With a recovery cycle in full swing, mining and metals are the expected sweethearts of the project finance market for the coming year. There has been an enormous amount of equity capital raised - particularly in North America - in the last 12 months.

However, it will take time for that to emerge as project equity, according to market participants, so the market will really start to pick up in the next two quarters and into next year.

For non-US-dollar projects, however, this recovery process could take much longer. With a weak dollar and soaring costs, many companies and projects have yet to see any benefit from the rise in metals prices. This benefit will happen, say advisers, but it will be some time in coming. And it may require some change in attitude, on the part of shareholders, the companies themselves, and project financiers.

Russia - easier than oil

One area that has seen a lot of interest is in gold, although as yet few deals have gone forward with project financing for funding. Russia is a hotbed of new developments right now, with the large Sukhoi Log reserve in Siberia expected to be privatised soon, and a number of smaller deals under way. Sukhoi is the largest unmined gold deposit in Russia: it has an expected reserve of more than 20 million ounces, and capital development costs will run around $1 billion, according to market sources.

Norilsk Nickel is reportedly the frontrunner in the auction. Barrick Gold is vying to compete both independently and through Highland Gold, in which it recently increased its stake. Polymetal - based in St. Petersburg - is also in line, along with Khazret Sovmen - the former owner of Russia's largest goldmining operation Polyus, which it sold to Norilsk Nickel two years ago.

But how the auction will go forward is not yet known, as the eligibility of foreign mining interests to participate is still being debated. Pressure to rule out non-Russian entities was brought to bear by the last Russian parliament, among other interested groups, but no decision has yet been made. The parliament was formally dismissed last month, and a new parliament has yet to be called. The final decision rests with the regional government in Irkutsk and the federal Ministry of Natural Resources.

Regardless, with such a large project price tag, most Russian mining firms would likely look to outside partners for risk capital. In addition, some have speculated that frontrunner Norilsk Nickel would consider spinning off its gold assets and listing them on a foreign exchange. The auction parameters should be decided soon, however, as both Irkutsk and federal officials are aware of the staggering level of tax revenues and licence fees that such a large project will garner.

Aside from Sukhoi, Russia has strong potential for other big-ticket gold projects. Comments Gerard Holden, global head of mining and metals at Barclays Capital: "The interest in Russia as it stands is the strongest I've seen it. There are a large number of gold opportunities being explored there."

Canadian group Bema gold is developing the Kupol gold and silver deposit in eastern Russia. It has already announced a 4 million ounce reserve, with the potential to double that. It is expected this will come in as a $200 million to $300 million project finance deal. In addition, Trans-Siberian Gold has announced a 3.2 million ounce reserve, split between its Veduga venture in Siberia and its Asacha project in Kamchatka. The group has finished its bankable feasibility study for Asacha and is just beginning one for Veduga.

Africa - lowest first

In addition to new developments, a lot of older gold projects that were put on hold in bad market conditions are also being re-evaluated. Says David Street, director and head of mining and metals at NM Rothschild: "We are seeing renewed interest in gold, but not that many new projects being built to date." One exception is the Loulo gold project in Mali. Randgold Resources has mandated Rothschild, along with SG, to organize a $60 million loan backing the project, which is expected to go into production in mid-2005. Loulo, which is the third mining project for Randgold in the country, should average 200,000 ounces a year over six years.

The venture has an $80 million price tag and the government of Mali has a 20% share. But Street at Rothschild says this is one of few deals around on the gold side that will be project financed.

"Although few of these deals have gone forward with project financing so far, a number may consider that route as the pipeline of new gold projects starts to fill up."

There are also a lot of gold mines changing hand at present. South African mining group Gold Fields will sell a 15% stake to Mvelaphanda Resources for R4.1 billion ($623 million)- including a new equity issue, bank debt, and mezzanine debt (for more details, see Project Finance, March 2004, p8). And Barrick Gold has just bought an interest in Russian group Highland Gold. The group will increase its existing interest in Highland to 17% by investing $40 million for about 9.3 million shares - at 235p a share.

Outside gold, the past year has seen enormous base metals volatility, but also a general upswing and recovery, particularly in nickel and copper. Nickel, in particular, is benefiting from the turnaround. With nickel prices rising more than 70% over the last year, there are a number of new deals being given the go-ahead and a number of old plans being dusted off and polished anew.

Base instincts

Canada's Inco has announced plans to go ahead with the Goro nickel-cobalt project in New Caledonia. The deal was put on mothballs in 2002 when expected project costs soared from initial expectations of C$1.45 billion ($1.1 billion) to around C$2.1 billion.

The group began a review with an eye to cost savings in mid-2003 and announced plans to go ahead with the deal late last year. The goal was to bring capital expenditures down to around C$1.8 billion, which the group now says is feasible. Explains Scott Hand, CEO of Inco, in a statement: 'We believe we have found ways to reduce the capital cost in amounts that will make the project economic.' Cost savings of $225 billion have been projected, with more expected after further analysis.

"The results of the review to date have confirmed that we can have a project which is economically feasible and which can be implemented in a financially prudent manner," says Hand. "That's exactly what we intend to do."

The group is counting on $350 million in financing from the French government - agreed before the deal was put on hold - to go ahead with plans. It is also looking into further French-backed debt and will look for more direct financing as well, according to the company.

Inco's Voisey's Bay project in eastern Canada is also expected to go forward sometime soon.

As for new developments, BHP Billiton has just approved a long-awaited big nickel project in Western Australia - Ravensthorpe. The deal is not expected to use project financing, but it is indicative of the fact that people are looking at nickel projects, says one market participant.

Ravensthorpe was given the go-ahead by BHP Billiton in March, and is expected to have a price tag of $1.4 billion. The project will also involve increasing the refining capacity of Yabulu - BHP's metal refinery in Queensland - by more than double.

The project will see first production in 2007, which is also when Inco in Canada expects to see its nickel output increase significantly. When it goes ahead, the Ravensthorpe deal will make BHP Billiton the third-largest nickel producer in the world.

Under the hedge

One trend that has picked up momentum is in the realm of hedging. With highly volatile metals prices, there has been increasingly more investment coming from hedge funds looking to take advantage of the volatility. Says one participant: "At the moment, not a lot of companies are hedging metals prices even though prices have come up a lot. With many funds now investing, shareholders are putting pressure on companies not to hedge."

Says another market participant: "A fund manager that buys into a gold company wants to be exposed to the gold price. By hedging it is giving away the possible upside to the gold price," he says. "But they would say that at the top of the gold market. There is a lot of anti-hedging sentiment right now, especially in North America."

This is particularly interesting for projects that have an extremely low cost - where banks may be able to get comfortable to do project financings without hedging. "But for mid-level and higher cost projects some hedging will be required," adds the participant. Once bigger projects are under way this trend may well turn. "Companies need to tread a fine line on the hedge debate."

For those looking to go the project financing route, Holden at Barclays says there is no question - that tune will have to change. For many banks hedging is the only way to get their participation. Says Holden: "We are very clear on this. We will not finance a project unless there is some sort of risk management program in place, not just for commodity prices but preferably also for foreign exchange and interest rates. Companies will have to hedge if they are looking to get project financing."

Some projects, at least, are already choosing to take advantage of favourable prices and set up hedging programs. For Randgold's Loulo gold mining venture, a risk management program is already in place. To speed up the process or organizing financing and to ensure consistent debt repayment, the group has hedged 300,000 ounces of gold at $409 per ounce, on average. This will guarantee constant rates of return - at about 33% on gold prices of $350 and 46% on $400.

Exchange an art

With so much equity investment in the past year, and with a number of projects on the go, for some mining groups the future is looking pretty cheery. Yet for many, all of that equity investment has led to little improvement in their overall financial condition. As Standard & Poor's analyst Olivier Beroud explains in a report, rising costs are having an impact: "Balance sheets still remain aggressive and, despite improved prices, many companies face rising raw material and high energy costs, partially offsetting the effects of improved prices."

"Furthermore, after years of limiting capital expenditures to conserve cash, Standard & Poor's expects companies to substantially increase capital expenditures to replenish reserves or increase production," he adds. As such, the pace of debt reduction is not what could be hoped for given that the market now stands at a high point in the cycle. And thus, much new development and the growth of the project finance market must wait for this to work itself out and companies to once more stand on firm ground before it is likely to take off.

For those companies not funded in US dollars, there are other factors making it difficult to boost profitability. Says Street at Rothschild: "The weak US dollar versus other currencies is taking a toll, as the increase in metals prices has not really transpired in local currency terms. Thus, particularly for Australian and South African firms where the local currency has been very strong against the dollar, the improvements in base metal prices have not been as significant as elsewhere."

He adds that there needs to be some strengthening of the US dollar against these currencies before mining operations there will feel the benefit. "Companies with costs in US dollars are seeing the benefit but others are not experiencing much of a difference. This is, of course, very different from a couple of years ago when the Rand for example was much weaker. For these companies, it is presenting a new challenge," says Street.

Holden at Barclays says this poses a problem for any project where both capital and operating costs are not in US dollars: "We are seeing capital costs increased for non-US dollar projects in US dollar terms. The question for these firms is how deal with the conundrum of investing in high US dollar commodity prices but paying non-US dollar expenses. It is a very difficult economic decision to determine whether and how you finance projects in those areas."

He says South African gold producers have been hardest hit. "They are getting hit in a number of ways. The strong increase in the Rand - at somewhere around 30% against the US dollar in the past year - in combination with growing wage demands and a number of other political and economic factors have made it a difficult environment." But, he says that most other mid-tier companies have seen a benefit from the rise in base metal prices. "The majority of diversified companies have been okay. The increase in metals pricing has outstripped the costs associated with a weak US dollar or strong local currencies."

It will, however, take some time for cashflows to reflect increased sentiment that and for companies to take advantage of it and look for growth. Says one participant: "There is an incredible amount of equity flowing around and companies are raising huge amounts of money but this is not yet seen in profits. Some are making profits but not across the board. Until such time as this flows downward - until needed capital expenditures are met, debt reduction is effected and a balance is reached in terms of increasing material costs, the pace of project financing will not take off."

However, that is not to say the pipeline is completely dry. Apex Silver just completed a $150 million convertible bond issue through Barclays to finance its San Cristobal mine in Bolivia. With a $500 million price tag on the San Cristobal project, the group has plans to come to market with a project financing deal at the end of the year, according to market sources. And Canadian group Canico has plans to bring a project financing to market early next year to finance its Onça-Puma nickel laterite mine in northern Brazil. The venture is expected to cost around $600 million.

"There are some spectacular deals coming to market, but there are also a number of average projects coming through," says Holden. "The key message for bankers and investors is not to make the same mistakes as last time we were at this point in the cycle. Remember where we were two or three years ago and handle things appropriately this time around. It is fundamental to look at the position of projects on the cost curve and sensitise cashflows properly."