22 February 2011

How Kennecott Succeeded in a Long-term Plan to Cut its Losses in Chile

Kennecott had always drawn on its Chilean mine, El teniente, like a renter draws income from a fixed property.  Mining capacity in the mid-1960s was only slightly higher than the levels of the mid-1930s.  Gross investment had amounted to only $53 million over the twenty-year period from 1945 to 1965.  Company policy consisted of investing only enough new funds above depreciation each year to maintain operations at the mine.  No serious efforts were made to explore or develop new properties in Chile.  

The company controlled huge reserves of low-cost copper in the

United States
, and although operations at El Teniente in the mid-1960s accounted for about 30 percent of the parent's total production, they produced only thirteen percent of total earnings. Kennecott's top management did not come up through Chilean operations, and expanding production in Chile
was not a prime corporate objective.

An early view of the Sewell Mine (1909)

Anaconda, however, had actively expanded its Chilean mining properties, its volume of output, and its claims on potential reserves in Chile.
The company's gross investment in the post-World War II period (1945-1965)
amounted to $347 million, including a large sulfide plant in 1948, a major new
mine in 1955 (El Salvador), and another smaller mine (Exotica) to come on-line
after 1965.  By the mid-1960s, Anaconda's annual copper output from
averaged over 350 thousand metric tons, accounting for 51 percent ofAnaconda's
total production and 67 percent of the company's total earnings.  Anaconda's
mines in the
United States were of lower quality and higher cost than those of Kennecott. Anaconda's top management had come up through the (North American management) ranks in Chile

Chilean mining had always been and continued to be considered the center of
Anaconda's corporate operations.For the period immediately following the Second World War when foreign expertise was indispensible in
running the Chilean copper mines and foreign capital was indispensible in
modernizing and expanding operations, Anaconda's aim was to demonstrate to as many domestic politicians as possible that the largest aggregate returns would accrue to the country through favorable treatment of the company's Chilean subsidiaries.  Since Anaconda was willing to expand investment and production in return for lower taxes--while Kennecott was not--Anaconda did the bulk of the maneuvering and bargaining.  

Kennecott then received the benefit of being taxed under the same mining laws as Anaconda. Anaconda clearly was willing to bring more and more of its corporate resources to contribute to the growth of the Chilean mining sector.  Kennecott  was not.  With mounting demands in the late 1950s for more vigorous performance to generate revenues and foreign exchange to fuel the country's development, Kennecott perceived the increasing vulnerability of its position.  Resentment against the company's lack of dynamic
contribution to
Chile--especially against Kennecott's failure to respond to the generous incentives of new mining legislation in 1955--was growing.  From the time he became head of Chilean operations for Kennecott in the mid-1950s,Robert Haldeman recalled that he considered it only a question of time until the Chileans nationalized El Teniente.

The prospects were complicated for Kennecott in the late 1950s because the El Teniente mine began to experience mounting problems in the attempt even to maintain production at former levels.  The company's management in New York
faced the choice of seeing output steadily decline or making a large lump-sum
investment to expand into adjacent ore bodies.  Feasibility studies for a
project that would increase the life of the mine and raise output from 189
thousand tons to 280 thousand tons per year were very encouraging, but Kennecott was wary of committing funds in a politically sensitive industry where the company already had a "poor public image" and where the domestic ability of the host country to run operations on its own was rapidly increasing. 

Therefore, Kennecott management decided to go through with the huge expansion project only if a satisfactory network of trans-national alliances could be constructed to protect the company's position.

The Equitable Building under construction: This location would serve as the world headquarters for Kennecott for about three decades.

In the absence of an option to have the United States government intervene militarily to maintain physical possession of the Kennecott mine, what could a "strategy of protection" for the company's position mean in operational terms?  First, a strategy of protection would mean subjecting as little of the corporation's own capital to the risk of nationalization as possible.  Second, it would mean lining up, from as many directions as possible, international supporters who would automatically share the Kennecott parent's
outrage in case of nationalization.  Third, it would mean raising the cost to
Chile of nationalizing the Kennecott mine as high as possible.

Eduardo Frei's demand for "Chileanization" in 1964 gave the Kennecott management the opportunity they were looking for.  To the surprise of Frei's negotiators, Kennecott (but not Anaconda) offered a plan to enlarge El Teniente, sell a 51 percent interest in the huge mine to the Chilean government, and run the operation through a management contract. Under the Kennecott plan, not
one dollar of new corporate funds would be brought by the company to

, nor one escudo in new obligations contracted for in the parent's name in

The bulk of the expansion plan would be financed from the proceeds of the sale
to the Chilean government of the 51 percent equity interest ($80 million) and
from a loan to the ew joint venture from the Export-Import Bank of
($110 million) would would be paid back over a ten-to-fifteen year period while
Kennecott managed production.  The Chilean Copper Corporation alsocontributed
$24 million to the new project.

Consequently, the capital for the El Teniente expansion would be supplied with no new financial risk to the Kennecott parent while, at the same time, the worth of Kennecott's Chilean holdings would be substantially increased.  Kennecott demanded a special reassessment of the book value of the El Teniente property (from $69 million to $286 million), demanded a special reduction in its tax rate (from over 80 percent to 44 percent), and demanded a management contract to run the new operation for at least ten years.  From a balance-sheet perspective, after the revaluation of net worth, Kennecott would still be 49 percent owner of a company worth about for times as much as it had been before.  From a cash-flow perspective, Kennecott would be receiving 49 percent of the proceeds from an operation exporting almost 64 percent more output at a tax rate cut in half.

To line up supporters who would come to the company's aid in case of expropriation, Kennecott began by insuring the amount of the sale ($80 million plus interest) supplied by Chilebut committed to the joint project by Kennecott under a United States AID contract of guarantee against expropriation.  Thus, upon entering into the joint venture with Chile, the Kennecott parent had an immediate US government guarantee to pay, in case of expropriation, an amount larger than the net worth of its total Chilean operations had been prior to the reassessment of book value.  At the same time Kennecott demanded  that the sale amount and the Export-Import Bank loan be unconditionally guaranteed by the Chilean state, and submitted to the law of the
state of New York

These arrangements meant that Kennecott would have a general legal claim against the Chilean state in any court should the Chilean operations be expropriated, and that the Export-Import Bank, the Agency for International Development  (AID) and the Congress would feel the effects of any nationalization simultaneously with Kennecott.  The Export-Import Bank would want  its loan repaid by Chile as soon as the Kennecott management contract was broken; AID would object to paying off a huge insurance claim; and these agencies and Kennecott could join in mobilizing support for the Hickenlooper amendment* in Congress. Washington would not be able to ignore harm done to Kennecott's Chilean operations.  The company's management spoke contemptuously of other corporations who counted on the Hickenlooper amendent's being applied "automatically." The aim of Kennecott was to make any threat of nationalization result unavoidably in a face-to-face confrontation between the United States  and the Chilean governments.

A model of the Braden Mine at Sewell, Chile

*NOTE on Hickenlooper Amendment: 
The Act of State Doctrine says that a nation is sovereign within its own borders, and its domestic actions may not be questioned in the courts of another nation.The doctrine is not required
by international law (neither customary international law nor treaty law), but it is a principle recognized and adhered to by
United States federal courts. Its aim is not to protect other nations' sovereignty by intervention from the U.S.[citation needed] but rather to protect the US Executive's prerogatives in foreign affairs from being frustrated by a decision issuing from U.S. courts.

The Act of State Doctrine enters consideration most often in cases where a foreign sovereign has
expropriated the property of a U.S. national located in that foreign territory (e.g. through nationalization). Rather than pursuing recourse through the courts,  
United States nationals are
to take their claims against foreign sovereign governments to the Executive so that the government can either espouse the claims of all
U.S. nationals as a group or seek recourse through diplomatic channels. The United States employs the Act of State Doctrine more broadly and with more frequency than other countries.

In 1964, the United States Supreme Court applied the Act of State Doctrine in Banco Nacional de Cuba v. Sabbatino, 376 U.S. 398 (1964). The case arose when Cuba nationalized its sugar industry, taking control of sugar refineries and other companies in the wake of the Cuban revolution. A large number of Americans who had invested in those companies lost their investments without compensation when the Cuban government assumed control. However, despite the loss suffered by
United States nationals, the Supreme Court upheld the Act of State Doctrine by assuming the
validity of
Cuba's domestic action and therefore rejected the claim of US nationals against Cuba
for their lost investments.The Court in Banco Nacional de Cuba v. Sabbatino stated that although the Doctrine is not found in the Constitution, explicitly or implicitly, it does have constitutional
underpinnings in the concept of separation of powers. The Supreme Court reasoned that because the Executive had exclusive authority to conduct foreign affairs with other nations on behalf of the

United States
, disputes arising from the official actions of foreign sovereign powers should
not be settled by the Judiciary because those decisions could interfere with the
Executives' conduct of foreign affairs.

In response to the outcome of the case, Congress enacted 22 U.S.C. § 2370, more commonly referred to as the "Second Hickenlooper Amendment," named after the bill’s sponsor, Bourke B. Hickenlooper, an outraged Iowa Senator. Generally, under the Hickenlooper Amendment, courts are not to apply the Act of State Doctrine as a bar against hearing cases of expropriation by a foreign sovereign. However, one provision of the Amendment instructs the courts to continue applying the Doctrine wherever the Executive tells them to. Essentially, under this Amendment, the Executive has the authority to decide on a case-by-case basis whether the Judiciary has the power to hear a case.

Finally, to assure itself of an international reaction to any threat of nationalization, Kennecott raised $45 million for the new joint project by writing long-term contracts for the new output with European and Asian customers and then selling collection rights on these contracts to a consortium of European banks headed by the Banca Comerciale Italiana ( $30 million), and to a consortium of Japanese institutions headed by Mitsui & Co. ($15 million).  This operation--similar to "factoring" in business finance or the selling of accounts receivable at a discount to a financial intermediary--was designed to bring international pressure on any nationalistic government not to void the 

Kennecott management contract and not to repudiate the debt obligations of the El Teniente joint venture.  Since repayment of the $45 million to the foreign banks depended upon faithful fulfillment of the long-term sales contracts to the customers, a crisis of confidence in the future production (brought on by any threat to the Kennecott management contract) would provoke outbursts from financial institutions as well as customers in Europe and Asia.

"The aim of these arrangements," explained Robert Haldeman, executive vice president of Kennecott's Chilean operations, "is to insure that nobody expropriates Kennecott without upsetting relations to customers, creditors, and governments on three continents."

Kennecott was trying to carry out a major expansion   project under conditions of great uncertainty at minimal risk to itself, while mobilizing international pressure in such a way as to raise the cost of nationalization as high as possible.  But how high was high? 

If Kennecott's strategy were completely successful, the company would have to be kept on in
Chile at least until the ten-year management contract ran out.   At a minimum, if the company were nationalized, Chile would be forced to assume all the international obligations of the joint venture, including the obligation to pay full compensation at least for the guaranteed debt owed Kennecott.  That would be a difficult task for any but the most determined and self-confident Chilean government.

=codelco logo

Here's an odd comparison for you:
Do these two logos look at all similar?
kennecott logo

CODELCO (Corporación Nacional del Cobre de Chile or, in English, the National Copper Corporation of Chile) is the Chilean State owned copper mining company formed in 1976 from the foreign owned copper companies that were nationalized in 1971, mainly the Kennecott and Anaconda properties. The headquarters are in Santiago and the seven man board of directors is appointed by the President of the Republic. It has the Minister of Mining as its president and six other members including the Minister of Finance and one representative each from the Copper Workers Federation and the National Association of Copper Supervisors.

It is currently the largest copper producing company in the world and produced 1.66 million tonnes of the metal in 2007, 11% of the world total. It owns the world's largest known copper reserves and resources. At the end of 2007 it had a total of reserves and resources of 118 million tons of copper in its mining plan, sufficient to ensure more than 70 years of operations at current production levels. It also has additional identified resources of 208 million tonnes of copper, though one cannot say how much of this may prove economic.

On the other hand, for comparison the proposed Pebble Mine in southwest Alaska contains an estimated 40 million tons of copper, 100 million ounces of gold and 5.6 billion pounds of molybdenum. Now that's not bad--a very favorable comparison, especially for what is effectively ONE mine as opposed to several in Chile.

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