To the max
There are over 7,000 producing mines in the world, and more being
developed each year. Likewise, reserves in existing mines are being
depleted, which calls for the continual need to explore for and
develop new mineral deposits. Increasingly, major mining companies
are exploring and producing metals in underdeveloped regions of the
world. To justify the capital investment and the inherent risks
associated with emerging markets, the magnitude of international
mining developments has increased. Project finance has been a
useful tool for mining companies in an effort to redistribute risks
as well as enhance the returns of its shareholders. Historically,
the debt component in the financings has come from commercial
banks, export credit agencies (ECA's) and multi-lateral agencies.
As liquidity in the capital markets has increased, the
attractiveness to mining projects has grown, due to the terms and
tenor available. Even if a mine's production profile would support
a 15 to 20-year debt amortization, commercial banks and ECA's,
unlike the capital markets, are not likely to provide a suitably
long tenor. We expect more mining projects to be financed, at least
partially, through the capital markets in the coming years.
Generally, Fitch breaks down the credit risk analysis of a project finance transaction into the following areas: sponsors risk, construction risk, operation risk, off-take risk, sovereign risk, and structural (financial and legal) aspects of the transaction. While the above categories principally capture the risks of a mining project, there is a significant risk unique to mining projects: ore body risk. It is important to remember that many risk factors are prevalent in more than one of the above categories. For example, a complex ore body will be a component in analyzing the sponsors, ore body risk, completion risk, operating risk and off-take risk. All of the above risks can affect a project's ability to generate free cash flow and thereby jeopardize its ability to service its the debt obligations. This article will focus on how the above risks apply to mining projects and how each risk may be mitigated. Lastly, the paper will outline what characteristics are likely in mining projects that achieve investment grade ratings.
Ore body risk
The ore body is the single source of cash flow in a mining project. A strong, low cost ore body may be able to sustain a project through a number of construction and/or operating difficulties, which hopefully can be resolved through time and money. However, the best construction and operations can not save a project that is not blessed with an acceptable ore body. Therefore an accurate estimation of the reserves, grade and recovery and dilution rates is crucial to the success of the project.
While reserve estimates of a project will be based upon the feasibility study, independent analysis and confirmation of the reserve base are essential to accessing the debt markets. Reserve sampling has become quite sophisticated, which has improved the accuracy of reserve estimates, yet they remain estimates based upon assumptions subject to change.
The complexity of the ore body largely determines the degree of metallurgical risk in a project. Despite accurate reserve and grade analysis and successful pilot plant testing, the ore may fail to perform as expected when mined and processed on a large scale, leading to higher cash operating costs. It may also result in premature closure if the problems are sufficiently grave, as was the case for Pegasus Gold's Mount Todd gold venture. Mount Todd suffered from an extremely hard ore body that did not positively respond to the installed crushing and grinding systems. That, coupled with the high presence of hard-to-treat copper in the ore, resulted in a write-off charge of $422.9 million and greatly contributed to Pegasus' decision to file for Chapter 11 bankruptcy protection in 1998.
Sponsors risk
The quality of the sponsors is an important consideration when assessing the potential success of a project. It is critical not only to ensure the sponsors have the financial wherewithal to complete the project, but also to evaluate the sponsors' commitment to the project and their experience and track record with similar ore bodies and mining operations.
Strong sponsors have significant experience within the project's product market and also internationally. Fitch looks for previous involvement with similar mining properties that have been developed and operated successfully. Prior experience in the region and country where the project is located is desirable. Likewise, previous experience with the technology being employed is important, particularly the more complex the ore body and the mining processes.
Typically, sponsors will provide between 20-40% of the project's initial capital cost through equity and perhaps, deeply subordinated debt. In addition, the sponsors commonly will guarantee the project's debt obligations through construction completion. It is important to establish that the sponsors have the ability to meet all required financial obligations, including contingent liabilities and cost overruns.
The evaluation of the sponsor's commitment to the project, both from a quantitative as well as a qualitative standpoint is critical. The amount of equity capital at risk is an important indication of commitment. Likewise, the strategic importance of the project to the sponsor is considered (whether the project is critical to other operations of the sponsors, the sponsor will be a major off-taker, the project is high profile and the successful development of the project could lead to additional opportunities within a country or region).
It is not uncommon to have multiple sponsors of a mining project, particularly in large-scale (high capital cost) projects and projects that produce multiple metal products. This is usually the case as different sponsors bring unique and/or complementary skills and strengths that enhance the probability of a successful project. The larger the project, the more likely and more advantageous it is to have multiple sponsors, if for no other reason than the financial risk is shared. The involvement of a local sponsor is considered to be positive, as it may be more sensitive to and influential in the business and political environment within the country.
Completion risk
The analysis of completion risk focuses on the extent the debt-holders bear the risk that the project is not completed on time, on budget, and/or up to the performance standards required to adequately service its financial obligations. Because each ore body has its unique characteristics, completion risk in a mining project is greater than in other projects, such as power or infrastructure projects. During the construction and start-up stages, a mining project will experience its own learning curve, dictated by the ore body's characteristics, the processing technology employed and the experience and quality of the construction and operating management teams. As a result, it is not unusual for mining projects to experience start-up problems that result in capital cost overruns, delays in commercial production and higher than projected operating costs. Extreme cases in which start-up and/or construction problems are so severe and chronic that the projects are not completed and prematurely abandoned have caused many sleepless nights to lenders and sponsors.
The sponsors commonly guarantee a project's debt obligations through construction completion, although there have been capital market transactions in which the sponsors did not guarantee completion. In the case of the Murrin Murrin Holdings transaction, the sponsor, Anaconda Nickel did not provide a completion guarantee. Financial support for completion was instead provided through a combination of liquidated damages from the general contractor, a cost overrun account funded by Anaconda and completion insurance.
When a completion guarantee is provided, the definition of completion is negotiated between the project participants, and thus will vary from project to project. Strong completion tests incorporate solid measures for both mechanical and economic completion for a sufficient period of time to substantiate the project has reached a steady-state of performance. Economic completion standards should include a combination of production criteria, inputs that have an impact on operating costs; financial criteria; and legal criteria. One must ensure that the production and efficiency criteria are tied to the base case projections and are sufficiently tight to safeguard against a material deterioration of projected performance. The independent engineer hired on behalf of the lenders will be involved in all aspects of the project will confirm the reasonableness of the completion tests, monitor the administration of the tests and certify completion.
A luxury not afforded mining projects is choice of location. The need for mining companies to continually discover new deposits to replace existing properties that are depleting, has lead to mine exploration and development in increasingly remote regions of the world. In many cases, the existing infrastructure (roads, transportation, port facilities, housing and access to water and power) surrounding a promising ore deposit is inadequate to meet the requirements to develop and operate a mine, leading to projects being postponed. The specific infrastructure requirements of a project are examined to ascertain if adequate planning has been done and what, if any alternative arrangements are in place.
Strong projects will have a single source of liability for construction, which should be the EPC (engineering, procurement and construction) contractor. The EPC contractor should be liable for all subcontracted work. The importance of having strong contractors in the construction process cannot be overestimated. A track record of successfully completing projects on time, on budget and up to required performance standards is advantageous, and becomes critical when the project's characteristics are unique or unusually challenging. Previous positive experience in the country where the project is located is beneficial, as is the involvement of local contractors. Generally, local support for a project will be greater if local parties are involved. The staffing requirements and labor relations of the contractors are studied.
An element of a strong EPC contract is providing financial incentives for the contractors to complete their work on-time and on-budget. This is typically accomplished through a combination of holdbacks, bonuses and penalties. Once the project has met its completion criteria, contractors will typically provide warranties relating to the quality of the construction and the performance of equipment and facilities.
Operation risk
While many initial operating problems will be identified, and hopefully rectified, during the pre-completion phase, there is still substantial operating risk once the project has reached completion and the lenders no longer have recourse to the sponsors or contractors. Given that mining operations are both labor and capital extensive, major disruptions in either the labor force or equipment could have a detrimental effect on production and ability to sell the product. There are also a number of items, which may not lead to production interruption, but may adversely alter operating costs, including inflation, fuel prices, power costs, environmental issues and changes in regulations and ore body qualities less favorable than projected. Some of the elements that are important in minimizing operating risk are: adequate and stable labor force, protection against equipment failure, experienced and highly motivated management team, strong environmental policies and safeguards and suitable geographic location, both in terms of socioeconomic conditions as well as accessibility.
Off-take (market) risk
While a mining project may have long term off-take contracts for its production, the contracts will generally commit to volumes, with the selling price tied to the prevailing market price for the metal. Fitch examines the term of the contracts relative to the debt maturity and the credit strength of the off-takers. Once a mine is complete and operating at the steady state (production and cost) predicted in the feasibility study, actual annual cash flows can vary greatly from projections simply because of the commodity price risk inherent in mining projects. Thus, the greatest risk to debt-holders of a producing mine may be market risk. The best mitigants to market price risk are being a low cash cost producer and having a relatively low debt service break-even price. In order to achieve an investment grade rating, a project would need to be in the bottom quartile (or better) on the global cash cost curve and be able to fully service its debt at the cyclical price lows. Since price cycles have the natural consequence of removing high cost production in the troughs, a project's ranking on the cost curve will determine its competitive position and likelihood of profitability through an economic cycle.
To understand the relative price cycles of a particular metal, it is important to fully examine its supply and demand fundamentals, since imbalances between the two will result in dramatic price swings. While in the long run, supply is commonly described as production, other sources need to be considered as they may influence the market price in the short run, such as inventory stocks, central bank holdings in the case of gold and smelting bottlenecks. For example, central banks around the world maintain approximately 30% of gold in circulation, which represents roughly 10 years of current demand. The dramatic and sustained fall in the price of gold over the past four years can be largely attributed to actual (and equally important, the prospect of) sales by central banks.
The global supply of a particular metal is largely determined by its relative economic abundance and the appetite of investors and mining companies to explore for and develop new deposits. A mine will not be brought into production unless it is forecasted to provide an adequate risk-adjusted return to investors. We will analyze historical production and cash cost trends, projected new production via expansions and greenfield projects and expected shutdowns due to mineral exhaustion or high cost. Advances in technology that assist in improving the economic viability of a deposit are also studied.
The demand for a mine's output is determined by the range of its applications, factoring in the availability of viable alternatives. One must analyze the economic drivers of the end-users' industries to determine how cycles in those industries will affect demand for the commodity. Fitch examines the historical global usage of the metal product, cyclical trends, and fundamental changes that impact substitutability. The risk of substitution is driven by a number of factors: technological advances (copper wire being displaced by fiber optic cables); price volatility of the metal; relative scarcity of the metal; and environmental concerns and regulations.
Sovereign risk
Due to the depletion of mineral deposits in developed countries, mining exploration and development in recent years has increasingly focused on emerging markets, such as South America, Asia, the former Soviet Union and Africa. While this has brought great opportunity to players in the mining industry, it has added an element of vast risk to financing mining ventures. Fitch's analysis of country risk centers on three broad categories: the economic environment, the political and regulatory environment and foreign currency risk. There are structural features that can help alleviate country risk and allow the project to be rated above that of the host country. These enhancements include offshore hard currency accounts, involvement of preferred creditors, such as multi-lateral institutions, and political risk insurance. Nevertheless, the rating of the sovereign acts as a magnet to other ratings in the country, including projects. Thus, as projects shift to lower-rated emerging market countries, the ability to achieve an investment grade rating is lessened.
Economic and structural analysis
The goal of the economic analysis is to quantify all the various risks, to the extent possible, into a financial model to ascertain the project's ability to service the debt. The project's base case, which is derived from the feasibility study, will be scrutinized to determine the appropriateness of the underlying assumptions. The base case will then be stressed to evaluate the project's sensitivity to changes in the assumptions. Fitch will evaluate both the base case and the sensitivities on a constant dollar basis, recognizing that while inflation cannot be ignored, its effects on particular components cannot be accurately predicted over time. It is also easier to benchmark and compare projects to one another using constant dollar methodology.
The assumptions in the base case that will be stressed will depend on the overall risk analysis, which includes issues highlighted by the independent engineer's report. The items that will be sensitized are variables that influence revenues and cash operating costs, such as: the selling price of the output, annual tonnage and production, grade of the ore, recovery rates, selling price of byproduct credits and treatment and refining charges.
When rating a project, Fitch will judge a project's ability to service its debt throughout a typical price cycle. Because project finance transactions are long term and it is futile to predict the timing and duration of future cycles, we favor two methods to evaluate a project's sensitivity to metal price changes. The first is a debt service break-even analysis on a year-to-year basis. The second method is selecting a price that represents a conservative estimate of the low price in a cycle and use it throughout the project life. Both methods will help substantiate whether the project will be able to service its debt obligations throughout a normal price cycle, which is critical since the sources of liquidity are limited.
Investment Grade Criteria:
As evident by the above commentary, mining projects present numerous and substantial risks to the involved parties. The risks associated with each project transaction will vary greatly depending on the ore body, the geographic location, the market for the output, the project participants and the financing structure. Due to the inherent risks, Fitch believes that most mining projects will be rated in the speculative-grade category. Yet it is possible to achieve an investment grade rating on strong projects that minimize the risks assumed by the debt-holders. The following is a brief overview of project characteristics which warrant consideration for an investment grade rating, recognizing that any singular project will not possess every desirable attribute. While the goal of this overview is to provide some consistency in evaluating projects, it should be used only as a guide, as the assessment of relative strengths and weaknesses of each project will need to be weighed on a case by case basis.
Strong Sponsorship:
? Financially sound and investment grade rated;
? Experienced in successfully developing greenfield projects;
? Project output is core business;
? Substantial commitment to project, financial and strategic;
? Equity component to be at least 20% of the project's capital cost;
? Previous or current involvement in host country;
? Having local public/private partner.
Acceptable Ore Body Risk:
? Extensive and thorough due diligence by a host of independent experts;
? Relatively simple and uniform ore body;
? Reserve estimate insensitive to reasonably low output prices;
? Generous reserve and production tail after maturity of debt;
Minimal Construction Risk:
? Completion Guarantee from sponsors/other financially strong entity;
? Solid completion test criteria, including date certain completion;
? Experienced and financially healthy contractors;
? EPC fixed cost, turnkey contract, with ample cost and time contingencies;
? Proven, low risk technology,
? Adequate engineering, environmental planning and labor situation.
Moderate Operating Risk:
? Conservative estimates for grade, recoveries, dilution and stripping ratio;
? An experienced and deep management team;
? Adequate back-ups systems for operations and transportation;
? Suitable infrastructure;
? Sufficient budget for R&M expense and sustaining CAPEX.
Mitigated Off-take (Market) Risk:
? Low unit cash cost producer (bottom quartile or better);
? Low annual variability in unit cash cost and production;
? Ability to fully cover each year's debt service at the bottom of price cycle;
? Long term off-take contracts with well-established, highly rated entities;
? Price hedging requirements;
? Excess cash flow prepayments, equity distribution tests and ample reserve accounts.
Satisfactory Sovereign Risk:
? Stable economic, political and legal environment in host country;
? Offshore accounts for export proceeds and various reserves;
? Long term export off-take contracts denominated in hard currency;
? Preferred creditor involvement;
? Political risk insurance.
Generally, Fitch breaks down the credit risk analysis of a project finance transaction into the following areas: sponsors risk, construction risk, operation risk, off-take risk, sovereign risk, and structural (financial and legal) aspects of the transaction. While the above categories principally capture the risks of a mining project, there is a significant risk unique to mining projects: ore body risk. It is important to remember that many risk factors are prevalent in more than one of the above categories. For example, a complex ore body will be a component in analyzing the sponsors, ore body risk, completion risk, operating risk and off-take risk. All of the above risks can affect a project's ability to generate free cash flow and thereby jeopardize its ability to service its the debt obligations. This article will focus on how the above risks apply to mining projects and how each risk may be mitigated. Lastly, the paper will outline what characteristics are likely in mining projects that achieve investment grade ratings.
Ore body risk
The ore body is the single source of cash flow in a mining project. A strong, low cost ore body may be able to sustain a project through a number of construction and/or operating difficulties, which hopefully can be resolved through time and money. However, the best construction and operations can not save a project that is not blessed with an acceptable ore body. Therefore an accurate estimation of the reserves, grade and recovery and dilution rates is crucial to the success of the project.
While reserve estimates of a project will be based upon the feasibility study, independent analysis and confirmation of the reserve base are essential to accessing the debt markets. Reserve sampling has become quite sophisticated, which has improved the accuracy of reserve estimates, yet they remain estimates based upon assumptions subject to change.
The complexity of the ore body largely determines the degree of metallurgical risk in a project. Despite accurate reserve and grade analysis and successful pilot plant testing, the ore may fail to perform as expected when mined and processed on a large scale, leading to higher cash operating costs. It may also result in premature closure if the problems are sufficiently grave, as was the case for Pegasus Gold's Mount Todd gold venture. Mount Todd suffered from an extremely hard ore body that did not positively respond to the installed crushing and grinding systems. That, coupled with the high presence of hard-to-treat copper in the ore, resulted in a write-off charge of $422.9 million and greatly contributed to Pegasus' decision to file for Chapter 11 bankruptcy protection in 1998.
Sponsors risk
The quality of the sponsors is an important consideration when assessing the potential success of a project. It is critical not only to ensure the sponsors have the financial wherewithal to complete the project, but also to evaluate the sponsors' commitment to the project and their experience and track record with similar ore bodies and mining operations.
Strong sponsors have significant experience within the project's product market and also internationally. Fitch looks for previous involvement with similar mining properties that have been developed and operated successfully. Prior experience in the region and country where the project is located is desirable. Likewise, previous experience with the technology being employed is important, particularly the more complex the ore body and the mining processes.
Typically, sponsors will provide between 20-40% of the project's initial capital cost through equity and perhaps, deeply subordinated debt. In addition, the sponsors commonly will guarantee the project's debt obligations through construction completion. It is important to establish that the sponsors have the ability to meet all required financial obligations, including contingent liabilities and cost overruns.
The evaluation of the sponsor's commitment to the project, both from a quantitative as well as a qualitative standpoint is critical. The amount of equity capital at risk is an important indication of commitment. Likewise, the strategic importance of the project to the sponsor is considered (whether the project is critical to other operations of the sponsors, the sponsor will be a major off-taker, the project is high profile and the successful development of the project could lead to additional opportunities within a country or region).
It is not uncommon to have multiple sponsors of a mining project, particularly in large-scale (high capital cost) projects and projects that produce multiple metal products. This is usually the case as different sponsors bring unique and/or complementary skills and strengths that enhance the probability of a successful project. The larger the project, the more likely and more advantageous it is to have multiple sponsors, if for no other reason than the financial risk is shared. The involvement of a local sponsor is considered to be positive, as it may be more sensitive to and influential in the business and political environment within the country.
Completion risk
The analysis of completion risk focuses on the extent the debt-holders bear the risk that the project is not completed on time, on budget, and/or up to the performance standards required to adequately service its financial obligations. Because each ore body has its unique characteristics, completion risk in a mining project is greater than in other projects, such as power or infrastructure projects. During the construction and start-up stages, a mining project will experience its own learning curve, dictated by the ore body's characteristics, the processing technology employed and the experience and quality of the construction and operating management teams. As a result, it is not unusual for mining projects to experience start-up problems that result in capital cost overruns, delays in commercial production and higher than projected operating costs. Extreme cases in which start-up and/or construction problems are so severe and chronic that the projects are not completed and prematurely abandoned have caused many sleepless nights to lenders and sponsors.
The sponsors commonly guarantee a project's debt obligations through construction completion, although there have been capital market transactions in which the sponsors did not guarantee completion. In the case of the Murrin Murrin Holdings transaction, the sponsor, Anaconda Nickel did not provide a completion guarantee. Financial support for completion was instead provided through a combination of liquidated damages from the general contractor, a cost overrun account funded by Anaconda and completion insurance.
When a completion guarantee is provided, the definition of completion is negotiated between the project participants, and thus will vary from project to project. Strong completion tests incorporate solid measures for both mechanical and economic completion for a sufficient period of time to substantiate the project has reached a steady-state of performance. Economic completion standards should include a combination of production criteria, inputs that have an impact on operating costs; financial criteria; and legal criteria. One must ensure that the production and efficiency criteria are tied to the base case projections and are sufficiently tight to safeguard against a material deterioration of projected performance. The independent engineer hired on behalf of the lenders will be involved in all aspects of the project will confirm the reasonableness of the completion tests, monitor the administration of the tests and certify completion.
A luxury not afforded mining projects is choice of location. The need for mining companies to continually discover new deposits to replace existing properties that are depleting, has lead to mine exploration and development in increasingly remote regions of the world. In many cases, the existing infrastructure (roads, transportation, port facilities, housing and access to water and power) surrounding a promising ore deposit is inadequate to meet the requirements to develop and operate a mine, leading to projects being postponed. The specific infrastructure requirements of a project are examined to ascertain if adequate planning has been done and what, if any alternative arrangements are in place.
Strong projects will have a single source of liability for construction, which should be the EPC (engineering, procurement and construction) contractor. The EPC contractor should be liable for all subcontracted work. The importance of having strong contractors in the construction process cannot be overestimated. A track record of successfully completing projects on time, on budget and up to required performance standards is advantageous, and becomes critical when the project's characteristics are unique or unusually challenging. Previous positive experience in the country where the project is located is beneficial, as is the involvement of local contractors. Generally, local support for a project will be greater if local parties are involved. The staffing requirements and labor relations of the contractors are studied.
An element of a strong EPC contract is providing financial incentives for the contractors to complete their work on-time and on-budget. This is typically accomplished through a combination of holdbacks, bonuses and penalties. Once the project has met its completion criteria, contractors will typically provide warranties relating to the quality of the construction and the performance of equipment and facilities.
Operation risk
While many initial operating problems will be identified, and hopefully rectified, during the pre-completion phase, there is still substantial operating risk once the project has reached completion and the lenders no longer have recourse to the sponsors or contractors. Given that mining operations are both labor and capital extensive, major disruptions in either the labor force or equipment could have a detrimental effect on production and ability to sell the product. There are also a number of items, which may not lead to production interruption, but may adversely alter operating costs, including inflation, fuel prices, power costs, environmental issues and changes in regulations and ore body qualities less favorable than projected. Some of the elements that are important in minimizing operating risk are: adequate and stable labor force, protection against equipment failure, experienced and highly motivated management team, strong environmental policies and safeguards and suitable geographic location, both in terms of socioeconomic conditions as well as accessibility.
Off-take (market) risk
While a mining project may have long term off-take contracts for its production, the contracts will generally commit to volumes, with the selling price tied to the prevailing market price for the metal. Fitch examines the term of the contracts relative to the debt maturity and the credit strength of the off-takers. Once a mine is complete and operating at the steady state (production and cost) predicted in the feasibility study, actual annual cash flows can vary greatly from projections simply because of the commodity price risk inherent in mining projects. Thus, the greatest risk to debt-holders of a producing mine may be market risk. The best mitigants to market price risk are being a low cash cost producer and having a relatively low debt service break-even price. In order to achieve an investment grade rating, a project would need to be in the bottom quartile (or better) on the global cash cost curve and be able to fully service its debt at the cyclical price lows. Since price cycles have the natural consequence of removing high cost production in the troughs, a project's ranking on the cost curve will determine its competitive position and likelihood of profitability through an economic cycle.
To understand the relative price cycles of a particular metal, it is important to fully examine its supply and demand fundamentals, since imbalances between the two will result in dramatic price swings. While in the long run, supply is commonly described as production, other sources need to be considered as they may influence the market price in the short run, such as inventory stocks, central bank holdings in the case of gold and smelting bottlenecks. For example, central banks around the world maintain approximately 30% of gold in circulation, which represents roughly 10 years of current demand. The dramatic and sustained fall in the price of gold over the past four years can be largely attributed to actual (and equally important, the prospect of) sales by central banks.
The global supply of a particular metal is largely determined by its relative economic abundance and the appetite of investors and mining companies to explore for and develop new deposits. A mine will not be brought into production unless it is forecasted to provide an adequate risk-adjusted return to investors. We will analyze historical production and cash cost trends, projected new production via expansions and greenfield projects and expected shutdowns due to mineral exhaustion or high cost. Advances in technology that assist in improving the economic viability of a deposit are also studied.
The demand for a mine's output is determined by the range of its applications, factoring in the availability of viable alternatives. One must analyze the economic drivers of the end-users' industries to determine how cycles in those industries will affect demand for the commodity. Fitch examines the historical global usage of the metal product, cyclical trends, and fundamental changes that impact substitutability. The risk of substitution is driven by a number of factors: technological advances (copper wire being displaced by fiber optic cables); price volatility of the metal; relative scarcity of the metal; and environmental concerns and regulations.
Sovereign risk
Due to the depletion of mineral deposits in developed countries, mining exploration and development in recent years has increasingly focused on emerging markets, such as South America, Asia, the former Soviet Union and Africa. While this has brought great opportunity to players in the mining industry, it has added an element of vast risk to financing mining ventures. Fitch's analysis of country risk centers on three broad categories: the economic environment, the political and regulatory environment and foreign currency risk. There are structural features that can help alleviate country risk and allow the project to be rated above that of the host country. These enhancements include offshore hard currency accounts, involvement of preferred creditors, such as multi-lateral institutions, and political risk insurance. Nevertheless, the rating of the sovereign acts as a magnet to other ratings in the country, including projects. Thus, as projects shift to lower-rated emerging market countries, the ability to achieve an investment grade rating is lessened.
Economic and structural analysis
The goal of the economic analysis is to quantify all the various risks, to the extent possible, into a financial model to ascertain the project's ability to service the debt. The project's base case, which is derived from the feasibility study, will be scrutinized to determine the appropriateness of the underlying assumptions. The base case will then be stressed to evaluate the project's sensitivity to changes in the assumptions. Fitch will evaluate both the base case and the sensitivities on a constant dollar basis, recognizing that while inflation cannot be ignored, its effects on particular components cannot be accurately predicted over time. It is also easier to benchmark and compare projects to one another using constant dollar methodology.
The assumptions in the base case that will be stressed will depend on the overall risk analysis, which includes issues highlighted by the independent engineer's report. The items that will be sensitized are variables that influence revenues and cash operating costs, such as: the selling price of the output, annual tonnage and production, grade of the ore, recovery rates, selling price of byproduct credits and treatment and refining charges.
When rating a project, Fitch will judge a project's ability to service its debt throughout a typical price cycle. Because project finance transactions are long term and it is futile to predict the timing and duration of future cycles, we favor two methods to evaluate a project's sensitivity to metal price changes. The first is a debt service break-even analysis on a year-to-year basis. The second method is selecting a price that represents a conservative estimate of the low price in a cycle and use it throughout the project life. Both methods will help substantiate whether the project will be able to service its debt obligations throughout a normal price cycle, which is critical since the sources of liquidity are limited.
Investment Grade Criteria:
As evident by the above commentary, mining projects present numerous and substantial risks to the involved parties. The risks associated with each project transaction will vary greatly depending on the ore body, the geographic location, the market for the output, the project participants and the financing structure. Due to the inherent risks, Fitch believes that most mining projects will be rated in the speculative-grade category. Yet it is possible to achieve an investment grade rating on strong projects that minimize the risks assumed by the debt-holders. The following is a brief overview of project characteristics which warrant consideration for an investment grade rating, recognizing that any singular project will not possess every desirable attribute. While the goal of this overview is to provide some consistency in evaluating projects, it should be used only as a guide, as the assessment of relative strengths and weaknesses of each project will need to be weighed on a case by case basis.
Strong Sponsorship:
? Financially sound and investment grade rated;
? Experienced in successfully developing greenfield projects;
? Project output is core business;
? Substantial commitment to project, financial and strategic;
? Equity component to be at least 20% of the project's capital cost;
? Previous or current involvement in host country;
? Having local public/private partner.
Acceptable Ore Body Risk:
? Extensive and thorough due diligence by a host of independent experts;
? Relatively simple and uniform ore body;
? Reserve estimate insensitive to reasonably low output prices;
? Generous reserve and production tail after maturity of debt;
Minimal Construction Risk:
? Completion Guarantee from sponsors/other financially strong entity;
? Solid completion test criteria, including date certain completion;
? Experienced and financially healthy contractors;
? EPC fixed cost, turnkey contract, with ample cost and time contingencies;
? Proven, low risk technology,
? Adequate engineering, environmental planning and labor situation.
Moderate Operating Risk:
? Conservative estimates for grade, recoveries, dilution and stripping ratio;
? An experienced and deep management team;
? Adequate back-ups systems for operations and transportation;
? Suitable infrastructure;
? Sufficient budget for R&M expense and sustaining CAPEX.
Mitigated Off-take (Market) Risk:
? Low unit cash cost producer (bottom quartile or better);
? Low annual variability in unit cash cost and production;
? Ability to fully cover each year's debt service at the bottom of price cycle;
? Long term off-take contracts with well-established, highly rated entities;
? Price hedging requirements;
? Excess cash flow prepayments, equity distribution tests and ample reserve accounts.
Satisfactory Sovereign Risk:
? Stable economic, political and legal environment in host country;
? Offshore accounts for export proceeds and various reserves;
? Long term export off-take contracts denominated in hard currency;
? Preferred creditor involvement;
? Political risk insurance.
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