MINING IN ECUADOR: FOCUS ON THE 2013

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February 14, 2013

MINING IN ECUADOR: FOCUS ON THE 2013 PRESIDENTIAL ELECTIONS Bottom line: Ecuador’s mining sector has faced a number of formidable challenges in recent years, including aggressive resource nationalism, an uncertain regulatory environment and strong indigenous opposition. However, the Rafael Correa administration is considering several policies that would kick-start a number of stalled projects to pay for the social programs that sustain his government’s legitimacy. This comes after Correa finalized Ecuador’s first commercial mining contract in March 2012 with China’s EcuaCorriente S.A. (for $1.4 billion). With Correa the heavy favourite in the Feb. 17th Presidential elections, we believe his victory could benefit ongoing contract negotiations for several long delayed projects largely priced out of NAV estimates (e.g., Kinross Gold Corp.’s Fruta del Norte). Ecuador remains a high risk environment, however, and the government faces a long uphill climb to restore its credibility with investors.

1. Socioeconomic snapshot An OPEC member since 2007, Ecuador is highly dependant on its oil industry, which generates some 44% of government revenues. Production of 500,000 barrels per day has helped finance high government spending (40% of GDP since 2007, up from 24% 2000-06), mainly on infrastructure development and cash transfers to the poor. This has in turn fuelled GDP growth of 4.2% 2007-11 (vs. 3.9% for Latin America). Agricultural exports (6.5% of GDP) and foreign remittances (3.5% of GDP) are also key sources of government revenue. Since 2006, increased social spending has greatly improved the quality of life for many poor Ecuadorians. The country’s Human Development Index ranking has improved accordingly (84 of 187, up from 91 of 130), with marked gains being made in healthcare and poverty (high at 28.6%, especially in rural areas, but down from 36.7% since 2007 and 64% since 2000). This has bellied President Rafael Correa’s widespread popularity, keeping his approval ratings at or above 50% since 2006. Inflation is relatively stable (4.5% avg. 2003-11), but the cumbersome regulatory environment has kept foreign direct investment (FDI) low compared with peers ($650 million in 2011 vs. $13 billion in Colombia and $7.7 billion in Peru). Less investment has subsequently resulted in declining oil production (down 16.4% since 2006) as well as net oil exports (down 25%, exacerbated by rising domestic consumption, see Fig. 1 below).

2. Socioeconomic vulnerabilities: oil dependency underlies exposure to external shocks, and the need for mining Dependence on the oil sector and lack of economic diversity leaves Ecuador vulnerable to external shocks, which has led to socioeconomic and political instability in the past. The 1998-2000 economic crisis, for example, was the result of falling oil prices, alongside El Nino floods (lower agricultural output), and capital flight following the Asian financial crisis. The economy subsequently contracted 5.3%, the poverty rate spiked to 64%, the currency imploded and was replaced with the U.S. dollar, and several governments collapsed following widespread protests. Pierre Fournier - (514) 879-2423 Geopolitical Analyst

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Michael Fini - (416) 869-7538 Associate Analyst

February 14, 2013

Oil production in 2012 averaged 504,000 bpd, missing the government’s target of 510,000 bpd, and well shy of an optimistic 530,000 bpd projected for 2013. Following the forced renegotiation of several production contracts by the Correa government in 2010, oil sector FDI fell to $330 million for 2012 from $421 million in 2011. The government will consequently need to invest in exploration, production and refining capacity ($1.82 billion was planned for 2012, likely more for 2013), eating into net oil revenues. In a bid to raise short-term capital, the government recently pursued an oil-for-cash loan scheme with China, to which it still owes $3.4 billion in future production. Fig. 1: Ecuador oil production and consumption, 2000-11

Source: EIA 2012

The expectation of declining oil revenues in the face of continued high government spending is pressuring the Correa administration to develop alternative sources of revenue. Total foreign reserves fell some 16% in 2012, to roughly $3 billion, equal to around six weeks worth of import cover. This money is needed to fund Correa’s sweeping transformation of Ecuador’s socioeconomic landscape, an ideologically-motivated movement known as “21st century socialism” (see Section 3). Mining represents one of the most realizable short-term revenue streams the Correa government has demonstrated its interest in pursuing (see Section 4).

3. Political climate a challenging one for investors Political instability has traditionally been high in Ecuador, with none of President Correa’s four predecessors finishing their elected terms, largely due to popular protests.1 Through his charisma and populism, however, Correa (a U.S-trained PhD economist) fast became the country’s main power broker after sweeping the 2006 election. Since then, Correa has taken a number of steps to consolidate his power:  Spearheaded a new constitution in 2008: Enables the President to unilaterally intervene in “strategic economic sectors” (e.g., oil and gas, mining, telecommunications, agriculture) and dissolve congress, and weakened congressional checks on Presidential veto and decree powers. While Correa’s PAIS party holds just 53 of 124 National Assembly seats, the opposition is weak and divided, and has proven largely incapable of obstructing his agenda. Due to re-districting of voter constituencies, furthermore, Correa and his PAIS party are expected to gain an outright majority on Feb. 17th. 1

In 2010, Correa was briefly trapped inside a hospital by policemen protesting his decision to cancel their bonuses. He was freed by the army but still declared the protest a coup attempt. Police pay was then raised and there have been no such incidents reported since.

Pierre Fournier - (514) 879-2423 Geopolitical Analyst

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Michael Fini - (416) 869-7538 Associate Analyst

February 14, 2013

 Won a major referendum in May 2011: This enhanced his influence over the media by limiting private ownership of news firms and increasing state censorship capacities. Correa accuses the media of being biased against his reform agenda as most media companies are owned by Ecuador’s banking elite, who have been a target of Correa’s policies.2 The 2011 referendum also enabled him to dismiss and appoint judges, compromising the independence of the judiciary.  Correa is in permanent campaign mode: He enhanced his popularity by broadcasting regular addresses to the nation in which he demonizes critics and extols the virtues of his policies. There have been over 1,365 such broadcasts since June 2007. Correa’s autocratic style is nonetheless seen as legitimate by most Ecuadorians. This follows from their low trust in political parties and the party system – which are approved by just a quarter of the population – combined with the widespread popularity of the President’s socioeconomic policies. Correa is consequently projected to retain the Presidency in February’s elections, with polls giving him some 62% of the vote (over 50 points ahead of his closest competitors, of which there are seven).3 President Correa’s government is based on the ideological movement of “21st century socialism”, which stems from a general mistrust of foreign investment and multinational corporations in Ecuador. This follows several decades of dependency on IMF and other international loans that many Ecuadorians accuse of compromising development. From 1980-2007, for example, some 70% of annual budgets went to debt servicing. This was until 2008, when Correa opted to default on $3.2 billion in outstanding foreign debt.4 He also introduced a range of new tax collection measures, as well as forced contract renegotiations for foreign oil and telecommunication companies. Total government revenues increased three-fold since 2006 as a consequence.5 That being said, Correa has demonstrated he is willing to compromise when it serves his economic and political interests. Facing declining oil revenues, he held an oil block auction in 2012 for unexplored regions of the Amazon, and finalized Ecuador’s first commercial mining contract with Chinese-owned EcuaCorriente. These deals were made despite widespread indigenous and environmental protests that, if they snowballed, could have weighed on his overall popularity in the lead-up to February’s election (see Section 5). In order to maintain the high social spending that underlies his government’s raison d'être, we believe he will also extend olive branches to the mining sector (see Section 5). This could prove beneficial for several companies attempting to finalize production contracts, which the markets have generally priced out of NAV estimates given several years of delay.

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New banking taxes were recently introduced to pay for the Human Development Stipend, which are essentially cash transfers to the poor. These included banks’ income taxes being effectively raised to 23% from 13%, and a new 3% tax on revenue. 3 Garcia, E. and Valencia, A. (Feb. 8, 2013), “Ecuador’s Correa has large lead in presidential race: polls”, Reuters 4 Ecuador’s debt-to-GDP ratio subsequently averaged 28.5% 2007-11, down from 52.9% 2002-06. 5 President Correa also cancelled 13 bilateral trade agreements, including one with major trading partner the United States, and also shuttered America’s Manta air force base, arguing it encroached on Ecuador’s sovereignty.

Pierre Fournier - (514) 879-2423 Geopolitical Analyst

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Michael Fini - (416) 869-7538 Associate Analyst

February 14, 2013

4. Challenges to Ecuador’s mining sector have been formidable Before we outline the reasons for our optimism, it must be noted that the investment climate for miners in Ecuador has been highly challenging for some time. Political support of the sector has traditionally been minimal, and anti-mining social protests have been widespread. Regulations were also largely ambiguous until the Correa-led government drafted and passed the 2009 Mining Law.6 The Mining Law provided a solid legal framework upon which the sector could develop, but is generally seen as punitive given the hefty tax take (e.g., 5% royalties and a 70% windfall tax, see below) and constricting labour regulations (e.g., 80% of mineworkers must be Ecuadorian nationals). It also formally established the President as having the final say on all matters relating to mining policy. Given that most miners (and shareholders) see the tax structure as punitive, final exploitation agreements have yet to be signed for a number of planned projects. These include Kinross’s Fruta del Norte, INV Metal Inc.’s (47% owned by IAMGOLD) Quimsacocha, International Minerals’ Rio Blanco and Chinese-owned EcuaCorriente’s Panantza-San Carlos.7 Kinross is renegotiating the terms of the Fruta del Norte project, for example, citing the proposed tax agreement (specifically the 70% windfall tax) is unlikely to be accepted by shareholders. The government’s lack of expertise with the complex technical and economic modelling aspects needed to draw up a mining exploitation agreement has also been cited as a key source of delay.8

There are three key investment risks likely to face mining firms in Ecuador: a. High-taxes: A major unknown facing mining sector development remains whether companies (and their shareholders) will be willing to operate under the strict and high-tax parameters likely to be required by the government. The constitution stipulates “the State will participate in the benefits of exploiting these resources, in an amount not less than those of the company that exploits them” (the so-called “50-50” rule), a sentiment supported by most Ecuadorians.9 The 2009 Mining Law introduced a range of new taxes, including a 70% windfall tax, a 5% royalty, a 25% income tax, a 12% tax on profits, a 12% value-added tax and a 3% employee profit-sharing tax. Some 52% of revenues generated from EcuaCorrientes’ El Mirador mine will go to the government, and it is likely future mines will be taxed at a similarly high rate. Throughout these negotiations, the government reportedly budged very little on the tax obligations stipulated by current legislation, especially with regards to the 50-50 rule.10 The deal was only reached because EcuaCorriente agreed to the 70% windfall tax, which was rejected by Kinross. 6

The law was created over nine months of deliberation, in which time the government revoked 75% of over 4,000 mining concessions and suspended commercial mining. According to the government, the concessions needed to be revoked and auctioned again to remove “testaferros”, or land speculators, as well as relatives of mining authority employees. 7 INV Metals completed the purchase of the Quimsacocha project from IAMGOLD in November 2012 for roughly 47% of issued and outstanding INV shares, valued at $30 million. 8 For the El Mirador negotiations, for example, the government was eventually required to hire external experts from Chile and the United States to help them with necessary expertise such as economic modeling, geology and engineering. See Andrews, C. (November 2012), “The Practitioner’s Guide to Negotiating Mining Investment Agreements: Lessons From Ecuador”, Craig Andrews LLC 9 Saavedra, L.A. (Aug. 17, 2012), “Ecuador: Legislative reforms favour mining companies”, International Working Group for Indigenous Affairs 10 See Andrews, C. (November 2012), “The Practitioner’s Guide to Negotiating Mining Investment Agreements: Lessons From Ecuador”, Craig Andrews LLC

Pierre Fournier - (514) 879-2423 Geopolitical Analyst

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Michael Fini - (416) 869-7538 Associate Analyst

February 14, 2013

b. Regulatory uncertainty: To reiterate, the concept of “21st century socialism” was enshrined in the 2008 constitution, which essentially recognizes both the free market and FDI as necessary to maintain a healthy economy, but also requires the state be heavily involved in its regulation. Private sector businesses are regularly threatened with nationalizations and embargos if Correa deems them as undermining the “national interest”, broadly defined. Furthermore, contract and property law lack safeguards given the weakness of Ecuador’s judicial branch, which could keep regulatory uncertainty elevated going forward.

c. Anti-mining social protests: Environmental and indigenous protests go hand in hand, and are likely to represent noteworthy obstacles for mining sector development. Projects tend to be near or surrounded by indigenous lands and areas. Roughly 25% of the population is indigenous, and a “Nature’s Right” provision was written into the 2008 constitution. This stipulates “citizens may require the state to protect nature, and promote respect for all elements that make up an ecosystem”. In March 2012, thousands of indigenous protesters marched on Quito to protest President Correa’s approval of the El Mirador mine, demanding they be consulted before any major projects are approved.11

5. Correa’s re-election could prove beneficial to ongoing contract negotiations Despite the aforementioned challenges to mining sector development, much of President Correa’s rhetoric and proposals prior to the Presidential campaign season suggest he and his government may be willing to extend the olive branch to several companies after the election. As just mentioned, his government needs to find new sources of funding to maintain high social spending as oil revenues and remittances are expected to decline. There are three additional reasons for our optimism:

a. Pre-election policy proposals: Correa has proposed reforms that would dampen the bite of current tax legislation. Specifically, he reportedly backed (but not yet submitted) a bill to (i) postpone levying taxes until mining firms have made back their initial investment (specifically, the 70% windfall tax), and (ii) to establish a maximum on royalties at 5%, which is the current minimum.12 In July 2012, Correa also made it easier for firms to transfer ownership of projects to other companies through Decree 740, which enabled IAMGOLD to divest its stake in Quimsacocha to INV Metals.13 It should also be noted that during El Mirador negotiations, the Ministry of Non-Renewable Resources (in charge of negotiations) intervened with the ministries of energy and transport at the behest of the President to secure power supply and transport infrastructure is developed for the project.

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Garcia, E. (March 21, 2012), “Indian protesters target Ecuador mining plans”, Reuters; see also Hongxiang, H. (June 8, 2012), “In Ecuador, home truths for China”, China Dialogue 12 Saavedra, L.A. (Aug. 17, 2012), “Ecuador: Legislative reforms favour mining companies”, International Working Group for Indigenous Affairs 13 Jamasmie, C. (July 13, 2012), “Ecuador to ‘make it easier’ for mining companies”, Mining.com

Pierre Fournier - (514) 879-2423 Geopolitical Analyst

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Michael Fini - (416) 869-7538 Associate Analyst

February 14, 2013

b. Pre-election rhetoric: Concentration of power in the hands of the President – alongside high social spending and bombastic antineoliberal rhetoric – is not unusual in Latin America, and Correa’s stance towards mining has been encouraging of late. After approving a long-term agreement with Chinese-owned EcuaCorriente to develop the $1.4 billion El Mirador copper project in March 2012, Correa stated: “I take full political responsibility for these acts, and the people of Ecuador in the elections of February 2013 will decide who acted for the benefit of the majority...The country needs these resources to develop and develop we will…we cannot be beggars sitting on a sack of gold”.14 More recently in December, at the 6th Binational Cabinet Meeting of Peru and Ecuador, he also stated, “The challenge is to have good mining and oil extraction and yes, we can have it…Natural resources are needed to overcome poverty”. This followed dialogue with Peru and Colombia on how to better address “the problem of anti-mining activists who provoke violence while acting under the false pretext of defending the environment”.15

c. Pre-election politics: Correa has appointed Jorge Glas Espinel as his Presidential running mate, suggesting mining will come to the forefront of his Presidential agenda if he wins. Glas served under the former Correa administration, responsible for the management of “strategic sectors”, such as oil, telecommunications and mining.16 Glas recently noted that mining “is a new issue in Ecuador…but now there is a clear legal framework…the takeoff of mining in the country is going to be very important”.17 He was intimately involved with the negotiations over the El Mirador project, acting as the main go-between for the President. It should also be noted that Correa is unlikely to back indigenous rights if it impedes his desire to raise revenues from oil and mining. While indigenous consultation for mining projects is written into the constitution, this requirement is non-binding. The 2009 mining law that soon followed, furthermore, only extended the right of “consultation” and not “consent” to indigenous groups. A recent judgement issued by the Supreme Court regarding the Mining Law’s marginalization of indigenous communities ruled in favour of the government’s right to exploit resources without gaining the consent of local communities. That being said, EcuaCorriente was required to pay an advanced royalty ($100 million in three instalments) that went towards local communities in attempts to win them over before production at El Mirador could begin.18 We believe that following the election, President Correa will be more freely enabled to pass legislation that should help encourage mining sector development, primarily revising the 70% windfall tax. Despite his pro-mining rhetoric, passing any concrete, pro-mining legislation represents an unnecessary political risk so close to the election. Such actions could potentially tarnish his image as a high spending social reformer in the minds of some voters. While Correa won the May 2011 referendum – which was widely viewed as a popularity contest for the President’s policies – it was by a relatively slim margin (he won with less than 50% support for all nine questions at issue). The size of the indigenous protests that followed his approval of EcuaCorrientes’ El Mirador mine in March also took him by surprise, and likely led him to temper his promining stance as campaign season began to heat up. 14

Varas, E. (Nov. 19, 2012), “Mining and Elections in Ecuador”, Bertelsmann Stiftung Patterson, B. (Dec. 6, 2012), “Correa criticizes anti-mining activists in Ecuador”, The Council of Canadians 16 Varas, E. (Nov. 19, 2012), “Mining and Elections in Ecuador”, Bertelsmann Stiftung 17 The Business Year (September 2012), “VIP Interview: Jorge Glas Espinel”, The Business Year 18 Andrews, C. (November 2012), “The Practitioner’s Guide to Negotiating Mining Investment Agreements: Lessons From Ecuador”, Craig Andrews LLC 15

Pierre Fournier - (514) 879-2423 Geopolitical Analyst

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Michael Fini - (416) 869-7538 Associate Analyst

February 14, 2013

Conclusion We believe a Rafael Correa victory on Feb. 17th could prove a catalyst for long-stalled projects like Kinross’s Fruta del Norte to reach final agreement. That being said, serious challenges and risks will remain for the mining sector: a high tax environment, cumbersome regulations enforced by government technocrats with little mining experience, and strong indigenous opposition to most mining projects. While investors should exercise great caution, however, the potential for a more favourable environment for mining projects to emerge as a result of Correa’s re-election should not be written off. At the very least, a more auspicious exit strategy may emerge.

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Pierre Fournier - (514) 879-2423 Geopolitical Analyst

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Michael Fini - (416) 869-7538 Associate Analyst