Mining Jurisdictional Risk...excellent article from Graham Analytics

"Below sure reinforces my desire to own advanced explorers like a T.RDK preferably in safe or de-risked jurisdictions. Exploration and metallurgy risk is one thing but political risk, well let's just say I'll be paying more attention in the years to come even with a thoughtfully presented alternative viewpoint provided here. To each our own comfort levels. T.RDK is a copper explorer in Arizona which raised $20+M @ $0.75 while SA, a really interesting Au-Ag explorer in Indonesia did PP raises of approx. $26M over the last 24 mos. @ $1.60 and $1.70 per share. Other examples are "SSP" Sandspring Resources $50M + and "RN" Rio Novo $50M+ both in price ranges of $1.60 to $2.30 . The latter 3 cos. trading way below recent IPO and 2ndary Financing Levels, are probably good buys but no longer in my comfort level. Location, location. location in accordance with political risk is my #1 prioirty going fwd. Kevin Graham is an entertaining and thought provoking writer whose blog I enjoy on a regular basis. Doing your own homework with the benefit of bloggers like him and the many folks here, can only help our portfolio results."

Political risk in Indonesia – another perspective

March 22, 2012

Rumblings of political risk in Indonesia have recently been raised a notch or two on the scale. On March 7th, it was announced that, on February 21st, President Susilo Bambang Yudhoyono (SBY) had enacted a new law that requires foreign companies to sell down their share of mines by the 10th year of production, leaving domestic ownership at no less than 51%.

Immediate reactions in the press and online forums were pretty much what you'd expect. The sky is falling, the end is near, no hope now or ever, etcetera, etcetera.

As usual, knee-jerk reactions don't school us much, except on the risks of knee-jerk reactions. For the past week, I've been laying in the sun doing absolutely nothing (don't believe the beach servers), so I've had the chance to ponder this latest development. Here's how it all breaks down for me.

As usual, we begin by scribbling down any and all questions that come to mind, including:

•Who's doing what?

•To whom are they doing it?

•For whom are they doing it?

•Why are they doing it?

•Why are they doing it now?

•What change does it represent?

•How will the landscape look when the dust settles?

•When is the dust likely to settle?

•What are the broad global comparatives?

•What are the long-term implications?

Of course, this apparent system shock is just one more highly nuanced issue. Aren't they all? Not listed above, I wonder why it took from February 21st until March 7th for this decree to become public. For sure, there's a back story in there, but I haven't a clue on where to start so let's not even try. I am comfortable speculating on the listed questions but warn that it's all just speculation. What I hope to achieve by this exercise is some structured understanding of both the environment and likely outcomes. The framework of first asking many questions seems to work best. Failure to respond to system shocks in this methodical way represents certain guarantee of incorrect conclusions… and actions to match.

On the surface, it's easy to jump to the conclusion that the Indonesian government is merely setting itself up to nationalize its resource sector, currently dominated by foreign interests. One-half layer down, one might be forgiven for seeing key domestic mining interests, some of which are represented in senior government positions, as behind a move designed to advance personal interests. This is to say that, unlike here in Canada, such protectionist moves in Indonesia are always nefarious and not crafted with the greater public good in mind (hmmm…?).

Let's be realistic here. There is a global trend towards nationalization of natural resources. Third world nations and emerging economies have been and continue to be key investment targets for multinationals. As long as these nations hold significant stores of sought-after resources, those with capacity will be engaged in a never-ending negotiation for the opportunity to exploit those resources. In turn, nations historically exploited (in the pejorative sense of the word) are highly motivated to ensure that their own interests are protected in this same negotiation. No longer prepared to be colonized, they are stumbling to their feet like the newborn fawn, unsure of the path ahead.

History is important here, as are context and comparison. The Indonesian government is in the middle of efforts to re-negotiate its contract with Freeport-McMoran as regards the Grasberg mine. Representing 1.6% of Indonesia's GDP, Grasberg is the lowest cost copper mine in the world. It is the third largest copper mine and the largest gold mine in the world. Grasberg is the world's most profitable mine. A very sore point for the Indonesian government, it is also 90.64% owned by Freeport, with the balance held by the Central government of Indonesia.

A sweetheart deal with the Suharto government, Grasberg is currently targeted for a re-jigging. The challenge facing the Indonesian government in this is that they are in the enviable position of being able to boast that they have never abrogated an agreement with a foreign mining concern. Avoiding that touchy issue and at the same time re-positioning this picture for the greater good must be a very knotty challenge, indeed. It doesn’t take a rocket scientist to figure out that this latest announcement is a shot across Freeport's bow in a messy and delicate negotiation. All the more delicate when you consider that Freeport-McMoRan is Indonesia's largest taxpayer.

The suggested 51% domestic ownership level is also not new. In fact, it matches perfectly with Newmont's Batu Hijau mine, located on Sumbawa Island, east of Lombok, home to Southern Arc's flagship property. Signed in 1986, the Newmont Contract of Work provided for a minimum of 51% domestic ownership of Batu Hijau by the tenth year of production, which turned out to be 2010.

"Under the Contract of Work, beginning in 2006 and continuing through 2010, a portion of PTNNT’s shares must be offered for sale, first, to the Indonesian government or, second, to Indonesian nationals, equal to the difference between the following percentages and the percentage of shares already owned by the Indonesian government or Indonesian nationals (if such number is positive): 23% by March 31, 2006; 30% by March 31, 2007; 37% by March 31, 2008; 44% by March 31, 2009; and 51% by March 31, 2010. The price at which such interest must be offered for sale to the Indonesian parties is the highest of the then-current replacement cost, the price at which shares would be accepted for listing on the Indonesian Stock Exchange, or the fair market value of such interest as a going concern, as agreed with the Indonesian government." Source link.

As the 2010 deadline approached, the double-edged challenge became: the ascertainment of fair market value; and finding someone with the money to buy the final 7% block.

This, in turn, raises for me the most puzzling aspect of the whole picture. If the Indonesian government is operating in good faith, and I have no reason to believe otherwise, they appear to have chosen a most ticklish path to serving the greater good… and I don't mean ticklish in the funny way. Mining companies are loathe to advance properties for which they cannot wield majority control. So… the latest move by the government immediately raises red flags for accountants in companies as they consider long-life mining projects.

For most mines, I would think that by 8-12 years, most of the resource has already been extracted, so this change will not come into play. For the mega projects, however, who wants to commit to a project for which control will necessarily be ceded after just 10 years? Maybe I've had one too many Bahama Mamas of late but, from where I sit, the smoothest path to the greater good would be secured in the royalty negotiation. Control of a project remains in the hands of those tasked with funding its creation, and benefits accrue to the domestic interest via a competitive tax structure. Playing with the ownership question, for me, just opens up suspicions that the underlying motivator at work here is not, as argued, the greater good of the Indonesian people, but rather the greater good of a few well placed individuals.

Strike an aggressive but equitable tax rate, I say. Collect the tax. Re-distribute the wealth appropriately to the people. Everybody's interest (well, almost everybody's interest) is served. The determination of what the tax rate should be is a simple matter of trial and error. Too high, and investment goes down. Too low, and your opportunity cost for revenue (as a government) goes up. There are scores of comparative tax regimes around the world with which to compare. Seems relatively straight forward to me.

Here's what this new structure is NOT. This is not Hugo Chavez nationalizing Venezuelan resources. Hugo Chavez is what I think of when we talk about political risk. The Indonesian experience is closer, I think, to the Canadian government saying 'no' to BHP Billiton in late 2010 on its deal to take over Potash Corp. They called the company a "strategic resource". How is this any different from the Indonesian government trying to come up with a formula to protect its own people's strategic interest in resources?

From the same Globe and Mail article, "The more clarity we have, the easier it is to sell Canada as an attractive foreign investment destination." Importantly, how is this different from the current Indonesian experience? To my way of thinking, if there's anyone in the Indonesian government listening out there, this need for clarity is your most important takeaway. If you are, in fact, negotiating with Freeport in the public eye, you need to make sure that you're not amputating your legs to save carrying the extra weight down the track. Collateral damage risk is high in an environment lacking in clarity.

On the subject of Southern Arc, many have concluded that hurdles and delays have been encountered owing to matters outside of the control of the Company. Rather, they blame ineptitude and corruption attached to the Indonesian bureaucracy. I do not have any direct related experience that supports any accusations of corruption in these matters. It may or may not be an issue. Like everyone else, I've read the country-risk ratings, and heard the rumours. The same 2012 Behre Dolbear report that describes Indonesia as having made small gains on this account also describes the United States as losing ground: "The financial influence (through fund raising) of lobbyists and other purported public-interest groups on the legislative process in the United States was considered to be legal corruption…" At the same time, I prefer to make no such accusations of corruption without direct personal experience. I think it's fair to say that the bureaucracy in Indonesia is nascent and is making the rules up as it goes along. Witness, as example, the recent requirement for the 'clean and clear' status on the IUP before moving forward on the West Lombok forestry permit. That one came right out of left field. Inept? Maybe. Lacking in circumspection? For sure. An absence of clarity? D'ya think?

I would go even further, though, to say that, in some cases, these hurdles and delays are currently outside of the control of the Indonesian government. Indonesia is a collection of more than 17,000 islands, comprised of innumerable tribes. I use that word without hesitation here, familiar with other nations governed under the influence of competing tribal interests. The very notion of a 'central' government in Indonesia is unlike anything we in the West can fully understand.

As a young democracy (third largest in the world), moreover, Indonesia is still trying to figure out how democratic processes work. With much progress behind in such a short period, much ahead still remains.

In my view, the 2009 Mining Law offered much clarity for international investors. At the same time, I think it opened many new cans of worms by its distribution of decision making authority. Many cooks in the kitchen make for an interesting bowl of soup. I'm not judging Indonesia's decentralization of authority in these matters to be wrong. Judging is easy for many people… not for me. Fair to say that it may have been the only available path at the time. Also fair to say that every decision has consequences. It's the rare move for which consequences are all good.

Clarity going forward in Indonesia will be the number one key for investors. It will also be key for the Indonesian government. Knowing that Grasberg is the most profitable mine in the world… knowing that, despite its very different ownership structure, Batu Hijau remains Newmont's most profitable mine worldwide… these facts must weigh heavily on Indonesian lawmakers as they endeavour to frame the next iteration of mining in what is indisputably one of the world's most attractive regions. While these successes are selling features, their primary rank in success must also stick in the craw of some in Indonesia. They must be thinking, "We want you to be successful… just not so successful that we're made the fool in the process."

Here's the thing. From where I sit, these huge successes are anomalous in an environment lacking in clarity. With enhanced clarity, there's virtually no limit to what can be had in Indonesia, both for investors and for the greater good of the Indonesian people. Finding a comparable tax structure to other countries without matching clarity (not to mention transparency) in process will not be promising on either account. On the other hand, improvement of understanding of the process, what to expect? and when? and how? and of course, why? will all serve to enable more profitable participation by the Indonesian government. Give me greater clarity and I'll be more prepared to pay a premium in the fare. Fail in this and I'll require much greater return on my investment to compensate for the risk.

Clarity, first and last. This is and will always be key.


Kevin Graham