In the week beginning 28 November record highs were reached across commodity markets: gold confidently broke $500 a troy ounce and was trading at a 23-year high; silver was at an 18-year high above $8.60; platinum was through $1,000 a troy once – a 25-year high; aluminium was at a 16-year high at $2,284 a tonne; zinc was at a 15-year high on $1,777 a tonne; copper was at a record $4,445 a tonne; and lead at a record $1,069 a tonne.

Ironically this puts miners in uncharted territory because concurrent with the growth in commodity prices the dollar has strengthened against the euro, yen and sterling on the back of expected Fed interest rate rises. This runs counter to the long-held inverse relationship between commodity prices versus equities and the dollar. Usually commodities provide a hedge against a falling dollar and underperforming securities, but seemingly this relationship has now broken down.

With metals pricing at such levels, a stampede toward new mine commissioning appears logical. But given the size of the highs there are also more risks for projects in terms of a downtrend or correction. Simply put – are current metals prices a blip? Consensus among financiers appears to be 'yes – but' with many expecting metals prices to fluctuate at higher levels albeit down from these current highs.

Natural hedge

Most mining project financings should be robust enough to withstand all but the most calamitous burst bubble. Project financings provide a solid natural hedge against commodity price fluctuations because most mining projects are relatively low cost and banks set their base-case scenarios on prices considerably lower than current spot prices.

Nevertheless there are some worrying signals that some metals' prices, and in particular gold and copper, are moving independently of fundamentals – perhaps a forewarning of an impending bubble. Gold prices have moved strongly upwards despite US economic data showing a dampening of inflation (gold is usually a hedge against inflation). Meanwhile in the copper market a game of poker is being played out between hedge fund managers in London and China's Strategic Reserve Bureau (SRB).

The SRB is believed to have sold short a large copper position in London, some 100,000 to 200,000 tonnes. Some commodity hedge funds are long on copper believing that the SRB will not be able to cover its losing short position by flooding the market. On Wednesday 7 December the SRB, sold 3,400 tons of copper at an auction out of 20,000 tons initially offered, which appears to indicate that China is looking to offset its loss by restricting the supply of copper to push up prices. The dilemma facing fund managers is that China, now a sizeable producer of copper in its own right, is believed to have been stockpiling copper for 10 years and no-one apart from top Chinese officials knows how large these stockpiles are. In one stroke the price of copper could plummet.

Hedging a double-edged sword

Given the 'black box' nature of Chinese inventories and volatility brought about by speculation, mining project lenders wisely ask for hedging – where it is available – from the sponsor in their covenant package.

A recent hedging example is the project financing of Apex Silver's San Cristobal open pit silver-zinc-lead project in southwestern Bolivia, which reached financial close on 6 December.

Barclays Capital and BNP Paribas lead arranged a $225 million facility for the project. At the designed production rate of 40,000 tonnes of ore per day, San Cristobal is expected to produce about 22.3 million ounces of payable silver, 182,500 tonnes of payable zinc and 85,000 tonnes of payable lead per year in the first five years of production, making it one of the largest producers of these metals in the world.

The financing consists of a $175 million facility syndicated among a total of 11 major international financial institutions and a $50 million loan provided by Andean Development Corporation, a multilateral financial agency that promotes the sustainable development and regional integration of its 17-member shareholder countries (including Bolivia).

As part of the conditions precedent of the financing Apex was required to have hedging in place. Apex's strategy was to hedge the minimum amount of metals possible to make lenders comfortable whilst maximizing shareholder-value upside potential relative to the price of silver. The hedging comprises a combination of forward sales and a variety of call options (struck at different prices) covering around 10.4 million ounces of silver, 358,150 tonnes of zinc and 159,000 tonnes of lead over a seven-year period (the mine is projected to have a 16-year life based on existing proven and probable reserves and throughputs). These hedge positions represent about 3.5%, 12.6% and 14.7% of planned life-of-mine payable production of silver, zinc and lead, respectively.

Hedging is a balancing act between lenders and the shareholders of the sponsor who invariably would rather adopt an un-hedged 'blue skies' approach that maximises upside against the needs of lenders for protection. Hedging is therefore something that sponsors tend to grin and bare but essential to make project financings sit with banks' credit committees, particularly for junior single-project companies.

The irony of hedging is that because it is a condition precedent to financing, it is put in place before drawdown often a year or more before the commissioning of the mine. If the mined commodity goes up in price thereby strengthening the underlying fundamentals of the project, the sponsor will in fact post sometimes sizeable losses due to losing puts marked-to-market on the commodity.

For the first nine months of 2005 Apex Silver posted a mark-to-market loss related to metals hedging of $7.6 million compared to a $0.4 million mark to market gain for the same period in 2004. The increased loss during 2005 is the result of pre-closing covenants related to the San Cristobal financing.

Such increased forward sales and derivative positions increase volatility in sponsors' future earnings and may have a detrimental affect on potential investors. The fair value of open positions are reported at the end of each accounting period, recording the difference in the carrying value to the current net loss, in accordance with FAS No. 133. Fair value measurements may fluctuate substantially from period to period based on spot prices, forward prices and quoted option volatilities.

No market, no hedge

While hedging, where available, is a standard requisite of most mining project banks – and rightly so given that the benchmark debt-equity ratio on mining projects is 70/30 – there is little liquidity for long-term futures contracts of five to 10 years beyond the gold and silver markets. Other metals tend to be hedged with a combination of shorter term contracts with varying strike prices.

But where there is a limited-liquid terminal market such as for mineral extractions hedging is impossible. Here lenders ask for robust marketing agreements or guaranteed offtake with a strong counterparty.

In August 2005, Sumitomo came in as 25% shareholder with an offtake agreement on the $2.25 billion Ambatovy nickel project in Madagascar, with the original shareholders Implats and Dynatec reducing their stakes to 37.5% each. While gaining a sizeable chunk of the upside, a heavyweight such as Sumitomo can also bring huge benefits to a project.

The offtake agreement stipulates that Sumitomo will ensure that for the first 15 years of production not less than 30,000 tonnes per year of nickel produced by the project will be acquired by offtakers (or, if required, by Sumitomo) on an arms-length basis. In effective Sumitomo is backing its marketing and trading acumen. Sumitomo will also provide pro rata completion guarantees and may provide a subordinated loan to Dynatec for its equity contribution to be repaid out of distributions, and may also stump up Dynatec's pre-completion guarantee in exchange for Dynatec shares.

The $269 million financing of Kenmare Resources' Moma Titanium project in Mozambique set a precedent for junior miners producing a commodity for which there is no liquid terminal market. With the financing in place Kenmare effectively quadrupled its size. Given the few buyers in the titanium compound market it was necessary to have offtake in place as well as conservative base case assumptions as the cornerstone of the project financing. The largest demand for titanium feedstock – some 94% of total demand – is for the manufacture of titanium dioxide pigment, which improves the opacity of paint. At financial close Kenmare had 57% of the first five years of production under contract to offtakers Dupont and Mitsui.

Newer sources of equity

Aside from the operation of a junior in an illiquid market, the Moma project was also significant in the way Kenmare sourced its equity stake for the project. While the lending appetite to well structured mining projects seems unremitting, juniors and mid-tier companies with the help of their advisers are becoming more creative at raising the requisite level of equity.

Mining is witnessing a growing number of advisory mandates that encompass not only the sourcing and negotiation of the terms of the project debt including political insurance, but are holistically weaving in raising equity as a condition of the financing by a share issue or through equity and quasi-equity participation by multilaterals.

A key issue regarding the issue of shares is timing. Does the sponsor tap the equity markets first and then put together the project financing, or, as in Kenmare's case, work out the structuring with the equity a condition of the finance and issue the shares toward the end of the process? It is a chicken and egg scenario. Adopting Kenmare's approach a sponsor is able to show added-value to the investor and may be able to price the issue higher than it otherwise would have done and either raise more money or avoid dilution. However, this is a risky strategy, particularly in a turning market where a placement could be unsuccessful and the sponsor would have to bear the sunk cost of arranging a moribund deal.

Another useful source of equity is available through equity and quasi-equity subordinated loan facilities provided by the multilaterals, principally the EIB and IFC.

Kenmare's Moma project was backed by a £55 million subordinated tranche, which decreased the level of equity required. The Dutch development bank FMO took Eu15 million ($18.5 million) of the subordinated debt, with the European Investment Bank (EIB) taking Eu40 million.

The EIB as a senior lender has in the past had something of a risk-averse image in the market, but under the Cotonou Partnership Agreement signed in June 2003 the EIB is able to support African Carribean and Pacific states' private sector and commercially run public sector projects with loans, guarantees and a series of risk sharing instruments. Among others, this includes subordinated loans to the Moma project and more recently a $50 million subordinated tranche in Equinox Minerals' Lumwana copper project in Zambia.

Symptomatic of the EIB's risk-sharing attitude, the bank is using sliding interest rates on its junior loans with a floor and cap, so as a project provides a higher return the EIB facility has a higher interest. In this way the bank aligns itself more closely to the sponsor than the lender group, almost the antithesis of hedging. It has been mooted that the structure could be used on senior facilities but it is difficult to see how this could work pari-passu commercial lenders given that it runs counter to normal lending considerations – if the project is not meeting expected returns the risk of default is greater so the lending rate should increase not go down.

The IFC is also providing greater equity support to mining projects. On 6 December the IFC provided a $25 million subordinated piece as part of the equity contribution to the Kupol Mine project in North-eastern Russia. The facility, which is non-recourse to project sponsor Bema, will have an eight and a half year term from drawdown. As part of the agreement, Bema will issue 8.5 million share purchase warrants to the IFC entitling the purchase of one common share of Bema at a price of US$2.94 per share. The proceeds from the exercise of the warrants will be used to repay the loan (see box below).

How long the lag?

While placements and multilaterals are helping miners raise their equity contributions and banks are willing to lend to well-structured deals, there is still a supply-side lag to the commodities markets.

Despite inventories approaching all time lows, and prices shooting upward, supply has been held back in the past because most of the high-value extraction areas have been in places of high political risk. This bottleneck appears to have been overcome with new mines moving toward commissioning across risky areas and political insurers and ECAs providing cover. The principal hurdles now facing producers are spiralling engineering, procurement, contracting and operating costs. Although not impossible, these costs are difficult to hedge. Greenfield mines are now effectively competing with existing mines operating from a lower cost base. Still with conservative base-case assumptions and a higher calibration of commodities prices there should be – to a lesser or greater extent – profits all round.

Box: Kupol financing secured

Chukotka Mining and Geologic Corporation (CMGC) signed financing of up to $425 million for the construction of Kupol mine on 6 December. The deal is notable for tapping a triple source of consideration for loan facilities – a combination of hard cash, gold and shares in a sponsor – and is one of the largest project financings of a mining project in Russia.

The project company CMGC – owned 75% by Bema and 25% by the Russian local government of Chukotka – has signed loan agreements for up to $425 million of financing for the construction of the Kupol Mine. The loans consist of a non-recourse loan for up to $400 million and a corporate loan for CMGC of $25 million. Endeavour Financial acted as the financial adviser to Bema.

The project loan consists of two tranches. The first tranche, for $250 million over 6.5 years is fully underwritten by the mandated lead arrangers, HVB and SG. The second tranche for $150 million over 7.5 years is lead arranged by Caterpillar Financial, EDC, IFC and Mitsubishi. In return for a $50 million portion that Mitsubishi is stumping up, Mitsubishi will receive a portion of the gold that is produced, as well as handle contracts for derivatives transactions designed to hedge against gold prices.

The total cost for the construction of the Kupol Mine is about $470 million. As part of the project equity contribution, CMGC has signed a subordinated loan for Kupol with the IFC for $25 million in exchange for share purchase warrants (see main text). Bema's remaining equity contribution to the project will be about $53 million and the government of Chukotka will be responsible for contributing about $18 million of equity. Bema's equity will be funded from a portion of the $120 million equity financing completed on 5 October 2005.

Drawdown of the project loan and IFC loan is expected in the first quarter of 2006. The material conditions precedent for drawdown are final construction permits for Kupol (expected in early 2006) and equity contributions from Bema and the Government of Chukotka.

HVB has also agreed to provide, at Bema's option, a $17.5 million cost overrun facility. If Bema exercises the company will issue to HVB convertible unsecured notes with a seven year term. The conversion price of the notes will be a 35% premium to Bema's average share price in the 20 trading days following the initial drawdown of the project loan.

Bema is currently on budget and on schedule to commence production in mid 2008, with an estimated resource of 4.2 million ounces of gold and 53 million ounces of silver.