The mining industry is historically cyclical. The size, complexity and cost of projects mean they require many years of exploration and development before reaching production.
In contrast, demand often changes rapidly as economic growth and technological innovations drive unanticipated growth in some commodities while others lag behind predictions. This can lead to extreme rises in commodity prices as demand continues to outstrip supply for a prolonged period and the lag between short-term demand and long-term supply takes effect.
These prolonged periods of price increases tend to encourage investment in mineral exploration and ultimately lead to the next bust as supply gradually catches up with demand and prices fall, leaving a glut of higher-cost projects unable to operate at lower prices. The resulting lower profit margin results in investors leaving 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.
As a result of the cyclical market royalties & streams have become an important source of funding for numerous companies within the mining sector in recent years. In the past both royalties and streams were considered specialist forms of funding but have become more widespread, leading to greater awareness of the model from resource companies and an increase in the transactions occurring.
A royalty is an agreement which provides, in exchange for an upfront payment made to the mining company, the right to receive a proportion of the revenue from a mining operation once in production. The royalty can take several forms; the most common are described below.
- Gross Proceeds Royalty (GPR): A royalty in which payments are made on contained ounces rather than recovered ounces.
- Gross Smelter Return (GSR) Royalty: A defined percentage of the gross revenue from a resource extraction operation less, if applicable, certain contract-defined costs paid by or charged to the operator.
- Gross Value (GV) Royalty: A defined percentage of the gross value, revenue or proceeds from a resource extraction operation, without deductions of any kind.
- Milling Royalty (MR): A royalty on ore throughput at a mill.
- Net Profits Interest (NPI) Royalty: A defined percentage of the gross revenue from a resource extraction operation, after recovery of certain contract-defined pre-production costs, and after a deduction of certain contract-defined mining, milling, processing, transportation, administrative, marketing and other costs.
- Net Smelter Return (NSR) Royalty: A defined percentage of the gross revenue from a resource extraction operation, less a proportionate share of incidental transportation, insurance, refining and smelting costs.
- Net Value Royalty (NVR): A defined percentage of the gross revenue from a resource extraction operation, less certain contract-defined costs.
Royalties may be:
- configured to cover particular commodities, providing mine operators the flexibility to raise finance on a commodity as well as project level;
- limited to certain areas of the mine, allowing the exploration upside to be shared by the operator and the royalty holder;
- set to follow production hurdles, ensuring that the operator only has to pay the royalty once an amount of production has been achieved;
Royalties on early stage exploration projects can represent good value, given the large amount of uncertainty over their future feasibility and development, as well as the often significant time before the asset will come into production. Royalties on later stage projects nearing production will have been significantly de-risked by additional exploration, with the route to production clearer and the time to production shorter. Royalties on mines already in production are usually more valuable as they provide income without a delay.
Mining royalties have a number of inherent advantages when compared to direct equity investment:
- Owning a royalty does not involve any operating or capital expenditure commitments.
- Royalties are non-dilutable because they are typically tied directly to production or revenue, where ordinary shareholders are frequently heavily diluted by equity placings.
- Royalties tend to be linked to gross revenue so as long as the mine can survive a downturn the royalty will continue to be paid, where shareholders may not.
- Royalties can be diversified by operator, commodity and country providing investors protection from commercial, political, geological and political risks.
- Royalties often benefit from future exploration potential, providing holders with significant upside.
- Royalties are far less management intensive than running a mining project directly, enabling a focus on portfolio growth.
A stream is an agreement which provides, in exchange for an upfront payment made to the mining company, the right to purchase some or all of the production from a mine, at a price determined for the life of the transaction by the purchase agreement.
Streaming agreements are often larger than royalty agreements, provide more flexibility in the negotiation of terms and conditions, and generally provide both parties with tax advantages.
Elemental does not yet hold any streams within its portfolio but is actively reviewing potential opportunities.