Freeport - McMoRan: A Major Miner Challenge
By: Frank Dong & Trevor Wright
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
Freeport-McMoRan (Freeport) is one of the world’s largest publicly traded copper mining companies, specializing in copper extraction and refinement from mines in the U.S., Peru, Chile, and Indonesia. Historically, Freeport has had a close working relationship with the Indonesian government, which has recently become strained as the latter has committed to keeping an increasing amount of its resource wealth within national borders. A dispute since 2009 climaxed in August 2017 when Freeport and the government reached a tentative agreement requiring the company to divest 51 per cent of its shares in its Indonesian subsidiary, build a $2-billion copper smelter in the country, and pay a 10-per-cent royalty on revenue from Indonesian copper sales. Although the valuation of the mine has yet to be finalized, Freeport must be proactive in establishing a long-term strategy to maintain profitability and operational capabilities within the changing Indonesian landscape.
Scratching the Surface
The outcome of this dispute reflects a perpetual and necessary risk mining companies face in the developing world: resource nationalization. Developing governments have shown a willingness to make decisions that favour their constituents, often at the expense of international companies operating in the country. For instance, in August 2017, Zambia shut down power to a Glencore copper mine after a dispute over an electricity price increase. Barrick Gold is facing a tax bill equal to four-times Tanzania’s GDP for its gold operations in the country. Although this is an assumed risk of operating in the developing world, companies often find themselves on the losing side of legislation.
Indonesia’s approach to foreign ownership has shifted over time. For years, Freeport and its peers operated in Indonesia with little government interference. However, years of public outrage regarding foreign ownership of Indonesian resources peaked in 2009. In response, the government passed the Law on Mineral and Coal Mining No.4. In addition to increased regulation and taxes on mineral wealth, the law requires foreign owners to divest up to 51 per cent of their interests in Indonesian resources. This prompted Newmont Mining, the second largest copper producer in the country, to sell its stake in one of the world’s largest undeveloped copper and gold mines in 2016. Around the same time, BHP Billiton, one of the world’s largest coal producers, also divested its Indonesian interests. The volatile Indonesian political environment is deterring new entrants to the industry; exploration spending and total investment has fallen 22 per cent and 31 per cent from 2014 to 2015 respectively. These metrics demonstrate the current skepticism in the global mining community with respect to doing business in Indonesia.
Digging Deeper into the Problem
Freeport’s primary property in Indonesia is the Grasberg mine in West Papua. Grasberg is the largest known gold deposit and second-largest known copper deposit in the world, generating 22.2 per cent of Freeport’s total revenues in 2016. After eight years of negotiations between the company and Indonesia, the government halted the export of copper concentrate from the Indonesian Grasberg mine in early 2017, causing Freeport to lose roughly $1 billion in revenue. The Indonesian government has illustrated its willingness to exercise substantial control over Freeport’s revenues in order to protect the sovereignty of its resources. In the month following the tentative agreement between Freeport and the Indonesian government, the company’s share price fell 7.1 per cent. CEO Richard Adkerson described the deal as a “major concession,” further eroding investor confidence. Investor relations are critical within a capital-intensive industry such as mining, where equity markets are often used to fund new projects. Specifically, Freeport has raised $3.5 billion in three equity offerings since 2015. Given that resource nationalization is a strong deterrent for investors, Freeport must develop strategies to foster healthy working relationships with the countries in which it operates.
After copper ore is mined, it is transferred to a smelter facility where the raw metal is processed. The refined copper is then sent to a central warehouse where it is stored until sold to the end consumer. Presently, the Gresik smelter, which is 25-per-cent owned by Freeport, is the only smelter in Indonesia and is capable of producing 300,000 tonnes of copper. This falls short of Indonesia’s approximate demand of 390,000 tonnes of copper per year, requiring users to import the difference. A $2-billion smelter investment will increase production capacity in Indonesia by an estimated 300,000 metric tonnes per year, based on similar smelter investments in other countries. This will enable Indonesia to reach its goal of copper self-sufficiency as well as create excess for export. In aggregate, the company can shift from mining and exporting concentrate to other countries, which then process the copper themselves, to ensuring that the entire extraction and production process remains domestic. In 2016, the Grasberg mine produced concentrate worth around 482,000 tonnes of refined copper. Assuming Grasberg production levels will remain the same in the near future, Freeport must sell its smelting capacity to other copper miners to maintain efficiency. This would involve charging companies a “tolling” fee to refine ore, while the mining customer retains mineral ownership throughout the process. Large amounts of ore in Indonesia and neighbouring countries will provide sufficient volume to keep the smelter operating at near capacity. To ensure that operations run smoothly within Freeport’s supply chain, the company must ensure it adheres to all regulations and operates in accordance with government mandates.
Mining for Minority Stakes in Existing Reserves
One of Freeport’s strengths is working with volatile governments to achieve the goals of all parties. Operating within resource-rich developing countries is an inherent part of the business model for all mining companies, which take on risk in hope of achieving a greater potential profit. In return, modern mining practices act as a vector for development within the often fragile economies of developing nations. Freeport’s Indonesian operations pose an interesting dilemma, since the company is one of Indonesia’s largest taxpayers and employs thousands of local workers. Nevertheless, given the Indonesian government’s recent actions, it is paramount that Freeport consider the government’s position when developing any strategy within the country. In this case, the Indonesian government’s goals are twofold: firstly, it must represent the interests of constituents. Indonesian citizens are unwilling to allow foreign entities to control large amounts of mineral wealth, and thus significant pressure is placed on the government to use legal devices such as transfer of ownership and revenue royalties to stop these outflows. Secondly, the government aims to promote economic development and ensure the well-being of its citizens. As such, any future business strategies in Indonesia will have to consider the needs of the local population. Ultimately, to fulfill both the government’s goals as well as those of its shareholders, Freeport should purchase minority stakes in existing Indonesian copper reserves. This long-term strategy will protect the $12 billion Freeport has already invested in Indonesia, ensure maximum efficiency of its smelters, and appease the needs of the Indonesian government.
There are still an estimated 124 million ounces of unrecovered gold and 75 billion pounds of unrecovered copper in Indonesia. As other multinationals are leaving the country, Freeport should secure its stake in these future profits while remaining as one of the only global mining companies committed to working alongside and providing opportunities to the Indonesian people. In 2016, Freeport sold much of its oil and gas reserves generating substantial amounts of cash; as the cash is not currently providing any future economic benefit, Freeport should offer to purchase Medco Energi Internasional’s (MEI) share of PT Amman Mineral Internasional (AMI). AMI owns the Batu Hijau and Elang mine properties, which together hold an estimated 30.1 billion pounds of copper and 42.2 million ounces of gold. Medco purchased 50 per cent of the mine in a deal worth $2.6 billion in 2016.
The partial ownership of AMI would benefit Freeport through three main verticals: first, the company would have access to 40 per cent of the future profits generated by Indonesian copper reserves, and since the purchase implies minority ownership, majority control would still be held by Indonesian companies. The government’s offer to let Freeport continue operating the Grasberg mine may suggest that Freeport has capabilities that are valuable for the Indonesian mining community. By purchasing minority stakes in multiple mines and helping refine operations, Freeport can maintain its presence in Indonesia without controlling the copper industry and antagonizing the local population. Additionally, AMI announced in March 2017 that it would invest $1 billion in a smelter near the Batu Hijau mine, introducing a new competitor to Freeport’s Gresik smelter and threatening Freeport’s share of the Indonesian copper smelting market. Freeport’s current smelter in Indonesia sources 20 per cent of its copper requirements from Batu Hijau, business that would potentially be lost to the new smelter. The vast majority of value in the production process is created during the mining stage; value added from smelters are magnitudes lower. This illustrates the importance of Freeport’s ability to control any new smelters that are built in the country so as not to forfeit any opportunities for profit. Lastly, Freeport can use its significant scale, which allows for a lower cost of capital, to reduce development and commercialization costs for the Elang property. Medco’s cost of capital on USD-denominated bonds is 6.1 per cent whereas Freeport’s average cost of borrowing is 4.2 per cent. Reducing interest costs by 1.9 per cent will also help entice the other Batu Hijau owners to support Medco exiting the investment.
Relationships to Build Riches
To ensure this recommendation can be adopted, Freeport should take advantage of its newfound relationship with Indonesian mining companies to foster better relations with the local population. The significant economic weight Freeport holds in West Papua has led to locals blaming the Grasberg mine as the source of economic and social anguish in the region. One of the largest factors presently contributing to local unrest towards Freeport revolves around a disregard for environmental policies. The local Indigenous people of Kamoro are especially upset with the company, as poverty, disease, and environmental degradation have damaged their previously fertile land. Freeport should aim to increase the amount of environmental scrubbers and filters both in Grasberg and in the new mines they will hold a stake in, as well as work with local citizens to address previous concerns. By making strides towards environmental restoration, Freeport will be able to better cultivate trust with locals and gain greater favour with the Indonesian government. Furthermore, Freeport should adopt an affirmative action hiring policy focusing on increasing the representation of Indigenous West Papuans within the Grasberg workforce. Making more Native-Papuans benefactors of Grasberg will build rapport with the local community and reduce social opposition against the company. Ultimately, the issues Freeport is facing are reflective of developing countries’ frustration and belief that the mining industry’s longstanding practices are exploitive. By reducing negative environmental externalities and increasing the number of people who benefit from the wealth of the mine, Freeport will be able to build a stronger relationship with the Indonesian people and subsequently its government.
While Freeport cannot control the regulatory environment, the company can make strides to solidify its importance in the Indonesian copper industry. By taking advantage of the exit of other Western companies, Freeport can secure ownership of important properties in Indonesia developed through operational expertise and economies of scale. Coupled with increasing environmental efforts and providing development opportunities for the local community, this strategy will demonstrate Freeport’s commitment to Indonesia, thereby improving its reputation and economic potential within the country.