CHAPTER 7 THE ECONOMICS OF NET PROFITS VS. NET SMELTER AGREEMENTS

• Jurisdiction: United States

Mining Agreements II
(May 1981)
CHAPTER 7
THE ECONOMICS OF NET PROFITS VS. NET SMELTER AGREEMENTS
Richard L. Brown
ASARCO Incorporated
New York, New York

One of the central issues in any negotiation between a mineral right owner and a prospective investor in a mine designed to exploit the mineral right is the rate of royalty and the type of royalty to be paid by the investor to the mineral right owner. Frequently, in such negotiations, one party or the other takes preconceived and ill-advised notions as to an appropriate royalty to the negotiating table, and deadlock on the issue may result. The mineral right owner, who may have expended considerable time and money in the acquisition and assembling of the property, will wish to be rewarded for his effort as handsomely as possible. The potential investor on the other hand has an obvious interest in maximizing the cash flow which might result from the proposed mining operation. The investor probably also knows that a poorly designed royalty regime, locked into the lease or agreement, might by itself render the property uneconomic.

The object of this paper is to demonstrate that a variety of royalty arrangements might be appropriate to the property involved, and that the straight net smelter return type of royalty is often not one of these. In order to examine this point, the writer constructed simplified conceptual models of a number of types of mineral deposit common to the western states, and from these models derived the characteristics of calculated cash flow which might be generated by a mining operation appropriate to each. The effects of various kinds of royalties and level of royalties on the return on investment is then outlined.

Two types of analyses were conducted in respect of each modeled mineral deposit. Firstly, the discounted cash flow rate of return which the investor might receive from the property under a variety of royalty arrangements is determined. Secondly, the net amount of money payable to the mineral right owner and to the investor is tabulated and examined.

Each of the models used in this exercise is described below. The writer cautions that the models are hypothetical and none of them have any relationship to a mine operated by his employer, and that the costs and performance suggested in relation to each of the models have no relation to any known operation.

This paper was prepared as an introduction for, and as background to, a subsequent paper to be given by Mr. Morris B. Hecox. Most of the data developed are best presented in

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the form of charts and diagrams, rather than in the narrative form generally seen in law books and in legal institute proceedings. The present paper describes problems; Mr. Hecox will demonstrate how these problems can be handled by the lawyer.

Small Underground Lead-Zinc Mine

The relatively modest 3.5 million ton ore reserve in our modeled small underground lead-zinc mine consists of a number of individual discrete masses of lead-zinc-silver ore, none of which contain more than 500,000 tons. These individual deposits are assumed to be scattered throughout a substantial area, both laterally and at depth. A crosssection through the modeled mine and a horizontal projection of all the deposits in the mine, projected to surface, are shown in Plate 1. The reader will note that the costs of developing each of the individual ore bodies are large, as substantial drifting and shaft sinking is required to develop them. The cost of stoping the ore, once it is developed, is apt to be comparatively modest. Because the ore is a complex lead-zinc-silver ore, the mill can be expected to be fairly expensive as compared to the planned designed daily through put. In sum, it can be reasonably predicted, even before a feasibility study is completed, that our small underground lead-zinc mine will be a high cost producer. In fact, in order to enable our investor to come close to a reasonable profit, we had to assume 50¢ Pb, and 60¢ Zn.

Assuming that a feasibility study is in fact conducted on the deposit, and the most efficient rate of production, mill design, and other necessary similar data are at least roughed out, it will be possible to make crude approximations of the rate of return which can be expected from the operation. In the case of our small underground lead-zinc mine, this rate of return is not attractive. However, acting on the assumption that a potential investor might be found, the following facts would soon become evident. Among them are a 5% net smelter return royalty, or a 10% net profits royalty, would each result in annual payments to the mineral right owner of about $450,000, approximately equal to the investor's own return. A 10% drop in metal prices, coupled with a 10% increase in operating cost, would put the operator in a loss position. If the operator should experience a 10% adverse situation in respect of operating costs, metal prices, and ore grade, his loss would be disasterous. If he should experience a 5-year period of 8% cost inflation, not offset by higher metal prices, he would experience a negative cash flow.

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The mine would have a 21-year life, quite a reasonable life expectancy, but the investor will not recoup his preproduction expenditures until the tenth year of production. The fundamental fact of life for this property is that even given the most favorable set of assumptions, it will only earn, absent of royalty, $42 million during a 21-year period following a $30 million preproduction investment. The discounted cash flow rate of return on the investment will be 11.9%, less than prime rate. The investor, who knows he is looking at a thin operation, but who nevertheless for some reason or other is willing to take a chance, will undoubtedly react sharply during negotiations to any suggestion that he be subject to royalty payments at times when he is losing money. This of course would be the case if the royalty arranged for in the agreement provided simply for the payment of a prearranged percentage of the mining return paid to the operator or investor by the smelter. If ever a property cried for a net profits arrangement, under which the investor paid the mineral right owner a prearranged percentage of the operating profit, our small lead zinc mine is it.

The investor will have noted from his preliminary calculations that a lengthy period of time can be expected before he is paid back or recoups his preproduction cost. He might feel it unfair that the mineral right owner should receive revenue from...