. Both Newmont and Freeport together account for 97% of Indonesia's copper production, which gives them bargaining power. It remains to be seen whether these companies can renegotiate with the Indonesian government.

Some financial perspective

Freeport posted solid performance over the past four quarters, with consistently rising cash flow from operations. Its cash flow as a percentage of revenue has increased from 18% in the first quarter to 39% in the fourth quarter of 2013.

Parameter

1Q 2013

2Q 2013

3Q 2013

4Q 2013

Cash flow from operations (In $ million)

831

1,034

1,878

2,337

Total revenue (In $ million)

4,583

4,288

6,165

5,885

CFO as a percent of revenue

18%

24%

30%

39%

This was largely driven by the acquisition of the oil and gas business in June 2013. The oil and gas business contributed 14% of the company's 2013 revenue, and with almost $3 billion of planned capital expenditures, or capex, in 2014, the oil and gas segment will generate higher revenue and cash flows.

The company generated around $2.27 billion from the oil and gas business in 2013 after incurring almost $1.45 billion in capex. This gives a cash flow-to-capex ratio of 1.56, and a ratio greater than 1.0 means that Freeport has been efficient enough to fund its future capex through internally generated cash flows. Assuming the company displays similar efficiency and $3 billion of capex in 2014, it could generate almost $4.7 billion in cash flow from operations from its oil and gas business.

Conclusion

Freeport will possibly generate lower revenue and cash flows from its Indonesian business until the tax issue is resolved. Diversification into the oil and gas business will help cushion the company some from the Indonesian ban. Hence, I recommend investors hold their positions until there is more clarity in the issue.

Source: Freeport-McMoRan: Indonesian Troubles Call For A Cautious Look