Royalties & Streams Explained
Royalties are ongoing economic interests in the production or future production from a property and, depending on their terms and the laws applicable to the royalty and the project, in general share the following characteristics:
- They are not subject to cash calls to fund exploration, development, capital, environmental or closure costs and so are lower risk in this respect than an operating interest.
- They provide exposure to the upside of commodity price, reserve and production increases.
- In some cases, they provide an interest in new discoveries made on a property which can result in significant value creation for Franco-Nevada.
- They do not involve operational or development management so a large and diversified portfolio can be assembled without the need for significant corporate overheads.
The two most common royalty types are:
Revenue-based Royalties are based on the value of the production or net proceeds received by the operator with defined deductions as specified by the royalty contract. Some forms of revenue-based royalties in the mining and oil & gas industries are:
- “NSR” Net Smelter Return Royalty
- “ORR” Overriding Royalty
- “GR” Gross Royalty
- “FH” Freehold or Lessor Royalty
Profit-based Interest Royalties are based on the operating profit as defined in the royalty contract. Often, royalty payments only begin after the operator has recovered its capital costs. The net profits interest royalty (“NPI”) is the most common form of these royalties. Similar to an NPI, a net royalty interest (“NRI”) is paid net of operating and capital costs.
In addition to royalties, Franco-Nevada holds stream and working interests:
Streams are metal purchase agreements that provide, in exchange for an upfront deposit, the right to purchase all or a portion of one or more metals produced from a mine at a preset price. Streams are particularly well suited to co-product production providing significant value for by-product precious metal production. Streams are not royalties because they are not an interest in land and there is an ongoing cash payment required to purchase the physical metal.
Working Interest (“WI”) holders have an ownership position in the property and operation and hence are liable for cash calls on their share of capital, operating and environmental costs usually in proportion to their ownership percentage. Working interests are not considered to be royalties because of their ongoing funding requirements although, for profitable operations, they can be economically similar in their calculations to NPIs.
An example of the financial impact of each different structure is provided below.
Royalty Equivalent Units (“REUs”) Explained
In the previous section, Mineral Reserves and Mineral Resources for assets in which Franco-Nevada has an interest were tabulated based on the publicly disclosed reports of each operator for each property on a 100% basis. This form of tabulation provides an overall indication of the growth of Mineral Reserves or Mineral Resources on projects within Franco-Nevada’s portfolio. However, the tabulation does not provide a specific measure for Franco-Nevada’s interest in such Mineral Reserves and Mineral Resources for the following reasons:
- Not all of Franco-Nevada’s assets cover the entire property associated with the operator’s publicly reported figures and Franco-Nevada is not in a position to report separate Mineral Reserves and Mineral Resources figures for those properties.
- As demonstrated on the previous pages, royalty and stream interests have different economics than an operator has for its stated Mineral Reserves and Mineral Resources. In addition, the economics differ between NSR, NPI and stream interests and by property and would need to be factored to be comparable to each other or to an operator’s interest.
- Directly attributing specific Mineral Reserves and Mineral Resources to Franco-Nevada may not be appropriate if the operators are not in turn deducting royalty and stream interests from their own publicly reported numbers and may lead to two companies quoting the same Mineral Reserves and Mineral Resources.
Franco-Nevada’s most common royalty interest is a simple percentage of the commodity produced by an operator from a property. A 2% NSR royalty on a gold property is typical. For this example, attributing 2% of the gold property ounces to Franco-Nevada can provide a view of the potential value realization to Franco-Nevada. NSR royalties are subject to minor transportation, refining and other deductions often approximating $5 per ounce that is generally seen as not material to overall valuations. Effectively, multiplying the number of attributable royalty ounces times the assumed average future gold price can provide a rough approximation of the potential undiscounted pre-tax cash flow to Franco-Nevada from that asset before metallurgical recoveries. By contrast, the valuation of Mineral Reserves and Mineral Resources from an operator’s perspective requires more significant assumptions including, but not limited to, an operator’s future operating, capital and other carrying and closure costs.
Franco-Nevada is providing guidance to analysts and investors on how the Company estimates the Royalty Equivalent Units (“REUs”) on a broad range of its assets. The objective of an REU for any property is that it should be a reasonable comparison to a calculation of the number of attributable NSR royalty ounces that Franco-Nevada might have with a typical straight forward gold royalty covering all of the reported operator Mineral Reserves and Mineral Resources. The use of REUs provides a common basis of comparison between different asset types and royalty property coverages. To achieve comparable REU figures, guidance and adjustments are required from Franco-Nevada management in the following circumstances:
- The royalty or stream property does not cover all the operator‘s reported Mineral Reserves or Mineral Resources.
Franco-Nevada’s management will provide its best approximation for each asset as to the appropriate percentage of Mineral Reserves and Mineral Resources that should be factored to estimate the equivalent REUs.
- A stream interest with an associated ongoing cost per ounce.
The number of attributable stream ounces will be factored to make them economically equivalent to an NSR ounce. In the example demonstrated in the previous section, for a $1,200 gold price and a $400 cost per ounce, the stream ounces are factored by 67% to become comparable to NSR equivalent ounces of REUs. The factor depends on cost per ounce or % margin written in the agreement.
- An NPI royalty.
An NPI is subject to the operating and capital costs specific to each asset. For planning purposes, Franco-Nevada’s management generates its own internal mine life projections for each of its assets in order to determine its own reasonable estimates. Franco-Nevada management has provided its best approximation as to the economically equivalent NSR rate using a $1,200 gold price assumption.
- An asset producing PGM or silver.
The number of attributable silver, platinum or palladium ounces are converted into gold equivalent ounces using pricing assumptions of $17.50 per ounce silver, $950 per ounce platinum and $750 per ounce palladium. In addition, NSR deductions are more material for certain PGM assets subject to NSR deductions such as Stillwater. For Stillwater’s REU calculation, 10-12% of the ounces have been deducted to reflect the higher NSR deduction for that asset compared to typical gold NSR assets.
- Base metal assets.
These REUs are calculated similar to precious metals but are done so in units of attributable copper or nickel net of NSR realization charges as these deductions are more material than for gold operations. The objective again is to provide an REU to which an assumption of future commodity prices can be applied to estimate an undiscounted pre-tax cash flow to Franco-Nevada before metallurgical recoveries.