There is a busy pipeline of new mining projects moving towards financial close over the next six months, as metals producers cash in on the price boom. And to keep lenders comfortable that means hedging a significant amount of production over the first few years of mining operations.

However, the level of hedging is becoming a source of heated debate between project developers and banks. The past five years has largely been an era of de-hedging, with the big producers preferring to take on added risk, but leave themselves with upside potential when commodity prices rise. They may do some currency hedging to protect their earnings stability, but prefer to leave themselves highly leveraged to commodity prices.

De-hedging

To take one example, the global hedge book for gold has been steadily shrinking, and big producers have strategies to reduce hedged positions still further.

One high profile example this year involved Barrick completing its acquisition of Placer Dome, and quickly setting about the task of closing most of the Placer Dome hedge book. "The company remains committed to its policy of reducing existing gold sales contracts," a statement explained. "With the acquisition of Placer Dome we will inherit additional contracts, but will continue to reduce the total number of contracts we hold, increasing Barrick's leverage to the gold price."

The first move was to eliminate all of Placer Dome's outstanding call options, as well as some of their forward contracts, representing a reduction of 1.5 million ounces. As of mid-February, Barricks' combined gold sales commitments totalled 18.5 million ounces, and out of this 9.5 million ounces of the hedge position has been allocated to the Pueblo Viejo and Pascua Lama development projects.

Newmont Mining Corporation also has a strategy of keeping hedging to a minimum, and tends to hedge on specific projects only in order to attract bank financing. As far back as 2002, when it acquired Normandy, Newmont set about reducing the Normandy hedge book in accordance with a no-hedging strategy, and in 2003 largely eliminated the Australian hedge book.

Newmont has sizeable gold interests in Peru, where it owns the Minera Yanacocha mine, but its latest big area of growth is Ghana. In January of this year Newmont closed a $125 million A-B loan for the development of the Ahafo mine in Ghana. This comprised a $75 million A loan from International Finance Corporation, and $50 million from group of commercial banks including RBS and Calyon.

The problem for miners is that hedging can mean carrying sizeable accounting losses because of having to mark-to-market a hedge book. AngloGold Ashanti is suffering form this at the moment and is restructuring its hedge book. Analysts expect to see a reduction in the amount of hedging, as well as a more simplified hedge book.

Keeping hedges simple

It is notable that where developers are hedging, the new philosophy is to keep it simple. Derivatives are being replaced by vanilla products. So-called exotic options, which were a fast growing product area for investment banks in the 1990s, have become virtually extinct. The days when bank loan arrangers could boost their fees by structuring complex derivatives transactions for their clients are gone.

"There is a tendency among producers to simplify existing hedge cover," comments one gold analyst. "Recent examples include Barrick's elimination of Placer Dome's barrier sold call options, and Buenaventura's conversion of its derivatives into simple forward sale contracts."

And he notes that the overall global hedge book continues to shrink in size. "Fresh hedging in recent months has largely been connected to conditions of loan facilities related to the development of new mines," he says.

For example, last December the San Cristobal project in Bolivia put together a financing package, led by BNP Paribas and Barclays Capital. In addition to a $50 million loan from Andean Development Corporation, a $175 million commercial loan was syndicated, and a pre-condition of this was that sponsor Apex Silver put hedges in place going out as far as seven years, on part of the various expected production of silver, lead and zinc.

Last December the $400 million debt financing closed for the Chukotka gold and silver mine in Russia, led by HVB and Societe Generale. The term of the loan was seven years, and in addition to Political Risk Insurance the lenders also required a system of hedges to protect lenders from the project undershooting estimates.
"Whatever numbers you can lock-in will underpin the economics of the project," says Don Newport, Global Head of Mining Finance at Standard Bank. "But generally speaking, in today's environment, our clients want straightforward plain vanilla hedges rather than complex derivatives."

Newport points to a large number of new mining projects nearing financial close around the world on the back of high commodity prices.

"For example, in the Democratic Republic of Congo, there has always been a lot of potential, and now that the elections are out of the way there, a lot of activity," he says. "And in Peru we are seeing a lot of activity, particularly from smaller indigenous mining companies."

Standard Bank is also involved in the Caldag nickel project in Turkey, which is expected to reach financial close in the first quarter of 2007. Together with Societe Generale and Standard Chartered Bank, it is arranging a $175 million debt facility. The sponsor is European Nickel.

Different strokes for different sponsors

For some of these projects there may be alternatives to hedging depending on the strength of the sponsor. One rare example where hedging was not insisted on by bank lenders is the Cerro Verde financing in Peru, which closed in September 2005. Phelps Dodge was not required to hedge the copper output, being instead trusted to use its vast experience to manage the successful marketing of the metal, along with its co-sponsor Sumitomo Metal Mining Co and Sumitomo Group. Sumitomo Corporation and Phelps Dodge are offtakers for most of the capacity of the mine.

Instead of insisting on hedging, the bank lenders put alternative safeguards in place. If certain financial targets are not met, then Phelps Dodge can buy down some of the debt. And the leverage of the project is also very low, in this case $450 million of debt with $443 million of equity.

Indeed some of the very biggest producers are currently so flush with cash that they may prefer to debt finance via corporate loans on balance sheet, rather than be forced into hedging their production in new mining developments.

Bankers can be flexible with a big global producer, but the rules are different for junior mining companies, who will still find that they will have to hedge upwards of 50% of production in the first few years of a project in order to get bank financing.

Some of these companies are now Chinese, going overseas as part of the drive to secure supplies of oil, coal and precious metals. In Zambia, for example, where there has been a notable number of mining projects with Chinese sponsors. The Chambeshi copper mine was acquired in 1998 by China Non Ferrous Metals Industries Corporation, and is now being run by NFC Africa Mining, producing over 50,000 tonnes of copper concentrates a year. Meanwhile Chiman, another private Chinese company, is developing a manganese mine in Zambia.

The big project currently approaching financial close in Zambia is the Lumwana Copper Project located in the north of the country.

The sponsor is Equinox Minerals of Canada, which has already successfully raised capital in the equity markets. Equinox is currently putting in place $355 million worth of project debt, in a financing that will feature a wide variety of Export Credit Agencies, development banks and commercial banks, and will include a subordinated tranche.

Among those expected to participate are Export Finance and Insurance Corporation (EFIC) of Australia, Export Credit Insurance Corporation (ECIC) of South Africa, African Development Bank, European Investment Bank, FMO of the Netherlands, and KfW and DEG of Germany. The mandated lead arrangers are Standard Bank, WestLB and Standard Chartered.

Chinese complications

The picture is complicated by the role being played by the Chinese economy in the rise in commodity prices. Chinese companies are scouring the world for opportunities to secure future supplies of gold, copper, zinc, lead and aluminium, in addition to oil and coal. Thus forecasting the continued strength of demand from China is a key factor in forecasting the future of commodity prices.

Even if it is hedge funds that have been responsible for some of the price increases and volatility over the past two years, it is the underlying demand from China that has come to dominate the medium picture for commodity prices.

Many contractors and offtakers involved are now Chinese, and they are bringing with them Export Credit Agency backing from China, plus the involvement of domestic commercial banks. But lenders say that, so far, this is not leading to more aggressive structuring or loan pricing, and that Chinese banks are taking a conservative view.

"Lenders have become comfortable with having Chinese offtakers for commodities such as nickel or copper, and we are now also seeing more Chinese contractors bidding to build plants," comments Martin McCann, partner at Norton Rose in London.

"While hedging is still required in all project financings, it has to be remembered that with commodity prices at historic highs, many of the mature projects are at a competitive disadvantage given the future prices agreed two or three years ago," McCann adds.

Indeed some older project sponsors have looked on in dismay as prices have soared, leaving them either with forward sales contracts well below market prices, or even worse with derivative contracts that have to be marked to market, leading to accounting losses.

Having hovered around $400 in 2004, by November 2005 gold was breaking through $500, to its highest level in over twenty years, and continued its surge in the spring months, driven both by underlying demand fundamentals but also by speculative hedge fund money. It was $640 an ounce in early September, before falling to $559 in early October.

Meanwhile silver continues to ride high at $11 an ounce, a level not seen in twenty years. Platimum is at over $1,000 an ounce. High grade aluminium trades at a twenty year high of $2,500 a tonne. Copper has soared this year to $7,400 a tonne. And zinc to $3,700 a tonne.

For mining companies, the tendency is currently to accept a higher level of risk, but reap the benefits. They do not want to be in the position of mines which began operations in 2003 or 2004, many of which are currently selling their production at less than half the spot price.

In addition, for most big mining companies, the current challenge is to expand output fast enough to take advantage of buoyant market conditions, and to deliver new projects on time and to budget.

PricewaterhouseCoopers notes that in 2005, there was a 31% increase in capital expenditure across the global mining sector, but that still left many producers with extra cash on their hands.

"Distributions to shareholders increased to $16 billion during 2005, and gearing fell to only 16%," says Hugh Cameron, PricewaterhouseCoopers Global Mining leader. "Unless the industry is able to identify attractive new developments or acquisition opportunities, investor pressure will mount for increased payments to shareholders," adds Cameron.