Issue 23
State of Gold: Financing Mining Projects in the Former Soviet Union
Since the collapse of the Soviet Union, there has been surprisingly little successful foreign investment and involvement in mining in Russia. Russia is one of the largest countries in the world and one of its greatest stores of natural resources; it is also still one of the largest producers of gold - over 120 tonnes per annum. Around 85% of all gold ever produced there has come from alluvial deposits, compared to 10% in the rest of the world. The implication is that there are still substantial hard-rock sources yet to be mined. There is no shortage of good quality and detailed geological data in Russia, but there is only a short history of mining for profit.
The largest single foreign investor in Russia, its natural resources and in gold mining in the Fonner Soviet Union (FSU) as a whole has been the European Bank for Reconstruction and Development (EBRD). Commitments to gold mining in the FSU to date have exceeded US$300 million, of which the Bank has invested over US$100 million in Russia. These figures may sound impressive, but when compared to EBRD's investments in oil and gas (over US$1.5 billion), they prove quite limited. The reason is a shortage of mining projects of substance since, to be blunt, exploration and development of new mining resources has been insufficient to offset the depletion of reserves in production.
Why are foreign investors reluctant to become involved? Generally, the main reasons cited are the uncertainty of the legal framework in Russia, the punitive and complicated tax system and corruption. While these difficulties have doubtless deterred many, there have been exceptions, most notably the Kubaka gold mine in Magadan developed by Kinross Gold (after absorbing Amax Gold), which had the benefit of EBRD and OPIC finance.
EBRD has also provided finance and hedging facilities for the Buryatzoloto project in Buryatia through a Russian company in which the Canadian company High River Gold has a 23% interest. This is now a successful 100,000 oz per annum producer. More recently, the EBRD, together with a consortium of Russian banks, pre-financed seasonal placer gold mining and the IFC, along with international project finance banks, granted a US$10million facility to Bema Gold for the completion of the Julietta mine in Magadan. Another recent development is the announcement by Celtic Resources that it is to proceed with the '1rst phase of the development of the Nezhdaninskoye gold deposit in Yakutia with a US$7 million credit from Russia's Zenit Bank
The Regulatory Environment
Precious metals projects face the additional obstacle of a regulatory framework that has not yet experienced the international scrutiny and pressure to reform that the Russian oil and gas industry has seen.
Due to the importance of the precious metals industry for the state and the historical state monopoly in this area, the government 's involvement continues to very significant. Development of mineral resources may be carried out only after having obtained a license from the Ministry of Natural Resources. Licenses for new deposits are issued on the basis of a tender or auction.
Environmental problems pose particular risks in Russia for two principal reasons. First, Russian mining practices have historically been undertaken with little thought to protecting the environment with - often - serious consequences. Second, the government has granted far-reaching enforcement powers to authorities, which potentially threaten even the cleanest operation. Although so far environmental protection authorities have not exercised their powers to their fullest apparent extent, legal actions available include suspending operations until environmental violations are cured and ordering the suspension of financing.
Apart from liability issues, mining developers must also cope with an environmental regulatory and approval process to begin operations. Each project is subject to an audit process, which reviews detailed feasibility studies and environmental impact assessments approve the initial design and monitor subsequent operations. While this is standard practice worldwide, Russian environmental and safety standards often differ substantially from generally accepted international standards.
One of the problems in doing business in Russia is that there are comprehensive and time-consuming laws and regulations concerning currency controls. In short, the record of this regulatory regime for mining projects is one of the extensive documentary requirements and record-keeping - with the associated costs they have brought.
Currency regulations stipulate that a percentage of gold sales must be received in roubles. This can be as high as 75%. Projects are therefore encouraged to source more and more goods locally, well beyond the usual local currencies used to pay for local taxes, labour and fuel. Of course, unless payments are closely married this can entail both a currency devaluation risk and a Russian bank bankruptcy risk. Also given the limited liquidity of most local goods suppliers, this gives rise to a substantial risk of delivery after down payments have been made to pre-finance the purchase of such goods.
Risks Involved in Selling Gold
The few foreign producers that operate in Russia normally sell their gold and silver to Gokhran, the state 's buying agent. Gokhran usually charges a 1% discount from the world price and is able to pay producers before the metal is transferred to it, thus reducing the risk to the producer. Gokhran is usually very willing to take delivery of gold bullion From Russian refineries, preferably close to Moscow. Unfortunately, Gokhran does not always have enough funding to buy all of the gold that producers have for sale. When this is the case, producers have to find other places to sell.
One alternative is to sell gold to the central bank. The central bank discounts gold by 2% plus whatever the prevailing export tax is currently running at 5%). Like Gokhran, the central bank can take delivery at Russian refineries. Sales to the central bank usually involves using a Russian bank as an agent. Simultaneous transfer of funds and metal can hopefully reduce risk. The major disadvantage of this method, however, is that the central bank pays 100% of the proceeds in roubles into a Russian bank account. Clearly, this cannot be satisfactory if the project has substantial hard currency debt obligations. Some local governments (e.g. Magadan) have the right of first refusal on local gold production hut, predictably, the lack of budget resources generally renders this right useless. Another alternative is to export gold. This carries a cost of 5% export tax plus whatever transportation costs are involved in getting the gold out to a location agreed with the buyer, usually a Western European city airport. In order to export gold, bullion mines must use a Russian bank as an agent. So far there is no evidence of discounts because of the quality of the gold exported. One major advantage of exporting gold quality is that the buyer pays 10% hard currency directly to the mine. The mine then must convert a percentage of' those proceeds into roubles.
A slightly different mechanism that has been employed by High River Gold is to draw clown project financing in the form of an EBRD gold loan. This accomplishes several things. It provides up-front cash for project development and mitigates political risk through the comfort of EBRD's involvement; it hedges the gold price (as the gold lent is initially sold at a spot price at the start of the loan and repaid later with gold production) and it avoids the necessity of selling gold, as it can be delivered to the project's lenders directly.
Production Sharing Agreements
(PSAs) Production sharing agreements, or PSAs, could help Russia substantially increase gold production. They can provide more stable future cash flows and a predictable tax regime for projects. They define costs and contribution and can link profit sharing to project profitability.
PSAs are essentially complex contracts between a foreign investor and the Russian state at both the federal and local levels. Their major advantage is the investor's ability to negotiate all major terms and conditions for future investment, including mining and production, as well as legal terms such as the ownership of production, sales and export quotas. The PSA provides stability the legal environment exiting at the time it is signed is guaranteed to last throughout the lifetime of the agreement.
An investor can thus, by proper due diligence and thorough negotiations, minimise the effect of all potential problems that may affect the mining project and determine a satisfactory mechanism for settling unforeseen difficulties.
The PSA regime is still under revision by the government. In the past, companies received seemingly contradictory advice on whether a project should have a production sharing agreement. Yet, PSA require passage by the Duma and they are therefore difficult to obtain. The difficulties surrounding the evolution of the Kuranakh project in the Saha Republic are relatively well known. Also though PSAs are subject to profits, taxation and therefore exempt from all "other" taxes, the definition of "other" is not clear.
Financing and Security
Financing and Security Russia continues to pose significant investment risk due to political, economic and legislative instability. To date these risks have made strictly private, long-term financing prohibitively expensive or impossible to obtain, leaving multilateral financial institutions and export credit agencies as the principal sources for medium- and long-term finance.
Any cross-border financing for a Russian project requires a huge investment of time and resources. Multilateral financings have typically taken at lea ta year between commencement of negotiations and funding.
The key components of a project financing in the sector have usually included: an effective off-take arrangement that limits risks associated with the government's gold purchasing rights, an offshore payment mechanism and pledge of all offshore accounts, political risk insurance (in the absence of a multilateral lender ) and a completion guarantee from a creditworthy foreign sponsor.
Lenders will require that loan proceeds and project revenue flow through a series of offshore accounts that are pledged to a collateral agent as security. The onshore account structure is a primary source of security to lenders and thus is heavily scrutinised. In addition to serving as security, these accounts act to clear loan and sales proceeds and help mitigate both country and project risks.
Russian commercial banks have increased their activities in the sector since 1999. Perhaps the best-known example of this is Celtic Resources' Financing of its Nezhdaninskoyc project in Yakutia, but perhaps more significant is the provision of working capital facilities to artels or local combinats (workers' cooperatives) by Zenit, Lanta and other banks.
Polyus, the largest producer in Russia today, is such a combinat, Polyus , with approximately 16 tonnes of gold per annum. Though little information reaches Western financial markets on such Russian producers, there is evidence that industrial groups are becoming increasingly active in the sector.
Validity Of Tenure
The Dukat and Sukhoi Log projects are the best-known examples of serious difficulties associated with the privatisation of Russian mining enterprises. Russian law requires that :
- The privatisation not be restricted
- Relevant stat approvals be obtained (and there can be very many)
- Detailed and often unclear regulations be followed
- There be a proper evaluation and publication of information
- The enterprise to be privatised be properly established.
ln short, detailed legal due diligence is very expensive but absolutely necessary.
Security
In practice, it is very difficult to take effective security over bank balance in Russia. It is not possible to take security over mining licence or business interruption insurance cover The straightforward solution is to limit the third-party debt of any project. Enforcement by secured creditors is difficult and essentially always requires court orders, which are costly and time-consuming.
Russian companies must take insurance cover with Russian _insurers. Re-insurance makes obvious sense, but assignments for security purposes require (at the very least) central bank approval. Enforceability as security is also not guaranteed.
Offshore insurance cover will be expensive and time-consuming, as offshore and local policies will have to be co-ordinated to be effective.
Looking Toward the Future
Gold mining everywhere in the world is subject to risks. These include technical risk, gold price risk, labour risk, supply risk and other production risks. Gold mining in Russia is subject to all these traditional risks - and more.
There is an uncertain gold sales regime, uncertain currency conversion rights and political and legal frameworks that remain unpredictable. It is admittedly possible to purchase political risk insurance, but the weight carried by a strong partner like EBRD, MIGA (The Multilateral Investment Guarantee Agency) or one of the multilateral agencies with influence in Moscow is much more valuable in the Russian business environment.
Currency devaluation effects can be mitigated through careful management of rouble balances with help f om commercial banks active in Russia. Gold sales can be a constant, shipment-by-shipment exercise, although they will probably never be as simple and straightforward as they are in North America. All these risks are mitigated at a cost either in dollars spent or in the amount of time that must be continuously devoted to navigating each problem as it arises.
In several cases, initial exploration and start-up phases of Russian projects have been facilitated and Financed by entrepreneurial junior mining companies who do not have access to traditional bank finance. Properties so developed can become attractive to larger companies, which would seem to accord with the current process of consolidation within the industry as a whole. In front of Russia's difficult and changing risks, working with EBRD can go some way to mitigating those risks. EBRD's local experience, knowledge and standing may also be able to assist in assessing whether local partners are trustworthy and capable.
Russia is the world fifth largest producer of' gold and output is increasing, although only 16 of Russia's 500 gold mines produce over one tonne per year. Major production increases can only lie in the development of hard rock mining. With Russian banks providing an increasing depth of domestic support, a strengthening Rouble and grounds for optimism in the legal environment, the climate for foreign investment may yet improve.
The European Bank for Reconstruction and Development ( EBRD) was established in 1991 in response to major changes in the political and economic climate in Central and Eastern Europe. It was created to support the development of market economies in tl1eregion following the widespread collapse of communist regimes.
The EBRD is an international institution with 61 members and associated members (59 countries plus the European Union and the European Investment Bank) and is based in London. The EBRD finances projects in both the private and public sectors, providing direct funding for financial institutions, infrastructure, industry and commerce. Its investments also help develop skills, improve the efficiency of markets and strengthen the institutions that support these markets.
The main forms of EBRD financing are loans, equity investments and guarantees. One of the strengths of the EBRD is its in-depth knowledge of its region of operations. As the largest foreign investor in the region's private sector, the EBRD is aware of the problems and the potential of each of its 27 countries of operations.