Royalty increases in Brazil: a renewed burden for iron ore miners or a threat to their international competitiveness?

After a prolonged drama resembling a Brazilian soap opera, the country's new mining code may finally go into effect. The so-called Novo Marco Regulatório da Mineração (the Code) is set to be "forwarded to Congress for voting by the end of April" according to Fernando Coelho Filho, the Brazilian Mines and Power Minister. If his speech proves to be true, the new mining code may become effective in less than four months, meaning among other things, extra costs for local mining companies already from the second half of 2017.

Setting the scene

In June 2013, the now-impeached president Dilma Roussef presented a bill that laid down a new mining code. Under the slogan "more competitiveness, more richness for Brazil," the proposal was presented to Congress under a constitutional urgency regime, which requires a bill to be debated in less than 90 days between the House of Representatives and the Senate. What an audacious plan for a country plagued with high bureaucracy levels and politicians looking at their own needs.

At the end, Mrs. Roussef's plans never went ahead due to disagreements between politicians, mining companies and impacted communities. Now under the tenure of a new president, Michel Temer, the Brazilian government is fighting once more to promote the Code mainly on the back of increasing the State's revenue, fostering a so-called fairer concession system as well as enhancing the controlling power of the mining regulator body.

Mining royalty rates, the so-called Compensação Financeira pela Exploração de Recursos Minerais (CFEM), are set to increase by as much as 2%, depending on the mineral. The basis of the calculation would also change and be applied over each company's gross revenue, as opposed to the net revenue in the current system. In this context, iron ore acts as the main character. According to Departamento Nacional de Produção Mineral (DNPM), in the first half of 2016 iron ore represented 58.6% (almost US$175 million) of CFEM's revenue.

Over the same period, iron ore exports totaled more than US$5.5 billion, or 60% of the entire country's revenue originated from exported minerals. As such, any changes in royalty charges can materially impact the State's coffers and strike iron ore companies cash cost position and their ability to remain profitable.

Miners' cash cost set to increase by at least 2%

Most Brazilian mines are conveniently placed on the low-end of our 2017 CFR China cash cost curve. This is largely driven by Vale's high-grade-low-cost deposits and its integrated logistics system. The company's 2018 FOB total cash cost is forecast to be US$13.9/wet tonne, with royalties and levies representing 11.5% with the current royalty model. But the game may change shortly. Applying a 2%, a 3% and a 4% royalty charge over gross revenue scenarios, Vale's FOB cash cost may range from as low as US$14.1/wet tonne to as high as US$15/wet tonne, which would represent an 8.1% increase in the miner's costs! Other producers will see their cost competitiveness impacted to different degrees. Like Vale, Samarco may see a 6.7% cash cost increase if the worst case scenario is applied. Ferrous is likely to be the less impacted one as it sells a lower-grade itabirite product with high levels of silica, meaning it does not get the same high premium as other producers.

In Western Australia, where almost 99% of the Australian exports came from in 2016, the royalty applied is 7.5% over the product sales value (5% for concentrate products). Only in a 4% royalty charge model, Brazilian producers would see their much welcomed competitive advantage threatened. In this scenario, royalties would represent 16% of Brazilian producers' 2018 total cash cost, the same ratio as their Western Australian counterparts.

Vale to remain the biggest payer

We expect total royalty payments from Brazilian iron ore producers to range from US$0.9 billion to US$1.3 billion in 2018, assuming a 2-4% charge over gross revenue. Discounting private royalties and levies, the government intake would increase by at least 55%, from US$270 million to US$419 million.

And yes, not surprisingly, Vale will pay for most of the party. In any scenario, the miner would be paying over 80% of the total 2018 royalty contribution originated from iron ore producers. Put differently, if the highest rate receives the green light, Vale would have to disburse over US$1.1 billion in royalties next year. The second and third largest producers in Brazil, CSN and Minas Rio, would also see their royalty contributions increasing by at least 30%, which certainly won't bring any smiles to both companies.