African miners in the danger zone

For Australian investors interested in putting some of their funds in the African mining industry, it is only necessary remember two things: transport economics overrides ore grade and politics overrides everything.

Get those points wrong and you will lose. Get them right and you might profit.

Rio Tinto is the latest, but certainly not the last mining company to stumble on the transport question. It misunderstood the local rules regarding coal shipments from its Benga mine in Mozambique, a mistake that flushed away $3 billion in shareholders’ funds and the career of the chief executive, Tom Albanese, in the process.

Base Resources is an example of a smaller Australian company that appears to have solved the transport question by developing a titanium and zircon mine just 50 kilometres from a major deep-water port in Kenya, but whether it’s got the politics under control is a question yet to be answered.

Over the past few days (and years) I’ve been fortunate to have visited both the Benga coal project, which has hurt Rio Tinto, and the Kwale titanium and zircon project of Base Resources near the port of Mombasa in southern Kenya, which has just passed the half-way construction point.

In between, I have made several visits to the biggest mining conference in Africa, Mining Indaba in Cape Town which, last week, attracted 7,500 delegates from around the world.

Hunting for investment opportunities was the major reason for the record attendance, including a larger-than-expected number of banks, which are re-discovering their interest in mining.

But, hanging over the investment ideas was a political cloud that is turning South Africa into a foreign investment “no go” zone. And while that might seem to be a problem isolated to a single country, there is a spill-over effect because South Africa sets the rules for the rest of the continent when it comes to tax policy and local “empowerment” requirements – code for nationalisation of foreign investment.

The good news, and there isn’t a lot of it, is that a handful of Australian companies active in Africa are finding ways to overcome local barriers and deliver reasonable returns.

Goldminers, particularly those operating in West Africa, have done best. But with the gold price looking fragile, and with risk rising in a number of countries such as Mali and Ivory Coast, it could be that the best years are behind the gold stocks – unless, of course, the gold price rockets higher, in which case all gold stocks will do well.

In North Africa it becomes much trickier as the “Arab Spring” unleashes highly unstable political and economic conditions, a point discovered to its cost by Centamin Egypt, a company born in Australia but now domiciled in London.

Centamin did well for a while, and continues to produce profitable gold, but domestic issues are dogging its Sukari project. This is despite protests from the company’s chief executive, Joseph El-Raghy at Mining Indaba, that the issues were largely a media beat-up and the cause of a 70% price fall late last year. This precipitous drop has been partially reversed, but the stock is still down 40% on last year’s peak.

Resolute Mining is another stock encountering “African risk” thanks to its major asset, the Syama goldmine, being located in Mali (where French troops have intervened to stamp out an attempted Islamist takeover), and because of concern about it plunging deeper into West Africa after taking a major position in Noble Mineral Resources, which is active in Ghana.

Since late October, when Resolute made its initial move on Noble, its share price has fallen by 30%. This drop is noticeably higher than the falls of around 20% by gold stocks with most of their assets in Australia, such as Evolution Mining and Northern Star, and represents a rough measure of what has become a “West African discount”, replacing what was once a “West African premium” when high ore grades in countries such as Ghana and Mali attracted Australian miners and investors.

Bulk mining of the sort proposed by Rio Tinto at Benga and at its flagship African iron ore project, Simandou in Guinea, and by Base at its Kwale titanium and zircon project, have different economics. While all have more attractive geology than equivalent Australian mines (higher ore grades and easier mining), they have worse transport economics.

Benga, as has been well reported, is a failure because Rio Tinto assumed (incorrectly) that it would be allowed to barge coal down the Zambezi River, a plan which locals warned years earlier (when I visited the project then owned by Riversdale Mining) would not be permitted. The back-up option of railing coal to the coast for export then encountered the problem of a small railway system unsuited to bulk commodity movement.

It is yet to be proven that the Simandou iron ore project in Guinea, on which more Rio Tinto careers are hanging, will deliver a different result. The ore at the project is some of the best in the world. But the politics and corruption of Guinea are some of the worst – and it was fascinating to attend a cocktail party held by Rio Tinto’s senior executive at Mining Indaba, including the head of diamonds and minerals, Alan Davies, only to discover that the man standing next to him (listening to every word) was a London-based public relations consultant working for the government of Guinea.

As for the politics of mining in South Africa, there is not a lot fresh to say except that the game of settling old “black vs white” scores is still being played out. This was seen last year in the massacre of 34 striking miners by South African police at the Marikana platinum mine.

The commercial aspect to the tit-for-tat exchange between South Africa’s government and mining companies still owned and managed by white South Africans is that capital is being withdrawn from an industry that accounts for 60% of the country’s exports with Mozambique, and the one-time bad boy of southern Africa, Zimbabwe, which is now rated less risky than South Africa.

Worse still, the government of South Africa is ratcheting up pressure on mining companies by proposing a “super tax” on mine profits similar to that introduced last year by Australia, a potentially damaging development as Australia starts moving towards abandoning its largely unsuccessful Mineral Resources Rent Tax (MRRT).

The push for higher taxes on mining, a possible export embargo on strategic minerals such as coal and iron ore, and greater black empowerment of the mining industry is spilling across borders. Other countries in the region are demanding higher local ownership, without government-preferred local investors or government agencies snatching a share of projects.

In Kenya, Base Resources is undoubtedly on a winner as far as ore grade, project size and transport economics size are concerned at Kwale, which I visited last week as a guest of Base.

What I saw was a first-class mine and processing centre emerging from the ancient sand dunes adjacent to the Indian Ocean.

That Kwale is proving to be a construction success (despite a standard capital cost blow-out) was never in doubt, because all of the original exploration work, and early-stage processing trials, were conducted by a previous owner, Tiomin Resources. Tiomin stumbled on issues of domestic politics and environmental opposition, and was eventually forced to sell Kwale to Base for about US$6 million (plus a future 2% revenue royalty), a fraction of the US$70 million invested.

If local politicians could leave Base alone to get on with the job of turning Kwale into a highly profitable mine, it should be producing in the early years around 350,000 tonnes of ilmenite, 75,000 tonnes of the more valuable rutile, and 40,000 tonnes of even more valuable zircon – making it a world-class mine contributor of “heavy mineral sands”.

The mine itself is connected to the local electricity grid, with a high-quality (by African standards) sealed road to a new purpose-built warehouse and port facility in Mombasa harbour. If there is a potential logistics issue, it will be local disquiet about heavy, mineral-hauling trucks, passing through a densely populated area close to the port.

Until last October, and despite the capital cost rising to US$300 million (close to double the US$175 million estimate in 2010 when the project was acquired), Base was one of the best-performing Australian miners operating in Africa.

But, on October 26, Kenya’s Minister for Environment & Mineral Resources unilaterally announced that all mining licences would require 35% Kenyan equity participation. Within 48 hours, Base’s share price plunged by 48% from 42c to 22c.

The Kenyan Attorney General has since announced that the 35% rule will not apply to the licence held by Base over the Kwale resource, helping the stock recover to around 37c and valuing it at $207 million.

In theory, Base is a stock which has been oversold by investors concerned about the lingering question of nationalisation (part or whole) and the ability of governments to keep their promises – an issue as alive in Australia as it is in Africa.

In reality, Base is a prime example of a company that has a world-class orebody, with a solid transport solution, good management, and a profitable future – weighed down by the uncertain factors of government action, including overnight changes to local ownership rules and the fear of rising taxes as South Africa toys with the idea of an Australian-style super tax on all minerals.

For investors with a high risk tolerance, Base is a stock which should do well ahead of the first shipments of minerals later this year.

But, for risk averse investors, it is a stock which may prove to be too successful for its own good. High early-year profits could prove too tempting for government to resist extracting a bigger slice of the profits from a project that has the potential to become Kenya’s fourth-biggest export earner, displacing coffee.

As an investment theme, and it is one pedalled by investment banks and stockbrokers keen to impress investors, rich orebodies and cheap labour make Africa an appealing location.

But it can be an expensive mistake to assume that ore-grade is king when the real king in Africa is politics.