There is a new reality various governments still dreaming of imposing 'windfall taxes' and other measures of this type on companies involved in the extraction of resources will have to face. So-called 'resource nationalism' is a constant threat mining companies have to live with. They are usually sitting ducks, since they cannot simply move their assets elsewhere. Usually a mine (or an oil field) involves very long range planning and a huge upfront capital commitment. As a result it often appears easy to blackmail mining companies. The calculation from the point of view of greedy politicians is that the companies will rather live with a much smaller profit than lose the entire value of their investment.
It becomes a bit more complicated when the investment necessary to build a big mine hasn't been undertaken yet. Ecuador has followed in the footsteps of a few other Latin American countries and has elected a distinctly left-wing government. Similar to Venezuela and Bolivia, the government immediately ripped up all agreements the previous government had made with regard to mining, as the resources of the country are held to belong to that mythical collective, 'the people'. All foreign-owned mine developments ground to a halt consequently. The government at first enacted a new mining law that simply made things impossible for miners. It then promised it would enact reforms that would once and for all clear up the legal fog in which mining has been mired since then and provide a more 'investor-friendly' framework, but it has so far failed to deliver.
Meanwhile, mining companies that were about to develop large projects were engaged in direct negotiations with the government in order to gain clarity on the status of their properties (actually, no longer 'their' properties, but those of the aforementioned 'people').
Now the putative developer of the biggest mining project in the country, Kinross Gold, has walked away after two years of fruitless negotiations, during which the government has played hardball with the company throughout. Specifically, the government would not back down from demanding a 70% 'windfall tax'.
Fruta del Norte (FDN), the project in question, is one of the biggest and best (in terms of grade) undeveloped gold projects in the world. The fact that Kinross nevertheless took the hard decision to abandon it speaks for itself (previously, Iamgold abandoned its large Quimsacocha project in Ecuador). The recent decline in the gold price has probably helped this decision along, but the new management at Kinross is on a mission to no longer invest in projects that do not promise to generate a decent return.
As the Financial Post reports:
“Kinross Gold Corp. has abandoned plans to develop the massive Fruta del Norte project in Ecuador after refusing to pay a 70% windfall profits tax demanded by the government.
It is a major disappointment for the company. Fruta del Norte was acquired for more than US$1-billion in 2008, and was expected to become one of the Toronto-based miner’s cornerstone operations. But more than two years of fruitless negotiations convinced Kinross that it was not going to get a deal that would generate good investor returns.
The Ecuadorian government played hardball with Kinross from the beginning, insisting on the monstrous windfall profits tax and never backing down. That was by far the biggest sticking point in the negotiations, chief executive Paul Rollinson said in an interview Monday. He is certain that walking away is the best move for shareholders. “It really was a tough decision, but I do think it was the right decision,” he said. “I’m not prepared to sign anything with a 70% windfall profits tax.”
The concession reverts to the government in early August – notably, the government prohibited Kinross from selling the property. In other words, the property never was the company's property, in spite of the fact that it was acquired for $1 billion. It has essentially been confiscated.
However, the shoe is now in the other foot. Now it is the government that can no longer hope to gain any revenue. The employment and other benefits Kinross would have provided will no longer materialize. These benefits would have been quite significant. Mining companies are extremely sensitized this days to the need to keep the locals happy. Many anti-mining NGOs tend to wage a propaganda war against mining companies, claiming that they bring only destitution to communities, but that is of course complete hogwash. In Ghana, whole villages are holding prayer meetings where they inter alia pray for the continued health of Anglogold-Ashanti and moreover also pray that it will hopefully find more gold. They now have employment, road, schools, hospitals, and so forth, all of which were and are provided by the company.
In Kinross' press release we find hints that it was engaged in similar activities in Ecuador. The press release also informs us of the theft:
“Any possible sale of the project is currently subject to the prior approval of the government, and the government has also indicated it will not support efforts by Kinross to solicit a potential new partner, or a buyer. As previously disclosed, when the current economic evaluation phase of the project expires on August 1, 2013, the La Zarza concession, which contains the entire FDN mineral resource, will revert to the government.
The Company intends to focus on assisting its employees and its local stakeholders during a transition period as it reduces its level of activities in Ecuador in the coming months. "I want to acknowledge our outstanding team in Ecuador for their dedicated efforts in establishing FDN as a model for responsible mining," Mr. Rollinson said. "I also want to thank our local stakeholders and the communities of Zamora-Chinchipe, including members of the Shuar Federation, who have partnered with us on a wide range of training, business development and community investment initiatives over the past several years as we worked together to advance this project," he added.
Kinross' decision to cease the development of FDN will result in a charge of approximately $720 million in the second quarter. Approximately $700 million of the charge is expected to be non-cash, reflecting the Company's entire net carrying value of the FDN project, and approximately $20 million represents accrued severance and closure costs.”
There is speculation that Ecuador could 'maybe' persuade the Chinese to come in as buyers and developers of the project, but that naively assumes that Chinese gold mining companies will be happy to agree to getting robbed instead of Kinross. Why would they? And if the government decides it should offer better conditions to the next would-be developer, it could have just as well offered those to Kinross. It seems to us the FDN resource will remain undeveloped for many years to come.
Naturally the stock of Kinross was sold down after the news hit, but one actually wonders why. Of course it is not exactly great news that a $720 million write-off will have to be taken, but on the other hand, developing FDN would have cost another $1.4 billion and once those costs had been sunk, who knows what the Ecuadorian government might have come up with next. You cannot trust socialists that they will respect property rights. Post war social democrats in Sweden argued e.g. that “the citizens should possess exactly that property which the parliamentarian majority of the day thinks they should possess, since “property” is but a “functional concept.” (according to Gerard Radnitzky in 'Is Democracy More Peaceful than Other Forms of Government?'). In fact, the Ecuadorian government's refusal to let Kinross sell FDN speaks for itself in this regard.
Clearly this is a case where it was better to simply take the loss, as bitter as it may be to lose such a great deposit. From the point of view of shareholders, proof that the new management takes a very tough-minded approach to the generation of returns should probably be considered to be worth much more than than FDN, especially at KGC's current share price.
KGC's already battered shares got whacked again after the FDN news were received – via StockCharts – click to enlarge.
Of course these days gold stocks get whacked on any and all news, simply because they are mired in a bear market. So this initial reaction may not necessarily be indicative of the market's ultimate assessment.
With lower commodity prices (gold is by far not the worst case in terms of price declines) governments elsewhere should take heed. What has just happened in Ecuador could become an example others will follow. The mining industry is under immense pressure from shareholders not to waste any more capital merely on the notion that companies should get bigger. Shareholders want to see returns, and a number of CEOs who have come to be seen as bad stewards of capital have been booted out over the past year or two. The new crop of managers has new priorities, and they do not include letting governments that cling to an outmoded and failed ideology grab the vast bulk of their expected profits.
Ecuador's socialist president Rafael Correa: overplayed his hand.
(Photo via globedia.com, author unknown)
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