One of the great stories I heard when I started finance journalism was the tale of a meeting between the American geologist, Dr Lewis Weeks and the then-BHP chairman, Sir Ian McLennan, in March 1960.
Dr Weeks had helped BHP find the rich Bass Strait oilfields, telling the company where to drill, having studied the area since the 1930s.
It’s history that McLennan and Weeks signed a deal for a royalty of 2.5% on the future oil production from the fields.
The story may have been embellished along the way, but as it went, McLennan asked Weeks after the pair had signed whether everything was fine. Weeks responded with, “I would have signed for 2%.” The response from McLennan: “My Board had authorised me to sign for 5%.”
The Weeks Royalty kicked off when Bass Strait oil began flowing in 1969. The Weeks Royalty is no longer owned by Dr Weeks’ family – he sold (and even gave away) portions of it, and ownership is spread across a number of people and institutions. The royalty represents a 2.5% over-riding royalty from the hydrocarbon production of 20 producing fields in the offshore Gippsland Basin, that are owned by ExxonMobil and BHP.
The Weeks Royalty lives on, on the ASX, through listed royalty company Fitzroy River Corporation (ASX:FZR), which owns 1% of it. In the six months to December 2020, that holding in the Weeks Royalty earned FZR $307,000: the amount fluctuates with oil prices and the A$/US$ exchange rate.
Another famous Australian royalty is the one shared equally by the heirs of Lang Hancock and Peter Wright (that is, Hancock Prospecting and Wright Prospecting), who in 1962 struck a deal with Rio Tinto that guaranteed Hancock and Wright a 2.5% royalty on every tonne of iron ore exported from the Hamersley Ranges. The deal continues and has generated staggering wealth for the Hancock and Wright families.
Unless you have a family member who makes a monumental resources discovery, you won’t get access to a deal like that, but listed royalty companies are an interesting area of the stock market. They are a $US70 billion sector in North America: royalty “streaming” has become popular with miners in recent years as a way to raise capital. A royalty represents a share of revenue or profit share from a specific mine or mineral asset; royalties have usually been created by mining/exploration companies selling an asset to another company (usually a fellow explorer/developer) but wishing to retain some upside. These royalties are often on-sold.
For investors, a royalty can offer a way to get exposure to rising metals prices with lower risk than investing directly in a miner. Revenue royalties can represent a pure play on the physical price of the commodity.
There are a few listed royalty companies in the resources space on the ASX, but the concept has only become investment-grade since mineral sands giant Iluka Resources (ASX:ILU) spun-off its royalties portfolio in October 2020, creating Deterra Royalties (ASX:DRR). Iluka retained a 20% stake in Deterra, which started trading at $4.87 a share.
Deterra has created a stir in the global listed royalty company space, being a virtually unique exposure to non-gold royalties – the North American companies are focused on precious metals royalties.
The Deterra royalty business generates most of its revenue from BHP’s Mining Area C (MAC) iron ore operation in the Pilbara. As operator of the mine, BHP owns 85% of MAC, with Japanese partners Itochu and Mitsui owning the 15% balance). MAC is part of BHP’s WA Iron Ore Operations, which includes the South Flank expansion.
This expansion will see in MAC iron ore production more than double from the current demonstrated annual capacity of 57 million dry metric tonnes (dmt) to at least 139 million dry metric tonnes by the end of 2023. South Flank is now 95% complete: first ore from South Flank is expected by the end of the 2021 calendar year, with the project expected to produce iron ore for more than 25 years.
BHP’s current MAC operations at North Flank and South Flank are expected to continue until about 2050, but the long-term strategy envisaged for Mining Area C is to continue operations to 2073 (this would require BHP to prove-up further resources). There are two potential mining areas identified by BHP in its long-term plan, Tandanya and Mudlark, likely to fall at least partially within Deterra’s royalty area, extending the potential royalty cash flows.
Deterra earns a payment equivalent to 1.232% of revenue (in $A) derived from the MAC royalty area (at present, only North Flank). In addition to this, Deterra also receives $1 million for each incremental tonne in annual production above the prior highest annual production level of 57 million tonnes. Analysts expect Deterra to receive about $73 million in capacity payments over the ramp-up. Deterra’s dividend policy is to pay out 100% of its net profit, fully franked.
Just the BHP MAC aspect alone makes Deterra probably one of the highest quality mining royalty streams anywhere in the world, given the counterparty (BHP, Itochu and Mitsui are all rated ‘A’), the outlook for iron ore production growth, and the likely lifetime of the asset.
Only three things affect DRR’s revenue: the volume of iron ore sold; the price at which the iron ore is sold; and the A$/US$ exchange rate (the weaker the A$ in US$ terms, the better for DRR shareholders. We know that the volume picture is going to rise – which leaves the iron ore price and the exchange rate.
Both have been extremely volatile over the last 30 years. Iron ore touched a low of US$26.47 per dry metric tonne in 1994, but only last week it hit a record high of US$237.57 a tonne. Similarly, the A$/US$ exchange rate has been as low as 0.4829 and as high as 1.1054 over the last 30 years. Currently, one Australian dollar buys 78 US cents.
A major part of that iron ore price surge is the fact that Brazilian production is still not back to normal, as regulators have not yet allowed some areas hit by disastrous tailings-dam failures to resume production. Despite China’s probable desire to hurt Australian suppliers, as part of the Beijing-Canberra geo-political dispute, it must be galling for it to see its steel mills have to pay these elevated prices, the market is the market. Prices above US$200 a tonne – even above US$150 a tonne – must be seen by iron ore producers as a bonus: longer-term, the iron ore price will come down eventually.
On the other hand, by 2023, Deterra will be generating royalties on attributable production of about 145 million tonnes – assuming that global demand, and most particularly, from China, will easily absorb this.
For the half-year ended 31 December 2020, Deterra paid an interim dividend of 2.45 cents a share, equal to 100% of net profit. Broker consensus at FN Arena expects a dividend of 10.7 cents a share in FY21, and 21.3 cents in FY22 – so, at the share price of $4.43, a 2.4% yield (grossed-up, 3.5%), rising to 4.8%, fully franked (grossed-up, 6.9%) in FY22. In yield terms, now you’re talking. Broker Morgan Stanley, for instance, assumes a yield of 5%–6.5% (grossed-up, 7.1%–9.3%) when MAC is operating at full capacity.
Deterra also has five other small royalty sources, from mineral sands projects in WA (which currently generate about $600,000 a year for it, mostly from the Yoongarillup mineral sands operation), and says it is looking around the world to identify and evaluate new royalty opportunities. Broker Citi expects Deterra’s efforts in this area to strengthen its uniqueness in the sector, by focusing on royalty opportunities in base metals, bulks and battery commodities rather than precious metals.
On comparison to the royalty companies that trade in New York and Toronto, brokers say Deterra looks very cheap. The price on the ASX has weakened from $4.87 to $4.42: FN Arena’s consensus of analysts’ valuations expects $4.79 to be regained. The final plank in Deterrra’s appeal is that analysts believe that the unique quality of its MAC royalty stream invites a takeover approach from other listed royalty companies.
There are some other interesting listed royalty players on the ASX – most notably High Peak Royalties (ASX:HPR), Emmerson Resources (ASX:ERM), Gullewa (ASX:GUL) and the aforementioned Fitzroy River Corporation (FZR) – but for quality and reliability, it’s Deterra and then daylight.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.
