Silver Wheaton (NYSE:SLW) is a silver streaming company that signs long-term purchase agreements with mining companies producing silver or gold as a by-product.
The silver or gold obtained at a fixed price is sold at market rates, which exposes it to the daily volatility of these metals’ prices. Its gains increase when the market prices of silver and gold rise. The prices of gold and silver have plunged this year, mainly due to the Federal Reserve Bank’s announcements regarding tapering of the Quantitative Easing (QE) program.
In this article, we focus specifically on the company’s silver streaming business from the Yauliyacu mine. It is a low-cost underground mine that produces silver, zinc and lead. Below, we talk about the reserve base at these mines, expected output, upfront payments made by Silver Wheaton, and the per ounce cash cost to be paid once production commences.
Silver Wheaton is the pioneer of the silver streaming business model. It provides funds for capital expenditure upfront when a project is being developed and obtains the right to buy precious metals produced at low, fixed prices. It does not pay for any ongoing capital or exploration costs at the mines. Thus, the company’s costs are one-time and fixed, which greatly reduces its business risk. The mining company that supplies the silver is happy to get funds for capital expenditure without taking additional debt. In exchange it only has to supply silver or gold which are marginal by-products of their core operations such as production of copper or zinc. Therefore, the business model is a win-win for both parties.
The Yauliyacu mine is a low-cost underground mine located near Lima, Peru. It has been in continuous production for over 100 years and is owned as well as operated by Glencore International AG. Glencore is one of the world’s leading integrated producers and marketers of commodities. 
In March 2006, Silver Wheaton entered into an agreement with Glencore to acquire an amount equal to 100% of the silver produced from Yauliyacu, subject to a maximum of 4.75 million ounces per year, for a period of 20 years. In a particular year, if the silver sold and delivered to Silver Wheaton totals less than 4.75 million ounces, Glencore is required to make up for the shortfall in subsequent years. For this transaction, Silver Wheaton made an upfront cash payment of $285 million and agreed to pay $3.9 per ounce of silver delivered (subject to an inflationary price adjustment).
Silver Wheaton is not required to fund any further capital or exploration expenditures at San Dimas, nor is it required to fund any expansion scenarios.
The Story So Far And Future Potential
As of September 30, 2013, Silver Wheaton has received approximately 18.7 million ounces of silver from the Yauliyacu mine under the agreement and has generated cumulative operating cash flows of approximately $282 million. On December 31, 2012, the Yauliyacu mine had proven and probable silver reserves of 12.7 million ounces and measured and indicated silver resources of 39.7 million ounces. 
In 2012, it received 2.41 million ounces of silver from Yauliyacu and sold 2.93 million ounces. The total 2012 sales volume for the company was 24.85 million ounces so Yauliyacu alone accounted for 12% of the total. At average realized prices of $31.35 per ounce of silver, this translates to revenues of nearly $91.85 million. Total revenues in 2012 for the company stood at $849.6 million. 
Since the agreement talks about a 20-year deal, the upfront cost per year can be assumed to be $14.1 million (282/20 ~ 14.1). If Silver Wheaton receives 4.75 million ounces each year (as guaranteed under the agreement), the cost per ounce would be nearly $2.96. Added to the procurement cost of $4.07 per ounce (the inflation-adjusted figure for 2012), the total cost of purchase would stand at around $7 per ounce. Given that silver is currently trading at around $20 per ounce despite the steep decline in prices witnessed recently, we think that it is a good deal by any standard. Even if we assume a conservative long term price estimate of $20 per ounce for silver and a 13 year remaining duration up to 2026, the Yauliyacu mine will generate around $1.24 billion for Silver Wheaton in revenues. 
Furthermore, during the term of the contract, Silver Wheaton has a right of first refusal on any future sales of silver streams from the Yauliyacu mine. It also has the right to make a first offer on future sales of silver streams from any other mine owned by Glencore at the time of the initial transaction. In addition, Silver Wheaton also has an option to extend the 20 year duration of the Yauliyacu contract in five year increments, on substantially the same terms as the existing contract and subject primarily to an adjustment related to silver price expectations at the time. While the upside to these options cannot be quantified due to obvious lack of any information on future events, we can be assured that it will only add to Silver Wheaton’s existing reserves and benefit its share price.
Benefits To Silver Wheaton
In our opinion, the deal fixes the price of silver at a relatively lower figure considering the huge jump in the cost of production over the last few years. Going forward, we think that production costs will rise further owing to higher costs associated with labor, energy, and regulatory compliance. Silver Wheaton, however, will be relatively insulated from these. Despite rising production costs since 2010, the procurement price has increased only to $4.07 per ounce from $3.9 per ounce originally. Also, with industrial demand expected to pick up eventually, the market price of silver is likely to rise despite the slump being witnessed now. This will allow streaming companies like Silver Wheaton to earn good returns. Hence, we think that Silver Wheaton has got itself a good deal at Yauliyacu.
We have a price estimate for Silver Wheaton of $19 which represents 12% downside to the current market price.Notes: