From Gold to Dust in South American Mining

Last month, citing the need to exercise greater control over national mineral resources, Ecuador suspended exploration and revoked a series of mining concessions. Late this week, Venezuela banned open-pit mining, and halted all activity in the vast Imataca reserve, which includes the town of El Dorado in the remote south-eastern part of the country.Equity and debt prices for internationally listed companies mining in large parts of Latin America have deteriorated sharply in recent weeks. What does the future hold?

Before assessing where prices, ratings and insurance costs are headed, it is critical to address the ideological gap: while foreign companies already invested in Latin America are claiming, expressly or implicitly, that left-wing governments are reneging on lawful contracts, the Latin protagonists of new legislation are making the case that existing laws are outdated, and bear no relevance to the fundamentals being cited by international companies, to either boost share prices or to reflect the value of securitized assets.

For example, the Ecuador mining condominium structures were conceptualized, historically, in an extremely restrictive context, to encourage small-scale placer-based exploitation of gold and silver; though a plain reading of the law has resulted in condominium concessions passing into the hands of foreign listed companies, such transfers are without foundation if the correct historical interpretation of the law is applied. Government royalties reflected in condominium-type mining properties are not legitimate for larger, mechanized operations undertaken with modern technologies.

Risk Insurance syndicates who have provided Latin American mining coverage over the previous decade are now in a quandary of their own making. Quite overwhelmingly, the pricing of risk on equity and securitization was predicated on the notion that the value of foreign capital, and fiscal realism, would far outweigh transitions in government. Quote Platform has always maintained that such risk was under-priced, and for good reason.

The pricing of political risk entails a thorough understanding of the law of the land, and the sustainability of such law within the framework of an evolving economic and political reality. Risk cannot be priced on populist notions, however persuasive.

Ever since the early 1990s, it was apparent that developments in Latin American mining laws (with few exceptions) were lagging the new emerging reality. In effect, laws which are inherently crying for change must attract a higher-than-usual risk premium.

Quote Platform must point out that the decline in share prices of Latin American-based mining companies does not represent the truth on the ground at all. At this juncture, the very concept of an equity valuation in countries like Ecuador, Venezuela, Bolivia and Nicaragua is undergoing substantive change.

The problem of pricing of Latin American corporate debt and equity has, without doubt, been aggravated by the widely-respected rating agencies who have blundered badly in utilizing two flawed statistical formulations for their assessments: (a) GDP growth data to determine that a vibrant business climate is either already in place or just around the corner and (b) the quantum of mining revenues to assume that future governments in the region will be hesitant to upset foreign investors.

Today, informed sources inside those agencies acknowledge that GDP growth numbers should not have been confused with poverty statistics. And as far as mining revenues are concerned, Latin American governments are realizing that foreign capital, if available, must be employed to prove up national mining reserves in the first instance, not to exploit existing concessions with proven surface mining opportunities.

In this regard, it cannot be over-emphasized that end-user pricing only enters the risk equation if there is a product to sell; we are dealing now with a situation where many of the international companies may have to spend money on identifying reserves, not on exploiting them, if they are to sign equitable agreements in Latin America through the course of 2008 and 2009.

 

 

 

 

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CREDIT QUALITY Heading towards Chaos, Catastrophe

Wall Street analysts and prominent economists are trying to convince investors that the worst of the mortgage debt crisis may well be over, and that the fundamentals disclose a sustainable basis for a gradual turnaround. In reality, unless there is a dramatic adjustment in the pricing of loans within the property market, any type of optimism is simply misplaced. For example, if all the facts (not theories) pertaining to 15-year mortgages are brought into play, the current rate, under 6%, needs to be revised to at least 9%, unless borrowers can prove credit quality in specific circumstances.

 

Primarily, the sub-prime crisis was triggered by valuations which were technically faulty and hopelessly inadequate. And, by all accounts, no analyst, economist or lawmaker has learnt the true lesson which history provides: the entire real estate industry has been unable to deal comprehensively with the risk inherent in property appraisals, particularly the risk embedded in the gap between a supposedly updated assessment on one hand and the variables which shape the debt service ability of borrowers over a period of 10, 15 or 30 long years.

 

To compound the problem, risk managers in financial institutions have clearly failed to meet the challenges represented by the securitization of mortgage debt. In the briefest of terms, a securitization process results, albeit indirectly, in a definite identification of the parameters of the underlying debt, an imperative which has serious consequences in the event of default. Hundreds of thousands of middle class homeowners are complaining that they are unable to find friendly bankers willing to restructure housing loans in line with changed circumstances; but nobody is telling desperate borrowers that the their debt is no longer subject to traditional client-banker relationships, and their loans have been repackaged and sold down to independent buyers all over the world.

 

More importantly, it is indeed surprising that there is no public recognition of the fact that the servicing of mortgage debt in the forthcoming months will be conditioned by a host of other factors: credit card defaults, rising food and energy prices, the decline in job quality and the performance of the equity markets. It does not take a rocket scientist to know that the ability of an average family to fulfil mortgage commitments in a timely manner is linked to several other obligations. Logically, statistical data used to develop forecasts for home prices must incorporate vital information impacting the quality of family balance sheets.    

 

For reasons which are very obvious, neither Wall Street nor Washington is ready to accept the proposition that mortgage spreads need urgent upward revision, regardless of where benchmark interest rates are headed over the next year or so. Of course, higher interest rates will further pressure debt quality. However, the conceptual crisis of the day concerns spreads, and the very risk matrix upon which such spreads are determined.

 

So how, if ever, will spreads (and prices) converge with reality? Or is the reality so unacceptable that mortgage lenders will be happy moving from one crisis to another, and applying temporary solutions in the process?

 

The near-term prospects for homeowners are dismal indeed. It is difficult to see any economic event on the horizon which will boost family incomes. And it is never a good idea to rely on promises of solutions (from Wall Street and from politicians) when there is no recognition and acknowledgement of the problem in the first instance. Ignorance, compounded by the right dose of incompetence and wilful blindness./

 

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Equity or Debt? Which is cheaper?

The question—debt or equity?—is rarely raised in North American corporate boardrooms. A good part of the blame rests with the fundamental structure of the financial marketplace: both the brokerage industry and the retail investor segment is governed, almost entirely, by the need to trade instruments (stocks) which inherently incorporate substantial short-term upside. But corporate managements must also be blamed for failing to substantiate business models capable of reasonable analytical scrutiny; after all, without a clear direction, it is impossible to draw any qualitative distinction between the respective roles of equity and debt in a corporation’s growth strategy.

 

The traditional argument against the applicability of debt for juniors is premised on the notion that, without hard asset security (perhaps in the form of proven reserves), a debt issue is not a viable proposition. That notion is seriously flawed. On the one hand, convertibility can take care of debt default in instances where the value drivers influencing strategic success are unable to take concrete shape within a pre-defined time-frame. On the other hand, debt is invariably a consequence of pricing; whereas a developed mining company may be able to issue loan paper at 300 basis points over a benchmark rate (e.g. US treasuries or LIBOR), a junior may have to pay 700 or 800 basis points.

 

That brings back to the “debt or equity” question. Is debt at 15 % per annum more expensive than equity raised at current market price levels? No. There are any numbers of examples of well-managed juniors achieving five- and ten-fold increases in share prices over a 18-24 month period. Therefore, in plain percentage terms, the balance between limited dilution via debt and excessive dilution via equity must weigh in favour of the former.

 

In addition to the rather simplistic percentage-per-annum relative comparisons, sophisticated mathematical assessments of cost of capital produce the same results: credible business models make their own case for debt in favour of equity until such time that market capitalizations reflect underlying value. Such results may not hold in an environment where applicable interest rates exceed 20-25 % per annum, or where a company’s market capitalization far exceeds management’s perception of corporate value. But, in general, the conclusions hold today.

 

Which brings us to the second question: Is junior-issued debt saleable?

 

Most certainly so; at the end of the day, debt placement is a function of price. And price, in turn, is a function of structure. Does the debt instrument offer convertibility into common shares? Will those common shares be tradable upon conversion? Will the debt paper undergo enhancement, potentially, during its validity, as exploration programmes lead to probable or proven reserves? Is the debt secured by a specific resource?

 

The exercise is not as complicated as it may appear in the first instance. On the contrary, most of the answers to structuring-related questions can easily be found in a company’s business model. For example, pricing depends upon where a particular company figures on the exploration-to-resource cycle, which impacts upon quality of the security on offer. To take another related example, the number of issued and outstanding shares—calculated on a fully diluted basis—directly impacts upon the conversion options.

 

All that said, what a junior requires today, at the very outset, is an acceptance of the fact that the sub-prime crisis has forced a total revaluation of pricing parameters, be it debt or equity, right across the investment spectrum.

 

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Asset Swaps become portfolio imperative

 

The economic and financial impact of the collapse in the sub-prime debt market has already been widely publicized. However, the average market participant, or potential participant, is unaware of the fact that the deterioration of mortgage-based securities has resulted in complete chaos in the equity and debt pricing sector. More specifically, the relationship between base valuations and risk spreads is being thoroughly redefined.

 

Issuers of securities, as a consequence, must boldly confront the new challenge: which assets are over-priced and which ones are under-priced? On a related note, given the unprecedented volatility, what methodology should be employed to adjust a portfolio?

 

The answer lies in asset swaps, which qualify as perhaps the most potent instrument to tackle the complexities thrown up in recent months.

 

In its most rudimentary form, an asset swap is an exchange of the cash flow or risk profile of one asset for another, over a given period of time. Assets swaps are undertaken for a variety of reasons but, fundamentally, they are driven by an investor’s need to improve or rationalize the character of an underlying asset (shares or bonds) within the context of specific market conditions.

 

For example, an investor might desire to switch from a floating interest rate profile into a fixed rate interest stream for a period of two years. Another investor might want to exchange a Euro risk for Yen for five years. Or, an investor might consider that the time is appropriate to switch from equity volatility to relatively stable debt paper. In the briefest of terms, the opportunities afforded by asset swaps, and associated credit enhancements, are limited only by a participant’s ability to comprehensively identify the scope of both the risk and the upside inherent either in a particular business model or investment portfolio.

 

Issuers need to realize that traditional hedges like futures, forwards and options are no longer workable; either the costs are prohibitive, or straight hedge contracts are simply not on offer pursuant to the dramatic market moves in recent weeks. An asset swap, as a consequence, is the only instrument which fills the void; asset swap structures are undeniably based on shares, bonds or hybrids; but they go beyond the scope of traditional investment vehicles by providing an extremely high degree of flexibility with respect to investment strategy, over the short or longer term.

 

Moreover, asset swaps capture the ability of participants to deliver commodities and precious metals in return for risk insurance or credit enhancements. In certain instances, dormant real estate or stock inventories may also enter the pricing equation.

 

From the perspective of the emerging markets or junior listings in the established exchanges, asset swaps will now be influenced by the need to swap equity into debt, primarily due to the fear of renewed potential downside evident in hundreds of share listings; asset swap specialists report a seemingly unending stream of inquiries seeking to cover downside scenarios. 

 

Despite its innovative capabilities, the asset swap is not by itself is not a new financial instrument. Over the previous two decades, derivative traders caused the volumes transacted in assets swaps to increase exponentially. What is new, nevertheless, is the foreseeable transition of the asset swap matrix, from a world dominated by professional or sophisticated market players to an era where an entire series of non-institutional investors will demand a shift in their risk-reward profiles. www.quoteplatform.com

The biggest risk in mineral exploration: Dilution

Equity issues invariably form an integral component of a corporation’s growth cycle. But they also result in dilution for existing shareholders, and too much dilution often turns a carefully crafted investment profile upside down. Take hundreds of junior mining companies as a classic example: exploration exercises, triggering repeated issuance of shares, have caused so much dilution that shareholders can only look forward to nominal returns (if any) even if a resource is eventually identified in accordance with industry standards.

 

The dilution rate is an expression of the ratio of new shares issued for each existing share on a corporate transfer book at any given point in time. In theory, dilution should be accompanied by substantive enhancement in shareholder value along a pre-determined timeline. In practice, however, proceeds from shares sold are spent on useless experimentation and head office costs; particularly in the case of an exceptionally large number of juniors, also rather presumptuously called “growth corporations”.

 

As history proves, exploration can lead to windfall profits for shareholders. “The trick is to discover operations which can find the balance between new equity and sensible, fact-driven exploration schemes,” a European asset pool advisor highlighted in a recent client circular. “Our benchmark is to work with managements who are willing to walk away from an exploration target if the facts so warrant, and then to quickly move on to greener pastures.”

 

It is indeed rare to find a mining junior acknowledging publicly that an exploration program has failed. On the contrary, geologists keep providing fodder for press releases which are conditioned by highly technical information and which, in most instances, essentially hide more than they disclose. And, given the low market capitalization of the bulk of junior companies, fresh equity can only be placed at prices which significantly dilute shareholders on record.

 

Therefore, to justify dilution in an exploration context, there are some fundamental thresholds which must influence the quest for value. For one, investors should remember that, in general, any well-structured exploration plan will suggest the presence of one mineral or another in a large underlying property; but will the potential resource ever lead to profitable mining? Another criterion is the use of a “drop dead” budgetary ceiling; at what stage, and under what conditions, will the money-tap be turned off? Juniors must also confront the challenge of diversifying risk on a continuous basis, without creating dilution scenarios. Should on-ground joint ventures be actively encouraged in the early stages of the exploration process?

 

Finally, exploration need only be undertaken in regions with a proven past of generating sizable mineral reserves, with above-average concentration levels. There is little point in being a pioneer—at least not with other peoples’ money–in a situation where there are any numbers of “safer” bets, relatively speaking.

 

Prior to investing in a mining junior, investors owe it to themselves to be aware of one critical piece of information: the dilution ratio. Without access to that information, you are better advised to keep your money in the bank.

 

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