New York University



Rio Algom in Perú

A Case Study

Copyright ©1996 Ian H. Giddy.

Rio Algom is a global metals company based in Canada. Its chief businesses are the exploration, mining and refining of copper, zinc and lead, and other metals.

In late 1996 the company was negotiating a $630 million loan facility with a group of banks lead by Canadian Imperial Bank of Commerce and Banco Santander. The purpose of the loan was to finance Rio Algom’s share of the purchase price of the Antamina copper-zinc mine in Peru. Antamina is located in the Ancash region, 300 miles (480 km) north of Lima, the capital.

Antamina was being sold by Centromin, the Peruvian state mining company, as part of Peru’s privatization program. Rio Algom was purchasing the mine in a 50-50 partnership with Inmet, another Canadian natural resources company, for a total price of $2.52 billion.

The project had proven and probable ore reserves of 128.6 million tonnes at an average grade of 2.2% copper equivalent. At least 10% of these reserve could be extracted each year for the first ten years of production. The bid provided for a cash payment of $ US20 million and an investment commitment of $2,500 million.

The commitment, in the view of some analysts, may have been excessive (capital expenditure estimates are put at no more than $1,200 million). Micheal Parrett, Rio Algom’s chief financial officer, noted that the figure should be seen as a "deferred payment" rather than a realistic estimate. Additional expenditures could be necessary if the joint venture required additional capacity because of strong world demand for copper. The agreement specified that if the commitment was not realised, Centromin would receive 30% of the difference but Rio Algom and Inmet would retain control of the project.

Total operating costs of the mine were uncertain, partially because some of the costs would be incurred in local currency, the Peruvian Nuevo Sol. A rough estimate was $120 million in annual fixed costs, plus variable costs of $950 per tonne of copper. The major risk facing the project, the company acknowledged, was fluctuations in the price of copper. Rio Algom estimated that the mine would be unprofitable at a copper price of $1,300 per tonne. If for any reason the mine had to be shut down temporarily, as had happened recently to their partner’s zinc-lead operation in Tunisia, the project would continue to incur maintenance costs of about $40 million per annum.

On the other hand, the interest rate risk was substantial too. At a spread of 45 basis points over Libor, the planned borrowing could add $6 million per year to the company’s costs for every 1% rise in rates. Hence they were looking for some means of hedging the interest cost. Given the current rate structure, the company was reluctant to lock in the cost with an interest rate swap. Parrett made it known that he was interested in proposals from banks.

As the Banco Santander representative, what can you suggest? What kind of loan would be appropriate? Should Rio Algom use derivatives to hedge its risk? If so, what kind?

Background (as of November, 1996)

Toronto-based Rio Algom has expanded internationally since RTZ sold its controlling interest in 1992. Base metal production has doubled in the past four years and nonstrategic assets have been sold. The company now operates two significant businesses: mining and metals distribution. Net consolidated earnings in the six months to end-June were $ C43.6 million, with 60 % coming from the mining interests and 40 % from the metals distribution businesses.

Rio Algom's roots remain in copper, and beneficial production of the metal is expected to double within five years. The company's current mining assets are centred upon the wholly-owned Cerro Colorado copper mine in Chile, a 33.6% interest in the Highland Valley copper mine in British Columbia, the 29.1%-owned Bullmoose coal mine (yielding Rio Algom 0.54 Mt last year) in British Columbia, and the 25% royalty interest in the Polaris zinc mine in the Canadian arctic. In its metals distribution division, Rio Algom has the Vincent Metal Goods subsidiary in the U.S., Atlas Alloys in Canada, and Aceromex in Mexico.

According to the company's chief financial officer, Michael Parrett, and the vice-president of mining, Don Cumming, the company intends to continue growing by focusing primarily on base metals, and expanding its exposure to copper in particular. Rio Algom is also seeking to add more gold assets, most likely through copper/gold developments. Despite its diverse assets, copper is by far Rio Algom's most important product -- a USD0.10/lb annualized change in the price of copper alters earnings by CAD0.34/share (which will rise to probably 46 c/share in 1998). Rio Algom's average copper production cost is USD0.60/lb, and is expected to drop below 45 c/lb when the new developments are online.

Copper production this year is expected to exceed 240 Mlb, with Highland Valley contributing 117 Mlb and Cerro Colorado 125 Mlb. This output is scheduled to rise to 350 Mlb in 1998, with a potential for up to 600 Mlb/y within five years as several developments reach production. Rio Algom has a 25% interest in the developing Bajo de la Alumbrera project in Argentina (North Ltd 25%, MIM 50%). When production begins in late-1997, Rio Algom's beneficial annual production will rise by 100 Mlb of copper and 160,000 oz of gold. Meanwhile, a detailed study of an expansion at the Cerro Colorado mine is under way. The reserves of 188 Mt at an average grade of 1.08% Cu are enough for a 30-year mine life at the current production rate, and an additional 130 Mlb/y is mooted.

Away from copper, Rio Algom is proceeding with development of its Smith Ranch uranium project in Wyoming. Production of 2 Mlb/y from this resource, which contains 60 Mlb of uranium, is expected to commence in the third quarter of next year. Costs are put at under USD11/lb, and Rio Algom has already established a six-year sales contract at a price of USD17-23/lb, compared with a current price of USD16/lb.

Appendix 1

Facts on File World News Digest, September 19, 1996

Inmet and Rio Algom offered a cash payment of $20 million in their Antamina bid and committed to spending at least $13.5 million on feasibility studies before 1998. Overall, the companies committed themselves to spending $2.5 billion on the mine, although company officials said that the project would likely cost between $1 billion and $2 billion. Inmet and Rio Algom agreed to pay 30% of the difference between their capital spending and their $2.5 billion bid to Centromin if the spending was lower than the bid. The two companies expected metal production to begin in the year 2001.

Reuters Financial Service

HEADLINE: RIO ALGOM, INMET PLAN $ 13.5 MLN PERU INVESTMENT

DATELINE: LIMA, SEPT 17

The Canadian consortium of Rio Algom Ltd and Inmet Mining Corp plans to invest at least $13.5 million on exploration at Peru's Antamina prospect in the next two years, the Peruvian government said Tuesday.

An Energy and Mines Ministry statement said in Lima that this money would be used "to complete the exploration tasks that allow them to prove with greater breadth and precision the level of proven and probable reserves which have been estimated at 130 million tonnes."

The ministry said drilling work had begun at Antamina, in the northern Ancash region, and the aim of reaching a depth of 60,000 meters should be achieved within nine to 10 months.

In addition to the proven and probable reserves, the site has an estimated 900 million tonnes of potential reserves of copper, zinc, silver and molybdenum, the ministry added.

"If the result of the evaluations at the end of the two years is positive, and the group decides to continue with the Antamina prospect, they will have to assume the investment commitment of $ 2.52 billion in a period of five years," the statement said.

The New York Times Company: Abstracts, October 21, 1996

HEADLINE: INMET MINING CORPORATION

DATELINE: TORONTO, Oct. 18

Inmet Mining Corporation (" Inmet" ) announced today that Societe Miniere de Bougrine S.A. ("Bougrine"), in which Inmet holds a 48% interest, has indefinitely suspended mining and milling operations at its zinc/lead mine in Tunisia. An evaluation of the capital required to lower operating costs has been completed. The investors in Bougrine have determined that the required

investment is not justifiable in light of current zinc prices. Inmet had made a partial write-down of its investment in Bougrine at June 30, 1996. Inmet expects to make payments in respect of approximately $ 33 million of loans made by two international development banks to Bougrine which have been guaranteed by Inmet.

IAC (SM) Newsletter Database (TM)

Report on Mining, Metal Making and Conversion

September 1, 1996

HEADLINE: PERU: JOINT VENTURE TAKE-OVER OF PRIVATIZED MINING PROPERTY COULD LEAD TO $2,500,000,000 INVESTMENT COMMITMENT, INMET MINING & RIO ALGOM CANADA

INMET MINING CORP., in which METALLGESELLSCHAFT AG of Germany holds a 50.1% interest, is involved in copper mining. The company also operates a copper smelter, refinery and associated power plant.

The Antamina deposit in question is said to have estimated reserves of 128

million metric tons (mt) of ore grading 1.6% copper, 1.3% zinc, 0.04% molybdenum

and 17.7 gr. silver per ton of ore. Further drilling is needed to better define the potential of the orebody, which at present is open in several directions. Plans reportedly envision the construction of a large-scale open-pit mine. Production output has been forecasted to reach 1 million tons per year of copper and zinc concentrates at what is expected to be a relatively low cost.

Financial Times, July 16, 1996

Potential reserves are estimated at 913m tonnes. Inmet/Rio Algom executives believe these figures, based on feasibility studies carried out over the years by the former Cerro de Pasco Corporation, by Mineroperu and by Geomin of Romania, underestimate the deposit's worth.

Located in the north-central department of Ancash on the eastern side of the Andes mountain chain, development of Antamina will involve substantial investment in road and energy infrastructure.

Inmet/Rio Algom executives said they had spent over Dollars 1m on serious studies of the deposit over the past 18 months. They have five drilling crews 'ready to go' and expect to lay out some Dollars 30m before their two-year option on Antamina expires. Rio Algom said within two years of closing, the winning bidder may elect to return the property to Centromin, provided that a minimum of US$ 13.5 million, in addition to the intial payment, has been expended on the property.

Appendix 2

Interest Rates and Commodity Prices

November 14, 1996

Eurocurrency Interest Rates

| | |

|Maturity |Rate per annum |

| | |

|1 month |5.38 |

|3 month |5.52 |

|6 month |5.55 |

|1 year |5.71 |

Government bond rates

| | | | |

| |Rate per annum | | |

| | | | |

|Maturity |Current |1 month ago |1 year ago |

| | | | |

|1 year |5.44 |5.59 |5.46 |

|5 years |6.00 |6.31 |5.72 |

|10 years |6.21 |6.57 |5.96 |

Metals Prices in London ($ per tonne)

| | | | | | |

| | |Yesterday | |Previous | |

| | | | | | |

| | |Buy |Sell |Buy |Sell |

| | | | | | |

|Copper |Cash |2142 |2145 |2085 |2088 |

| |1-yr Futures |2054 |2055 |2011 |2013 |

| | | | | | |

|Lead |Cash |733.5 |734.5 |728.0 |729.0 |

| |1-yr Futures |738.0 |738.5 |731.5 |732.5 |

| | | | | | |

|Zinc |Cash |1041 |1042 |1031 |1032 |

| |1-yr Futures |1054 |1055 |1060 |1061 |

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