Investors familiar with precious-metal streaming and royalty companies may be intrigued by Vale's (NYSE:VALE) decision to reportedly sell streams of future iron ore output for as much as $10 billion to help pay down debt. Fairly uncommon, though not unheard of, a mineral streaming deal would provide the mining giant with much-needed cash while also giving it some measure of future assurance. But there is a dark side to such arrangements, and the problems that may arise are serious enough that Vale investors ought to worry if this deal goes through.
A torrent of opportunity
In a typical precious-metal streaming deal, the company buying the stream makes an up-front payment to the miner in exchange for receiving future production from the mine at a predetermined, usually below-market, price. The contracts often remain in place for as long as the mine is producing, and the streamer continues to make ongoing per-ounce payments.
Silver Wheaton (NYSE:SLW) essentially created the industry that we know today in the early 2000s. It is the largest pure precious-metals streaming company in the world and has streams on some of the largest and lowest-cost mines.
In the first quarter, it paid on average $4.14 per ounce for silver, ranging from $2.98 at Teck Resources' (NYSE:TECK) Antamina mine, in Peru, to $5.38 per ounce at Glencore's Peruvian Yauliyacu mine. Silver Wheaton's average cash costs for gold were $389 per ounce, falling between the $400 the company paid Vale for production from its Salobo, Brazil, and Sudbury, Ontario, mines, and the $366 it pays for gold from a number of other projects.
BHP Billiton (NYSE:BHP) has a royalty contract that operates much the same way for one of its mines in the Pilbara region of western Australia, where it pays Iluka Resources a royalty rate of 1.232% for iron ore mined from its Mining Area C, plus annual payments based on increases in production.
Digging itself out of a hole
Vale is looking to sell 3% of its future ore output to a group of unnamed Chinese companies over a 30-year period in exchange for as much as $10 billion. The miner is desperate to reduce its $27 billion debt load, which it has committed to lowering by a third over the next 18 months. In addition to the streaming deal, Vale continues to unload assets and is said to be exploring the sale of its fertilizer business to crop nutrient producer Mosaic for some $3 billion.
While numerous miners have come under pressure from falling commodity prices and are turning to asset sales to pay down their debt, streaming deals are also growing. Reuters, which was first to report Vale was mulling a streaming deal, noted Glencore, Teck, and Barrick Gold (NYSE:GOLD) have all struck new precious-metals streaming agreements recently.
Not all that glitters is gold
But there's a big risk involved, too, particularly for Vale investors, as the miner is now considering expanding its use of streams.
The problem is that the price of the metal or mineral may not remain low. As more output is added to the stream, the contract, which, like the royalty contract Iluka Resources has with BHP Billiton, is in perpetuity, meaning the value proposition moves from the miner to the streamer, particularly if prices rise.
When gold and silver prices soared during the commodities boom a few years ago, with gold rising to $1,900 an ounce and silver hovering at $50, streamers like Silver Wheaton reaped a huge windfall because they were paying deeply discounted rates. It was a windfall that came at the expense of the miners and their investors.
Gold miners also used hedging tactics the way companies are using streaming contracts, and after prices soared, it cost them dearly to extricate themselves from the hedges. It cost Barrick Gold some $5.1 billion to completely unwind its hedges, while AngloGold Ashanti had to spend almost $1.4 billion to get out of its hedges after gold began rising.
Iron ore will rise again too
Analyst expectations for iron ore prices have been all over the place lately, with some seeing increases while others are forecasting a decline, but import prices for 62% iron content fines at the port of Qingdao, China, just jumped to a three-month high of around $62 per metric ton, still below their peak but well above the $37 per-metric-ton nadir they hit last December.
There are certainly contradictory signals as to whether pricing can keep rising this year, and the miners themselves are warning the boom cannot last, but by locking itself into a long-term streaming contract, Vale may be cutting itself and its investors out of the loop for future profits if and when iron ore prices do bound higher.