Given the current environment of falling metal prices and increasingly elusive sources of attractive capital, mining issuers are turning to unconventional financing structures to fund their development and production costs. In particular, junior explorers have faced significant difficulties in obtaining equity financings. For example, the TMX Group has reported that the total number of financings raised on the TSX Venture Exchange in January was down 71% from December 2012 and down 51% from January 2012. Further, the Prospectors and Developers Association of Canada estimates 80% of Canadian mining companies are struggling to raise capital.
Recently, we discussed how stream financing is used in the resource sector. In this post, we will provide an overview of another alternative that can be used by mining issuers (particularly junior mining companies) trying to get a new mining project off the ground, or obtain financing for production stage mines.
Commodity Forward Purchase Agreements
A prepaid commodity forward agreement is a facility whereby a buyer agrees to purchase a certain quality and quantity of a commodity from a producer in exchange for an up-front payment. In short, the buyer is acting as a lender in the sense that it is providing money up-front in exchange for future production.
For example, under a typical gold forward purchase agreement, a gold miner is required to deliver a designated quantity of gold at monthly intervals over a specified term. The quantity of gold to be delivered can be structured to steadily increase in a manner commensurate with the development and production of gold at a developing mine.
In addition to obtaining the seed capital necessary to kick-start a new mining project or to invest in capital expenditures at a mine that is already in production, this unique financing vehicle can help a mining issuer achieve multiple objectives while simultaneously reducing financial risk, commodity risk and the risks with associated start-up delays.
Entering into a commodity forward purchase agreement can have potentially significant benefits over traditional forms of equity and debt financing:
- avoidance or minimization of share dilution (as opposed to an equity offering);
- access to a diverse range of finance sources;
- preservation of management control (as opposed to a joint-venture);
- often no or limited financial covenants (i.e. no monitoring of the company’s financial performance such as leverage or fixed charge tests as would be expected in a typical bank loan)
- absence of conventional interest payments;
- protection against commodity risk (however seller could retain opportunity to benefit from rising prices); and
- advantageous accounting treatment which may result in the forward contract not being accounted for as debt on balance sheet if structured appropriately.
Scope of the Agreement:
Under a commodity forward purchase agreement, the seller agrees to exchange a specified quantity of a commodity over the term of the entire agreement, with such quantity being delivered in amounts that are commensurate to the anticipated output of the project in question. Normally, the buyer bears the price risk associated with the commodity while the seller bears the costs and expenses associated with the production, transport, refining and delivery of the commodity.
If the company already has a similar mine in existence, the deal can be structured so that the commodity can be delivered from either the existing mine or a developing mine, which can serve to reduce start-up risks and delays that are associated with the development of new mines.
Moreover, as a condition to closing, the buyer will likely require that the seller enter into, and maintain, refining agreements with respect to the commodity being produced in order to ensure that the quality of the commodity meets its standards.
Pricing and Valuation:
The commercial negotiations usually revolve around the setting of minimum and maximum prices of the commodity. The buyer assumes the risk that the commodity price may fall below the minimum price, while the seller largely assumes the risk that the price may increase beyond the maximum price.
In the event of the commodity price falls below the minimum price, the transaction could be structured to provide for the parties to enter into an ISDA Master Agreement requiring the seller to enter into a swap that would have the net effect of reducing the seller’s exposure to movements in the commodity price. Conversely, the seller may retain the opportunity to benefit from a rising commodity price through the implementation of price participation terms requiring the buyer to provide additional payments in the event the price of the commodity exceeds the maximum price.
It should be noted that achieving some of the substantial benefits above often comes at the cost of the commodity being sold at a discounted rate to the buyer.
Protections for the Buyer:
The buyer is likely to seek a comprehensive security and warranty package that is similar to that which would be provided on a debt financing transaction. Buyers are likely to focus on certain specific protections, including warranties that the licenses are in full force and effect, warranties that there are no existing charges over the specified quantity of production that is subject to the forward agreement and warranties as to the accuracy of any reserve reports and/or protection reports or forecasts used in the valuation.
Although the buyer is likely to seek a covenant package similar to that which would be provided on a debt financing transaction, the seller would often not be required to meet certain financial and performance thresholds (i.e. in form of financial covenants), as is the case in typical commercial loan.
Finally, if the seller is unable to deliver a portion of the scheduled quantity, the buyer will likely require the seller to pay an amount equal to the shortfall. This would result in a proportionate reduction in the contract quantity that is to be delivered over the course of the agreement.
Normal Course Due Diligence:
Commodity forward purchase agreements are usually subject to normal course due diligence on the seller and on the mine in question and conditions to closing are akin to those which lenders seek in a debt financing.