What mining companies should know to succeed in Russia

During the past 11 years of working in Russia and the FSU, I have been asked many times if it is possible to do business there. My reply has always been yes, but it is neither simple nor easy. Russia is a risky place for business. The country is gradually awakening from 70 years of centralized management and the excessive regulations that were part of that system. It is also recovering from the 1998 financial crisis. The country is gradually moving towards a market economy. Additionally a bloated bureaucracy enforcing many outdated regulations and laws, often conflicting, makes progress bothersome, time consuming and add to the costs of business.

The country is in need of foreign management expertise, investment and technology in order to improve existing operations or develop new deposits. The Government has tried to level the playing field by establishing laws to protect the foreign investor and permitting repatriation of capital and profits. Corporate taxes have been reduced to 24% and personal income taxes are 13%. Regulations have been proposed to permit the direct export of precious metals by the producing company. This should allow hedging programs and reduce the difficulties in securing project financing. There is talk of eliminating the 5% export tariff on gold and 6.5% export tariff on silver. Notwithstanding the difficulties and risks these changes encourage Western companies to continue to come to the country to establish ventures and provide the investment, management and import the necessary technology in order to develop the resources. This should provide a good source of income for the western investor, create high paying and much needed employment for the local work force, as well as produces a source of foreign capital for the country through the export of products and adds substantial revenue to the budget. Everyone wins, in principle!

The competition among the few large Russian companies to gain control of large resources and thus the generators of significant sources of foreign and domestic revenue has been fierce and will probably continue to be so for some time to come. Some western companies have been badly bruised in the process. The pace of acquisition activity does appear to be slowing down as most of the readily available substantial deposits have been acquired. Some of these large companies are now swapping or selling assets in order to rationalize their businesses.

There is a legal system however the justice system leaves a lot to be desired. Western companies have not had stellar success in the Russian courts. Until there is a respected “rule of law” and a working justice system that is fair for all, this trend will continue. Projects have been lost by western companies for a variety of reasons, few of which can be justified. These are, for the most part, projects where the investor thought the ownership was bullet proof. Some companies, after having spent considerable sums of money and time in bringing a project to the point of securing project financing or starting construction, have been blindsided by local entrepreneurs or the local Administration or both working together. Others have been stiffed by their Russian partners who have blatantly failed to honor agreements. Still others have come under pressure by locals who want “in” on what appears to be a good project. This pressure can include unpleasant meetings with the interlopers, support for them by the Regional Administration and yellow press attacks. Yet others have been told they are “not welcome” to participate in tenders for large deposits. To date very few western mining companies have had success in Russia. Some have been successful and appear to be quite happy with results of their investment. To be fair, some early mining deals were more promotional than real attempts to develop mines. Others of course were real and were well funded and managed by reputable companies. There are two sides to this.

Making the decision to participate in Russia and developing a corporate action plan for investing is not simple or easy. There are some actions that one might consider in order to reduce the risk however nothing will guarantee success.

Selecting a Russian partner who is well positioned in the region where the project is situated and who also is well connected in the halls of power in Moscow is a necessity. It is much easier said than done. It takes time and care. The partner, who often brings a project to the investor, will usually not be participating in management of or funding of the operations as he probably does not have sufficient capital to do so or he may not see any necessity to do so. The right partner should be invaluable in solving “Russian” problems with the regulatory agencies and others who might appear on the scene from time to time. He should provide invaluable information on what is happening in the country and the region that will affect the project. He can provide liaison with senior government officials. He can provide information on new opportunities that may become available through privatization and assist in the process of tendering for and negotiating for acquisition of projects or assets. He can also provide an insight into Russian events that is not apparent to the western person due to language, cultural and historical reasons. The ideal partner will be legitimate and have the necessary network and relationships to smooth the road. This “krisha” is an essential part for all, even for Russian companies, in doing business there.

When the partner has a carried interest in a project and can anticipate a stream of revenue for a lengthy period of time, he has an interest in seeing the project succeed. When the western investor buys out his carried interest, the partner no longer has any interest in the success of the project and the “krisha” is lost. Usually the partner is bought out when the western investor believes that the partner is getting too much of a good project for little or nothing. Hard negotiations usually follow and relationships, which took considerable time and effort to develop, can be harmed or destroyed. Disaster can follow close behind. One should not underestimate the value of a good Russian partner.

Completing tender documents that comply with Russian legal codes as well drafting and executing contracts, which satisfy the Russian legal system, requires experienced and competent lawyers. The lawyers that are young and speak the best English are not necessarily the most knowledgeable or the most experienced in the Russian legal system. Extensive interviews and reference checks are necessary and receipt of proposals from competing firms should be undertaken before selecting a firm. There are several very experienced and qualified legal firms serving Russia and the FSU.

Russia is a vast country spanning 11 time zones. It has been endowed with an abundance of “world class” resource deposits that are well explored and well documented. The quality of the work and documentation, for the most part, is of very high caliber. The amount of exploration work that is performed on a Russian mining deposit usually exceeds the amount that would be performed by a western company before making a production decision.

Due to infrastructure and logistical difficulties, high costs and risks, only significant deposits are normally attractive. There could be some small high grade deposits which would make a successful project but they are probably the exception to attract a western investor. The total taxes and royalties of all types are in the range of 25-35% of the gross revenue. A detailed project cash flow model incorporating all currently applicable royalties and taxes is a necessity. Moscow based tax advisors can provide the details necessary to develop the model.

Geological data will be in Russian, thus it is necessary to have a good and experienced translator when reviewing the data and meeting the geologists to discuss the geological model. A careful review of the data and the ore reserves and methodology may reveal a good project. In the soviet system of reserve
estimation the cut off grades were established on an economic basis that is no longer valid in Russia and differs from what western companies are accustomed to. Thus the grade of a deposit may appear to be low rendering the project uneconomic. A good project could be masked by a low grade, large tonnage reserve estimate. Raising the cut off grade could result in an excellent project. It is quite likely that the tonnage would decline and the grade increase with very little reduction in contained or recoverable metal. In order to obtain permission to mine the higher grade deposit it will be necessary to obtain an official re-registration of the reserves with GKZ in Moscow, a process that could take 6-8 months and cost upwards of $100,000. Approval for mining the higher grade deposit will be required from Gosgortekhnadzor.

Projects worthy of development are normally long term projects. Thus one should establish a long term business plan. This implies adequate funding for the project or the ability to obtain the funding. Business in Russia takes longer than expected and is usually more expensive than anticipated. Overcoming regulatory hurdles are time consuming and can be expensive. Persevere and be prepared to amend the plan if necessary. Above all be patient. Not very much happens quickly there.

Experienced senior management is an absolute necessity. An experienced General Director who will be in charge of managing the Russian operations is a critical employee. He need not have experience in your industry but he should know Russia and how to get things done there. You can provide industry specific experts to execute the project. Provide moral and staff support for the person placed in charge as well as giving him the responsibility and authority to act. Do not try to micromanage from abroad. This can lead to unnecessary stress and management discord. The General Director will be facing many unexpected problems and frustrations that often times are not understood in the home office. Home office support is appreciated and necessary.

The project will not run without an experienced Russian staff. There are many highly educated and experienced Russian experts that can be hired for intermediate and senior management positions. These experts normally are not experienced in western operating and business methods and thus will require training to achieve the best results. There are some well established recruiting agencies in Moscow to help with the selection process.

Building trust with the Russian staff and workers is critical. Lack of trust due to the language and cultural barriers that exist can create friction and is a large hurdle to overcome. It requires a conscious effort of the General Director, the other senior western managers and the Russian managers and workers. When visitors from the head office travel to the project they must spend time with the senior Russian managers as well as the western managers. Include the Russian managers in management meetings and make them part of the project team. Site visits and meeting with workers in the work place also builds up the trust and respect.

When it is necessary to deal with the regulatory authorities, as is often the case, let the senior Russian managers deal with them. They know how the system works and how to obtain the desired results. The presence of western managers often complicates the process and extends the time of negotiations or processing of applications. This can delay receipt of permits and progress. Be certain to explain clearly what is desired, whether it be reserve re registration, approval of the TEO or OVOS by the Experetisa, seeking permits for such things as overhead cranes, removal of fill from a borrow pit for a tailings dam or whatever else is required.

The local labor force contains many excellent workers who are willing to work hard in difficult conditions. They often lack initiative to act on their own thus it is necessary to give clear instructions of what the objectives and time tables are for achieving specific results. They do follow instructions well and can perform excellent work when properly instructed and managed and provided with the necessary tools and equipment.

Some EPCM contractors are of the attitude that they can do pretty much as they wish and ignore the Russian regulations or take short cuts. It isn’t so. Sooner or later this cavalier approach will cause problems and possibly even the levy of fines, some possibly substantial, to the project owner from any one of several regulatory agencies. It can also delay the project completion approval and start up. Construction of new facilities or renovation of existing facilities is regulated by a set of well-defined regulations, which must be adhered to.

Proper customs declarations and inventory control are very sensitive areas. For new projects it could be advisable to have a bonded warehouse and storage site approved at the site. Care must be taken to not remove anything from the bonded area until customs inspectors have given clearance. Otherwise the customs fines could be heavy and may only be levied several years after the project is operating including interest penalties for the intervening period. A bonded warehouse at site will save time, aggravation and money in the long run.

Most Russians view westerners as moneyed. They will try very hard to get as much of that money as possible. It is advisable to be as low profile as one can be. This extends to satisfying regulatory reporting requirements of public companies. Telling the world how profitable and good a project is supposed to be can be subject to scrutiny from local entrepreneurs who may want to obtain a piece of the project. This extends also to expatriate employees in their relations with the local residents. Don’t flash the cash. Trouble may not be too far away for flashy actors.

There is no guarantee that an investment in Russia will be successful. There is always the hope that it will, that is why investors go there. One can try to reduce the risks.

James Wade is the director of Moscow-based GNK Consultants and can be reached at capricorn@simcoe.net; web site www.gnk.ru

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