When a construction aggregate company does not own the land being mined, a mineral lease agreement is negotiated with the landowner. Within the lease agreement, a mineral royalty is established. The mineral royalty represents the fee paid by the operator to the landowner for the right to extract and sell minerals from the property covered by the lease.
In the construction aggregates industry, royalty rates are commonly established using a couple of different approaches:
1. Percent (%) of the Average Sales Price
2. Dollar ($) per unit of volume (ton or cubic yard)
After the royalty rate is established, the lease agreement will generally indicate a method for adjusting the royalty over time to account for inflation. Using the percent of average sales price approach, no additional adjustments are needed because the changes in price over time will naturally account for inflation. However, for the $ per unit of volume royalty, an adjustment method needs to be selected. There are two common indexes used for calculating these adjustments:
1. The Consumer Price Index (CPI), and
2. The Producer Price Index (PPI)
The CPI is a measure of the average change in prices for consumer goods, while the PPI measures the average change in prices of the inputs used to manufacture a final product.
During lease negotiations, a royalty rate adjustment method is often selected without considering the long-term effects on royalty payments. This article presents a comparison of each method to illustrate how important this decision is to the bottom line.
Two scenarios are used to illustrate the importance of choosing how to adjust the royalty for inflation. For both scenarios, the average sales price for construction sand and gravel from 2000-2017 was selected by using the $/ton value reported in the California Non-Fuel Mineral Annual Reports published by the California Geological Survey.[1] In the year 2000, the $/ton value for construction sand and gravel in California was $5.76.
For comparison purposes, all royalties begin at the same value. This value was calculated using 10% of average sales price (ASP); or $0.58/ton. Each scenario begins at this value and were subsequently adjusted using the following methods.
Royalty Rate = $0.58/ton; which is adjusted for inflation by:
a. 10% of ASP: Naturally adjusted by changes in the ASP
b. CPI
c. PPI
Scenario 1 – Annual Adjustments
In the first Scenario, the royalties are adjusted annually. Figure 1 illustrates the annual adjustments in royalties between 2000-2017 using % ASP, CPI, and PPI from 2000-2017. The figure reveals that the % of ASP royalty is much more volatile than the other two methods. Additionally, the royalty adjusted by PPI increased at a greater rate than if it was adjusted using CPI.
To measure the effectiveness of an operation’s bottom line, the total royalties paid over the same time period for an operation that produces 500,000 tons annually is calculated and presented in Figure 2. When compared to % of ASP, adjusting the royalty by CPI resulted in payments 23% lower and just 8% lower with PPI. The importance of choosing the method for adjusting royalties becomes much more clear after considering the total payments made over the long run.
Scenario 2 – Adjustments Every 5 Years
Scenario 2 looks at the impact of choosing to adjust the royalty every 5 years as opposed to annually. Many lease agreements adjust royalties over a longer period as opposed to annually. Figure 3 illustrates how the royalties adjust over time. Again, each royalty begins at the same rate and is adjusted based on the selected method.
Adjusting every 5 years evens out the dramatic fluctuations for the % of the ASP method but introduces a potential for substantial changes in royalties adjusted by CPI or PPI.
The difference in total payments is less dramatic when royalties are adjusted every 5 years. For instance, when compared to % ASP, the total royalties paid adjusted by CPI is 18% lower. Adjusting every 5 years introduces less volatility and can potentially provide for more certainty for budgeting purposes. Additionally, total royalties paid by each method can also be reduced when compared to annual adjustments.
This basic comparison clearly illustrates that the royalty adjustment is a critical component of the mineral lease negotiation. It is also important to consider that there are several different Index Series or types of indexes for both CPI and PPI. As a result, the outcome can be different depending on which CPI or PPI Index Series is selected. For example, there are multiple CPI indexes for California separated by geographic region. However, there is not a PPI for California. Additionally, there are several PPI indexes that represent mining. Selecting the right index for an operation will depend on the location and type of products produced.
Additionally, the average sales price for a particular operation may adjust differently than the state average value presented here. Thus, the royalty adjustment that is best for each operation may be different depending on the location. Despite the site-specific conditions, the results of this analysis reveal that royalty adjustment methods have a dramatic effect on an operation’s bottom line.
If you want to gain some insight on what royalty adjustment is best for your operation, contact Crystal Howard for a consultation. crystal@EnviroMINEinc.com
[1] https://www.conservation.ca.gov/cgs/minerals/mineral-production