WA Gold Royalties – Really dumb idea

...but that’s what we expect from politicians. Mineral royalties are a well-established mechanism to provide a risk-free financial reward to the ultimate owners of minerals – ie the nation or the state in which a mineral is produced. This is fair – minerals are non-replaceable and therefore compensation is warranted. 

Sadly for the inhabitants of mining jurisdictions, mineral royalties have a history of being continually tinkered with by governments of the day, which undermines investor confidence in the jurisdiction.  A recent and topical example being Western Australia where the freshly elected Labor government has announced its intention to increase the royalty on gold by 1.25% points, from 2.5% to 3.75% as of January 2018 so long as gold is above $1200/oz.

The problem that all miners have grappled with through history, and face more than ever today, is that governments have a very poor understanding of the business of mining.  They love cutting ribbons at new mines !  But politicians have a low understanding of business generally, and are just as succeptible as society of which only a small portion is exposed enough to mining to understand much of its importance and impact on the economy – a much smaller portion than are actually directly affected.  At first glance, when casting around for sources of additional revenue, either the perceived profitability of mining (based on producing valuable minerals) or some reflection on profitability at the time provides a tantalising target for a government.  The temptation of course at present is driven by the parlous state of state finances in Australia.  The mixture in WA forms a toxic cocktail: a new government with little understanding of the mining business cycle, who are hoping to outspend their previous incumbents (presumably key to their political longevity), and an industry that is at a point of (for now) reasonable profitability.

Australia, disturbingly, has had a number of recent episodes of government grabs for extra revenue – each one originating from a government wanting a quick fix for their spending gap matched with an absolute lack of willingness (or capability) to cut costs of their own.  I’m thinking the Resource Super Profits Tax, which when it comes to outrageous tax grab, would have made Tanzania blush.   This was watered down to become the Minerals Resource Rent Tax, which no longer exists.  The election campaign that brought the WA Labor government to power featured a proposal by the Nationals Brendon Grylls to boost the levy on iron ore mined by BHP and Rio Tinto by 20x.

The industry has predictably and with great justification swung into action to defend this recent gold royalty proposal in WA, and the government is tackling the campaign with equally expectable rhetoric, based principally on the short term argument that “gold miners can afford it”.  This as a central argument highlights the magnitude of disconnect between politicians and the industry.  Every cost has to be funded, and purely based on company financials at present – yes, the gold industry in WA probably can afford it, this year.  But this isn’t about this year – royalties are forever. 

Public debate, and principally the understanding politicians have of the industry, needs to consider the longer term:

Immediate and unsustainable cost

• Royalties are levied on revenue, not profit.  Free cash flow (after reinvesting in a project to enable future production) to mine owners varies tremendously through the cycle, often out of synch with commodity prices.  Free cash generated by ASX listed gold miners from 2001 to 2014 were all negative, and during 2011 to 2013 provided fresh multi-decade lows, despite gold price reaching an all-time high in A$ terms in 2011.   
• At $1500/oz, the proposed royalty increase is near enough to $20/oz.  It doesn’t sound like much when you say it like that (which is precisely why it is said like that by Premier Mark McGowan).  But it equates to as much as the industry spends on brownfields extensions (given greenfields work is almost negligible still) each year – which as we know from five years of bust (2011-15) is an area of expenditure in recovery, and a budget that is first to go when times get tough.
• Even at present, $20/oz puts some mines in the red immediately.  Exhibit A is Telfer, which is a significantly sized operation in the domestic industry.  This makes it quite possible for the government to start the exercise with a fair bit of blood on their hands.
• Had this been levied in 2011, it would have shut many more mines in the couple of years to follow – and this is exactly the point.  Margins waver between what they are now (a cyclical high) and nothing, or in free cash flow terms – less than nothing, where expenditure is so high that the industry collectively raises money to break even after capex.  Declining production, or a loss of growth in production tends to put the mockers on the royalty funded government Christmas party, me thinks

Immediate effect on funding

• How do miners maintain a margin ?  They kick the cost can down the road.  You can’t avoid capex forever, that’s the nature of mining, but that is precisely where $20/oz will come from.  There will be plenty of years where the industry needs to raise this $20/oz, rather than make it. 
• Investors have learned not to trust governments, and events like this push distrust to a crescendo.  That extra $20/oz – it doesn’t belong to the mining company – it belongs to their shareholders.  Call it greedy and non-altruistic, but it’s a simple emotion for investors – you’re taking my money, so I’ll look elsewhere to do business.  The industry threatens this because they see it happen – their investors tell them directly. 
• The effect of increasing effective taxation on investors becomes acute in mining, which is a business that requires ongoing inputs of capital.  Some is reinvested profits, but a great deal has to be raised afresh – from a versatile and fickle pool that is ultra-sensitive to perceptions of risk.  Let me boil that down to a simpler phrase – new money won’t fund exploration or new projects in WA if the jurisdiction is seen to be too risky.  A government reaching out and stealing lunch money puts it in the "risky" basket.

Entrenched distrust

• All of the arguments above completely overlook the election campaign promises made by the new government.  No new taxes, and a commitment to engage in industry consultation on any proposed adjustments.  The miners have been let down in this instance, but they aren’t the only industry in WA – everyone is on watch now for the next tax grab.  Micro-breweries hot right now ?  Look out, that’s taxable !  Hot tip to Premier McGowan - Miners drink beer, you've missed a taxing point !

Should gold royalties be increased ? 

This does pose a threat to the industry long term – there will be many years that the additional cost increase pushes mines out of business.  Right now, there will be an effect on expenditure – exploration budgets will fall and people will loose their jobs.  This is simple - Mr XYZ who is Managing Director of ABC gold mining Ltd, needs to show his European and North American investors a steady / unchanged profitability margin knowing full well those investors compare his company with every other jurisdiction and will move their capital elsewhere if it is more profitable.

There is immense irony that WA, a state that has depended on a vibrant mining industry within which gold is a central pillar, would look to literally bite the hand that feeds it.  Mining in WA needs more investment, not less, to thrive through this cycle and beyond.  Rest assured, investors taking money out of (or just not investing in) WA gold won’t discriminate on commodity – the whole industry will feel it.