Ecuador’s windfall profits tax deepens uncertainty (February 04, 2008)

News in December that Ecuador was following in the footsteps of Mongolia and Thailand with a windfall profits tax on miners has left the industry reeling with uncertainty.

Reform of the tax law late last year under the country’s new left-leaning president, Rafael Correa, brought in a 70% windfall profits tax on the mining industry.

Then, in a one-two punch, on Jan. 25 the government declared it would revoke hundreds of mining concessions because companies had failed to pay fees or committed other infractions.

The moves are seen as part of efforts by the Andean nation to boost its control over the industry, as well as to increase the impoverished country’s revenues from resource extraction industries such as oil and mining.

“Correa needs money in the treasury to pay for all the programs he wants to put into place, including those which contribute to the redistribution of wealth around the country and the creation of jobs,” says Darryl Jones, chief financial officer of Corriente Resources (CTQ-T, ETQ-X), which holds primarily copper deposits in the country.

Now Ecuador is in the midst of drafting a new mining law, which is expected to be completed in May.

The notion of taxing profit started in the petroleum industry. Until recently, Ecuador received a 50% windfall profits tax from oil companies based on a threshold price over and above the price of oil at the time an investment agreement was signed.

Last fall, the government hiked that tax to 99% from 55% and “shocked the heck out of oil companies,” Jones says.

Correa looked at the petroleum industry and saw that the state was only getting tax revenues based on investment agreements signed four or five years ago at a threshold price of around US$23 per barrel of oil, Jones explains.

“While the companies were getting to keep fifty per cent of anything over the US$23 threshold price, which to the government was fine when prices were down in or around that level, when oil is closer to US$100 that’s a different story,” Jones says. “That’s when the windfall profits tax craze really gained steam in Ecuador.”

In November, Correa turned his attention to the mining industry after learning more about its potential and the big tax dollars it could bring to his coffers. Says Jones: “He knows that just over the Andes ridge you’ve got Peru, which is doing very well on the expansion of its mining industry.”

The critical component of the windfall profits tax is what price the government will determine the threshold price to be in each investment agreement it signs with foreign mining companies. So far, no details have been released.

“If (the threshold price) is consistent with what they did with the oil companies, it would be close to the current market price for copper, which is trading at over three dollars (US) per pound,” Jones adds. “This is a price that would ensure project feasibility.”

The question is what happens if the threshold prices are lower. Bankable feasibility studies required to raise project financing are never based on spot prices, he argues. Project feasibility studies are not done based on market highs or current market prices, but on a conservative estimate of long-term pricing.

In Corriente’s case, for example, a bankable feasibility study today would not use US$3 per lb. as a longterm price going forward, but rather something in the range of US$1.50-1.65 per lb.

Corriente filed its first bankable feasibility study for its Mirador copper project in April 2005 based on a copper price of US$1 per lb. and plans to release an updated version in April.

“Generally speaking, the implementation of windfall profits taxes would wreak havoc in the mining investment community,” Jones notes. “If you look around the world today, there are really only two jurisdictions that have brought in windfall profit taxes and there’s a reason why they don’t work.”

The most successful mining jurisdictions in the world, such as Chile and Peru, recognize that when commodities prices rise, the tax taken by the country goes up automatically, Jones explains.

Moreover, such taxes on profits don’t take into account the explosion in capital costs in recent years.

“Ecuador is in its infancy in the world of mining, especially in comparison to its neighbours like Peru, Chile and even Bolivia,” Jones says. “They need to understand that you cannot apply spurious taxes in the early days and expect that industry to prosper.”

Still, Jones remains hopeful that the government can implement a sensible new mining law and that industry and government can work through key issues together.

On Jan. 8, the government declared it would meet with certain mining companies to work towards defining laws and processes that would strengthen investment in mining in Ecuador and determine royalty levels for the state, as well as ensure adequate controls over the environment and social responsibility.

“At this stage, I would call it an education phase,” Jones says. “The companies are trying to educate the government on what it takes to bring a significant project into being and the absolute need for a solid stable investment environment, and the government wants to educate us on the need for transparency and oversight by the local communities and the state.”

As for the suspension of Corriente’s fieldwork activities at Mirador, which were curtailed last year under Ecuador’s previous government due to protests near the mine site, Jones says he is confident the order will be reversed soon as part of a broader commitment to mining in the country.

“We believe what they are waiting for is making the lifting of the suspension part of a larger announcement that Ecuador is open for mining. We expect that any week.”