Mining Royalties: How to Decide
Making a discovery is half the battle… The royalty decided upon will impact the project and the royalty holder for, in some cases, decades. So, what royalty is right for the project and right for the future?
According to the World Bank, royalties are calculated based on either units or values.
Unit-based royalties can be calculated based volumetrically, by weight, or by a sliding scale of incremental unit production. These unit-based royalties are generally more stable and more transparent than other royalty models, such as net-smelter royalties.
A unit-based royalty might be right for you if:
The project has robust economics
The project is in a stable jurisdiction
Royalty holder is averse to commodity market volatility
Unit-based royalties do have a few drawbacks, however. Primarily, there is no exposure to market upsides in metal commodity prices. Another drawback to unit-based royalties is that the per-unit basis of the royalty does not take into account the grade of material being mined. If a project has largely fluctuating grades or has marginal economics, a per-unit royalty may detrimentally affect project economics and may impede the project from operations altogether. On the other hand, a benefit to unit-based royalties is that they generally are not impacted by the market prices and therefore allow for a consistent revenue stream for the royalty holder.
Value-based royalties are the largest category of royalty and frequently the most sought after by royalty holders. Value-based royalties fall under three categories that provide different advantages and disadvantages to royalty holders and operators. The three categories for value-based royalties are: Ad valorem (proportional), profit/income based, and hybrid models.
An ad-valorem royalty is commonly the most sought-after royalty on new projects. Examples of ad-valorem royalties are net smelter royalties (NSR), gross smelter royalties (GSR), and gross sales royalties.
Generally speaking, ad-valorem royalties will provide the largest return on the held royalty, but that doesn’t mean it is a one-size-fits-all royalty type.
An ad-valorem royalty might be right for you if:
The project has robust economics
The project is in a stable jurisdiction
Royalty holder desires exposure to commodity market upsides
Ad-valorem royalties are much like unit-based royalties in that the project they are applied to needs to have healthy economics, and operate in a stable jurisdiction. Operations in stable jurisdictions are less prone to additional taxes, government intervention, or a number of other factors that can seriously impact the economics of the site. Ad-valorem royalties also expose the royalty holder to upsides in the commodity market, allowing the royalty stream to generate more revenue in years of strong commodity prices.
Canada’s Voisey’s Bay is subject to a number of ad-valorem NSR and NVR royalties on its metals production. It is also subject to Canada’s standard profit-based mining royalty. Image by Vale.comNext on the list is profit/income-based royalties. The main benefit to this royalty type is that project economics are not fundamentally impacted. If the mine is making money, so is the royalty holder. Profit/income-based royalties essentially preserve the net present value of the project under any given circumstances in the market. This means that the royalty is only paid in years that yield profits.
A profit/income-based royalty might be right for you if:
The project has marginal economics
The project is in an unfavorable jurisdiction
Rapid payback is required
Profit/income-based royalties will not generate an income in years when the mine is not in production (i.e. startup). This royalty is also suited to projects in unfavorable jurisdictions as it allows other royalty types to be applied to events that may impact the mine (civil unrest, protests, etc.). For example, if a mine is under strike, an ad-valorem royalty can be added to the profit/income-based royalty to generate an income to pay the impacted parties.
The final royalty type is the hybrid royalty. Hybrid royalties can be a combination of any of the previously discussed royalties; although, the most common rendition of a hybrid royalty type is an ad-valorem with a floor price applied. The addition of a floor price ensures that project economics are not impacted to the point of closure in poor commodity markets.
A hybrid royalty might be right for you if:
The project has robust economics
The project is in an unfavorable jurisdiction
Rapid payback is required
Hybrid royalties are the most sophisticated on the list, often setting floor prices for the royalty around metals prices that might be deemed at the margin for the project. A hybrid royalty is most easily decided upon when a project is already in production (royalty leveraged for funding), or with a project that has already had preliminary economics run. Although this model is arguably the most beneficial to both the operator and the royalty holder, it is also the most nuanced.
So, what royalty do you pick? This depends on both the stage of the project and the type of project. If the project is an early-stage exploration target, an ad-valorem royalty that is most beneficial to the royalty holder makes the most sense, considering the risk involved and the potential on the new deposit. If, for example, you are funding a well-defined deposit in return for a royalty stake, a hybrid-royalty model may make the most sense. With a project closer to production, a hybrid model will protect the project during operation if commodity prices drop and ensure cash flow to the royalty holder under most circumstances. If you have a project in an unstable jurisdiction such as Guatemala, or Peru, it might be prudent to pursue a profit/income-based royalty to ensure room for additional funding if civil or local unrest threatens the project. If you have an aggregate operation, a unit-based royalty may make the most sense as grade is of little issue and the royalty is based solely on production. Governments also favor unit-based royalties as they are the easiest to calculate, collect, and are the most predictable.
As can be seen, there is no cut and dry answer to “What royalty is right for me?” but in understanding the benefits and drawbacks to each royalty type, the problem can be approached pragmatically. Best of luck in exploration! As always, if you need help with advancing a project, give Convergent Mining a call.
A comprehensive discussion on mining royalties for investors and governments by the World Bank can be found here.
