Mining Finance: Mining For The Miner Or Mining For The Bank?

Summary

• Cash borrowings by commodity producers pose an existential risk to miners should they face price deflation.
• The extent of price downside risk is disproportionately negative for cash debt servicing and repayment where even a small decline in price will have a huge negative consequence.
• Product-funding as opposed to cash-funding does not suffer from the same risk and will eliminate the existential risk posed by cash-funding.
• South African gold miners are assessed for there exposure to existential risk from cash borrowings in the event of ZAR gold price decline.
• The conclusions drawn from scenario analysis and from the evaluation of South African gold miners can be applied equally to miners around the globe and under any currency jurisdiction.

"According to Darwin’s Origin of Species, it is not the most intellectual of the species that survives; it is not the strongest that survives; but the species that survives is the one that is able best to adapt and adjust to the changing environment in which it finds itself."

Megginson, ‘Lessons from Europe for American Business’, Southwestern Social Science Quarterly (1963) 44(1): 3-13, at p. 4.

Financing a new mine or mining project typically involves a mixture of share capital and cash debt financing. It is seldom the case that a new mine is financed entirely from debt. Enterprise survival risk rises disproportionately when the cash debt ratio in the funding mix rises. The reason for the skewed rise in risk lies in the fact that the resource producer has only one source from which it can settle the debt, and that is from the sale of the commodity (in case of a single commodity producer) or commodity basket (multiple commodity producer).

Seems like a statement of the obvious?

Hidden in this statement of the obvious is a mining debt trap which can easily turn into a death trap. The commodity producer typically is a price taker with regards to its product. A vehicle producer (or perfume producer), for example, can set his own price and then design a marketing campaign around that vehicle (perfume) to support its price strategy. A miner has an extremely limited ability to influence his product’s price. He can engage in hedging to protect a given price level for a given level of production but even hedging does not alter the fact that the miner does not have control over the price of his product. Hedging takes place in-market at the price levels determined by the market.

This lack of control over price gives rise to a disproportionate risk of cash debt financing when a price decline shrinks the margin between production costs and the selling price. Most mining projects have long lead times, easily up to 10 years, while prices in all markets have been extremely volatile since the 2008 global economic crisis. In fact, the 2008 global economic crisis heralded in a low interest rate environment combined with low inflation. Previously, commodity producers could initiate a new mining project inside the protection of an inflationary environment. In the current economic environment that protective cocoon has been removed. Investment markets now increasingly influence commodity prices at the margin rather than price discovery between producers and consumers. Prices of commodities can and do fall in this new environment and bear markets can linger long enough to threaten the survival of any miner with significant debt.

A slight shift in perception and one can see that a miner pays off his debt together with interest in product volume. That product volume is linked to the product price. Thus, in a rising price (inflationary) environment less and less volume of the commodity is required to settle a cash debt, but in a falling price (deflationary) environment greater volume of that commodity is required to settle the cash debt and service interest. Interest payable adds material risk to the equation when the production margin is at the mercy of external market forces. It follows that ever-increasing quantities of the commodity will be required to settle the cash debt unless the price of the commodity increases at a rate faster than the cost of interest.

The commodity producer is mining for the market as long as his production is driven by market forces, but when the miner has to increase production simply to add the volumes necessary to settle debt then the miner no longer mines for himself but mines for the bank. We all have seen this happen often since 2008, across all commodity producers. The surprising and unintended consequence is that miners will increase production in a bear market because he has no choice but to generate the cash flow to service debt. Often servicing debt is all that the miner does while trying to dig himself out of the cash debt trap.

See, for example, a comparison between the changes in the South African rand (ZAR) gold price and the South African inflation rate (CPI). South African gold miners suggested to me that they enjoy an inherent price protection due to inflation. The thesis being that a rise in inflation will be followed by a rise in the ZAR gold price. This simply is not supported by the statistics. There is no correlation between the ZAR gold price and the South African inflation rate, so the South African gold miners cannot expect to be protected by the inflation rate.

Interest payments will consume production margin to the extent that commodity quantities are allocated for servicing interest. Commodity price advances can mitigate the interest cost to the extent that the commodity price increases consistently at a rate greater than the interest rate. If the miner cannot rely on this (which he cannot), then it would be better for the commodity producer to use a product-funding approach rather than cash funding. More about product-funding later in this article.

How often did the ZAR gold price change exceed the South African Lending Rate?

In only 10 instances in the 38 years since 1980, depicted by the chart above, did the average gold price change exceed the annual average South African Lending Rate (that is, in only 26% of the years). In 28 years out of a total 38 years (74% of the time), the South African gold miner would have had to pay away larger volumes of gold against cash borrowings of up to one year in duration. The increments are measured in the chart at annual averages so one can only generalize on a one year basis. The indication is however that cash borrowings by South African gold miners would generally have a very high risk of creating the negative scenario of “mining for the bank”.

The South African gold miner with a relatively high level of cash debt would have experienced significant repayment distress in the 14 years when the ZAR gold price actually declined. Debt repayment in gold ounces would have disproportionately increased by the interest rate together with the margin squeeze from the drop in the gold price. A simplified example using the following variables would be:

ZAR gold price at starting date (Data source: World Gold Council, ZAR average gold price for 2016):	R18,438.50
ZAR Gold price at maturity date (Data source: World Gold Council, ZAR average gold price for 2017):	R16,742.40
Cash borrowing:	R1bn
Annualized interest rate:	10%
Effective gold ounces allocated to debt repayment at starting date:	54,500 ounces
Effective ounces required to repay the R1.1bn debt plus interest at the maturity date:	65,701 ounces
The effective cost in ounces increased by:	11,201 ounces

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Not only did the gold miner have to repay the original 54,500.36 ounces he also had to mine (or allocate from other projects or mines) an additional 11,200 gold ounces (20.6% more than the number of ounces originally anticipated) to generate sufficient cash to settle the cash debt plus interest. This simplified example has been done in absolute ounces. Note also that the variables used are actual in-market numbers.

The miner will, in reality, have only the profit margin per ounce available to repay the debt. Let’s expand the example to say that the gold miner has a 20% profit margin against all-in sustainable costs, at an R18,438.50 spot per ounce. The all-in sustainable cost would then be R14,678.80 per ounce. His profit margin for 2016 available to repay debt would have been R3,669.70 per ounce which, if costs remained unchanged from 2016 to 2017, will drop to R2063.64 in 2017. This ZAR price decline from 2016 to 2017 is a mere 8.75%.

ZAR gold price at starting date (Data source: World Gold Council, ZAR average gold price for 2016):	R18,438.50
ZAR Gold price at maturity date (Data source: World Gold Council, ZAR average gold price for 2017):	R16,742.40
Cash borrowing:	R1bn
Annualized interest rate:	10%
Effective gold ounces allocated to debt now using available profit margin per ounce at starting date:	272,502 ounces
Effective ounces required to repay the R1.1bn debt plus interest now using available profit margin per ounce at the maturity date:	533,039 ounces
The effective cost in ounces increased by:	260,537 ounces, or by 95.6% arising from a mere 8.75% decline in the ZAR gold price

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Would this gold miner even have the capacity to produce the required additional ounces? He would not unless he had a cash debt to sales ratio of less than 51%. Compare the debt to sales ratios of the South African gold miners evaluated later in this article and you will see four out of the five had a ratio greater than 51% and the remaining one had a very thin profit margin. I have mentioned that the cash borrowing risk is a disproportionate risk and can be a death trap. Here it is patently evident that a simple 8.75% drop in the ZAR gold price caused a 95.6% spike in the number of ounces required to service and repay the debt. That bears repeating: it is patently evident that a simple 8.75% drop in the ZAR gold price caused a 95.6% spike in the number of ounces required to service and repay the debt. It must be clear to everybody that the South African gold miner who borrows significant amounts of cash plays Russian Roulette with its existence. He must remind himself every night when he goes to bed, “I’ll be ok as long as the ZAR gold price does not decline”.

This is one example for gold, in a ZAR currency environment, but does it also apply to other minerals and other countries? The answer is an emphatic YES. All miners in all countries in any currency face the same dynamics subject to the specific variables applicable to each, but the fundamental horror story remains the same. A decline (even a small decline) in the mineral price in the currency of the producer will have a disproportionately negative impact on its ability to repay or service cash debt and can easily pose an enterprise existential risk.

The alternative to cash borrowings is product-funding. There are product-financing alternatives available for most of the commodity producers. How does product financing work and what is the logic behind it?

As mentioned above, all cash debt must eventually be settled in product and there is an unreported open risk as to the volume of product which will be required to settle a cash debt plus interest. It is also part of the product-funding logic that the commodity producer is hugely “long” on the product which it mines given its levels of mineral reserves.

Product-funding would provide the cash a miner needs through a sale of product upfront, which sale then has to be settled in product at a future date. It is preferable for product-funding to be obtained directly from commodity investors rather than from the banking sector. It would also be imperative that cash is generated upfront and the obligation would be to deliver a predetermined volume of product into the sale agreement.

The Pre-Paid product would achieve all product-funding objectives but it is not generally available across commodities and it is a banking-based product. A Pre-Paid Forward Gold Purchase/Sale Agreement is an agreement between the miner and his banker to sell a pre-determined volume of gold forward preferably for settlement in gold. A forward sale would not generate any funding at inception so the banker will then make a loan amount available to the miner, for the calculated forward gold sale, usually less interest, and advance the net amount to the miner. The effective “interest costs” are netted off in the transaction. The miner will receive the forward interest on the forward sale (usually at or near the same base rate as the loan) but will pay the loan interest. The net effect is usually that a Pre-Paid would be priced at approximately the spot mineral price minus the credit spread of the miner. One would need this information for a comparison with the cash borrowing example.

The other product-funding alternative is a PurePlay® Note, which is a sale of a specified quantity of fungible unmined mineral from the proven and probable reserves of the miner directly to an investor in the form of a tradable security (listed as an ETN or unlisted as OTC) for delivery at a future date. The miner would undertake to perform the extraction, refinement and delivery at his own cost by the maturity date and would store the mineral in unmined form in its reserves for the duration of the Note. The Note would be settled in the mineral at the maturity date. The pricing of the PurePlay® Note is the spot sale price of the mineral discounted by the miner’s credit spread. The investor will hold a pure mineral investment risk together with a delivery risk on the miner. The miner will not pay interest but will transfer the price risk to the investor at inception of the Note. The PurePlay® Note is not debt but a spot sale with a deferred delivery obligation which places it outside the banking sector and is settled by the miner in mineral on the maturity date. Investors can engage the miner as their selling agent or take delivery of the physical mineral.

The miner would “fix” his product volume risk when he uses a product-funding method to generate cash. Interest rates are generally eliminated with only the credit spread remaining. There is however a sacrifice. The miner has to give up the potential profits which he may have received if the commodity had increased in price and he had used cash funding to carry the price and volume risk. The question is whether the miner is justified to run an open enterprise existential risk in an attempt to profit from a commodity price risk?

The product-funding scenario using the same variables as in the cash funding scenario will play out as follows:

ZAR gold price at starting date (Data source: World Gold Council, ZAR average gold price for 2016):	R18,438.50
ZAR Gold price at maturity date (Data source: World Gold Council, ZAR average gold price for 2017):	R16,742.40
Product funding:	R1bn
Annualized average credit spread (South African gold miners generally have a credit spread ranging between 1.75% to as high as 3.5%):	2%
Effective gold ounces allocated to settle the delivery obligation at starting date:	54,500 ounces
Effective ounces required to deliver into the R1.02bn obligation plus credit spread at the maturity date:	55,590 ounces
The effective cost in ounces increased to cover the credit spread by:	1,090 ounces

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Now the gold miner only has to deliver the original 54,500 ounces together with 1090 ounces to cover the credit spread. Again, this simplified example has been done in absolute ounces. The variables used are still actual in-market numbers.

The miner will, in reality, only have the profit margin per ounce available to allocate to the settlement of the obligation but under the product-funding scenario will not experience a change in profit margin as the profit margin is locked-in at inception. Again, let’s expand the example to say that the gold miner has a 20% profit margin, using an R18,438.50 per ounce spot gold price. All-in sustainable costs would be R14,678.80 per ounce. His profit margin for 2016 available to settle the obligation would have been R3,669.70 per ounce which, if costs remained unchanged from 2016 to 2017, will not change at all as the profit margin has been locked-in. (The remaining cash per ounce is allocated to the payment for all-in sustainable costs.)

ZAR gold price at starting date (Data source: World Gold Council, ZAR average gold price for 2016):	R18,438.50
ZAR Gold price at maturity date (Data source: World Gold Council, ZAR average gold price for 2017):	R16,742.40
Product funding:	R1bn
Annualized average credit spread (South African gold miners generally have a credit spread ranging between 1.75% to as high as 3.5%):	2%
Effective gold ounces allocated to settle the delivery obligation at starting date using profit margin:	272,502 ounces
Effective ounces required to deliver into the R1.02bn obligation plus credit spread at the maturity date using profit margin:	277,952 ounces
The effective cost in ounces increased to cover the credit spread using profit margin by:	5,450 ounces

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The miner got destroyed in the cash borrowings scenario by a 96% increase in deliverable product or borrowing the equivalent of 272,502 ounces and having to deliver 533,039 equivalent ounces. Yet, year in and year out, miners globally run this disproportionate open existential risk. The product-funding alternative eliminates the existential risk, containing the delivery at maturity to a mere 277,952 ounces as opposed to the 533,039 equivalent ounces required in the cash funding scenario.

Scenario analysis is used in this article to demonstrate the difference in cash funding vs product-funding. In the next article, I will proceed to evaluate case studies of miner-funding since 2008 where the disproportionately higher risk of cash borrowings have hurt commodity producers. The relative risk to which a miner is exposed to cash borrowings can easily be estimated by using the simple ratio of its cash, interest paying debt to its annual sales. The higher the ratio the higher the risk and as described above a mere 8.75% decline in price can cause a near 100% increase in required commodity production to maintain the cash generation to “pay the bank”. The production margin is equally important and in the scenario analysis, a 20% profit margin on all-in sustainable costs was used.

The results of the scenario testing can now be applied to a sample of South African gold miners for evaluation.

South African gold miners Cash Borrowings to Annual Sales ratios.

Company	Cash Borrowings	Annual Sales	Cash Borrowings to Annual Sales ratio expressed as a percentage	Comment
	ZAR billions	ZAR billions
AngloGold Ashanti Limited (AU)	R27.90	R53.59	52%	A borrowings to sales ratio of 52% together with a small margin between all-in sustainable costs per ounce (R13,852.73) and the average ZAR gold price received during 2017 (15,476.67) at 10% indicate a very high cash borrowings risk exposure to a potential ZAR gold price decline. (Data obtained from the AU 31 December 2017 Integrated Annual Report and converted to a ZAR amount at R12.3026 to $1.)
Gold Fields Limited (GFI)	R21.81	R33.98	64%	A borrowings to sales ratio of 64% together with a small margin between all-in sustainable costs per ounce (R13,385.23) and the average ZAR gold price received during 2017 (15,439.76) at 13% indicate a very high cash borrowings risk exposure to a potential ZAR gold price decline. (Data obtained from the GFI 31 December 2017 Integrated Annual Report and converted to a ZAR amount at R12.3026 to $1.)
Harmony Gold Mining Company Limited (HGM)	R5.61	R20.36	28%	A borrowings to sales ratio of 28% together with a small margin between all-in sustainable costs per ounce (R16,889.32) and the average ZAR gold price received during 2017/8 (R18,933.6) at 11% indicate a high cash borrowings risk exposure to a potential ZAR gold price decline. HGM has done price hedging transactions which allowed them to achieve a significantly higher average annual gold price which generated the 11% margin. The margin would have been materially less if the effect of the hedges is eliminated from the average gold price received. The very thin profit margin in this case is the greater risk rather than the cash borrowings to sales ratio. (Data obtained from the HGM 30 June 2018 Financial Report.)
Pan African Resources PLC (OTC:PAFRF)	R1.66	R1.92	86%	A borrowings to sales ratio of 86% together with a negative margin between all-in sustainable costs per ounce (R18,631.76) and the average ZAR gold price received during 2017/8 (R17,849.72) at -4%% indicate that PAF may already be trapped by the high levels of cash debt relative to turnover. The very high levels of cash debt combined with a significant increase in AISC and a negative production margin indicate that PAF cannot even service interest based on currently reported results and ignoring any debt repayment. The consequential risk for PAF of even a small decline in the ZAR gold price is now already at the existential risk level. PAN has also done price hedging transactions (gold price collars) but achieved a significantly lower average gold price than HGM above. PAF further had to account for the closure of the Evander underground mining operation which impacted the reported data. It is expected that AISC will reduce as a result of the closure of Evander underground mining as well as the lower cost production from the Elikhulu tailings project but the high level of cash debt remains an existential risk for the time being. (Data obtained from the PAN 30 June 2018 Integrated Annual Report.)
Sibanye-Stillwater Limited (SBGL)	R25.65	R45.91	56%	It is not useful to assess the production margins on SBGL in isolation referencing gold only as it is a multi-commodity producer. A borrowings to sales ratio of 56% of turnover is however indicative of a potentially high cash borrowings risk exposure to a potential ZAR price decline in the average basket price of all the commodities produced by SBGL. The diverse nature of its production does assist SBGL in mitigating some of the risk associated with a price drop in any one commodity. (Sales and borrowings data obtained from the SBGL 31 December 2017 Annual Financial Report.)

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It is truly frightening that miners are managing their businesses, by need or by choice, to assume the dreadful risk associated with cash borrowings while exposed to and at the mercy of product price determination external to the enterprise. The scenario analysis did not factor in any annual production cost increases which would have further exacerbated the negative outcomes. The point however is vividly demonstrated by the example without a need to elaborate. The open risk of a highly leveraged miner to cash borrowings is comparable to the risk of a highly leveraged commodity derivative trade.

It would be prudent to check whether a miner is mining for himself or mining for the bank when contemplating any investment in a commodity producer. Will they survive a decline in the price of the commodity which they produce if they are predominantly using cash funding, or will they succumb to mining for the bank where all strategic decisions are aligned to the generation of sufficient cash to service and repay cash debt?

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.