Indonesia has asked metal mining companies, including the local unit of Freeport McMoRan Copper’s (NYSE:FCX), to raise royalties to 10%. This demand has been made as a part of ongoing broad-based negotiations with the mining companies operating in Indonesia. These negotiations are focused on six main issues: increase in royalty payments, the obligation to process mineral ores in Indonesia, use of local goods and services, divestment, contract extensions, and the size of mining areas.^[1]

Freeport has not commented on this latest demand as yet. We think that these companies would much rather prefer to discuss these things with negotiators behind closed doors, than indulge in a public debate. We believe that doing the latter would attract attention of the public at large, which is likely to side with the government. This would reduce flexibility and maneuvering space for government negotiators. The hardening of stands by both sides might reduce scope for amicable resolution.^[2]

Freeport is a global miner with mines in the U.S., South America, Indonesia and Africa, and has a product portfolio spanning basic metals like copper, gold and molybdenum. Its primary asset in Indonesia is the Grasberg mine, which is the largest gold mine and the third largest copper mine in the world. The mine accounted for 19% of the Freeport’s revenues in 2011. In the first half of 2012, Grasberg produced 296 million pounds of copper (against 545 million pounds in the first half of 2011) and 459,000 ounces of gold (against 766,000 ounces in the first half of 2011).^[3]

See our full analysis for Freeport McMoran here

The Indonesian government formed its negotiation team early in January this year, appointing Coordinating Economic Minister Hatta Rajasa as the team’s Chairman. The group has been given time until December 2013 to conclude negotiations, according to a decree signed by President Susilo Bambang Yudhoyono on January 10, 2012. Coal mining companies in Indonesia pay 13.5% of revenues as royalty. The government is seeking to bring royalties paid by mineral miners like Freeport McMoran to a similar level. PT Freeport Indonesia, the subsidiary through which Freeport McMoran owns Grasberg, currently pays 1% as royalty for mining gold and 3.5% for mining copper.

Freeport’s Grasberg project has been dogged by controversies for years over various contentious issues such as royalties, workers’ pay, and pollution. This has often resulted in strikes by workers which has had direct bearing on Freeport’s production figures and profits. However, the potential of the Grasberg mine is so huge that Freeport has persisted against all odds.^[4]

If the government succeeds in having its way, increased royalty will have a direct bearing on margins, and by extension, on profits. Copper prices have been drastically decreasing across the world for quite some time now, due to a twin combination of rising supply and declining demand. The copper price outlook for the future, in our opinion, hinges largely on a Chinese economic recovery. You can use our interactive chart below to get an idea of the impact which a decrease in Freeport’s Indonesian copper business EBITDA margins might have on its valuation:

Although Grasberg also produces gold, its price has been climbing steeply for quite sometime now and this trend is expected to continue in the near future. This should mitigate any adverse impact on margins and profits in Freeport’s gold business. While copper business constitutes 81% of the Trefis price estimate for Freeport McMoran, gold constitutes only 15%.

We have a Trefis price estimate for Freeport McMoran Copper of $44 which is nearly 7% above its market price.

Understand how a company’s products impact its stock price at Trefis

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