Getting the most value out of quarry royalties

For the purpose of this paper and for explanation we identify three separate parties, namely the ?landowner?, the ?mineral owner? and the ?quarry operator?. We recognise that for freehold quarries that all three parties may be the same, but we still need to identify the separate interests to provide an understanding of their role within the assessment of royalties.

It is understood that the word ?royalty? has been derived under Common Law from Mines Royal in the UK and was followed by the Case of Mines 1567 which vested gold and silver in the Crown. The case established the principles that the Crown was to receive a rent and capital payment from any mining operator who extracted any quantities of gold and silver. The payment was otherwise known as a royalty. The Case of Mines was extensively considered within the Mabo judgement in Australia when considering Native Title claims.

Therefore, a royalty is quite simply both a rent and capital payment per unit, whether it be tonnes, ounces, grams, etc, and is only payable following the extraction of the mineral. The royalty can also be based on a percentage of the selling price, as nowadays, the royalty for gold extracted in the UK is four per cent of the selling price.

Minerals are a wasting asset, in that once they have been extracted and sold then they cannot be replaced. So when a royalty is defined as being a rent and capital payment, then this can be confusing. Obviously, the owner of the mineral sells the capital asset in exchange for an income which effectively reflects the interest on the capital.

In order to obtain a royalty or income for a mineral then you firstly have to establish the ownership rights. The Crown ownership of the gold and silver in the Mines Royal case did not extend to owning the surface lands in which the minerals were located. Consequently, the Crown could not benefit from royalties from their assets until such time as a quarry or mine operator and/or the landowner let down the surface to gain access to the minerals. It is possible that the quarry operator could also pay a rent to the landowner by way of a royalty for being allowed to gain access to the minerals. Ironically, the quarry operator may not own any physical assets other than the necessary plant and machinery required to work, win and process the mineral.

Consequently, it is quite common for there to be a mineral owner, a surface landowner, and a mine or quarry operator involved within a quarry extraction. Ownership issues play an important role in identifying the different assets involved.

For instance, in NSW, the majority of minerals are vested in the state. The state is consequently the mineral owner and receives royalties from any operator who extracts and sells their resources. Each mineral is separately identified within the NSW royalty list. As a result, if there is a change in geology within a site, then one geological deposit may be included as a state mineral, but the deposit above, below or either side of that resource, may not be included as a state mineral. Therefore the landowner may own a mineral deposit both above, below or either side of a state-owned mineral.

As a result of this complexity to ownership, quite often a suitably qualified mineral expert is required to identify any potential differences in ownership which are clearly linked to the geology. This can be very different from a geological report or a resource evaluation where generally the whole resource is considered without due consideration to the different ownership constraints.

A good example of the complexities to ownership in NSW involves sandstone. If the sandstone is of high quality and used for the dimension stone or landscaping market, then it is a state mineral. However, if the sandstone is of a more friable nature and used for the construction industry as a sand, then the mineral is owned by the landowner. Difficulties can occur when there is a mixture of sandstone on-site utilised for both of the above markets. Nevertheless, it is generally accepted that the processing operation will often determine the ownership rights.

It is recognised that there are a variety of ownerships and rights in relation to extractive industry properties. The different mineral ownership or rights can be broadly split into four distinct categories:
? Surface rights.
? Native Title surface rights.
? Mineral rights – Crown or state ownership.
? Mineral rights – private ownership.

The surface rights involve the ownership of the surface of the land or the fee simple in possession of the surface lands. There is often an assumption that the fee simple owner owns everything on the surface and above and below down to the centre of the earth.

However, there are some specific exceptions to this scenario. For quarrying, the surface rights are better understood, as everyone appreciates that the surface lands have to be removed to gain access to the mineral deposit beneath. The other instance is where a shaft, drift, adit or other excavation is made within the land to gain access to the mineral, but this often concerns coal or metalliferous minerals which are not considered for this paper. Nevertheless, any landowner would still wish to receive the same amount per tonne extracted as a surface payment for a shaft as they would from a surface extraction such as a quarry or open cut mine.

The surface rights royalty is made up of several elements and should, in part, amount to the profit and benefits that otherwise would have been earned from use of the surface lands. Once these rights have been removed then they are unlikely to be replaced until the quarry has been exhausted and fully restored. There is the question then as to whether any restoration scheme would enable the land to be used for a beneficial after-use but also whether the landowner or the quarry operator benefits from the after-use, and the time taken to achieve this. In certain circumstances, mostly driven by location, then the void space left by quarries can be used as a landfill. There is no doubt that landfills are considerably more valuable than quarries in most instances. So in addition to the surface owner receiving compensation for loss of land, they would also wish to receive a payment to reflect a share of the profit of the quarry operation, any future landfill potential or, once fully restored, the value of the land. If the landowner does not lease the land in the first place, then the quarry operator cannot obtain a profit, so it is only right that the surface owner gains a share of that profit to be encouraged to lose their surface rights.

Native Title rights can be complicated, but basically provide the Native Title occupiers the right to roam and use the land but no entitlement to either the freehold surface or the mineral rights. These issues were considered extensively in the Mabo judgement based on the Case of Mines 1567. However if a mineral operator wishes to let down the surface of the land to gain access to the minerals, then this interferes with the Native Title occupiers? rights to roam and they are therefore entitled to either refuse the access, or be compensated for their loss.

The mineral rights involve the ownership of the land beneath the surface lands. These rights can be more complicated and ownership more uncertain. In some cases, all of the mineral rights are vested in the Crown or the state. In other instances, there may be particular minerals that are owned, eg coal seams, which are vested in the Crown or state, but the other minerals are then owned by the owner of the surface rights. Therefore, it is considered appropriate to split the mineral rights into two classifications:
? Mineral rights – Crown or state ownership.
? Mineral rights – private ownership.

Certain minerals are fully owned by the Crown or state and a royalty is often paid for the rights to extract and sell the mineral. The circumstances of ownership can only be determined when sufficient geological information is available to identify either Crown or state-owned minerals. In addition, the different states and territories have different legislation for identifying ownership and working rights and these can quite often only be fully assessed following a site inspection.

It also needs to be appreciated that as a quarry evolves and further geology is revealed, then there may be circumstances where state or Crown minerals are exposed. If state or Crown minerals remain in situ and are not removed, processed or sold, then there is no requirement to register them. However, sterilising part of a resource may cause working difficulties for the operator and they may need to apply for a state mining licence to be able to remove them.

We identified earlier the difficulties of identifying ownership of sandstone in NSW, and similarly many hard rock resources can be borderline cases where clarification needs to be sought, especially where complicated geology exists.

Private ownership is where the fee simple owner in possession does own both the surface lands and the mineral rights beneath to the centre of the earth. There are instances where the mineral rights are held by a different owner from the surface owner. In Queensland, for instance, the mineral rights for most quarrying operations are not held by the state but by the landowner. However, there are exceptions for this.

Mineral ownership rights are wide ranging, but in order to commercially benefit from those rights then there often has to be a planning consent or development approval to develop the resource and a licence to work and process the minerals. This is assuming that the geology is consistent and there are no constraints to ownership by the state or Crown, or other private ownership. The planning regulations and licensing can stipulate a maximum depth of working, or identify the maximum extent of workings which act as a constraint to fully maximise exploitation of a resource. Other legal constraints can include easements, over or under the land, way-leaves, rights of way or other encumbrances. There are also additional constraints that involve flora, fauna, wildlife habitats, heritage issues, indigenous artefacts and many other issues.

Adjoining landowners also have rights to pillars of support that prevent extraction from taking place within certain distances along common boundaries, usually 20m or so for hard rock but up to 40m for sand and gravel. For public roads and other structures, this can be from 30 to 50m. Occupational health and safety requirements often determine heights and depths of quarry benches to be retained which, depending on the area of the site, also limits exploitation of a resource. The incorporation of benches into a quarry determines the maximum depth that can be fully exploited.

Having considered the different ownership circumstances, this then forms the basis for calculation of appropriate royalties for every party with an interest in the land and minerals. These are summarised as follows:
? Landowner – owns the royalty rights to the surface lands.
? Mineral owner – owns the royalty rights to the mineral deposit.
? Quarry operator – owns nothing, but wishes to pay a royalty for use of the surface and mineral rights to gain a profit.

We identified earlier that the landowner and the mineral owner need to merge their interests for both of them to benefit commercially. The mineral owner wishes to exploit and profit from its resources and the surface owner wishes to receive a profit in excess of the current use of the land and other benefits. As a result, it is common practice for both the landowner and the mineral owner to share in the profits via a royalty and to then lease out this interest to a quarry operator.

The landowner would wish to receive a payment equal to the royalty value of the mineral. If the mineral were a state mineral, then the quarry operator would make two royalty payments, one for the surface lands and one for the mineral. If the mineral and surface lands are privately owned, then the quarry operator will make a single bid equivalent to double the surface or mineral royalty.

It should not be forgotten that the quarry operator also makes a profit which can be equated to a royalty. The quarry operator and the landowner and mineral owner together would wish to share in the profit of the overall operation, and consequently, the quarry operator?s share should equal the royalty for both the surface and mineral.

When considering the state mineral royalties, a great deal of caution needs to be applied, as these royalties are not negotiated in an arm?s length agreement, nor are they indexed to CPI or reviewed very often, if ever. However, they can provide a very basic starting point for determining a current market value of the mineral royalty and, in turn, a surface royalty.

Ideally, market evidence of royalties derived from recently agreed good quality lease or sales evidence for a similar quarry working the same deposit and operating in the same market would provide the best market evidence. However, more frequently, geological deposits are rarely the same, and even if they are similar, there can be geological complexities, ownership differences, working difficulties, overburden ratio issues, restoration liabilities, access to the market and a range of other factors that need to be reflected within the royalty. Some quarry markets are highly competitive with many operators, and others may enjoy monopoly or oligopoly conditions, which again can make it difficult but not impossible to compare royalties.

In other instances, there is market lease evidence of royalties being based on a percentage of the selling price of the minerals. Many state governments adopt this basis for many minerals over which they have control. However, state royalties are not freely negotiated and cannot be classified as good market evidence but can form a basis for adjustment where no other market evidence is available. It should be borne in mind though that percentages for state minerals are only for the mining rights, and do not reflect a surface royalty payment.

The percentage of sales method to derive a royalty is generally used either as a broad rule of thumb check or a last resort, when there is no market evidence available within the local, regional or national market. The rule of thumb is that royalties should be based upon somewhere between five per cent and 25 per cent of the ex-works revenue for the quarry which is often akin to saying that royalties should be between 50 cents and $10 per tonne, depending on location.

Surface and mineral market royalties for construction aggregates within NSW are in the range of 40 cents up to $9.23 per tonne. In essence, all transactions would come within this realm and unless supported by market sales or lease evidence then it demonstrates a lack of market understanding of the issues that make up the market value of the royalty.

There are a number of dangers associated with the percentage of sales method that need to be distinguished. Quarry market sales and lease evidence provides the knowledge that all the circumstances of the quarry were taken into account by both the buyer and seller. So any royalty derived would form a strong basis for comparison. However, where only a single item of a quarry is considered, the ex-works revenue, then this may not properly reflect the costs or liabilities of the operation, or the profit, or the potential. Therefore, basing a broad percentage against a single factor is by no means an accurate method for determining a royalty value and is tantamount to guesswork. If, on the other hand, lease evidence is available and suitably adjusted to the subject site, then this can provide a tangible outcome.

The other significant problem with a percentage of sales method is that both the ex-works revenue and any profits derived are part of an assessment for a going concern value which would include the goodwill of the business. This is very different from the value of the real estate interest which involves the surface and mineral owners? interests only. The valuation methods for a quarry real estate and going concern values are completely different and should not be confused with hybrid versions which attempt to achieve both.

The capitalisation rates used for quarry real estate and for going concern values are not the same as the interests operated under separate risk management categories. The landowner and mineral owner often have a more secure interest than the quarry operator and this may need to be reflected and adjusted accordingly.

As indicated earlier, a royalty purely to determine the value of the real estate value of a quarry, which ignores the quarry operator?s or going concern interest, is based upon the value of the surface owners? and mineral owners? interest. This would be based on the royalty lease evidence of appropriate transactions and not based on either the revenue or profits as these are part of a going concern value approach.

Most market sales transactions for quarries are made on a going concern basis. The sale includes tangible assets such as land, buildings, plant, machinery, equipment and the minerals, but also intangible assets such as the development approval and licensing and the goodwill of the business. Further, an appreciation of any contingent assets or liabilities, often relating to the restoration which may include landfill or other development benefits or which require rehabilitation back to the original landform, may involve a liability. Therefore, the real estate value of the quarry element is included with the overall value of the business, assuming that the profits are sufficient to support that value.

These aspects need to be distinguished, as the going concern value involves the quarry operator?s profits being appropriately capitalised to produce a value. Consequently, any method of valuation which uses either the revenue (percentage of sales) or profits would be considered to be a going concern valuation. This is highly relevant for mortgage security purposes where often banks only require the real estate value and do not consider the going concern value.

It also needs to be noted that some going concern sales include debt either on real estate or plant machinery and equipment, and this needs to be factored into the acquisition price which predominantly only involves the equity of the business.

Royalties play an important role within quarry valuations and generally to arrive at a value for the quarry the estimated future output is multiplied by the royalty to produce an income figure which is then capitalised over the life of the quarry at an appropriate risk rate. For the purpose of this paper, we only wish to consider the main aspects of royalties and will consider quarry valuations in a later paper.

Great care needs to be taken before executing a lease. There are many instances where a quarry company has agreed royalties and a lease with a landowner, with no intention to work the minerals but only to prevent other companies from operating the site. However, the landowner has been unaware of this intention, leaving the landowner with no income and unable to transfer the lease to any other party. Solicitors are not valuers and often do not understand issues or clauses that should be included within quarry leases that affect the value of the lease.

It is therefore crucial that expertise is sought before a lease is entered into, as once signed, there is little scope to alter the terms of the lease. The motives of all companies are to obtain profits, so unless a landowner or mineral owner is properly represented, they could be losing significant values from their assets.

It is usual within a quarry lease for a minimum or certain rent to be paid to the landowner or mineral owner in order to provide an incentive for the quarry operator to work the mineral resource. The minimum or certain rent provides the landlord with a fixed income, regardless of whether the quarry is operated or not. Royalties are often merged with the minimum or certain rent, in that no payment is made until the royalty dues exceed the minimum or certain rents. Therefore, it is important to maximise the minimum rent where possible and often to minimise the royalty to encourage workings to take place. Also, other clauses often need to be inserted within a lease which can trigger break clauses in the event of a lack of intention to work a mineral deposit.

Potentially, every clause within a lease can have implications on the value of the lease to both parties. The overall royalty agreed should reflect all of those circumstances and expertise is required prior to any lease being executed. Many mineral leases can be for 20 to 30 years and once agreed cannot be altered to capture errors or losses. There are often opportunities to make representations when rent reviews take place and these can provide a platform for agreement on issues of concern.

Royalties come in many forms and the different rights, ownership structure and interests of minerals needs to be evaluated before a royalty assessment can be made. Royalties are used as a unit of comparison for quarry valuations and a range of other uses. The value of royalties forms the basis for growth within the quarry industry. A large number of leases within the industry do not reflect the current market circumstances and review clauses need to be actively pursued to capture lost values.

Roderick Stephens is a chartered valuation and mineral surveyor and the director of Stephens Valuation and Consultancy Pty Ltd. Email:

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