Chile - Lota and Schwager Coal Mine Modernization Projects

RESTR IESTRCTED RETURN TO FILE COPY Report No. TO-410a REPORTS DESK WITHIN ONE WE This report was prepared for use within the Bank and its affiliated organizations. They do not accept responsibility for its accuracy or completeness. The report may not be published nor may it be quoted as representing their views. INTERNATIONAL BANK FOR RECONS-TRUCTION AND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION APPRAISAL OF THE MERGED LOTA AND SCHWAGER COAL COMPANIES CHILE May 22, 1964 Department of Technical Operations  CURRENCY EQUIVALENTS_ Chile has two fluctuating exchange markets, one primarily for trade transaction and the other for private capital movement and invisibles, As of February 1964, the rates were E 02. 3 and E03. 0 respectively. At the time of the basic reappraisal, however, the rate of E02. 0 to U. S. $1 was applicable and has been used in this report.  APPRAISAL OF THE MERGED IOTA AND SCtrAGER COAL COIAPANIES (Chile) TABLE OF CONTENTS Paragraphs SKTVARY ANqD CONCLUSIONS i - xiv I. INTRODUCTION 1- 3 II. THE COIPA1Y -4 - 26 History 4- 9 Coal Comnission Recommendations 10 Merger Negotiations and Agreement 11 - 15 Effects of the Merger 16 - 17 Earnings Record and Flnancial Position 18 - 22 M4anagement and Ownership 23 - 25 Labor 26 III. THE MARKET 27 - 31 General 27 Present Market Forecast 28 Historical Market for Coal 29 Previous Market Forecasts 30 Competition writh Oil 31 IV. THE PROJECT 32 -50 General 32 Description of Operations under the Merged Project 33 Estimated Investment Requirements 34 - 37 Status of Procurement and Bank Funds 38 - 39 Construction Schedule for Merged Project 40 Engineering and Construction Mdanagement 41 Operating Management 42 Coal Reserves 43 - 145 Coal Production Schedule 46 - 147 Labor Requirements 48 - 50 V. FINANCING PLAN AND FINANCIAL PROJECTIONS 51 - 64 Proposed Financing Plan 52 - 59 Financial Prospects 60 - 64 VI. ECONOMIC BENEFITS 65 - 66 VII. PROTECTIVE ARRANG,RVIENTS 67 - 71 VIII. CONCLUSIONS ArD RECOMIENDATIONS 72 - 73  TABLE 0w CONTEIJTS (Contfd) ANNEXES 1 - Income otatements, 1957-1963 2 - Balance Sheets (As Restated by IRiD), 1957-i963 3 - Status of Lota Project 4 - Status of Schwager ProJect 5 - Construction Schedule for Completion of Project 6 - Capital Expenditure Program 7 - Allocation of Production - Lota-Schwager - L964-1972 8 - Total MIanpower on the Books 19.64 - 1972 9 - Comparison of Forecasts olade in 1957 and 1963 for Sales of Coal by Lota and Schwager 10 - Sales and Consumption of Coal in Chile 11 - Market Forecast by Classes of Consumer 1964-1972 12 - Lota-Schwager Coal Corapany (1lerged) - Income Forecast 13 - Lota-Schwager Coal Company (ilerged) - Estimated Cash Flow 14 - Lota-Schwager Ccal Company (Mlerged) - Balance Slheet Forecasts 15 - Lota-Schwager Coal Company (M4erged) - Notes and Assuimptions for Financial Tables 16 - Comparison of Present Loan RLepayment Schedules and the Forecasted Cash Available, 196' -1)72 e CAP 3 1 - iap of lJorthern and Central Chile 2 - Lota and Schwagei' Coal Companies - Locations and Miining Concessions  APPRAISAL OF THE MERGED LOTA AND SCHWAGER COAL CGiqPANIES (Chile) `U1 iK:-l A1ND CONCJLUICLIS i. The Compania Carbonifera e Industrial de Lota and Compania Carbonifera y de Fundicion Schwager, S.A., have miled coal from the deposits under the Bay of Arauco on the coast of central Chile for more than a hun- dred years. Together they produce 8Qio of the coal mined in Chile. ii. In 1957 the Bank made Loans 171-CH and 172-CH for USQ12.2 million and US$9.6 million to Schwager and Lota respectively, in order to complete modernization programss. The Chilean Developsient Corporation (CORFO) was a co-borrower on both loans and undertook to provide local currency for pro- ject expenditures whenever the funds available to the companies were inade- quate. iii. Deterioration of the coal market, a three month strike at the coal miines, and an earthquake in 1960, created a serious crisis in. the coal indus- try. In an attempt to reduce operating costs and avoid duplication of effort the two companies reached an agreement to merge in October 1961. After the Bank had indicated its approval in principle a Presidential Decree authoriz- ing the merger was published in October 1963. Approval of the merger by the stockholders was voted in December 1963 and formalized by government action in March 1964. iv. ihe principal effects of the merger will include improvement of operating conditions of the companies, the strengthening of management and technical staff, the reduction of administrative costs and the elimination of distortions in the production ana development programs. v. Lodifications of the projects due to the merger are relatively minor and the major effect is to concentrate mining operations in certain areas of the coal field. vi. The Lota project is nearly completed, while the Schwager project is behind schedule with the development and outfitting of the new mine. Delays in signing the loan documents and placing order for equipment, plus the deliberate slow down because of market developments and the shortage of cash all contributed to delaying completion of the projects. vii. During the period the loans have been in effect, profits have been considerably lower than anticipated, and the merged company does not have the ability to meet the present loan repayment schedules. A financial breath- ing spell is required to complete the project, permit the company to reap the benefits of the merger, and to recover from the adversities of 1960-1963. viii. While no new funds are being requested, all the undisbursed funds (UW35.3 million) from Loans 171-CH and 172-CH of US$21.8 million will be necessary to complete the merged project. Funds previously allocated to the Schwager project will be used to complete the mechanization of Lota and Schwager's coal mining operations, to replace outmoded equipment and to pay additional interest during construction which is scheduled to be completed in 1965.  - ii - ix. Total investment requirements for the merged project are estimated at US$21.8 million in foreign exchange and E033.8 million in local currency. As at December 31, 19633 total expenditures and commitments for the project amount- ed to US$16.7 million in foreign exchange and Eo25.4 m'illion in local currency. x. The companies' share of the Chilean coal market has dropped from 1.4 million tons in 1957 to 1.2 million tons in 1963. Present market fore- casts indicate a modest rise in coal consumption from 1964 to 1972. xi. Assuming that the Bank and CORFO loans are adjusted to allow a moratorium on principal repayments until 1966 and that graduated amortiza- tion schedules are extended to 1975 and 1978 respectively, cash flow should be adequate to service debts. xii. Key assumptions in the financial forecasts are that the relationship betueen the cost of producing coal anid the selling price prevailing in September 1963 will be maintained and that coal will be protected from the artificial pricing of competitive fuels. xiii. The Chilean Government, in a letter to the Bank, has formally expressed a satisfactory policy with respect to the pricing of coal and competitive fuels. Unless the stated policies are reasonably administered, and timely price adjustments are permitted, the financial forecasts are somewhat fragile. xiv. It is recommended that the sank give its approval for the use of the undisbursed funds of Loans 171-CH and 172-CH to complete the merged pro- ject. At the same tie, it is recomnended that repayments be rescheduled to begin October 15, 1966 and the repayment period extended to October 15, 1975.  I. INTRODUCTION 1. In July 1957 the Bank made Loans 171-CH and 172-CH to two coal companies, the Compania Carbonifera y de Fundicion Sch-ager, S.A., and Compania Carbonifera e Industrial de Lota, for U3132.2 million and USPI9.6 million respectively, with the Corporacion de Fomento de la Produccion (CORFO), the Chilean Development Corporation, as co-borrower. Under the terms of the Loan Agreements CORFO undertook to provide the companies with whatever funds were not available to them to meet project expenditures. The purpose of these 'Qans was to finance the modernization of surface installations and concentration of underground workings in the case of Lota and the development and outfitting of a new coal mine and modernization of surface installations for Schwager in order to extend the economic life of the property. 2. Following a series of crises in the coal industry, the two companies agreed to merge in order to reduce production costs and improve operating conditions. Action on the merger was delayed when on H-arch 12, 1962 the Chilean Anti-ihonopoly Commission ruled that the merger would consti- tute a monopoly. There foLlowed a long series of negotiations between the companies and the government, which culminated on October 18, 1963 with the publication of a Decree authorizing the merger. Approval of the merger by the stockholders of both companies was voted on December 16, 1963 and formal governmental approval was given in Harch 1964. 3. Meanwhile, the affairs of the companies deteriorated and CORFO asked the Bank to reschedule the loans' repayments in order to give the merged companies time to complete the projects and to get themselves into a position in which they could service the Bank loans from earnings. In order to obtain a current review of the companies' situation the Bank asked Powell Duffryn Technical Services, Ltd. (PDTS) to update a report which it had made in 1962 on a merged operation. This work was completed in October 1963 and served as a basis for the field appraisal ruade by a Bank mission in November-December 1963. The report which follows is based upon the findings of Powell Duffryn and data gathered by the Bank IKission.  - 2 - II. THE COMPANY History 4. The Lota and Schwager conmpanies have mined coal from deposits under the Bay of Arauco in the central part of Chile (See Map 1) for more than a hundred years. Together they produce about 8a/ of the coal mined in Chile. During the 1940's both companies began modernization programs which were soon postponed due to lack of funds. In 1957 the companies obtained US$21.8 million in loans from the Bank to complete their moderni- zation programs which included: winding and ventilation equipment; coal preparation plants; workshops, surface traffic and buildings; underground haulage and electrical equipment; coal face equipnent; mine development equipment; accounting equipment, trucks, etc. The total cost of the pro- jects was estimated at US$21.8 million in foreign exchange and U3419.7 million equivalent in local currency. The modernization programs of the companies were designed to increase their coal production capacity from 1.75 to 2.25 million tons per year and were expected to reduce the cost of production substantially. 5. The projects were begun several months behind schedule due to delays in completion of the Loan Agreements with the Bank, delays in placing of orders for mine development equipment, and the unexpected time consumed in the preparation and analysis of tenders for some of the main parts of equipment. 6. In view of the inability of the companies to get the projects back on schedule and the decline of the coal market in Chile, the Bank decided early in 1960 to have both projects reappraised by Pierce Management Corpora- tion of Scranton, Pennsylvania. Concurrently with this reappraisal the coal companies made a new market study using information gathered by Sofremines (French Coal Consultanus contracted by the Chilean Government) and Mr. Bressler, a UN staff member who spent several months in Chile studying the energy situa- tion of the country. Based on the new market forecasts Pierce Mianagement recommended the following modifications to the coal projects: For Schwac~er: 7. To scale-down the esti.ated output of coal from 4,000 tons per day (1.1 million tons per year) to 2,800 tons per day (780,000 tons per year) thus reducing mine development to some extent; to postpone indefinitely the installations of the secornd winder and the coal preparation plant; and to speed up the completion of tne new mine since cost of production was increas- ing sharply as the coal faces in the old mine grew more and more difficult to mine. For Lota: 8. To scale-down mine development to fit a maximum production of 3,500 tons per day instead of the 4,000 tons per day as originally planned. Lotats project involved mainly the concentration of existing underground workings tf enable them to bring their coal through the new Carlos Cousino shafts and this  concentration did not require as much mine development as Schwager's. At the time of Pierce Management's study Lotats underground concentration as well as the modernization of their surface installations, was at such a stage that there was no way to postpone any major works with the exception of some mine development and the coal washing plant. The coal washing plant at Lota could not be postponed since the high ash content of Lota's coal required washing in order to meet market specifications. 9. These modifications were accepted but other problems soon arose. In April 1960, the workers went on a strike which lasted for 3 months. To make matters worse,the Concepcion area had a severe earthquake in May which damaged some surface installations at Lota and destroyed a large number of workers' and employees' houses at both Lota and Schwager. Losses to the companies due to the strike and earthquake were estimated at approximately U'44 million equivalent. The market was affected by the strike since close to 500,000 tons of coal had to be imported in 1960 and the change from coal to oil by many small consumers was hastened due to the "unreliability" of coal supplies. Coal Commi_ssion Recomiendations 10. The reduction of internally generated funds by the companies due to market deterioration, strikes, etc., forced CORFO, the co-borrower, which had undertaken to provide funds for the project, to furnish larger amounts of funds than previously expected. 'This situation prompted the Chilean Government to appoint a Commission composed if COhFO officials and prominent industrialists to study the entire coal industry and make recormendations for its improvement. The Commission submitted a report to the President of Chile strongly recommending the merger of Lota and Schwager in order to reduce production costs and eliminate unnecessary duplication of activities (marketing, shops, administration, etc.) that the companies could ill afford. Merger Negotiations and Agreement 11. Even before the recommendations of the Commission were publicly known the directors of Schwager had suggested to Lota's directors the con- venience of merging their companies. The merger and its desirable long- range economies, especially in the face of a reduced market for coal which was already under heavy competition from oil, was not readily accepted by Lota. At the time, Lota had beLun to benefit from concentration of under- ground works and its financial position had improved with lower production costs and increased sales. 12. Schwager, on the other hand, was facing increased production costs in their old mine due to the distance of the coal faces and the diffi- cult mining conditions in some of them. They had also neglected to reorganize their Sales Department after their Sales hanager left the company to become the Minister of Labor under the newly formed Alessandri Government. 13. The apparently strong position of Lota and the relatively weak condition of Schwager made it difficult for agreement to be reached on the merger and these negotiations lasted for a year despite pressure from the  -14 - Chilean Goverrnent to merge as soon as possible. The companies finally reached an agreement to merge in October 1961. Under this agreement Lota is acquiring Schwager by exchanging a 35% interest in the Lota com,pany for the outstanding shares of Schwager. The name of the new merged company will be the "Carbonifera Lota-Schwager S.A." (Lota-3chwager Coal Company). As one of the initial steps toward preparing for the merger, the companies, in November 1961, contracted Powell Duffryn to make a study of the techni- cal, financial and administrative aspects of merged companies and to recom- mend how their operations could be most effectively combined. Subsequently, on Miarch 12, 1962, the Chilean Anti-lonopoly Commission, to which the matter had to be referred, ruled that the merger would constitute a monopoly and could, therefore, be legally undertaken only if authorized by a Presidential Decree. Although it was politically difficult for the President to sign a Presidential Decree authorizing what had Xfficially been found to be a monopoly, he nevertheless issued the Decree on October 18, 1963 after receivring from the companies and the Bank an agreement in principle to the terms of the Decree. This Decree requires the government to have a repre- sentative on the Board of the new company, with special powers designed "to protect the public interest". To satisfy both the government and the owners of the companies, the powers of the Government Delegate are specified in some detail in the Decree: basically, the Delegate's approval is required for the disposal of assets in excess of certain amounts, large sales agree- ments, special sale conditions different from the prevailing ones, and dismissal of employees above a certain percentage of the total labor force. The Decree also restates the government's right to control the price of coal under a 1953 law. 14. After the Decree was published Lota's directors had second thoughts about the merger and sought specific commitments from. the Bank and CORFO regarding the repayment of the combined debts of the two companies. There followed six weeks of further evaluation and discussions before the stock- holders were asked to vote on the merger. During this period the merged pro- ject was reappraised by a Bank mission and the tentative financial forecasts were used byr the companies in arriving at acceptable agreements with CORFO regarding the repayment of debt. On December 16, 1963 the stockholders of both companies approved the merger and authorized the directors to proceed with the legal formalities. These formalities have been cornpleted and the final Governmental Decree approving the merger was published on March 12, 1964. 15. The prolonged period of negotiations relating to tne merger and the rumors associated with such a situation resulted in low morale among employees, the loss of initiative by the management of both companies and the loss of key technical personnel. This period also coincided with a sharp change in cost/ price relationships as the government permitted wages to rise but imposed controls on the price of coal. while tne imposition of price control oni coal was contrary to the government's commitment to the Bank, the Bank did not oppose this measure since it was a part of the government's program to curb inflation. By 1962 the finances of the companies had become precarious and by 1963 it was clear that neither the Bank nor CORFO could be repaid accord- ing to existing schedules. In August 1963 coal prices were adjusted and a reasonable cost/price relationship was restored. At this point CORFC for- mally requested the Bank to consider a revision of the loan repayment schedule, stating that the maintenance of the present schedule would place a  - 5 - heavy burden on the Governmelnt of Chile and CO?FO. In reply, the Bank indicated its willingness to make a formal appreisal of the merged comnpany and then consider what arrangements would have to be nade to p2ace the company on a sound financial basis. Effects of the Merger 16. The immediate technical effects of the merger will be the elimina- tion of the distorted production and developIaent program which Schwager has undertaken av the expense of good mining practice, to mine the type of coal needed to maintain its position in the market. Administrative economies can also be made by combining sales, accounting, purchasing and other services, but these will be relatively minor. An important psycholo&gcal effect will be the removal of the feeling of uncertainty which is causing some unrest amonlt the labor force and staff at Schwager who do not know hou the merger will affect them personally. By the same token, the probleim of replacing lost technical staff will no longer be so acute as the merged company can offer nrospective employees longer term contracts. The merger will also strengthen the management of the Schwager mining operation which has been deteriorating for the past several years and should result in a more expedi- tious completion of the project. 17. Regarding the Bank and CO,FO loan agreements, the changes occasioned by the mierger will be incorporated in a supplementary agreement between the Bank and the Lota-Schwager Coal Company and a revised agreement between CORFO and the company. CORFO's revised agreement will eliminate the CORFO repre- sentative to the Boards of Directors; provide that the CORFO loans be adjusted after December 31, 1963 according to the changes in the Price-Index of i;ning Products rather than be adjusted on the price of coal to the railroad as at present; and change the loan repayment schedules to CORFO to conform to the ability of the merged company to repay. Earnings Record and Financial Position 18. Income statements which cover the years 1957-1963, the total period of the Bank's loans, are given in Annex 1. Separate statements for each company are sho-m for 1957-1962 while the year 1963 is combined since the merger will be effective on the basis of the accounts as at December 31, 1962. Balance sheets for the years ending December 31, 1957-1963 are given in An-nex 2. 19. During the period the loans have been in effect, the profits of both companies were considerably lower than anticipated. Together the conpanies earned only 7.