Foreign Money, Siberian Gold And the KGB

Since 1992, Star Mining and its Russian partner, the semi-private Lenzoloto mining company, have been sitting patiently on the formal rights to exploit Sukhoi Log, a potentially huge gold field in Siberia.


Unfortunately, so far it has not been able to make a single drill hole.


The problem has not been lack of money or confusion over property rights as it is so often in Russia. No, the hitch has been the Federal Security Service or FSB, the domestic successor to the Soviet KGB, which kept an iron grip on the keys to the vault.


Trouble was that while a group of opportunistic executives from Star Mining had convinced the pro-foreign investment Gaidar government to hand it a stake of the gold field, they had forgotten to check with the FSB.


This was a problem. As far as the FSB was concerned, gold was a matter of national security and a state secret. Foreigners could not get involved.


Star Mining raised $20 million in 1993 and was ready to start drilling by 1993 but the FSB stepped in and ruled that "grade" data, geological studies of the gold mine, were a Russian state secret. Without that precious treasure map, the field's fabulous gold reserves were unattainable.


The situation was almost absurd. Star Mining had acquired title to a gold field but was barred from finding out where the gold was or even how much gold was there. "We didn't know exactly how large it [the reserve] was," said Christopher MacNee, the executive director of the Star Mining company in Moscow.


Led by Cristopher's father, Ian MacNee, one of the founders of Star Mining, the company did not give up hope and trusted their hunch.


"We knew they [the Russians] were not bluffing ... because we saw some infrastructural work had been done around the mine," said Christopher MacNee. "Also we had learned from academic journals it had at least a thousand tons of gold."


Star Mining pressed ahead, backing their hunch with money raised from speculative investors on the Australian stock market. As proof of their commitment, over the last four years they have invested $48 million in the project without even knowing where the gold was or exactly how much there was to extract.


They invested $38 million in Lenzoloto, the company that owned the Sukhoi Log gold field, and a further $10 million on the feasibility study of the project. They currently hold a 31 percent stake in Lenzoloto.


In the meantime, the communist opposition took up the issue. Sukhoi Log was the subject of a special hearing held by the State Duma's Security Committee under the watchful gaze of hardline communist Viktor Ilyukhin to investigate threats to Russia's national security from this "shadowy" Australian company.


In the end, their four years of patience was rewarded. Prime Minister Viktor Chernomyrdin signed a decree last month lifting the veil of secrecy from the Sukhoi Log mine. At last, Star Mining received from Russia's secret services the classified geological information on how much gold there was, and where it was in the mine.


Star's Christopher MacNee said recent political events explained why the company finally gained access to information that had been withheld for four years.


He said the sacking in June of Federal Security Service director Mikhail Barsukov and of Alexander Korzhakov, President Boris Yeltsin's security guard and right-hand man who had kept Barsukov under his control, was a main factor in lifting the veil of secrecy.


"Barsukov wouldn't even sign a draft resolution allowing for the secrecy to be lifted," said MacNee. He explained that Star would never have received the information if both Korzhakov and Barsukov were still in power today.


The appointment of the pro-reform Anatoly Chubais as Yeltsin's chief of staff also "had a lot to do with it," MacNee said.


While Chubais had little direct involvement in Sukhoi Log, the deal was shepherded through the government by Pyotr Mostovoi, formerly Chubais' deputy in the State Property Committee.


MacNee added that the summer's presidential elections also played a significant role. It would have been impossible for Star to gain the classified information from the government before the elections, he said, because the communists could have used it to accuse Yeltsin of selling Russia's "biggest treasure" to the West.


According to the official data, the mine holds 1,170 tons of gold, which MacNee said was worth about $13.6 billion. A potential jackpot for Star.


But the pot of gold is still not there for the taking. Now that the Russian government has declassified the Sukhoi Log survey, Star's next challenge will be to raise the additional $200 million they will need to finance the first stage of the project.


According to their contract and the law on joint ventures, Star has to find $200 million within the next year and a half. Its Russian partner, Lenzoloto, must raise another $300 million, but the timetable is less strict. If Star cannot find the cash it will lose a portion of its shares in Lenzoloto, said Melvyn Williams, Star Mining's finance director.


The investments required are huge. The mine is located in the remote region of Bodaibo, north of Lake Baikal. Around the gold field, there are no roads, no houses and, more importantly, no electricity or running water. There is only a small village called Kropotkin, located some 10 kilometers away.


"We will have to upgrade the electricity transmission lines from Taximo [330 kilometers away in the Buryatia region] to Shukhoi Log and build and improve the roads of the region," said Williams.


But before Star can raise any capital to get construction started, it will have to wait for the completed feasibility study of the project. This study was delayed by the FSB's intervention. If the results meet Star's expectations, only then will Star be able to proceed to raising the $500 million, analysts say.


"Banks will lend money only if the feasibility study is satisfactory. That study helps them quantify the risks and the rewards," said Graham Birch, a mining specialist at Mercury Asset Management, an investment company that holds "a significant amount of shares" in Star Mining.


After they complete the feasibility study at the end of this year, Star will then have to convince investment bankers around the world that they should bet on Siberian gold.


"Star will have to compete against other mining companies who are also trying to find investors for their projects on the world markets," said Birch.


He said projects in countries such as Chile, Indonesia and Peru where "the gold market is less state-regulated than in Russia" offered investors a more secure environment for investing in large projects.


Russia's political instability and the state's stranglehold on the gold industry are serious concerns for investors. The Russian Federal Security Service's secrecy on the mine was a good example of that.


"In a country like Russia, having contacts in the right place is a very important factor," said Rag Kohli, a mining analyst at MC Securities in London.


Having good contacts in the government will also be crucial for the company's financial survival. According to Kohli, bankers won't look at the project until Star has cleared the remaining legal and regulatory hurdles that could undermine the profitability of the gold mine.


"Unless Star solves these legal problems, it is unlikely investors will want to put their money in this project," he said. In short, their main worry will be selling their gold and getting paid for it.


At present, the Russian government still holds a monopoly on the gold industry.


Gold producers are obliged to sell their gold to the government, which in turn "holds back payments for long periods of time, sometimes several months," said Andrei Galkin, head of the privatization department of Roszoloto, a division of the Committee for Precious Metals and Precious Stones.


"Russian gold producers are stuck in a very difficult and complex situation. They have no buyers, no market and no money because the state budget is too poor to pay for the gold," Galkin said.


According to Viktor Tarakanovsky, chairman of Russia's union of gold mining cooperatives, the government is still 1.3 trillion rubles ($244 million) in debt to producers.


Ninety percent of the gold produced in Russia is bought by the government, which Galkin said purchases at world prices. The remaining 10 percent is sold to banks, who can sell on the Russian market to jewelers or to other banks, but who cannot export it.


Galkin said he expects a law to be passed that will permit banks to sell gold on international markets, but he did not know when.


But MacNee said he hopes Star will get special permission from the Russian government to export their gold, "if the Russian government does not purchase it within a certain number of days."


To achieve that they would have to "get the president to approve it by decree," said Yury Kotlyar, first deputy head of the Committee for Precious Metals and Precious Stones.


But "right now, we don't have a paper that says we have such permission," MacNee said.


MacNee said his only "guarantee" was that the U.S. mining company Cyprus Amax Minerals, which hold the rights to the Kubaka gold mine in the Far East region of Magadan, received such permission by presidential decree last year.


But MacNee is confident that by the time the exploitation of the gold mine starts in three or four years, he will get the gold export issue resolved either by decree or thanks to the ongoing liberalization of the industry. But on the other hand, investors who put their money in the project might not be willing to wait that long.


After Star rids itself of these bureaucratic and legal headaches, their next concern will be to figure out a well-balanced financial plan.


Aside from using export credits, Star is planning to raise capital through a mix of debt and equity, said MacNee.


But if they want to borrow money, first they will have to get support from an international financial institution "which carries some political clout" to give more confidence and comfort to their creditors, MC Securities' Kohli said.


"Realistically, no Western commercial bank will finance a natural resource project in Russia unless it is backed up by the European Bank for Reconstruction and Development or the International Finance Corporation," he said.


MacNee said he was planning to seek help from such an organization only after the feasibility study is completed at the end of the year. But this could make raising the capital a real long shot, because it means Star will be left with just over one year to find the $200 million.


Birch said the price of Star shares are lower than those of average gold projects around the world "because they reflect the risks of the project."


"Star has 658 million shares at 16 Australian cents, which gives it a value of 105 million Australian dollars [U.S. $82 million], and puts it at a far end of the mining industry. The average gold mining company is worth 10 times that amount," he said.


If Star Mining can clear all these roadblocks, the mine's exploitation will start in 1999 or 2000 and churn out a least 20 tons, or 650,000 ounces of gold a year, bringing a U.S. $250 million revenue to the company each year, said Williams.


The development of the mine will take place in three stages. After the first stage is completed with the first $500 million investment, the second and third stages will require a further $250 million investment each. In all, developing the mine to its full potential will cost a total of roughly $1 billion.


But once the mine gets working, part of the remaining $500 million will be financed by the company's profits, said Williams.


The mine will become "extremely profitable," Williams said, his eyes shining. But he said it was too early to give figures on how exactly profitable it will be.


Until Star extracts its first gold from the field, it will have to rely solely on its investors for financing, as its partner's other mining activities do not bring any profits. Star is entitled to a 35 percent share of Lenzoloto's profits, even though it has only a 31 percent stake.


"All this time, [since 1992] Lenzoloto has not paid us any dividends, and we don't expect any until the completion of the project," Williams said.


Although Lenzoloto has been mining gold for 150 years and was singled out as the Soviet Union's third or fourth gold producer, today its alluvial operations do not bring the company any profits. Lenzoloto is undergoing major restructuring: Cutting down the number of employees and privatizing some fields have caused Lenzoloto's gold production to drop to six tons a year, down from 10 tons before 1991.


Williams said high and wasteful energy costs and the burden of high taxes partly accounted for the company not being "cash positive."


But according to Galkin, the real reason Lenzoloto is not bringing any profits is that the company has "huge debts to its creditors, its workers, the federal budget ... which reach at least several hundred billion rubles."


He added that because of these debts, it could be possible that they would need to raise more capital than the $300 million planned.


But despite the burden of Lenzoloto's financial and structural problems added to its own, Star has no choice but to struggle and hope that one day it will get access to the Siberian treasures of Sukhoi Log.


"Star Mining's only purpose in life is its investment here in Russia," says MacNee.