Minnow mining companies and their financial advisers are wrestling with a paradox: high commodity prices, which have led to more flattering business models and healthier margins, are making financiers nervous, because volatility has increased, and prices have room to fall.

Nevertheless, despite the credit crunch and a wave of natural resources re-nationalisation starting in Russia and spreading to Venezuela and the Congo and beyond, strong demand for mined commodities means mining, perhaps with oil and gas, remains one of the most robust project finance sectors in a faltering global economy.

"We have quite a lot of exposure to the mining sector through debt and equity financing," says Brian Kennedy, managing director, Nedbank Capital. "But we would rather be in that sector in the last five years than currently retailing or TMT or media because there has been a great cycle. The question is how long is it going to last and how do you protect yourself from that."

"The equity markets are still fairly hot, but there is more of an interest in bank debt now, since the realisation of the gyrations in pricing in the equity markets," adds Mark Tyler, head of mining and resources, Nedbank Capital. "It takes a lot of work to do a project financing, but if it's competitive it's still good for shareholders. I think this year we will see a great many more deals."

Lender belt tightening

While the increased spreads over Libor and reduced bank liquidity brought about by the turbulence of the credit markets are unlikely to deny projects access to market, it seems certain to effect structuring, lender assertiveness and the speed at which deals get away.

"When the market got very competitive, people were prepared to do things a lot quicker and with a lot looser covenants than there were five years ago," says Tyler. "I think we've seen those covenants tightening up, and I think its taking a little longer now than it used to with lenders doing their due diligence and properly structuring transactions."

"Possibly not so much tightening the covenants but trying to enforce them also," says Eberhard Gschwindt, technical advisor, EIB. "Some of us have been lax in waivers, but these waivers are being reduced so covenants are more and more enforced." Perhaps one of biggest obstacles facing growing mining companies wishing to secure a project financing is the time it takes to put a deal together and the administrative burden lenders' covenants impose.

"If there is to be a comparison between different financing instruments, then an important consideration is the timeframe it takes to accomplish a project financing and close a deal, and also the amount of work and the number of restrictions on the rest of the operation," says Saila Miettinen-Lahde, CFO, Talvivaara Mining. "Some acknowledged PF experts said that it would take 1 to 1.5 years to complete our deal, but we met our schedule." Talvivaara, a $320 million cobalt/nickel mine in Finland, closed its debut project financing in less than six months from the start of 2007.

As lenders demonstrate a more anaemic appetite for risk in the current economic climate deals will probably take longer to close, because more due diligence is undertaken and additions are made to the standard covenant package. Pekka Pera, CEO, Talvivaara Mining adds: "Our deal was done in four months, but I don't think that would happen today after last summer; I think we would have to at least triple the time because of the more detailed due diligence."

"The delay to financial closure is not the real constraint any more, it is the fulfilment of all the conditions precedent in order to draw the first money," says Gschwindt. "The time-lag between signature and drawdown seems to be increasing now."

Other funding sources

Sponsors deterred by the length of time to raise bank debt are being swayed by equity raising in the markets, quasi-equity debt instruments or forming joint ventures with offtakers. Chinese metals giant Jinchuan has been heavily engaged in such ventures in Africa and Asia.

Convertible bonds have long been touted as an emerging cornerstone of mining finance, but their use has not been as widespread as mining bankers anticipated. "At one stage everyone was predicting that there was only going to be convertible bonds, but there certainly wasn't as many done last year that we thought were going to be done," says Tyler. "They're a lot quicker than project finance but also a lot more expensive."

But Pera adds: "From speaking to my colleagues, at this moment it seems you have to have some kind of convertible element if you want to get a financing in place particularly with companies with a short history."

"To get a project done quickly you do need to have an equity element," says Tyler. "But I don't think the trade off there is between equity and convertibles, it's between convertibles and going to the market – whether the dilution you get out of a convertible is better than the dilution you would get from the market."
We saw last year in the Canadian market that even a convertible was a long-term job, and an investment bank would turn up with a bought deal in the morning and the mining company would have a have a cheque by two in the afternoon."

The gap between the equity markets and senior lending can be met by banks willing to move up the risk-reward curve. According to Tyler, Nedbank moved two years ago from vanilla project financing to also providing convertible and mezzanine debt with equity upside, particularly in the South African market.
"I think [quasi-equity] is a better way of sweetening a deal for a bank," says Tyler. "Traditionally hedges have been a way that banks have sweetened deals but they come with their own risks, so naked risk on the equity side would probably be better."

The EIB, particularly in Africa, has a mandate to use a range of instruments, from plain vanilla senior loan via junior loan to equity. "It should be emphasised that EIB, as a development finance institution, only comes into a financing plan, if commercial sources are not sufficient or do not have the same flexibility or risk appetite. For example commercial banks tend to have shorter terms on their loans so we come in on the long end, or if equity is not sufficient we come in with some sub-debt or we also could do equity," says Gschwindt. "Our job is certainly not to crowd the private sector out."

Increased prices, more risks?

High and rising commodity prices have led to an increased tension between senior lenders and developers, particularly where volatility in prices comes with this increase. Lenders and sponsors find it harder to make reasonable assumptions about forward pricing and where to place the floor price on senior lending. As the eagerness of exploration and development companies to finance their project increases with rising projects, so does the uncertainty in lenders' forecasters.

"Commodity prices have been at a high level for such a long time but nobody really believes that this will hold," says Pera. "People want to get things done before the downturn. Although the signs are there that the prices are on a higher level for good, I feel that somehow people don't trust them and that's why people don't have time to spend two years to get a project finance package in place. People want the money today or tomorrow."

Talvivaara closed its 8-year $320 million project financing for a nickel and cobalt bioleaching mine in May 2007. The offtaker, Norilsk Nickel, which is also a shareholder in Talvivaara, is taking all of the nickel output (75% of revenues) and all cobalt (5%) at the prevalent London Metal Exchange price for ten years. The price of nickel was very volatile in early 2007, illustrating the difficulties facing project financiers. Nickel prices rose from $30,000/tonne at the beginning of the year to over $53,000 in early May, before dropping to below $26,000 in August. Nickel has since traded in a range around $29,000.

"Banks wanted higher hedging at the beginning," says Miettinen-Lahde. "Given where the market is right now, we are at a happy medium, at a level we can be comfortable with. It was always important to us to keep enough upside to keep the equity markets happy. If we eat all the upside for equity it's not a great investment story for the IPO or even for later development."

Tyler adds: "I think that's a change that we may see in the future. In the past banks have forced sponsors into quite an onerous hedging programme, because they saw hedging as a sweetener for the deal. Banks take risk on the hedging programmes which many people perhaps do not appreciate, because if the company never produces and the prices rocket the banks are on the hook because of margin calls, and their exposure can often dwarf the amount of debt put into the project."

Our approach is to take the view that hedging is to protect the price, so if the thing is so robust it doesn't need hedging we would rather not add additional risk to the problem.

If we did enter into a hedge, and we were to structure it, we certainly wouldn't enter into one of those flat forward structures. We like those structures where you sell a slice of the upside but limit the banks total risk."

However, sponsors should remember that banks are providing senior lending; they are not taking a naked punt on commodity prices. Kennedy says: "It is a balancing equation because if we want take a views on the gold and platinum price there are many different ways we can do that; when we lend money we want to mitigate as many risks as we can within reason."

The base case model is one dimension, what you really do is flex that price down 20, 30, 40, 60% and see what happens to the model and what your coverage ratios are then. We all accept that forecasts vary. When you sit on a credit committee you only see the forecasts go up, when you sit on other committees they occasionally go down."

Gschwindt adds: "The difficulty is currently, within the last two years, is forecasting agricultural-linked commodities, such as phosphate and potash. It is a quantum leap and they're therefore very difficult to predict."

The most reliable method of testing a mine's viability is to assess its position on the cost curve, compared with production costs of the market as a whole. But obtaining a true assessment of the market cost, let alone producing accurate costs estimates for a project's completion, is fraught with difficulties.

"Most commodities at the moment are at about three times the maximum price that a sane project would need to be in business," says Tyler. "Another way to look at it is to put in base prices at the 80th percentile, but that is a difficult price to come up with these days because of cost inflation. What the cost curve was like last year is nothing like what it is this year."

Capital cost inflation

Mining has been hit as badly with cost inflation as any other project finance sector, and as in other sectors, sponsors have increasingly dispensed with fixed-price turnkey construction contracts. The picture varies geographically, with mining-intensive remote regions hardest hit, such as remote parts of Canada and Western Australia. "I visited Western Australia," says Pera, "and some operators had a personnel turnover of 120% per year, and the worst one had a 60% turnover per month."

Cost inflation poses stiff challenges for financiers because it is close to impossible to have firm capital expenditure numbers months in advance of completion. One way to mitigate inflation is to stick to countries where inflation is lower. "Places like Chile for instance – although there's a lot happening in Chile – the workforce is coming home and staying there and you're not seeing huge labour turnovers," says Tyler.

Small firms with the requisite expertise are opting to develop projects themselves rather than employ a large contractor, which are geared to provide services to the majors and are often accused of sending in their least impressive personnel, rather than their best workers, for smaller sponsors and without offering a fixed price.

"We had to attract people from retirement, as it was the only place to get properly experienced people in senior positions," says Pera. "We are six months away from production, and we're on budget. We have exhausted all the spare capacity in the Nordic area, that's why new operators call us the black hole, because we suck in all the engineers, contractors and raw materials."

Consolidation is almost inexorable among mid-tiers. Whereas previously the largest mining companies were buying up the mid-tier producers, now mid-tier producers are buying juniors. In time juniors are more likely to start buying up exploration companies.

"I think we have yet to see half the consolidation, which is not necessarily good for the end-user," says Pera. "In nickel we could effectively be led back into producer prices, but we are not there yet. We do not have any exit plans for now, since we are focused on organic growth. In future we would look at acquisitions and project financings."

Congo looms large

The next big challenge for serious mining project financiers is Congo. Any project financings will be multi-sourced and will probably require complete political risk mitigation for commercial banks and heavy multilateral or development finance institution (DFI) support.

"In Congo it's going to be a question of first past the post – there's not room for all of those projects," says Tyler. "We'll go in under ECA cover, and there are more applications than will ever get approved for South African government exposure to the Congo."

"We are looking at projects there," adds Gschwindt (EIB). "Our big advantage is that we are able to take political risk on behalf of the EU Member States, who actually ask us to do so as part of the EU cooperation policy with its Partner Countries. But we certainly won't play around with it; unless there are stable conditions we won't disburse any money."

The mining review commission, which published its review 20 March, recommended cancelling some contracts and transferring stakes to state-owned Gecamines because miners are earning internal rates of return far in excess of international standards. Government ministers are reviewing the findings.