Gold Diggers in Asia: Centerra Gold’s response to attempted expropriation in Kyrgyzstan
Corporate Finance Case Final Project
Finance 663: International Finance Campbell Harvey
3/4/2015
Prepared by:
Jin Hao Paul Kundel Whit Morehouse Cameron Platt Eric Vanderbrink
Gold Diggers in Asia: Centerra Gold’s response to attempted expropriation in Kyrgyzstan
Financial and operational decisions for Centerra Gold Inc. as the Kyrgyz Republic demands an increased share of equity and risk factors weigh-in high.
Leonard Homeniuk, CEO and David Petroff, CFO of Centerra Gold Inc., boarded their early morning connecting flight in Urumqi, China in January 2006. They were headed to Bishkek, Kyrgyzstan en route from Ulaanbaatar, Mongolia. They left their Toronto headquarters a week prior to check up on expansion plans at the Boroo gold mine in Mongolia and to participate in the final negotiations with the government of the Kyrgyz Republic, in the heart of Central Asia.
As the Air China A320 took off from Urumqi’s International Airport, Leonard and David made eye contact and each took a deep breath, tensely exhaling as they looked out the window climbing over the harsh frozen desert of Xinjiang province in the winter. The aircraft headed west towards Lake Issyk-Kul and the Tian Shan Mountains. Leonard quickly fell asleep, but David continued to gaze out the window as they approached the border of Kyrgyzstan and passed over the Kumtor Gold Mine approximately an hour later (Exhibit 1). The mine was majestically nestled at a dizzying 14,000 feet, just south of the pristine shores of the second largest alpine lake in the world. The blue skies and early morning sun gave David a clear view of his company’s largest operation. He could see the harsh winding gravel road leading up from the small village of Barskoon. The road ended and Kumtor began. Large cuts of earth interspersed with temporary housing units, trailer offices, and machinery were neatly organized in clusters. The 20,000+ ft. snow-capped peaks surrounded the site.
David projected that the meetings in Bishkek would be intense that week. Government officials would again demand a greater equity stake in the Kumtor Mining Company. Given the riskiness of operating in Kyrgyzstan, David would need to think creatively about what percentage of Kumtor he could realistically give up and still remain profitable long-term.
As the Kumtor mine disappeared in the distance, David became more uneasy. The mine was by far the most important part of Centerra, contributing 85.9% of revenue.1 What would the future hold for Centerra? David began to fall asleep before the pilot announced the flight’s descent into Bishkek.
Kyrgyzstan: Background
Kyrgyzstan gained independence in 1991 after the Soviet Union collapsed, leading to the privatization of economic sectors and some foreign investment. The Kyrgyz Republic is in the bottom quartile of GDP per capita, exporting mainly agricultural products, including cotton and tobacco, as well as natural resources.2
1http://globalbb.onesource.com.proxy.lib.duke.edu/Web/Reports/ReportMain.aspx?KeyID=48997228&Process=CP&Report=U NIFIEDOVERVIEW 2 https://www.gfmag.com/global-data/economic-data/the-poorest-countries-in-the-world
2 Nestled between China to the east, Kazakhstan at the north and Tajikistan and Uzbekistan to the south and west, Kyrgyzstan is a small country of under 6 million people (Exhibit 2). Most of the country is mountainous with 94% of the country sitting over 3000 feet. 3 Large mountains separate the northern, majority Kyrgyz region, from the southern Uzbek-speakers. Russians who immigrated during the Soviet Era, are present throughout the country.
Since independence, Kyrgyzstan has operated under a fragile constitutional democracy. According to the constitution, the President is supposed to be eligible for a single, six-year term. However, court rulings allowed the first President to run for reelection four times, 4 and caused the Organization for Security Cooperation in Europe (OSCE) to question the fairness of Kyrgyz elections, as well as divisions between between those who question the elections and the defenders of the President. Opposition parties have protested at unfair elections and there have been several bouts of violence.
Kyrgyzstan’s first post-independence transfer of power took place earlier this year, following a dispute over the results of the 2005 elections. The Tulip Revolution ended with the appointment of Kurman Bakiyev as interim president in March 25th.
Centerra Gold History
Centerra Gold was listed on the Toronto Stock Exchange in 2004, became a publicly traded company on the Toronto Stock Exchange in 2004 when Cameco Corporation spun off its gold mining business.5 Centerra is the largest North American-based producer of gold.6 Its largest assets are Kumtor mine in the Kyrgyz Republic, which produced approximately 5.5 million ounces of gold between 1997 and 2005, and the Boroo mine in Mongolia, which began production in 2004 and has produced 1/2 million ounces of gold.7 Currently, Centerra is looking to diversify its mining assets expand its exploration efforts in Mongolia and Kyrgyzstan. A total of $21 million has been set aside for exploration in 2006.8
Centerra Gold’s origins can be traced back to 1994 when Cameco Corporation acquired a 40% interest in the Kumtor Gold Company. Cameco agreed to take on the project and began construction in late 1994. Commercial production at the Kumtor mine began in 1997 and it has produced between 300,000 and 750,000 ounces of gold annually. In 2002, Cameco Gold purchased a controlling stake in the Australian gold company AGR Limited, which owned 95% of Boroo mine in Mongolia and all of the Gatsuurt exploration project. By 2004, Cameco acquired the remaining interest in AGR and started commercial operations at the Boroo mine, producing 245,000 ounces of gold.
3 https://www.cia.gov/library/publications/the-world-factbook/geos/kg.html 4 http://www.bbc.com/news/world-asia-16185772 5 http://en.wikipedia.org/wiki/Centerra_Gold 6 http://www.centerragold.com/corporate/quick-facts 7 Centerra 2005 annual report 8 Centerra 2005 annual report, pg 21. 8 Centerra 2005 annual report, pg 21.
3 On January 5, 2004, Cameco completed the spin-out of Centerra Gold. As part of the deal, the Kyrgyz government exchanged its 60% interest in Kumtor for a 33% interest in Centerra. 9 Simultaneously, the Kyrgyz government sold most of its Centerra shares, retaining a 15.6% interest.10
Kumtor Gold Mine
Located in Issyk-Kul Province of Kyrgyzstan the Kumtor Gold Mine is an open-pit site. In the Tian Shan Mountains, the mine site is more than 14,000 ft. above sea level and is the second highest gold mine in the world.11 Typically Kumtor is responsible for around 10% of Kyrgyzstan’s GDP. In 2005, the mine accounted for 9% of GDP and more than 40% of exports.12
The mine had a major environmental incident in 1998 when a truck carrying 1,762 kg of sodium cyanide (used to purify the ore) crashed into the Barskaun River. Several citizens died and hundreds became sick as a result of the sodium cyanide. The Kumtor Mining Company paid $3.7 million in compensation to the victims’ families.13
The Kumtor Gold Mine sells gold doré processed from ore at the on-site mill exclusively to government owned, Kyrgyzaltyn JSC. This company processes the gold dore at a refinery in the town of Kara-Balta, not far from the originating mine. After processing, Kyrgyzaltyn sells the gold on domestic and international markets.
Business and Financial Structure
Project financing
Cameco began the 28-month construction process of the Kumtor Gold Mine in 1994 with capital costs of $452 million, a figure well above the feasibility cost estimates. The mine received financing from several sources. Chase Manhattan underwrote a $155 million syndicated loan. International financial institutions, in the form of The World Bank’s International Finance Corporation (IFC) and European Bank for Reconstruction and Development (EBRD) committed $30 million each in senior loans as well as $10 million each in subordinate loans for a total of $80 million. Canada’s Export Development Corporation (EDC) provided $50 million in export credit, and Cameco pledged $45 million in equity as well as $122 million project loans.14
The Gold Market
The global market for gold is driven by several distinct sources of demand. Jewellery accounts for roughly half of global demand, followed by gold bars and coins used for private investment. Sovereign purchases (for central bank reserves) and industrial applications (for electronics, dental, and other uses) each account for approximately
9 http://www.centerragold.com/corporate/history 10 http://www.eurasianet.org/node/63603 11 http://en.wikipedia.org/wiki/Kumtor_Gold_Mine 12 Centerra 2005 Annual Report 13 Ibid 14 http://www.unc.edu/courses/2010spring/econ/560/002/kumtor.html
4 10% of global demand. Demand for gold is expected to grow in line with or above global GDP, driven by demand from China in particular. China has numerous mines across the country and new sites are opening throughout the region to meet growing demand.15
Over the past 10 years, the price of gold increased from $384/troy ounce to $445/troy ounce. A table of historical annual averages in found in (Exhibit 3).16 During the first several years of production at Kumtor Gold Mine, the price of gold dropped until 2001 when it began to rebound from a low of $271 per ounce.
Revenues & Costs
All of Kumtor’s revenues come from the sale of gold doré bars to Kyrgyzaltyn. Kyrgyzaltyn (Kyrgyz Gold) is a State-Owned Enterprise (SOE) which processes the doré bars and sells the pure gold on the international market. It has an official monopoly on gold trading in Kyrgyzstan.
In 2005, the average cost per ounce of gold produced was $275 with 500,000 ounces of gold produced per year. 17 Kumtor incurs major costs including significant exploration expenses to extend the life of the mine. Operations also require large capital expenditures to upgrade equipment, perform maintenance, and expand facilities.
Kumtor is the highest payer of taxes in Kyrgyzstan; the amount of taxes and environmental protection costs due (including fines and clean up expenses) has been variable throughout the life of the project.
Country and Mine Risk Profile
The risk profile of the Kumtor mine can be divided into three types of risk: idiosyncratic, operating, and financial.
Idiosyncratic Risk
Idiosyncratic risk is associated to the specific operation of the mine. Historically, Kumtor has dealt with environmental damages due to the use and transport of chemicals for gold extraction. Although the company has implemented environmental controls, future accidents are prone to occur. The mine also assumes high liability for employee safety, machinery maintenance, and site-specific weather conditions including the possibility of avalanche or other high elevation conditions that might halt operations.
Operating Risk
Kumtor was largely isolated from the Tulip Revolution protests and violence that has occurred in Bishkek and the southern regions of Jalalabad and Osh. The site’s seclusion diminishes the impact of political events on physical business operations,
15 gold.org… 16 http://www.nma.org/pdf/gold/his_gold_prices.pdf 17 Centerra 2005 Annual Report
5 but due to the high volatility of domestic affairs, Kumtor pays extremely close attention to this type of operating risk for contractual purposes. Political transition and unrest has not caused restrictions on executive travel, or mine operations.
Financial Risk:
Financial risk is largely tied to the price of gold. Kyrgyzaltyn has a monopoly on gold within Kyrgyzstan, so interruptions in deliveries to, or payments from, the SOE could have a significant impact on revenues at Kumtor.18
Options Moving Forward: Decision Time
As they enter negotiations in Bishkek, Homeniuk and Petroff have three options: Centerra can seek redress in international court, exit the Kumtor investment, or seek an accommodation with the Kyrgyz government and continue operations.
If they decide the Kyrgyz government demands are unreasonable, Centerra might seek legal redress in Kyrgyz or Canadian court. However, it is unlikely that Centerra would receive a favorable ruling in local court, and, it may be challenging to enforce a favorable ruling from a Canadian judge. Moreover, starting a legal battle could halt operations in Kumtor and jeopardize Centerra’s main source of revenue.
Centerra could decide to cut their losses and exit the Kumtor investment. The Kyrgyz government is a major shareholder in Centerra and appoints one board member. Assumping the government in not able to prevent the sale, there are a limited number of potential buyers who have the expertise in high altitude gold mining, ability to operate in Central Asia, and financial ability to make the acquisition. Any buyer would still need to deal with the Kyrgyz government, Centerra may therefore be forced to accept a price well below intrinsic value.
Finally, Centerra can negotiate an accommodation with the Kyrgyz government. This accommodation could take many forms: a larger stake in Centerra, a stake in Kumtor, cash payments, royalties, or other solutions. In order to negotiate an accommodation, Homeniuk and Petroff need to clearly understand the value of the agreement, and minimize its impact on Centerra’s continuing profitability.
As they reflected on the three options, Homeniuk and Petroff considered the third most likely. However, an agreement could take many forms. How could they ensure that they were making the best decision for their shareholders? How could they solve this issue once and for all, with minimal the impact on Centerra’s profitability? And would appeasing the government today increase the chances of future issues? The future of the company was at stake as they stepped into the meeting room…
18 http://www.reuters.com/article/2012/07/04/kazakhstan-gold-refinery-idUSL6E8I40FA20120704
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Exhibit 1: Photo of the Kumtor Gold Mine19
Exhibit 2: Map of Kyrgyzstan and Kumtor Gold Mine20
19 http://www.centerragold.com/operations/kumtor 20 http://www.economist.com/news/asia/21573615-attitudes-towards-foreign-investors-hold-troubled-country-back- gold-hills
7 Exhibit 3: Historical Annual Price of Gold 1994-2006
Average Price of Gold: 1994-2006 500 450 400 350 300 250 200 150 100 50 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Average Price of Gold
Data: http://www.nma.org/pdf/gold/his_gold_prices.pdf
8 Exhibit 4: Centerra Balance Sheet (2005)
9 Exhibit 5: Statement of Cash Flows (2005)
10 Exhibit 6: Relationships between the parties, 2005
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