Ukraine to hike royalty rate for iron ore mining, change payment base

Ukraine’s parliament plans to raise the rate for the
mineral resource royalty for iron ore mining to 10% from 8%, according to a
draft bill dated Aug. 30 to update Ukraine’s tax code.

 

In the current version of the tax code, a 1.1
coefficient is applied to the iron ore mining royalty rate for 2019, and the
draft does not appear to remove this provision. Therefore, if the updates to
the tax code are approved, the rate for the remainder of 2019 will rise to 11%
from the current 8.8%.

 

The bill also changes the base for the royalty payment
from raw (before enrichment) ore to the price of final products (concentrate,
pellets, sinter).

 

Industry associations Ukrmetallurgprom and Ukraine’s Metallurgist
Federation wrote a letter to Ukraine’s president, prime minister, parliament
and other government bodies expressing grave concerns over the plans to change
royalty calculations, Interfax-Ukraine reported on Sept. 5. The letter
particularly characterizes the plan to change the payment base as unreasonable,
comparing it to using revenues from gasoline sales as the payment base for oil
extraction royalty payments, as cited by Interfax-Ukraine. The letter urges
postponing consideration of the draft bill in parliament and arranging for
in-depth discussion of its proposals, the news agency said.

 

The royalty rate hike and the change in payment base
will impact Ukraine’s largest steel producer Metinvest (METINV), including its
joint venture Southern Iron Ore; Ukraine’s largest iron ore pellet exporter
Ferrexpo (FXPO LN); and Black Iron (BKI CN), a Canadian iron ore exploration
and development company with assets in Ukraine.

 

Dmytro Khoroshun: The planned
change in the payment base would increase royalty payments much more than the
royalty rate hike.

 

Namely, we estimate that for 2018, Ferrexpo paid no
more than USD 2.9 per ton of pellets in royalties, which at an 8% rate
translates into USD 36.4/t as the base for the royalty payment. This is lower
than our USD 85-90/t estimate for the realized price of Ferrexpo’s pellets at
the gates of its main asset, Ferrexpo Poltava Mining. Therefore, we think that
Ferrexpo is using some inferred price for raw ore (with iron content not more
than 35%, raw ore is not traded on any markets). Indeed, in its 2018 financial
statements, Ferrexpo states that royalty payments “are based on the cost of
concentrate production”.

 

We estimate that Metinvest paid not more than USD 3.4
in royalties per ton of its iron ore products in 2018, a similarly small
amount.

 

In contrast, Black Iron in the Preliminary Economic Assessment(PEA) for its Shymanivske iron ore project apparently pays royalties of 8%
using the net (at the plant’s gate) price for its final product.

 

If Ferrexpo continues using its raw ore price as the
payment base, in a year similar to 2018, the company would pay an additional
USD 7 mln in royalties due to the royalty rate hike itself, which is 0.6% of
its revenue and 1.5% of its EBITDA for 2018, based on our calculations.
However, if Ferrexpo further switches to paying royalties using the net price
for its pellets as the payment base, its royalty payments in a year like 2018,
and at a 10% rate, will increase by an additional USD 50 mln, which is 4% of
revenue and 10% of EBITDA.

 

We also note that Ferrexpo’s stockpiling of lean oremight lead to significant savings because the company likely already paid
royalties on its stockpiles using the past rate and payment base. Ferrexpo’s
stockpile of lean ore has reached USD 233 mln valued at cost at the end of
1H19, or about 60 mmt of ore containing 30-33% of iron. We estimate that it is
possible to produce about 22 mmt of pellets from this stockpile. Therefore,
Ferrexpo would save about USD 100-130 mln if it does not have to pay royalties
on these pellets at the new rate and with the new payment base.

 

Additional royalty payments for Metinvest due to the
royalty rate hike itself would amount to USD 24 mln, 0.2% of revenue and 0.9%
of EBITDA for 2018, we estimate. In case Metinvest switches to paying royalties
using the net price for its concentrate and pellets as the base, its payments
in a year like 2018 and at a 10% rate will increase by an additional USD 115
mln, which is 1% of revenue and 5% of the holding’s total EBITDA.

 

For Black Iron, we estimate for the base case pre-tax
calculation in the company’s PEA (product selling price of USD 97.2/t, 10%
discount rate) that the project’s NPV of USD 2.12 bln will drop 4%, or by USD
75 mln, as a result of the royalty rate hike. The project’s IRR will drop by
1pp to 42% from 43%.

 

It might be difficult for Ukraine’s mining industry to
influence the consideration of this draft bill because its majority
stakeholders currently do not have sufficient political power. We believe it is
likely that the payment base will be changed and the rate will be hiked. The
effects on finances of Ukrainian miners will be bearable, but not negligible.

 

We maintain our bullish view on METINV bonds.