How is net smelter royalty determined?

Answer 1

A Net Smelter Royalty (or Net Smelter Return) is a royalty that is a certain percentage of the revenue generated by the mine by selling its product, minus the expenses of producing the product, usually with a limit on what can be deducted.

Most royalties include more deductions: the costs of building the mine and infrastructure, the cost of exploring to find the deposit, the cost of repaying the loans needed for construction, and so on. It's possible for a mine to operate for years (indeed, theoretically possible for it to go its entire lifetime if it;s not making much money) without paying a royalty.

Most examples of an NSR, on the other hand, either don't take those "sunk costs" into account, or have a limit on how much of them can be used as deductions.

Example:

A mine costs $200 million to build, paid for by bank loans (we'll ignore interest) that has to be paid back. The mine produces $100 million worth of product a year, and spends $50 million a year to produce it, netting them $50 million in net revenue (we'll also ignore taxes and other fees).

At $50 million a year net revenue, it will take them 4 years to pay back the loan, after which they will actually generate real profit. If there was a 10% government royalty, the money it would collect would look like this:

Years 1-4 - $0

Years 5-10 - $5 million a year, total $30 million.

If there was an NSR, the $200 million that has to be paid back is ignored; the NSR focuses only on what's sold versus expenses to sell the product. So if there was a 3% NSR, it would look like this:

Years 1-10 - $1.5 million a year (3% of $50 million), total $15 million.

While the 10% royalty sounds like a better deal, if the mine wasn't as profitable it wouldn't be. Imagine that the annual costs are $75 million: at $25 million gross revenue per year, it will take 8 years to pay back the loan (rounding up). In that case, the result would be:

10% Royalty

Years 1-8 - $0

Years 9-10 - $5 million a year, total $10 million

3% NSR

Years 1-10 - $1.5 million a year (3% of $50 million), total $15 million

The advantage of a normal royalty is that, when a mine is generating good revenue, the royalty will generate more income than an NSR. However, it may be some time before a royalty starts paying.

The advantage of an NSR is that while it can pay less than a royalty, it starts generating income immediately.