Uncertainty reigns over Ecuadorian royalty regime

Vancouver – Despite signs that a tentative heartbeat is returning to Ecuador’s mining industry, questions still loom over how onerous Ecuador’s royalty regime is to be on future producers.

Ever since the Ecuadorian government shut down mineral exploration to begin a review of its mining laws in early 2008, the news coming out of the country has seemed increasingly positive. The first major injection of optimism came with the completion of a revamped mining law in January, 2009. To follow was a stream of announcements that the government, on a case by case basis, was confirming title to mineral concessions of numerous Ecuador-active companies such as Kinross Gold (K-T) Corriente Resources (CTQ-T) and Dynasty Metals & Mining (DMM-T).

Nov. 4, 2009, the country met another important milestone with assent of a set of mining regulations, which are to govern the reformed mining law, that now allow authorized mineralogical exploration to proceed. Within a week of Ecuadorian president Rafael Correa’s signature to the mining regulations, for instance, Kinross announced it had received a green light to restart its drills on what is one of the world’s richest gold deposits, Fruta del Norte, in southern Ecuador.

But, while big steps have undoubtedly been made in rectifying some of Ecuador’s standing in the eyes of the global mining industry with the creation of the mining law and concomitant regulations that allow exploration to continue, a critical matter to prospective miners in Ecuador is as of yet unresolved: What will be the government’s share in revenues generated by the country’s nascent mining industry?

At the heart of the matter is vaguely worded language outlining the government’s economic stake in the mining industry found first in Ecuador’s 2008 constitution, then in its January 2009 mining law and again repeated in its recently approved mining regulations. Article 408 of the Ecuadorian constitution contains the vaguest language of all. “The state will participate in the benefits from the use of these resources (minerals included) in an amount that will not be less than those of the company that exploits them,” reads article 408. The question here is what does the government mean by the at least equal “benefits from the use of resources”?, a phrasing which as it stands is grossly open to interpretation.

The January 2009 mining law goes a step further than the constitution. Not only does it reiterate the applicability of article 408, it adds a minimum – but no maximum – to Ecuador’s mineral royalty regime. The mining law states in article 93 that Ecuador’s royalty will be no less than 5% of the value of all mineral sales. Already considered high in terms of worldwide royalty rates at 5%, it remains to be so seen just how much higher the government is willing to push.

There had been hope that the loose language might have in part been clarified with the newly minted mining regulations. The final paragraph of article 93 in the January mining law states that the parameters of the royalty would be established in those regulations as well as through exploitation contracts.

But a veteran Ecuadorian mining executive, who works closely with the government and requested anonymity in The Northern Miner citing a “difficult situation” in Ecuador, says that the recently approved mining regulations, which he has read but that have not yet been published in Ecuador’s official resgister, do not substantially clarify what Ecuador’s royalty regime will look like and, furthermore, do not stipulate how the government will define its constitutionally mandated right to at least equal benefits from mining projects.

“That is not clear yet, also for us,” he says. “So therefore what is more or less clear is what is already established in the mining law in article 93.”

In terms of greater clarity essentially the only light that the regulations shed on the royalty regime, he says, is to state that mining companies will be allowed to subtract transportation and smelting costs – but not other production costs – from net revenues of mining operations before the minimum royalty of 5% is applied.

Otherwise, the mining executive says, further understanding of how high the government is willing to go with its royalty and how it interprets its constitution will have to wait for completion of a model exploitation contract on which the government is working, he says. Individual exploitation contracts negotiated on a project by project basis will further define the royalty rates.

At the earliest, he says, the newly formed Ministry of Nonrenewable Natural Resources, which this year replaced the Ministry of Mines and Petroleum, will complete a model contract by February, 2010. “With the general model this definition (in the constitution) should be more complete,” he says. As for how the government will interpret the basis of at least equal benefits from resources outlined in the constitution, he speculates: “Well logically it has to be (based) on net profits.”

That speculation, though just a shot in the dark at what the Ecuadorian government might ultimately decide, underscores the extreme level of uncertainty that – even if under-reported upon – still maintains a stranglehold on Ecuador’s mining industry. An independent mining consultant who has advised numerous governments on their mining laws, James Otto, describes the 5% minimum royalty and the vague wording of the constitution as creating “some pretty big hurdles” for investment in Ecuador’s mining industry. For investors, he says, “it could have a chilling effect.”

Even after having worked in some 45 countries, Otto says he has not encountered anything quite like Ecuador’s royalty regime except in the Phillipines where the government stipulates it must have a 60% partnership in all projects. Otto says that the 5% on net revenues minus transportation and smelting is already, as a minimum, on the high side. “More typical would be around 2%,” he says. Likewise he notes that in most cases where governments set a minimum royalty, they also set a maximum. “If bounded on both sides,” he says, “then you can at least study a project’s economics.”

Not so in Ecuador’s case. Until signature of an exploitation agreement stipulating royalty rates, as it now stands a company could not produce an accurately costed mining plan.

As for the wording of Ecuador’s constitution, Otto says the devil is in the details. For example, he says, the interpretation of the clause might not be so bad if understood as a 50% effective corporate tax rate, which he calls reasonable in terms of rates levied elsewhere in the world. But at the other end of the spectrum the wording might be interpreted as something far worse – more or less a 50% equity stake.

While the Ecuadorian government has not gone so far as to say anything along the lines of the latter scenario, the point Otto makes is that as currently stated, it is a big unknown as to where the parameters of Ecuador’s royalty regime will ultimately fall. In the end, that, it seems, may largely be decided by negotiations between Kinross and Ecuadorian government over the development of Fruta del Norte, for which Kinross intends to produce a prefeasibility study by early 2010.

“It’s going to really take a pioneer project to see how things unfold,” Otto predicts.

For Kinross’ part, vice-president of corporate communications Steve Mitchell says the company is pleased to have received authorization to restart drilling at Fruta del Norte and that the company is optimistic about continuing a constructive relationship with the Ecuadorian government to advance responsible mining.

“Our read of (the constitution) is it is not dissimilar to arrangements we have in other jurisdictions that we operate,” Mitchell says, citing Chile and Brazil as examples.

As of presstime the Ecuadorian Ministry of Nonrenewable Natural Resources had not responded to calls or emails.