An Analysis of Silver Wheaton’s Streaming Agreement for Vale’s Salobo Mine

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SLW
Wheaton Precious Metals

Silver Wheaton (NYSE:SLW) is a precious metals streaming company which signs long term purchase agreements with mining companies producing silver or gold as a by-product. 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. The silver or gold obtained at a fixed price is sold at market rates. The company does not pay for any ongoing capital or exploration costs at the mines. Such a business model greatly lowers its business risk, as compared to other companies that are directly involved in mining.

In this article, we focus specifically on the company’s gold streaming agreement for Vale’s Salobo mine. We will incorporate various dimensions of the streaming agreement such as the reserve base at the mine, expected output, upfront payments made by Silver Wheaton, and the per ounce cash cost paid.

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The Salobo Mine and Streaming Agreement

Located in Brazil’s Pará state, the Salobo copper-gold mine represents the largest copper deposit ever found in Brazil. The mine began operating in May 2012 with a design throughput capacity of 12 million tons per annum (Mtpa). Vale subsequently began a second phase of construction to expand mill throughput capacity to 24 Mtpa. ((Salobo Mine, Silver Wheaton Website)) This expansion reached 97% physical completion during the first quarter of the year and is expected to come on stream in 2014. ((Silver Wheaton’s Q1 2014 Quarterly Report, SEC))  The ramp-up to 24 Mtpa milling capacity will be completed in 2015.

On February 28, 2013, Silver Wheaton entered into an agreement to acquire from Vale an amount of gold equal to 25% of the life of mine gold production from its Salobo mine. The company made an upfront cash payment of $1.33 billion in order to acquire rights to purchase the gold produced from the mine. [1] In addition the company will pay Vale the lesser of the prevailing market price or $400 for each ounce of gold purchased under the agreement, subject to a 1% annual inflation adjustment starting in 2016. [2] Gold prices are currently trading at levels of around $1,300 per ounce. [3] Thus, Silver Wheaton’s purchase price is likely to be $400 per ounce for the foreseeable future.

The mine will average 45,000 ounces of gold production attributable to Silver Wheaton during the ramp-up to 24 Mtpa capacity, that is between 2013 to 2015. Over the long term, the mine is expected to average 60,000 ounces of gold production over a 30 year period. [4]

As on December 31, 2013, the Company’s 25% share of Salobo’s proven and probable gold reserves stood at 3.4 million ounces.((Silver Wheaton’s 2013 40-F, SEC)) These reserves are sufficient to provide 60,000 ounces of average gold production over a 30 year period.

Analysis of the Agreement

As of March 31, 2014, Silver Wheaton has received approximately 27,500 ounces of gold related to the Salobo mine under the agreement. This has generated cumulative operating cash flows of approximately $25 million. [5]

As the company expects gold shipments from Salobo for a 30 year period, we will assume a 30 year life for the mine. The mine is expected to deliver 60,000 ounces  on an average over this period. Thus Silver Wheaton will receive approximately 1.8 million ounces of gold under the agreement. The $1.33 billion upfront payment for the streaming agreement translates into an average cost of roughly $44.3 million (~1,330/30) per year. This translates into roughly $739 per ounce (~44.3/0.06). Adding to this the acquisition cost of an ounce of gold ($400 per ounce), the total average cost of an ounce of gold comes out to be roughly $1,139 per ounce this year. Given that gold prices are currently trading at around $1,300 per ounce, this is a fairly good deal.

However, one must consider that the inflation adjustment to the purchase price will raise the total cost per ounce for the company. If we take into account the 1% inflation adjustment starting in 2016, the acquisition cost per ounce of gold in the thirtieth year of the agreement would be roughly $523. Thus the total cost per ounce of gold in the thirtieth year of the agreement will be around $1,262 (523+739), as compared to the current $1,139. Thus, from Silver Wheaton’s perspective, for the success of the agreement gold prices must remain above these levels.

Demand for gold over the term of the agreement will mainly be driven by major emerging economies such as China and India. With robust economic growth, rising middle class populations with growing disposable incomes, these countries will drive the jewellery and investment demand for gold. In 2013, China accounted for 26% of the global private sector demand for gold. [6] Chinese private sector demand for gold is expected to grow from 1,132 tons per year in 2013 to 1,350 tons per year in 2017. ((China’s Gold Market: Progress and Prospects, World Gold Council)) Between 2009 and 2020, the global middle class will grow from 1.8 billion to 3.2 billion, with Asia’s middle classes tripling to 1.7 billion by 2020. [7] These trends will provide support to gold prices. From Silver Wheaton’s point of view, for the success of its streaming agreement for the Salobo mine, these trends must keep gold prices above the the total cost per ounce as calculated earlier in the article.

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Notes:
  1. Silver Wheaton’s 2013 40-F, SEC []
  2. Salobo Mine, Silver Wheaton Website []
  3. Gold Price Chart, Kitco []
  4. Silver Wheaton’s July 2014 Corporate Presentation, Silver Wheaton Website []
  5. Silver Wheaton’s Q1 2014 Quarterly Report, SEC []
  6. China’s Gold Market: Progress and Prospects, World Gold Council []
  7. The Rise of The Global Middle Class, BBC []