The Value of Net Smelter Royalty Returns

In today’s challenging financial climate, royalties give junior miners the capital to move forward and give investors exposure to future production and improved metals prices.
Royalties also give the seller of a resource property the ability to retain a position in future production from the property — without the associated risks or costs associated with that development.

Net smelter return royalties

Royalties are paid to the holder by the property owner, and give the holder the right to a continuous economic interest in future production of a mineral property and exposure to commodity price upside.
The most common types of royalties in the mining industry are the revenue-based net smelter return (NSR) royalty and the profit-based net profits interest (NPI) royalty. Of the two, NSR royalties are touted for providing the best returns, on par with a larger-percentage NPI or working interest in a project.
Mining output generally requires further processing by smelters to produce a marketable metal. Net smelter return refers to the gross revenue an operator receives from the sale of the mine’s products to the smelter, less any transportation, insurance, marketing and refining costs. Therefore, NSR royalties are based on net proceeds received by the operator from a smelter or refinery.
NSR royalties can be purchased for a single upfront payment, granting the owner a life-of-mine percentage of those returns. In contrast, NPI royalties pay out only after operating costs have been recovered and the operation starts turning a profit.
Typically, the standard NSR agreement runs between 2 percent and 5 percent, meaning a mine operator is obligated to pay 2 percent to 5 percent of the net smelter return to the royalty holder. Depending on the terms negotiated in the contract, the payments may be variable or fixed.
Calculating the value of an NSR royalty agreement is as simple as multiplying the number of attributable royalty ounces by the assumed average future commodity price to arrive at an approximate figure for the potential undiscounted pre-tax cash flow.
For example, if a mine operator sells gold for $900 per ounce to a smelter and its cash costs are $300 per ounce, the holder of a 2-percent NSR would receive roughly $12 per ounce. If the price of gold is projected to increase to $1,300 per ounce, the NSR holder then receives $22 per ounce.

Advantages of NSR royalties

For the royalty holder, NSR royalties are attractive assets that represent several benefits beyond leverage to commodities prices, including revenue at a reduced risk and ease of liquidity.
NSR royalties confer the advantage of cash flow without exposure to the risks of fluctuating operational costs at the mine, or the need for further capital costs such as those related to exploration or development. The royalty holder is not responsible for operating and capital costs or environmental and reclamation liabilities. The royalty holder can continue to have a stake in the upside of the property, but without any additional costs.
“You’re not obligated to pay for cost overruns,” explains Adrian Day, founder of Adrian Day Asset Management. “If the government increases taxes, you don’t have to pay them. If the water table breaks and the mine shaft floods, you don’t have to pay to fix it. You mitigate the risk by avoiding all those unforeseen additional expenses. The owner of a royalty just has to be a little patient and wait for the mine to finally get built and produce gold. That’s a big benefit.”
Payments to NSR holders begin as soon as mine product is shipped to the smelter, whereas NPI holders don’t receive payments until the operator has recovered any pre-production expenditures and other capital investments — increasing operating costs can also stall the commencement of NPI payments.
For the operator, NSR royalties are preferable to NPI royalties because they take considerably less of a producer’s cashflow stream, allowing for more room to finance growth through exploration and development — also a win for the NSR holder. There is also less chance for operator manipulation of the factors that go into calculating the NSR as compared to the NPI, which has at times been referred to as the “no payment intended” royalty based on publicized accounting scandals.
NSRs also offer better liquidity. “There are fewer factors that go into the calculation of an NSR which are subject to change, with the result that its value can be estimated at any time with a greater degree of certainty than an NPI,” states law firm Lawson Lundell. “This may give the NSR holder an advantage he or she would not have as the holder of an NPI, should a decision be made to sell the royalty.”

Royalties help retain upside

NSR royalties can be secured at any stage in a project, from early exploration through to mine construction. In a challenging financial climate, a royalty sale allows a junior resource company to raise capital for acquisitions, exploration and development without incurring equity dilution.
Some companies find this funding strategy to be more attractive and flexible than a traditional joint venture partnership. For the property buyer, they are beneficial in that they allow project acquisitions at a reduced price and only require additional payments once production commences, reducing the inherent risks associated with structured loan payments.
“Typically, NSR agreements are used by resource companies to help finance either additional exploration or even development of a mine,” says Terry Lynch, chairman of Chilean Metals (TSXV:CMX,OTCQB:CMETF,SSE:CMX,MILA:CMX,FWB:IVV1,BER:IVV1). “They also represent a way for resource companies to sell an asset and maintain some of the upside of a project. This was the case with the sale of our Copaquirie asset to Teck Resources (TSX:TECK.B,NYSE:TECK).”
Chilean Metals owns a 3-percent NSR royalty interest on any future production from the Copaquire copper-moly deposit, recently sold to a subsidiary of Teck. Copaquire borders Teck’s producing Quebrada Blanca copper mine in Chile.“We didn’t really want to sell the asset given its huge potential, but in the economic conditions it was literally sell or die,” adds Lynch.
“Choosing life, we did get this attractive royalty. Thanks to rising copper prices and declining Teck mine resources, Copaquirie is coming closer and closer to going into their mine plan.” Teck recently announced that it will cease mining at its QB1 mine in 2018, and production will end mid-2019. Perhaps Chilean Metals’ royalty property Copaquire will no doubt be investigated to extend the life of QB1?

How should investors evaluate NSR agreements?

NSRs have attractive features for shareholders as well, including the potential for dividend payments and non-dilutive exploration and development funding. But not all NSR agreements are cut from the same cloth. How can interested investors evaluate a company’s NSR royalty and assess its value?
First of all, be cautious of earlier-stage exploration or development properties. The project may have interesting drill results, but that’s not an indication that it has the potential to become a viable mine — and that NSR royalty doesn’t start paying out until product is sold to a smelter.
Understanding the likelihood of a project going into production is critical, explains Lynch. “I would say investors first need to have a view as to if and when this will happen, as some projects just don’t seem feasible in any real-world sense. For a copper project, it takes hundreds of millions, if not billions, of dollars to bring a mine into production. Very few companies have the capital and expertise to make this happen.” In the case of Copaquirie, it has two NI 43-101 resources adjacent to a producing mine, and Teck has both the capital and technical expertise to complete a mine project.
Once you’re certain of a project’s viability to become a mine, the next question is “when?” This is an important factor for use in the discounted cash flow model investors must use to calculate a valuation for the royalty, says Lynch.
Another part of the financial analysis is the production rate and grade of the mine. These figures typically can be found in prefeasibility or feasibility studies. “In the case of Copaquirie, we have the existing production records of the Que Brada Blanca mine, which ranges from a peak of sales of $696 million in 2012 at an average copper price of $3.42, to sales in 2016 of $229 million,” says Lynch. “We also have the feasibility study on Que Brada Blanca to analyze, which can give an investor a sense of what the numbers might be if and when Copaquirie gets produced.” The feasibility study will also provide analysis on the long-term forecast for the price of the commodity under production.
The last piece of the puzzle is how the company with the royalty will realize on its asset. Will it be sold to a royalty company? Or will the company hold onto the royalty until the property comes into production?
“We have reviewed both options and have opted to hold the royalty until it goes into production,” says Lynch. “Our largest shareholders are very savvy real estate investors, and they view the royalty as comparable to holding raw land surrounding a growing city. You sell now and some developer reaps the benefit. You wait, and the closer the project gets to production the more the value increases. With declining mine grades, the ecological challenges of developing new mines and the tremendous growth in copper demand, we think this royalty is getting more and more valuable by the day.”

The takeaway

Challenging credit markets are pushing resource companies to get creative in finding funding sources that don’t dilute shareholder value. Royalties are attractive alternative financing structures that offer profitable leverage to commodities prices while maintaining a stake in a project’s production potential. NSRs for projects with near-term production potential and highly capable operators hold the most value for investors.
This article was written according to INN editorial standards to educate investors.