The Mineral and Petroleum Royalty Bill is one of the final pieces of legislation meant to give effect to the Minerals and Petroleum Resources Development Act, passed last year. It provides for a quarterly charge to be imposed on holders of mineral rights for the extraction and transfer of mineral resources.
The imposition of royalties is not unique to South Africa; most other mineral-producing nations levy them as part of a tax package. They are levied in addition to income tax, but count as a tax-deductible expense in the production of income.
The rationale for the Bill states that “the charging regime strikes a balance between the need for adequate compensation and the imperative of maintaining the international competitiveness of the mining sector”.
Most commentators embrace its aims, but implementation in its current form, especially with regard to the royalty levels, could hamper the government’s other goals of growth and employment creation. The argument is that high royalties may curtail much-needed investment flows into mining, reducing the proverbial cake all stakeholders must share.
A central purpose of the minerals Act is to encourage and facilitate “broad-based socio-economic empowerment” of the historically disadvantaged in the mining sector.
The idea is to spread the benefits to the widest possible range of previously disadvantaged people. Growth and empowerment are perceived as complementary processes, the aim being more than the redistribution of existing wealth.
The argument that high royalties provided for in the royalty Bill may harm inward investment is based on a study of the potential impact on mining companies with South African exposure. Mining companies with the least exposure (55% earnings exposure or less) will be least affected, losing between 6% and 7% of forecast earnings.
Companies with a relatively low exposure include Anglo, BHP Billiton and Xstrata. Initial estimates are that Anglo will suffer a 6% impact on earnings, amounting to $106-million, due to its 55% profit exposure to South Africa, largely in the high-royalty commodities of diamonds (8% proposed royalty), platinum (4%) and gold (3%).
By contrast, the black empowerment company Kumba derives almost all its earnings — with the notable exceptions of the Rosh Pinah mine in Namibia and Ticor’s Australian Tiwest operations — from South Africa.
In a worst-case scenario it would take a 10% to 13% drop in earnings. This takes into account a 2% royalty for iron ore, coal and base metals; a 3% royalty on heavy minerals; and a 1% royalty on industrial minerals.
Empowerment mining firm ARMgold’s entire gold production is derived from South Africa, hence a 3% new royalty on gold produced will negatively affect earnings to the tune of about 11%.
A 4% new royalty on platinum would bring about a fall of between 18% and 30% in forecast earnings of an operation like Northam.
In an unintended way, the royalty Bill may support geographical diversification, and lead to reduced inward investment in new development projects by local mining companies. This could certainly retard the transformation of ownership patterns.
The authorities must be particularly cautious in the implementation of the 3% royalty in the gold industry, as it may hasten the industry’s decline, and halt most of the newer projects aimed at reviving it. Key factors here are the long-term weakness in the gold price and the high cost base of an ageing industry. The current price is R79 000/kg, while the total cash cost was R60 254/kg last year.
In this context, royalties may serve to exclude new empowerment players and slow or freeze broader-based socio-economic empowerment as the bigger players close ranks.
While the mining charter’s racial ownership transfer targets of 15% in five years and 26% in 10 years could be met, it is less certain that the broadest possible empowerment process will take place.
The success of the new mineral policies cannot be overemphasised. As one foreign investor put it: “The concentration of empowerment in a few hands is worrying, as it leaves the expectations of the many unsatisfied. We would look for broad-based projects for ‘future-proofing’.”
South Africa needs to facilitate a swift move where many, if not most, projects are largely held by South Africans or empowerment players to help relieve foreign investor fears. Lower royalty levels may help in this regard.
The two commonest ways of structuring empowerment deals are equity-type investments, where the acquisition is financed by a third party and the empowerment company is entitled to dividends after debt repayments; and project-type initiatives, where the empowerment company participates at an early stage and contributes resources, such as mineral assets and skills.
As the royalty is charged on gross sales revenue, revenue that can be used to operate and grow the business is reduced. This influences dividend policy, which in turn affects the ability of historically disadvantaged South Africans to finance transactions.
In addition, the royalty rate may affect decisions to proceed with new mining projects, with the result that project participation by black players may be significantly diminished or delayed.
They may also affect prospects for generating cash flows above a project’s required rate of return, resulting in longer pay-back periods.
The full impact of the new royalties on the valuation of companies will only be apparent when there is greater certainty on the timing of its implementation and clarity on the definitions of revenues.
But a steep royalty regime may well dilute the objectives of the Mining Charter by diminishing black participation in development opportunities and delaying the economic benefits of new projects.
Larger royalties will have the effect of raising mine cut-off grades, which is unfortunate in a context of declining commodity prices and the strengthening rand. For large-scale new projects, it may be prudent to consider a royalty break or holiday.
Royalties should be fixed at levels that take into account the cost of mining, so that they do not deter investments or lead to sub-optimal investment or operating decisions.
They are unlikely to be entirely removed. But as they are a new reality, the government would be well advised to consider capping them at 3% to 4% for higher-margin mining businesses such as platinum, and at lower levels for others.
Dennis Mashile is a mining analyst at HSBC Securities. This was written in his private capacity. Parts of the article are taken from a presentation at the South African Institute of Mining and Metallurgy colloquium on the Mineral and Petroleum Royalty Bill by Mashile and Mzila Mthenjane, as members of the Association of Black Securities and Investment Professionals