The Chilean Copper Stabilization Fund (CSF) provides an impressive example of what is possible through effective operation of such a fund.
By: Dr Adrian Saville
The Davis Tax Committee has rejected the introduction of new mining taxes such as windfall taxes, surcharges based on cash flows, separate flat royalty charges and rent resource taxes, saying they are not necessary given the existing mineral royalties, which should be retained. This may not seem significant now, given that the mining industry finds itself in dire straits, but the industry is notoriously volatile and its fortune is bound to turn and profits recover.
This begs the question of how to put excess profits to good use when better days return.
The Davis Committee has rightly recommended that a windfall tax, which simply swells state coffers but does not necessarily bring any benefit to the industry which generated the income, is inadvisable. The receipts should be used for the specific benefit of the industry when commodity prices have slumped and jobs are on the line.
I recently proposed that government look at introducing a stabilisation fund into the platinum industry and I believe that this could readily be extended beyond platinum to other parts of the resources sector. Not only that, a stabilisation fund would strengthen and enhance the agreement reached on Monday between the mining industry, unions and government to stem a wave of job losses.
A stabilisation fund, which is a mechanism aimed at providing a degree of protection to producers from volatile resource prices, could be an option to contemplate. By stabilising prices, such funds dampen the wild swings in revenue that characterise most parts of the resources industry. The way in which the mechanisms work is relatively straight forward. An “industry effective” price is determined, which is a price level that corresponds with a healthy return on shareholder capital, fair tax revenue, reinvestment of profits and rising employment of all factors of production. If the platinum (or other resource) price rises above this predetermined level, all “surpluses” are paid into a side pocket. If the price falls below the agreed level, funds are withdrawn from the side pocket to stabilise revenue.
By way of an example, say the platinum price is $2,200/oz and the pre-determined price is $1,500/oz, then for each ounce sold, the mine would receive $1,500 on its income statement and the remaining $700 would be ring-fenced, to be drawn on when, or if, the platinum price dipped below $1,500/oz. By the same convention, if the price fell to the current $1,000/oz the platinum producers would recover an additional $500/oz from the fund for their production. This still would leave $200/oz in the fund for another rainy day.
The effect is to establish stable – rather than elevated – prices, thereby providing producers with a greater degree of certainty. The consequent smoothing of earnings would be an effective way to ameliorate one of the most negative effects of price volatility namely the risk-averse and risk-chasing patterns that have become associated with large profit swings. The average profit before interest and tax (PBIT) for the total platinum industry for the past decade is R17.1 billion and the standard deviation of annual PBIT is R16.3 billion. In other words, a single standard deviation – which captures two-thirds of outcomes – takes the industry into super profits or a loss, and two standard deviations means the difference between hyper profits or deep losses.
In turn, stabilisation of profit assists in improved planning, such as capex; more effective operations; lowering the cost of capital; bolstering profitability; encouraging re-investment of profits; and boosting investment in the more-stable labour force. If effective, the fund’s impacts should go beyond private gains and promote public gains, such as greater stability in employment and greater certainty in tax revenue collections. In turn, investment in labour and capital, in particular, should lead to productivity increases which would translate into rising incomes in the workforce.
The Chilean Copper Stabilization Fund (CSF) provides an impressive example of what is possible through effective operation of such a fund. Created in 1985, the CSF sought to bring stability to the copper industry specifically, and to Chile’s copper-dependent economy in general. Such is the success of the CSF that the Chilean copper industry has become notably stabilised, mines have invested extensively in this more certain environment in capital and people, and productivity gains have led to income gains, hosts of other private gains and material improvements in public welfare.
To illustrate the extent of private gain, Erik Moreno, a miner in Esperanza copper mine in northern Chile, after tripling his salary, said the pay was so good that he’d never take another job. He also commented “I am going to die in this industry; I don’t see myself anywhere else”. The irony of Moreno’s comment cannot be lost against the tragedies of the Marikana massacre of August 2012. Whilst the copper price has fallen markedly since the global financial crisis, it is commonplace for miners to earn bonuses in excess of $30,000 every two or three years, a number that is beyond imagining to mine workers in South Africa’s platinum industry. In 2013, Bloomberg reported that truck drivers at BHP Billiton’s Escondida mine were paid the equivalent of $80,000 a year, excluding bonuses, more than their counterparts in the US.
The success of the first fund led Chile to establish a second stabilisation fund to help the economy more broadly during “rainy days”. The fund in 2014 held $14bn in surplus assets equal to 5% of the Chilean economy. The equivalent figure in South Africa would amount to R200bn – effectively almost double the current market cap of Anglo Platinum, Impala Platinum and Lonmin, combined.
Notably, a stabilisation fund is not the same as hedging output. Hedging locks producers into a specific price and forces them to deliver. A stabilisation fund reprices every day and does not lock producers into delivery but rather monetises production immediately.
A stabilisation fund is easily within reach of an industry that is highly erratic and that faces growing structural pressure. Guided by the experiences of Chile – as well as others, such as Columbia, Mexico, Panama and Peru – a stabilisation fund has the capacity to support the South African mining industry, boost employment and wages, encourage investment and add to the overall wellbeing of the South African economy and one of its most important industries.
A portion of this article first appeared on Mineweb.
Adrian Saville is Chief Strategist of Citadel Investment Services and he holds a Visiting Professorship in Economics and Finance at the Gordon Institute of Business Science.