On October 12, amidst the financial turmoil caused by the troubling situation in the U.S. and Europe, Chilean government-owned Codelco, the world's largest producer of copper, surprised markets by closing a multibillion dollar deal with Japanese multinational Mitsui & Co., whoseinvestments in the Chilean mining sector include holdings inCompañía Minera Doña Inés de Collahuasi, Minera Los Pelambres and the Caserones mining project.

The largest business deal in the history of Codelco, it would have enabled Mitsui to provide Codelco with a loan of US$6.75 billion, which would have allowed Codelco to exercise an old purchase option for 49% of the shares of Anglo American Sur (AAS), the subsidiary of U.K.-based mining company Anglo American. AAS owns the copper deposits at Los Bronces, one of the most important private mines in Chile because of its high concentration of untapped copper sulfates. AAS also owns the El Soldado deposits, the Chagressmelter and various other exploration projects in the central region of the country. The purchase option was to expirein January 2012.

According to Pablo Orozco, Codelco’s manager of communications, the contract with Mitsui would have enabled the state-owned company to make use of its option to purchase 49% of Anglo American Sur, owned by the government of Chile ever since 1978. This option was previously owned by Enami (Chile’s National Mining Company), which promotes and develops small and midsize mining firms in the country. In the past, Codelco had wanted to exercise this option, but it didn’t have sufficient funding to do so. Thanks to the agreement with Mitsui, Codelco would now have that funding.

Codelco took the step because it “faces a big problem,” notes Jorge Oyarzún, professor of economic geology at the University of La Serena in Chile. At the root of its problem, he adds, is "the exhaustion of [Codelco’s] higher-grade copper reserves and the poorluck that it has had with the outcome of its exploration projects." The main goal of this initiative, he says, was to address those challenges.

JoseYáñez, professor of economics at the Universityof Chile, agrees with that assessment. "There is a growing gap between what private firms in Chile are producing in copper and what Codelco is exploiting." At the end of 2010, midsizeand large private mining companies in the country recorded output of 3,646,000 tons of copper, while state-owned Codelco produced less than half that amount, or 1,689,000 tons, according to Sonami, the national mining society which represents large, medium and small mining firms in Chile.

The Added Value of Los Bronces

Codelco's alliance with Mitsui would enable the state-owned giant to guarantee its leadership as the world’s largest copper producer, says Aldo Casali, director of the department of mining engineering at the University of Chile. "That position was at risk. Byexercising the purchase option, the state-owned firm would wind up with partof the production from Los Bronces and El Soldado, thus preserving its hegemony in the global copper industry."

By obtaining a portion of the Los Bronces mine, notes Casali, Codelco would create great synergies between that mine and its Andina division. Separated by a very short physical distance, both locations are at more than 3,000 meters above sea level in the country’s Fifth (“V”) Region in central Chile. In addition, Casali emphasizes, "Los Bronces has excellent prospects because of its undeveloped reserves of copper sulfates, which arean [extra benefit] for Codelco. It is getting harder and harder to find [copper] deposits whose purity level exceeds 1.4%, as in this case.”

Nevertheless, in an unexpected turn of events, the agreement between Codelco and Mitsui was suspended after AAS announced on November 9 that it was selling 24.5% of its assets in central Chile to Japan’s Mitsubishi Corp. for a price of US$5.39 billion. That would mean that if Codelco now wanted to exercise its option to buy 49% of AAS, it would now only be able to purchase 24.5%.

Anglo America’s SurprisingMove

What motivated AAS to make such a surprising move? Miguel Angel Durán, president of AAS, told the local media that the deal was an attempt to “defend the long-term interests of [its] shareholders.” He added that selling 24.5% of the company’s shares to Mitsubishi balances the benefits for all of the parties involved.

Obviously, AAS “is taking advantage of a tremendously convenient opportunity,” notes Codelco’s Orozco, because for 49% of AAS´s shares Codelco would pay US$6.75 billion, and Mitsubishi is not going to pay US$5.39 billion just for 24.5%. “Nevertheless, with this sale, the British firm [AAS] would be violating the agreement it signed with Codelco in 1978,” says Orozco.

Clearly, says Oyarzún, “Anglo American Sur does not want Codelco as its partner — not, at least, with 49% ownership of its assets.” That is ironic, he adds, because by associating itself with Codelco, AAS would be strengthening its ties with the government of Chile, which would enable it to obtain significant benefits from mutual cooperation. “Instead, AAS chose conflict with the state-owned firm.” This could lead to a legal battle, because the option to buy 49% of the ownership of AAS “is a right that Codelco has,” notes Casali, “and it was clearly established in a clause of its agreement with Anglo in 1978.” This option is opened up every three years.

This much is certain: AAS’s unexpected sale of a 24.5% stake to Mitsubishi has created an adversarial climate between AAS and Codelco. Codelco, which is supported by the government of Chilean president Sebastian Piñera, has announced that it is studying whether or not to take the case to the Chilean courts if AAS should decide not to sell Codelco 49% of its shares next January.

An ‘Extremely Productive’ Alliance

Without doubt, Codelco has powerful reasons to launch an all-out battle to defend its purchase options for AAS. One of those reasons is the recent agreement signed with Mitsui, which has now been suspended.

If Codelco managed to exercise its 49% purchase option in AAS, Codelco would be acquiring that ownership for US$6.75 billion financed by Mitsui. “And if Codelco were to decide in the future to sell that 49%, then Mitsui would be prepared to buy it for US$9.75 billion,” notes Codelco’s Orozco. That means that Codelco would have a guaranteed profit.

Beyond that,Orozco points out that "the contract states that if Codelco decided to sell its stake in AAS, then it has the right — but not the obligation — to sell to Mitsui half of its 49% stake (24.5%) for US$4.88 billion dollars, a price well in excess of the US$6.75 billion dollars of its purchase option for 49%.” The rest of the remaining debt to be paid to Mitsui (US$1.87 billion), he notes, would be paid off by a company formedin equal parts by Mitsui and Codelco, using the same revenues generated by production from AAS.

As a result, Codelco is completely protected from any financial risks, says Orozco, "since if this agreement with Mitsui materializes, it would not be changed by conditions in the marketplace. The valuation of US$9.75 billion dollars made ??by Mitsui is still established in the contract, and it cannot be altered.”

Apparently, Codelco’s rate of indebtedness would also wind up being very low, considering that Codelco and Mitsui have signed their ownparallel sales agreement for 30,000 tons of fine copper per year at market prices.“As a result, the alliance with Mitsui would be extremely productive for Codelco,” Casali says, “and it would not jeopardize the resources that are needed by Codelco to finance its own development projects."

"Mitsui would be assuming the greater risk in this deal,"according to Gustavo Lagos, professor at the Catholic University of Chile’s Center of Mining. That’s because Mitsui is prepared to buy the ownership shares at a higher price than Codelco would pay. He adds that in case macroeconomic imbalances in Europe and the United States increase, “the economic instability would have a temporary [effect], while the [positive] impact of this deal would be felt over a much longer time period."

Whether or not the alliance between Codelco and Mitsui eventually generates attractive profits won’t depend simply on both companies, but also ultimately on certain variables in the marketplace, warns Yáñez. "At first glance, the agreement between Codelco and Mitsui is a very good deal, assuming that the price of copper remains at high levels, as it has in recent times” – currently $3.40 per pound on the London Metals Exchange.

How Much More Would Codelco Produce?

If the deal for 49% of Anglo American Sur’s shares took place, Codelco would be in a position to increase its copper production by about 10%, which would mean about 400,000 additional tons each year, according to comments made by the company’s executives to the local press.

Nevertheless, this projection differs from estimates made by Chilean mining experts, who have also failed to reach a consensus. According to Lagos, “If Codelco manages to exercise its purchase option for Anglo American Sur, its copper production would grow in the short term by 120,000 tons a year; that’s about 6% more than it currently produces [1,689,000 tons annually].”

However, Yáñez’s forecasts are completely different from those Lagos. In his view, Anglo American Sur’s reserves “would produce about 500,000 additional tons of copper annually, starting in 2012, which would mean a considerable increase in production for the state-owned firm.” If Codelco winds up buying the deposits of AAS, notes Casali, “Codelco’s closest competitors — U.S.-based Freeport McMoRan Copper; Australia’s BHP Billion, Anglo American, and Chile’s Antofagasta Minerals — would wind up several steps down the ladder” below Codelco.

Oyarzún does not think that it is so important that Codelco considers itself the main player in the copper industry. “What is really important here is whether there is demand for the ‘red metal,’ and if the state-owned company [Codelco] is a viable enterprise, and is reasonably successful in generating surpluses.” Demand for copper, he notes, depends on developing economies such as China, and on speculation in financial markets. What really matters today, adds Oyarzún, is trying to keep Codelco at a certain level of competitiveness, “because it is likely that important competitors will emerge in Asia who change the current balance.” A significant amount of mineral exploration is taking place in Asia, where countries such as Pakistan (where Chile’s Antofagasta Minerals operates), Afghanistan, Kazakhstan and Mongolia have discovered significant deposits of copper reserves.

It remains to be seen how the courts will resolve this case. However, if Codelco is ultimately able to exercise a purchasing option for only 24.5% of the shares, it will lose part of a subsidiary that it had been betting heavily on for the future.

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