Commentary: Making sense of royalty structures and rates, part II

The first article in this series (TNM Dec. 5-11, 2011) examined what a royalty is, the different ways it can be structured and used and its history in Canadian mining. The series continues with a look at which royalty structure is appropriate for which resource, and future trends in the use of royalties.

The three most commonly used royalty structures – fixed rate, net smelter return (NSR) and net profit interest (NPI) – all have different features that make them suitable for different resources.

A fixed rate royalty will be suitable for a mine that produces a product that can be sold without significant alteration of its basic character, or which has a low value and predictable extraction costs (e.g. uncut diamonds, coal, gravel or aggregates).

It will be less suitable for a product that must undergo major alteration of its basic character to make it marketable, or for a product that is sensitive to fluctuations in metal prices and operating costs, in which case an NSR or NPI royalty will be more appropriate.

NSR and NPI royalties have very different features, all of which would be expected to influence their choice for a particular resource:

• An NPI royalty is more sensitive to fluctuations in metal prices and operating costs than an NSR royalty.
• An NSR royalty is paid as soon as mine product has been shipped to the smelter, whereas an NPI royalty is only paid when the operator has recouped pre-production expenditures and capital investments.
• An NSR royalty is a fixed cost that the operator must bear even if the mine operation is not profitable, whereas an NPI royalty varies with profitability and is only paid if the mine is profitable.
• Fewer factors go into calculating an NSR royalty, meaning that its net present value can be calculated more easily, allowing for easier selling.
• An NSR royalty is easier to calculate and verify than an NPI royalty, and requires less disclosure (including of confidential operating and profitability information) and easier administration by the operator.
• There is greater potential for, and the appearance of, manipulation by the operator under an NPI royalty because of the scope and complexity of deductibility and recoupment provisions.

Based on these differences, a royalty holder would be expected to prefer an NSR royalty in the case of a small, low-grade, complex orebody, when operating costs are expected to rise and the financial capacity and technical expertise of the operator is unknown. Whereas, in the case of a large, high-grade, simple orebody, with known and constant costs and a good operator, the holder should prefer an NPI royalty. However, notwithstanding their different features, a survey of market royalty structures shows that NSR royalties are more commonly used, irrespective of resource type.

The popularity of NSR royalties cannot be explained by merely looking at the bargaining power of the different parties. Rather the complexity involved in calculating and verifying an NPI royalty and the risks presented by the different structures needs consideration. NSR or value-based royalties present a medium risk to both the holder and payor, while fixed rate or production-based royalties present a high risk to the royalty payor and NPI or income-based royalties present a high risk to the holder.

One of the most promising new trends is the use of royalties as a financing vehicle.

The global financial crisis has made it harder and more expensive for mining companies to raise money in the debt and equity markets. As a result, companies are considering the grant of royalties to raise money for exploration and development activities, mine development and construction and property acquisition.

The use of royalties as a capital raising tool can be contrasted with debt, equity and joint-venture methods.

In contrast to debt financing, which features payments that may begin prior to production, but that terminate on loan repayment, royalty financing payments begin on first production and continue for the life of the mine. 

In addition, repayment under debt financing is often a fixed amount due at specified times, whereas with royalty financing, repayment is more flexible and depends on production levels and timing.

Finally, with debt financing there is no or only minimal risk accepted by the debtor – the miner is required to pledge project and other assets, execute guarantees and accept negative covenants and the possibility of accelerating repayment, whereas with royalty financing, risk is shared by the royalty holder and there is generally no need to provide security or accelerated repayment.

The features of equity financing include its non-project specific nature and the dilution of the miner’s existing shareholders. In contrast, royalty financing is project-specific and non-dilutive.

Joint-venture financing may limit a miner’s participation in the management, and operation of the mine and the miner’s interest in the property may be diluted for failure to meet cash calls, neither of which occurs with royalty financing.

Royalty financing can be used for mine development, mine expansion and acquisitions. A mine-development example is the 2009 transaction between Silver Wheaton and Barrick Gold in respect of Barrick’s Pascua-Lama project in Chile. An example of royalty financing’s use for mine expansion includes Royal Gold’s 2010 transaction with Teck Resources in respect of Teck’s Andacollo mine in Chile.

Royalty financing was also used in the 2010 acquisition of the Mount Milligan project by Thompson Creek Metals, when Royal Gold paid part of both the acquisition cost for Terrane Metals and the construction costs of the Mount Milligan mine, in exchange for the right to purchase gold produced from the mine at a discount to the market.

As part of my research, I have surveyed royalty types and rates for various resources. The survey shows: the popularity of the NSR royalty among all resource types (base metals, precious metals, bulk commodities and speculative rare earth elements) with the exception of diamonds, where the gross overriding royalty is the dominant structure; the relatively low rate of NSR royalties compared to historical highs; and the varying royalty rates and structures that can be negotiated for the same property, in the case of different resources, and even identical resources. Readers interested in a copy of this survey can email me at jlotz@vectorlaw.com.

– Based in Vancouver and called to the bar in B.C. and New York State, the author is an associate at Vector Corporate Finance Lawyers, and practices exclusively in the areas of corporate finance, securities and mergers and acquisitions. 

Vector’s areas of practice include natural resource law, corporate finance and securities law and company law. For more information, visit www.vectorlaw.com.