Flush with cash from the commodities boom, the mining majors – such as Rio Tinto and BHP Billiton – are generally not showing much enthusiasm for project finance. When they do a greenfield mining project it tends to be financed from revolving credit facilities or from cash flow. And if they choose to use project finance, they do so on very favourable terms.

In most cases, the big players are tending to mine for new metal reserves on the world's stock markets – the sector is beset by frenzied mergers and acquisitions activity. And as further proof of an embarrassment of riches, many are handing vast amounts of cash back to shareholders. Since the beginning of 2006, Anglo American is on course to return $10.5 billion to shareholders via share buybacks and special dividends. BHP Billiton has also announced cash returns of $17 billion since 2004 via similar mechanisms.

This leaves much of the new mine development occurring at the more risky junior end of the market where many are turning to banks for finance rather than relying on the majors like they used to. The normal route is to float on the stock market once it is proven that there are commercially viable metal reserves within the concession area. From then onwards, project finance is likely to be sought for the mine's development to bring it on stream.

But the mining boom has brought a new set of challenges, such as rising operating costs, staff and equipment shortages and expensive raw materials. And although project lenders have been pushing the risk envelope, uncertain cost structures are a pressing issue.

Volatile costs

"One of the big issues at the moment for mining companies is securing a fixed price contract from the contractor," says Chris Worcester, Head of EMEA Metals and Mining with WeslLB. "Because input costs have risen so dramatically it is unlikely that a construction company will want to take on the risk of operating on that basis."

To get an Engineer Procure Construct & Manage (ECPM) contractor to take that risk would involve the mining company paying them a huge premium. The usual route is to go for a cost reimbursable structure. Essentially, there is a target price. There are bonuses if the contractor comes in below the target price and limited penalties if it over-shoots.

On the back of this, mining companies arrange contingent funding. This can be in the form of equity, mezzanine or senior debt. In some cases, cost over-run funding can come from the final off-taker.

Another factor that is increasing uncertainty is metal prices. Copper, for example, was below $1 per lb prior to 2005, currently it is around $3.50 and prices are a lot more volatile. And even then base metals can only be hedged out to seven years at the most.

This can pose challenges for hedging the output as exposures are much greater. Another issue is a potential conflict between the bank's need for certainty, namely hedged income streams, and shareholders' desire for exposure to any upside in metal prices. Usually, this is resolved by partial hedging or hedging only one of the metals.

Tenors for greenfield mining projects are typically 30% shorter than the mine's life. This can be under a decade. For projects located in emerging markets tenors will be shorter, possibly by two to three years. For example, this might involve a two-year draw-down during the construction phase. Typically there would be a cash sweep once the mine is operational with a view to amortising the debt ahead of schedule.

Margin levels depend on the credit rating of the country, the quality of the EPCM contractor and the quality of the off-taker can play a part. A junior operating in a developed country can obtain margins on senior debt of 150-300bp over LIBOR. In an emerging market this can be around 300-350bp. Once the mine is operational, it can be re-financed at 50-75bp lower. Equity tranches often represent over 30-50% of the project.

More complexity

A recent trailblazer for the mining sector was Equinox Minerals' $846 million Lumwana project in Zambia – the largest greenfield mine to date in Africa. The debt is $583.8 million.

During construction, debt tranches are priced at 350bp to 440bp over Libor, depending on seniority. Margins fall to 300 to 390bp once it is operational. With the cash sweep the nine-year loan should be paid off in seven. Around 30% of the output, mainly copper, is hedged.

It wasn't just the size of Lumwana that broke the mould. "if you look at any one aspect of this deal, it may have been done before," says Pramod Vijayasankar Director, Mining & Metals with Standard Chartered. The innovation was derived from being able to thread together all the different types of financing. Such as combining the senior and subordinated debt with commodity exposures, bespoke political risk insurance, ECA covered loans and partially guaranteed loans, not to mention the complex inter-creditor arrangements. "That's when you appreciate the level of innovation that has occurred to get all these different parties comfortable with the transaction," says Vijayasankar.

For example, the transaction was structured so the commodity hedging banks would have minimal interference in the operation of the mine. The fleet financiers have no recourse on the mine, although they have priority over its revenues.

Each financing is different and individual to the mine and its owner's needs. Last year, First Quantum Minerals put together a five-year $400 million structured deal. The loan is being used to refinance a previous facility and to fund general operations: the lead arrangers were BNP Paribas, Fortis Bank, Standard Bank, Standard Chartered Bank, and Bayerische Hypo-und Vereinsbank (Unicredit).

One of its innovations was to roll trade, corporate and project finance into one package. Another coup, was to fund properties in three jurisdictions. Two of them are in Zambia and Mauritania and the other in the Democratic Republic of Congo (DRC). The consortium managed to structure political risk insurance for all three jurisdictions. Indeed, countries such as the mineral-rich DRC represent a new frontier for banks, given the high levels of political risk.

Again there is a cash sweep to pay down debt and there are cross guarantees on the company's assets.

In some cases mining companies can turn to structured trade finance to expand an existing mine. Some deals – lasting up to five years – can be structured so the margin is calculated according to metal price rather than interest rates. This effectively insulates the user against interest rate risk.

More projects to come to market

According to mining analysts there are many mining companies likely to be seeking project finance. One of them is London-based Zincox Resources, which plans to invest $395 million into four projects, all metals related, but not all mines.

The company has a market cap of about £160 million and cash resources of around $100 million. "It doesn't intend to raise any significant equity, if any. It will use it's own cash resources to supplement the project financing," says a London-based mining analyst.

Other prospects for project finance include Peter Hambro Mining, which is looking into developing the Garinsky iron ore field in Russia estimated to be worth around $1.2 billion.

"We assume that there will be some sort of project finance facility on that. What it does is off-load the risk from the corporate entity onto the project," says the analyst. "Once up and running they generally become non-recourse."

Others with potential deals include International Ferro Metals, which might look for more project finance for the second phase of the construction of its furnaces. It raised £99 million in September 2005 floating on AIM and wants to join the ranks of the lowest cost ferro-chrome producers. The company has guaranteed off-take agreements with Jiuquan Iron & Steel Group Co, a Chinese steel producer and with Co-Metals, a trading company.

Nautilus Minerals, which is backed by Anglo American and Barrick Gold, could also be a contender. The sea-floor explorer has done several private placements and earlier this year raised $100 million in equity via Numis Securities for its Solwara 1 deep sea copper and gold project.

Israeli controlled Nikanor, which is re-opening a copper mine in DRC at the cost of $1.6 billion, is also in the frame say analysts. However, at the time of writing it had received a bid approach. It was reckoned to be looking for $650 million in additional funds to keep the project going.

Junk bonds

High-yield bonds from junior companies are steadily building a following with investors desperately hunting for yield.

These high-yield bonds, also known as junk bonds due to low credit quality, were given a boost when US mining company Freeport-McMoRan Copper & Gold sold the largest junk bond issue on record at $6 billion. It was to part finance its $26 billion purchase of Canadian mining group, Phelps Dodge.
However, Fidelity International recently warned that the nine-year rally in junk bonds is looking unsustainable.

Many of the juniors chose to issue convertible bonds, often with fairly low conversion rates to help get them away. Peter Hambro mining for example has a strong track record in this area.

Private equity groups buying mining companies could turn to project finance, and a big mining house falling to a private equity group is a real possibility. Merrill Lynch has touted BHP Billiton as an ideal prospect. The bank's analysts reckon metals are in a super cycle and expect prices to remain above historic averages for many years. Potentially providing the revenue stability private equity seeks. If a private equity group can lock in all the revenues and costs, it can bag an instant profit on its balance sheet.

The outlook for lenders is that with more sources of finance coming to the market, margins are likely to steadily tighten. The universe of project finance banks is relatively small with about 20 in all. But margins are already under pressure due to new entrants attracted by decent returns. Not all of them are banks either. Many are private equity groups, hedge funds or other specialist financiers, some from the oil and gas sector.

The generally positive outlook for metals with strong demand from the likes of China and India, is providing lenders with considerable comfort. Few analysts are expecting a slump in commodity prices anytime soon. In fact, many expect these markets to keep on rising due to the lack of new mining capacity after decades of neglect.