PPB Advisory Insights - Resources and Infrastructure November 2011

Coffey takes the lead but gets caught up in an uncertain market

Insight:
Over the past five years we have seen mining companies increasingly ‘de-risk' their businesses by moving capital intensive processes from their own balance sheet to that of their contractors. The predominantly equity-funded mining companies have become more flexible and are able to respond quickly to market volatility. Unfortunately, the opposite is true for a growing number of mining contractors and services companies which are becoming highly leveraged and will find it increasingly difficult to respond at short notice to changes in production output.

On 5 October, mining consultants Coffey International Limited (ASX:COF) announced a fully underwritten placement and 1 for 1.75 accelerated non-renounceable entitlement offer in a bid to raise $40 million.

The placement and institutional component successfully closed on 6 October 2011, raising $18.1 million. However the retail component, which closed on 2 November 2011, fell $15.1 million short of its target raising only $6.8 million with just 31% of eligible retail investors participating. The shortfall was subsequently allocated to various institutional sub-underwriters.

The fact that Coffey fell considerably short of its retail target says more about general investor sentiment and a sign of things to come than it does about Coffey’s rationale for the capital raising. Coffey will use the funds to pay down bank debt. Given the continued market volatility and declining commodities prices, this seems like a prudent move. In fact, it would also be prudent for a number of mining services and contracting companies to also reassess their debt positions and put plans in place to start reining it in.

Source: PPB Advisory research, ASX:COF media announcements

Delays turn to claims on two of Australia’s largest energy projects

A number of contractors including AJ Lucas, Kentz, Leighton’s, Saipem, Thiess and UGL are reported to have been in talks with their principals, Chevron and Woodside, over delays and changes to contracts relating to the Pluto and Gorgon LNG projects.

It is inevitable that there will be delays (and cost overruns) on these projects, considering the:

engineering complexity
extreme and remote locations
skilled labour shortages
IR activity increasing
material costs rising
feasibility studies undertaken years ago in a drastically different global environment.

However, in the case of Pluto, Chevron is still maintaining its project timetable of first gas by 2014. With little or no time to sort out disputes as they arise, contractors continue to plug away and principals park the issues to one side in a bid to keep focussed. As a result, expect to see a mountain of litigation and arbitration proceedings filed in the next two years and parties fighting it out for many years to come.

Source PPB Advisory research, AFR 21 September 2011

Impact of the PPSA on resources companies

Insight:
The eventual introduction of the Personal Property Securities Act 2009 (PPSA) will have a big impact on resources companies and those that work with them. If careful consideration is not givento the PPSA, it could lead to a loss of confidential information or worse, the loss of a security interest.

Aside from banks and financiers, resources companies will be one of the groups most impacted by the PPSA when it comes into force (currently proposed to be 1 February 2012, but this is likely to be pushed back following the recent introduction of the Personal Property Securities (Registration Commencement) Bill 2011).

Compliance with the PPSA will not only be important for resources companies themselves, but also for those dealing with resources companies, such as:

lenders
advisors
investors
those undertaking due diligence exercises for acquisitions
valuers.

Existing joint ventures (JVs) will need to reassess their agreements (JVAs) before the new legislation is introduced and make changes to ensure:

compliance with the PPSA
confidentiality of certain information is maintained
interests are enforceable, particularly in the context of insolvency.

In a JV, a cross charge or default provision is likely to create a security interest, which must be registered on the Personal Property Securities Register (Register) to be ‘perfected’. The JVA typically defines the nature of any security interests and will need to be cited on the Register. This means certain third parties can request to see the JVA, which is likely to contain extremely confidential information. Lawyers have suggested that a way around this may be to redraft JVAs, with any confidential information contained in a separate document. However, additional costs and complexities will likely stem from splitting the JVA into separate documents.

If security interests are not perfected, following the appointment of an administrator or liquidator to the JV counterparty, those interests (such as a default purchase right) ‘vest’ in the defaulting joint venturer. Ultimately, this would mean that the default purchase right no longer exists and the cross charge itself is irrelevant. This is why it is important to register the JVA, in addition to the cross charge, on the Register and ensure it is perfected.

Source: ‘PPS Legislation and the Impact on the Resources Industry’, David John, Freehills and PPB Advisory research

LNG – the future

Insight:
Australia is poised to become the second largest LNG producer with four major projects worth approximately $70 billion of investment going ahead in 2011. However questions remain on whether Australia is equipped to capitalise on the prosperity delivered by the development in LNG.

The four new projects comprise: the $29 billion Chevron-led Wheatstone LNG project, Santo’s $16 billion GLNG, Shell’s $10 billion Prelude floating project and the $14 billion APLNG project of Origin Energy and Conoco Phillips. The excitement around Shell’s Prelude Floating platform stems from the fact that it will allow gas fields once thought to be too small or remote to now be considered for development. The Prelude will allow gas processing to be undertaken off-shore with a facility almost a quarter the size of an on-shore facility.

Wood Mackenzie estimates that investment in oil and gas projects in Australia will triple to $US150 billion over the next 5 years driven by LNG. This will make Australia the fourth largest country by oil and gas investment dollars behind Russia and ahead of China and Brazil.

However questions remain on whether Australia is equipped to capitalise on the prosperity delivered by the development in LNG.

These projects face major threats, including pressure from investors to meet tight deadlines, budgets and scheduling issues. Costs are rising sharply due to mining industry inflation and it does not help that projects are all being built simultaneously. This will place pressure on the already scarce skilled labour market.

The project owners are struggling to convince investors that their projects will defy the trend of spiralling costs. Analysts are expecting final project costs to be up to one-third higher than estimated. The five largest resource projects under development are collectively $14 billion over budget and more than four years late. Another issue that Chevron and Woodside are facing is a number of major claims from contractors over changes to the Pluto and Gorgon project contracts. Both major LNG projects have experienced ongoing delays.

Only time will tell whether increasing costs and the labour shortage will impede Australia’s attempt to become the world’s largest LNG producer.

Source: PPB Advisory research and AFR 21 September and AFR 6 October

In focus

Foreign banks and Basel III pose significant threats to Australia’s resources sector

by Tim Treadgold

Insight:
Higher taxes, and the threat of increased union militancy, are seen as threats to Australia’s resources sector, but a focus on domestic issues could be masking more significant risks – Europe’s financial crisis and new international banking rules.

Until recently most observers would have dismissed these suggestions, pointing out that Europe is a long way from Australia, and that the mining and oil industries have little to do with banking regulations.

However, last month (late October) the first small waves of Europe’s banking woes washed ashore in Australia, and a few days later a second banking issue surfaced – this time coming from China.

While funding issues were affecting two Australian mining deals there were even more sinister rumblings in the background, in the form of the new bank lending rules that some observers say could dry up a large part of the world’s commodity lending business with knock-on consequences for mining.

First, we will review what is happening locally, and then look at Basel III, a package of banking rules laid down by the Swiss-based Basel Committee on Banking Supervision.

Cobar Consolidated, an emerging Melbourne-based miner with a promising silver project in New South Wales, became the first victim of Europe’s banking woes when it was forced to undertake a heavily-discounted equity raising after a German bank pulled out of a funding syndicate.

WestLB, a German bank with a long history of lending to the resources sector, had teamed up with Australia’s Commonwealth Bank last March to lend up to $38 million in project finance and working capital for the development of the Wonawinta mine.

In late October 2011, WestLB walked away from the deal, forcing Cobar to replace WestLB’s $16 million component of the debt package with a share issue prices at an 18% discount to the ruling market of 79c by issuing 26 million new shares at 65c. Fortunately for Cobar, Australia’s Commonwealth Bank stood firmly behind the deal.

Cobar’s Chief Executive, Ian Lawrence, diplomatically said in a statement filed at the Australian stock exchange, that: “WestLB’s decision to withdraw from the financing package was unexpected”.

In hindsight, perhaps it might have been expected if the dots had been connected between Europe’s banks facing a torrid time in dealing with their internal commercial debt and sovereign risk crisis which threatens to be bigger than the 2008 US banking crisis.

In effect, Europe’s banks are being forced to raise their lending standards to much higher levels, and in some cases, rein in all forms of lending.

The second example of a bank upsetting a previously agreed deal was in the proposed takeover of uranium explorer Bannerman Resources by China’s Hanlong group.

Internal issues at Hanlong would probably have played a part in it walking away from an offer for Bannerman. However, they stated that the deal did not go through due to China Development Bank’s demands for greater due diligence inquiries into the timing and conditions of a mining licence covering Bannerman’s project in Namibia.

The common thread in both deals was foreign banks – with credit quality and fear of risk exposure at the heart of both decisions.

Basel III will further decrease risk appetities. It is a set of new rules to be introduced over several years which will significantly toughen capital adequacy requirements and make it much harder for commercial banks to provide commodity trading letters of credit and trade finance.

The new rules are designed to strengthen the international banking system but will make trade and commodity lending less profitable, and far less attractive. There is speculation in London that three of the biggest banks in France – BNP Paribas, Societe Generale, and Credit Agricole – are considering abandoning commodities lending.

The biggest hurdle to remaining in the commodities business is that under the current (Basel II) rules, banks only need to hold capital equal to 20% of the value of a letter of credit, while the new (Basel III) rules lift the capital requirement to 100%, which London’s Financial Times said would “greatly increase the cost of lending”. Other observers believe it will kill the commodities lending business outright.

It is the combination of Europe’s banking emergency and the imminent introduction of Basel III which ought to have mining company executives looking very closely at their funding arrangements.

Top 5 movers (Gains)

*Note: Analysis has been conducted for companies with greater than $50m market capitalisation as at 31 October 2011.

Comments

Mineral Deposits – On 26 September 2011, Mineral Deposits announced the continued ramp-up of its Grande Cote Mineral Sands Project in Senegal, West Africa. Major achievements included the granting of a 25 year concession by the Government of Senegal for largely exclusive use of an existing rail line and execution of a letter of intent regarding its mineral separation plant and associated site infrastructure.

Silver Lake Resources – Silver Lake announced on 17 October 2011, a positive drilling result in the Wombola Area which is located five kilometres north west of its Daisy Milano mine. The Wombola Dam deposit currently has JORC gold resources of 433,000 tonnes at 3.9g/t for 54,500 ounces.

Papillon Resources – On 15 September 2011, Papillon Resources announced that the Fekola discovery continues to deliver wide and high grade intercepts. The Fekola prospect is located in Mali West.

Avanco Resources – On October 2011, Avanco announced a positive drilling result from the Rio Verde Copper Project. Results included 27.70m at 5.96% copper and 2.80g/t gold from 53.15m.

Azimuth Resources – Azimuth announced on 15 September 2011, further positive drilling results for its Smarts Deposit in Guyana, South America. This announcement continued to confirm the robust grades that had previously been announced in June 2011 Quarterly activities report.