Freeport-McMoRan faces higher levels of political risk

A visit to the Grasberg copper-gold mine has prompted mining analyst Roger Chaplin of Canaccord Capital to issue a “speculative buy” recommendation for Freeport-McMoRan Copper & Gold (FCX-N), which operates the massive mine perched in the remote highlands of Irian Jaya.

While production results in 2000 were somewhat disappointing, Chaplin sees potential for a major turnaround this year. Accordingly, he set a 12-month target price of US$10 for the company’s shares, up from the present level of about US$7.

Despite the improved outlook, Chaplin notes that Freeport still faces two major negatives: its high level of debt and gearing; and increased political risk. “Freeport has US$2.1 billion in long-term debt, plus US$800 million in preferred shares, which pay dividends,” he writes. “This requires interest/dividend payments of some US$240 million per annum, which eats into the strong operating profits.”

On the issue of political risk, Chaplin notes that since the fall of former president Suharto and the successful bid for independence by East Timor, pressure is growing for the independence of West Papua, as Irian Jaya was once known. Even if this is successful, the country will need the Grasberg mine for the tax revenues that it generates, Chaplin says, though he adds that “the uncertainty clearly has a negative effect on Freeport.”

Through an Indonesian subsidiary, Freeport holds an 81.3% direct interest in Grasberg (85.9% indirectly). In 1995, Rio Tinto (RTP-N) acquired 23.9 million shares of Freeport at a cost of US$500 million. A year later, the mining giant agreed to finance capital costs associated with a fourth concentrator mill expansion, which brought production to its present level of more than 200,000 tonnes per day. It agreed to pay 40% directly and fund the other 60% by way of a loan to Freeport. The expansion began operations in early 1998, and by the middle of 2000, Freeport had fully repaid the loan with interest.

The joint venture gives Rio Tinto 40% of the expanded production within Block A, which includes all the Grasberg operations, through to 2021. After 2021, the major will have 40% of all production from Block A, rather than just the expanded portion.

“This looks to have been a good deal for Rio Tinto,” Chaplin writes, “which has seen its share of the capital repaid in just two years and can now look forward to many years of positive earnings and cash flow from its share of the mine.”

That is something of an understatement as reserves at Grasberg are truly mind-boggling. They total 2.3 billion tonnes grading 1.13% copper and 1.05 grams gold for a total of 50 billion lbs. recoverable copper and 62 million oz. recoverable gold. Net recoveries are about 84% for copper and 76% for gold.

Chaplin notes that based on reserves at the end of 1999, the Grasberg operations are projected to last at least 35 years. “The reserves, however, are likely to increase in the long term as further development/exploration takes place,” he writes.

The Grasberg open pit accounts for 46% of current reserves (41% of recoverable copper and 52% of recoverable gold). The remaining reserves are found in an underground extension of the Grasberg deposit and in several surrounding deposits, all of which will be mined using underground methods. However, the exploration potential of Freeport’s holdings, which total 3 million acres, suggests that major additions to reserves and resources will be made in the years ahead.

Cash costs of US47 per lb. for copper and US$175 per oz. for gold are expected to remain stable over the next five years. “We estimate that the operations will generate operating cash flows (before interest and tax) of around US$900 million per annum,” Chaplin writes.

He also notes that last year’s results were adversely affected by mining of a low-grade area in the open pit, the effects of a stockpile slippage caused by heavy rains, plus some inefficiencies following the fourth concentrator expansion. “All of these are being addressed, and we look for a major turn-around in 2001.”

On the operations front, Freeport has identified 10 areas where improvements can be made to productivity. Four of these include: improving haul roads in the open pit; improved training of the workforce; planning operations using real-time data on a daily basis; and improving equipment availability.

“As one of the operations managers said on the visit, the mine has been in a permanent state of expansion for eight years, right through to 1999,” Chaplin explains. “It is only now that more focus is being placed on improving efficiencies in the mine and plant to maximize production and lower costs on what is now seen to be a relatively steady production level.”

Even so, the natural variability of gold grades within the Grasberg open pit means that the average production rate of metal will continue to be variable. However, an average of 1.6 billion lbs. copper and 2.5 million oz. gold is expected annually over the next 10 years.

Freeport will have to arrange about US$1.1 billion of new financing in the next few years, mainly to replace its existing credit facilities. This represents about half of the company’s total debt.

Over the past five years, the company not only funded expansions at Grasberg; it has been buying back its own shares. From July 1995 to the fall of 2000, Freeport bought 66 million shares at a cost of US$1.2 billion.

“The cost of these purchases, together with interest paid on the increased debt [probably around US$300 million], equates to 90% of the rise in the overall debt within Freeport over the past five years,” Chaplin explains. “In other words, the mine expansions were broadly funded from operating cash flow — and the increased debt was solely due to buying back the company’s own shares.”

Chaplin describes this strategy as “high risk,” though he views recent purchases as bargains relative to those made earlier at more than double the current share price.

He concludes that the one redeeming feature, which also ties in with the political aspects of operating in Indonesia, is that the consortium funding the debt consists of banks that are generally heavily involved in lending to the Indonesian government. “The debt, therefore, could be seen as a form of ‘political insurance,’ as any interference by the government with Freeport’s rights and operations would not be appreciated by the government’s own bankers — who could bring pressure to bear on the government.”