2008-03-18, Why the WFT Would Be Bad for Both Ecuador and its Mining Industry
Why a Windfall Tax Would Be Bad for Both Ecuador and its Mining Industry
By Mark Turner
Latin America Equities Analyst
Hallgarten & Company, New York
Overview
Ecuador is going through a period of wide-ranging political and social that goes far beyond one sector of economic activity. However the mining industry is certainly part of the process, and the changes proposed to Ecuador’s nascent mining sector have made many headlines over the past few months in both English and Spanish. Some of those changes have been seen as either good or bad inside the industry, the view often depending on personal opinion. However, one proposal that has caused concern from virtually all quarters of the mining community is that of the proposed 70% windfall tax that may be levied on miners when prices at market for its precious metals, base metals or non-metallic goods rises above a certain level.
This short paper uses the example of a gold miner operating in Ecuador and examines why a windfall tax would cast a dark cloud on the mining sector and could in fact scare away any further investment in Ecuadorian mining.
Windfall tax is not welcomed by miners
Ecuador’s government has made it clear to the mining sector that it wants to increase the total tax burden on producing miners, and has recently been in talks with at least two of the companies behind large mining projects currently in development stage in the country. While there is a consensus that while prices for the metals at market remain high there is certainly room for these private companies to hand more revenues over to the state, the proposed 70% windfall tax is not viewed as a progressive and industry-friendly option. Mining companies are businesses after all, and would prefer to pay the least burden possible, but if they have to pay extra to the state in which they operate preference is for royalty payments on gross revenues.
The misconception of guaranteed profits
At first sight, it may seem that as the price of gold (our example metal in this note) rises it would be good news for a miner, even if a windfall tax took away much of the potential profit. Many people assume that if gold moved up from U$1000 to U$1500 an ounce, even though the government would pocket U$350 of the extra U$500 the mining company would still benefit by U$150. Unfortunately that is not the case.
Our example metal of gold is traditionally a good barometer to how inflation affects currencies. Gold (and other commodities) does not suddenly “get expensive” all by itself; gold gets expensive because everything else gets expensive in relation to the currencies we use to buy them, in our case the US dollar. We normally call this phenomenon ‘inflation’. We therefore expect gold to rise as the price of everything else rises in real terms. This theory has proved good recently, as Fig. 1 illustrates.
In the chart below we see that as gold rose approximately 30% in dollar terms through 2007 and so did costs in dollar terms at the established and large gold miner Barrick (ABX). As another example of cost creep, the projected capex needed to build new mines has risen dramatically in this last year, with examples such as the Galore Creek project in Canada (run as a joint venture between Teck Cominco and Novagold), whose projected capex costs rose from under U$2Bn to a whopping U$5Bn in less than 18 months, a cost increase that has halted development at the site completely.
Fig. 1. Price of Gold Influences Production Costs
| Barrick 4q06 total gold production costs |
$373 |
| Barrick 4q07 total gold production costs |
$482 |
| percentage change |
29.2% |
| Gold price per oz 1st January 2007 |
$639.75 |
| Gold price per oz 31st December 2007 |
$833.75 |
| percentage change |
30.3% |
Source: Barrick filings, London gold fix
As the price of gold rises, so do the costs of mining the gold (in everything needed to run a mine, including labour, fuel, infrastructure, vehicles etc). We can therefore assume that if gold reached a U$1500/oz, the cost of mining that ounce of gold will not be the same as they would be if gold were at U$1000/oz.
Our model
In the simplified model that follows, we examine how a windfall tax of 70% might affect a gold mining operation. Ecuador has not publicly mentioned any base reference prices that mark when the windfall tax might begin to take effect for gold or for any other commodity for that matter, but for the purposes of our model we will use U$1000/oz as the start point.
Parameters
Therefore, in our model we assume the following:
1) Ecuador sets a 70% windfall tax on gold, with a reference base price of U$1000/oz
2) As gold rises, costs rise accordingly. In our model the percentage cost of producing gold remains constant to the percentage rise in the price of gold. In the real world there may of course be differences in the comparative price rises, but we are keeping this model simple for the sake of clear illustration.
3) The price of gold rises steadily in the next few years to approach U$2000/oz. The windfall tax therefore kicks in when gold passes U$1000/oz and the burden becomes progressively greater as the price rises.
In the charts below, the blue line represents a company that has low relative costs, and we assume that 50% of gross revenues covers its total production costs (which includes cash cost and other costs not included in the normal cash cost calculation such as sales, admin etc) The green line represents a company with average relative costs, with 60% gross revenues covering its break even point. The black line is a company with relatively high costs and needs 70% of gross revenues to get to break even.
We see that as the price of gold rises from U$900 to U$2000, the amount of windfall tax due to the government rises accordingly. However costs also rise, and little by little company profitability is crimped between the rise in costs and the rise in windfall payments. In the case of the company with relatively low production costs (blue line), when gold is U$1400/oz or more the company would be less profitable than when it was priced at U$900/oz! A similar but even more depressing story is told by the company with average total production costs (green line). Perhaps the most dramatic is the high total production cost company (black line), who would actually make a loss as gold climbs past U$1700/oz!
The contrast to royalty payments
Now let us examine the same three companies that are obliged to pay a large royalty to the government instead of a windfall tax. In Fig. 3 the royalty is 5% of gross revenues.
In Fig. 4 the royalty is a very large 10% of gross revenues.
It is clear that, even though a mining company would have to pay more to the state under a royalty agreement as the price of its commodity rose, the company would still benefit from rising profits as the market price increased. This is true even for a 10% royalty on gross revenues, a percentage that would be higher than any other country royalty in the world. As a comparison, Ecuador’s neighbour, Peru, levies a 1% to 3% royalty on gross revenues to operating miners depending on the size of the operation. The conclusion we can draw from the three charts above is that even a large royalty is better than the current windfall tax proposal put forward by the government of Ecuador.
Fig. 5 below compares the three methods of payment outlined in the above charts. We see that until our hypothetical base reference price of U$1000/oz for gold, the windfall tax would bring in no extra revenues while the model royalty system would pay between U$45 and U$100 per ounce of gold. In the U$1200 to U$1400 range, the windfall would produce greater benefits for the state. But as the price of gold passed U$1600 note we have put the windfall charge figures in italics, because from this point onwards it is feasible that some miners will close down operations rather and walk away from a business that offered them an ever diminishing, marginal or even negative return.
Fig. 5
| Gold Price per Oz (U$) |
900 |
1000 |
1200 |
1400 |
1600 |
1800 |
2000 |
| Gov't Revenue 70% windfall tax (U$) |
0 |
0 |
140 |
280 |
420 |
560 |
700 |
| Gov't Revenue 5% royalty (U$) |
45 |
50 |
60 |
70 |
80 |
90 |
100 |
| Gov't Revenue 10% royalty (U$) |
90 |
100 |
120 |
140 |
160 |
180 |
200 |
Source: Hallgarten estimates
This is the first significant risk with a windfall tax system. If the price of the commodity produced rose to a ‘choke point’, miners start closing up shop. If that happens, everybody loses. The mining company loses revenue and has an idle asset. The employees lose their jobs. The state loses valuable income.
The second significant risk is the lack of investment appeal it makes for those not already in the country. If a mining company wanted to set up a new operation in a foreign land, a potentially inhibitive burden on future earnings such as Ecuador’s proposed 70% windfall tax would greatly discourage it from setting up in a country operating such a system. The miner would simply go somewhere else to do business. Again, the loss would be felt by the state, but this time the mining company would not be affected as it set up its business elsewhere.
Conclusion
Although Ecuador’s government may believe a windfall tax would be a good way to bring in extra revenues from the mining sector, it would be a serious mistake on their part to take this proposal and make it law. Gold and other commodities may or may not rise to new heights in the years ahead, but the windfall tax will always appear as a major stumbling block for any mining company looking continue operations or to invest in the Ecuador’s future. On the other hand, a royalty payment system on gross earnings guarantees extra income for the state at high metals prices and has the advantage of being applicable at all price levels as well as being generally accepted nowadays in the mining industry.
President Correa has stated that, “Foreign investment that generates wealth and jobs and pays taxes will always be welcome.”(1), but if President Correa wants new foreign investors to play fair with Ecuador, he should remember that Ecuador must play fair with the foreign investors, else risk losing their revenue or even never seeing them arrive.
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