General
There are three well established types of contracts available for the mining investor: Equity Contract, Production Sharing Contract, Streaming Contract. These have three key elements in common, which are ownership, cost recovery, and profit sharing, but deal with them in very different ways. Which form the investor and owner choose depends on the situation.
The basis of any investment is a prior verification and estimation of the fair value of the gold mine or asset. Each contract will be designed according to the specific needs of the owner, investor and host government.
Equity Contract
Equity participation represents the ownership in an asset, such as a company or a mining licence. The mine owner gives away a certain equity participation and independence. Whatever, the owner must agree that there is some percentage of the company or mining licence it is willing to share with one or more partners.
The owner and partners share all costs at certain proportions ('working interest') and may cap the cost recovery at some percentage (e.g. 60% of the gross revenue) to hedge the profit revenue. The profit revenue is also to be shared proportionally to their equities ('beneficial interest'). The working and beneficial interests aren't necessarily the same number.
Equity participation allows the owner to reduce its financial and operational risk in return for giving up some control.
It is significant that equity participation allows investors to exert greater control over the project, as opposed to a production sharing contract. It is noteworthy that the ownership in the gold mine or mining licence does not result in the ownership in the gold (gold in the subsoil belongs to the state).
The equity contract is the oldest form and dates back to the colonial period. It is still popular in the Anglo-Saxon countries. Elsewhere, it has widely been replaced by the production sharing contract (see below). The Mongolian government is currently negotiating with Rio Tinto the replacement of the present equity contract for the Oyu Tolgoi mine with a new production sharing contract to bring the ownership of the mine back to Mongolia.
Downside
Under the equity contract, the owner must have access to the necessary funds to bear its cost share. This often is not the case when risk capital is required. In some cases the owner gives up the leadership of the project. In addition, the transfer of an asset is heavily taxed in Mongolia.
In these cases a production sharing contract or streaming contract can be more advantageous.
Production Sharing Contract
The Production Sharing Contract or Agreement is an agreement where the ownership in an asset, such as a gold mining licence, remains with the owner. The partners are permitted to develop the asset, but have no ownership in it. The owner so maintains full control over the project, as opposed to an equity contract (see above).
Cost Recovery
The partners are allowed to recover current costs, such as Capex, Opex, administrative costs, and interest. Cost recovery is immediate in the period in which the expenditure incurred, whereas cost recovery for the capital investment is usually spread over the entire production time.
A firm portion of the gold sales revenue is allocated for this ('cost gold'), which means that the amount is capped at a fixed percentage. In case the available revenue is not sufficient to cover all costs in the current period, the balance can be carried forward into the next period.
Profit Sharing
The revenue remaining after the deduction of the 'cost gold' and royalty is shared ('profit gold') between the partners and owner at the agreed percentages. The partners get their share in the gold production as a reward for the financial risk taken and the performance provided.
Streaming
Gold streaming is an agreement between a mining company and a financier. Streaming transactions are used by mining companies to obtain upfront capital prior to production begin. The mining company sells part of the gold in advance and delivers the gold in the future when production has begun. The financier will not take any ownership in the mine or mining company. Stream financing was developed in early 2000.
The financier agrees to buy a percentage of the future gold production ('stream') at a fixed price below the market price and near the production cost. The financier then makes an upfront cash payment ('deposit') and a series of subsequent deposits to the mining company. The stream agreement is commonly valid for the life of the mine.
The streaming involves the acquisition of physical gold, which exposes the financier to the volatility of the gold price as well as to the ultimate amount and grade of the produced gold. However, the financier is not exposed to the risk of the mining costs and is not involved in the management and operations of the gold mine.
The mining company retains the full control over the project.
Upside
The financier will get an unexpected windfall profit in case the gold price increases more than expected. The financier has no responsibility for the mine.
Note: Under the similar royalty agreement the financier receives a portion of the revenue in cash, unlike the streaming financier, which receives physical gold.