Take Away the Financial Crisis Mentality and Gold Looks Precarious
Commodities / Gold and Silver 2010 Oct 14, 2010 - 04:00 AM GMTBy: The_Gold_Report
When Tony Parry, a senior analyst with Sydney, Australia–based Resource Capital Research, builds his long-term models for Australian junior gold companies, he's using a long term gold price of $900 per ounce. Tony thinks gold's fundamentals are weak and that fear is artificially propping up the price. In this exclusive interview with The Gold Report, Tony makes the case for a lower gold price and tells us about some small gold companies Down Under with exceptional prospects for growth even at $900 gold.
The Gold Report: Tony, you joined Resource Capital Research as a senior analyst in 2008. Tell us about your coverage sector.
Tony Parry: At Resource Capital Research, we cover exploration and development companies, typically those with emerging production profiles that have not been picked up by the market or major brokerage firms and need further research coverage.
We cover three sectors—gold, uranium and iron ore. We publish major reports each quarter covering a number of significant companies in those sectors, and these reports contain a commodity price outlook for the commodity we're looking at.
TGR: On the gold side, Australia has quite a history of gold mining, especially in the Kalgoorlie area. In other countries, gold mining has taken on something of a stigma in recent years. What's the general sentiment toward gold mining right now in Australia?
TP: Australian mining is a very positive and somewhat booming sector. It's growing strongly, and there's no major resistance to further development, apart from the normal environmental and social concerns about developing mining operations.
TGR: What sort of play is gold receiving in Australia's mainstream media? Is there a buzz about gold at $1,300 an ounce?
TP: It's exciting times for the gold market; $1,300 an ounce is a pretty significant breakthrough and, of course, that's getting a lot of play in the financial reporting sector. We're seeing lots of articles on the gold price. Every article seems to be placing a bet on gold. So, yes, there's quite a buzz in the press and there are a lot of people talking about gold.
TGR: Do you think the average Australian is aware that $1,300 per ounce is really good for the Australian economy in terms of exports?
TP: Yes, I think they're pretty in tune with what's happening in the resources sector; as I say, it's such a significant part of the Australian economy. Even in the largest cities there's no doubt the gold price is widely visible.
If you got in a taxi in the capital city of Australia and talked to a taxi driver about what's going on, he would probably talk to you about the gold price.
TGR: What are we looking at in terms of mining's contribution to GDP there?
TP: I don't have the exact numbers, but something like 30% of Australia's total exports are made up of mining-related commodities. The three big exports in Australia are coal, iron ore and gold, in that order.
TGR: Your firm predicted an average gold price of just below $1,200 an ounce for 2010; obviously that was a little low. What sort of fundamentals did you see in the gold market and in the global economy that led you to say in a recent report "take away the 'crisis mentality' and gold looks precarious"?
TP: What we were seeing and what we're still seeing is that the "doomsday mentality" is driving investment demand in the gold market. The simple fact is the "crisis mentality" has not been removed from the equation since we made those forecasts. In fact, the "crisis mentality" is bubbling along very well, perhaps even increasing as European sovereign debt concerns continue to make headlines.
And we're still seeing major concerns about the U.S. economy and the issues surrounding quantitative easing, which are starting to have an impact on the U.S. dollar. There's quite a bit of pressure on the U.S. dollar.
Perhaps we felt that there was going to be some easing of that crisis mentality in the coming quarter or two, but at the moment there's no sign of that and it may very well be increasing.
TGR: But in looking through RCR's September report on gold, your price estimates are quite conservative across the board. In your financial models, you're now using a long-term gold price of $900 an ounce. That seems particularly bearish.
TP: It does in the current environment. We say in Australia that predicting the gold price is a bit of a mug's game. The fundamentals are pretty tricky to go on, so you've really got to go on the psychology of the market. Gold doesn't have enough underpinning it to make a projection on the fundamentals.
TGR: I agree, but you must see something in those supply and demand fundamentals to project such conservative prices.
TP: That's right. At the end of the day we have to come up with some sort of basis for our forecasts. We asked ourselves: is $1,300-an-ounce gold sustainable or is that a spike? We believe that in a few years' time and once everything gets back to normal—and please don't ask me when that is—we will see gold come off the top quite significantly.
Our argument is that the gold price is being sustained by strong "safe haven" investment demand. But if you take that demand away, we see weak fundamentals; jewelry demand is quite weak, which has been the main source of gold demand, before investment demand started challenging jewelry demand in recent times.
Mine production is increasing because of the increased gold prices, so there's more supply coming on the market. We're also seeing increased scrap supply from recycled gold.
On the demand side, we're seeing negligible purchases from central banks, perhaps because they just don't want to buy more gold at these prices. And as I mentioned, we've seen the end producer de-hedging, which has been a demand-side factor in recent times. We may even see more hedging from producers.
If you put all that together, and significantly reduce investment demand, we see gold coming significantly off the top. We wouldn't be expecting that in the short-to-medium term. But if you ask what's the fundamental value of gold? At the moment, we say that's about $900 to $1,000 an ounce. That is probably the ultimate baseline that gold will come back to when it's safe to go back into the water with the other asset classes that people don't really trust at the moment.
It could be a number of years, but investment banks will be doing the same; they won't be factoring the current gold prices into their long-term valuation models. And I think that's fine because if we're wrong, and a company still looks good on that basis, that's pretty good news for the company.
But we do see the speculative element washing out in time.
TGR: In your report you said that in the future you could see a sustained inflationary uptrend that could ignite gold's "store of value" demand. You added that it's too far off to be a factor in the short-to-medium term. Could inflation prop up gold once this "crisis mentality" subsides?
TP: That's a good question. There's no doubt that inflation is in the melting pot as an argument for holding gold. Quantitative easing is the pump priming the U.S. economy and other economies. The classic theory is that the more money you pump into the system, the higher inflation is going to be in the end. At the moment, we're seeing more concern with deflation in the U.S. and European economies. You'd have to say inflation is not a strong factor right now.
Longer term, yes, inflation could rear its head. But inflation would require some economic growth to become a real factor, and by then you may see equity markets back into the next bull phase. I have a hunch that by the time that is happening, some of the speculation in gold will have washed out. I see that as a bigger factor than the "big inflation" argument.
For the record, we just published our September quarterly gold report, and we're feeling less bearish. Given the continued concerns in the market, we expect gold to keep pushing up into the first half of 2011. We're looking at around $1,335 to $1,350 during that period.
TGR: In your June report you said that in the last five to seven years, one of the major trends in gold mining has been for gold producers to buy out their hedging contracts to gain more exposure to the spot price. But you also said in a recent report that the gold sector could see a "return to net producer hedging at gold prices above a $1,000 an ounce driven by producer concern that the highs for gold may have been seen for now and the requirement by project financiers to lock in for future margins." That's remarkable. Barrick Gold Corporation (NYSE:ABX; TSX:ABX) just spent about $6 billion buying out its hedging contracts, and so they certainly aren't going to be re-hedging soon. Have you seen any evidence of hedging above $1,000 per ounce?
TP: Well, I'll be honest—not a lot at the moment. There's no doubt that the producer hedge book has run down to virtually zero.
In terms of hedging, there's only one company that we follow that has gone down that path; it's called Catalpa Resources Ltd. (ASX:CAH). It just started a 100,000-ounce per annum mining operation in Western Australia. In putting together financing for that about 18 months ago, the banks required them to hedge about 70% of production for five years. That's about 12 tons of gold, not a big contract, but it's at a record price in Australian dollars.
TGR: What was the average hedge price?
TP: AUD$1,557 and the current Australian gold price is about $1,320. Currently, an Australian dollar is worth $0.96 USD.
Catalpa was pretty lucky; they did the deal in February of last year when the Australian dollar was down around $0.65–$0.70 USD. But the hedging contract was required because of the more conservative lending environment. The banks wanted some extra comfort in terms of having their operating costs covered by hedging.
Now, is that going to be more widespread? It's not going to happen with the Barricks and the Anglo American Plc.s (NASDAQ:AAUK) of the world. But with the Catalpas of the world, the emerging 100,000- or 200,000-ounce producers, they're obviously going to require project financing. We may see a trend whereby banks just like that extra bit of coverage.
And if I were a gold company CEO, I would not mind locking in some of my forward production at these sorts of prices.
TGR: I've talked with a number of analysts who like gold juniors that are producing, but that also have some strong exploration upside. They believe these companies are valued on their cash flow and that investors basically get the exploration potential for free. You talked about Catalpa as an emerging producer. That's a company that's still looking for more gold on its property. Do you follow other names that we haven't talked about that fit that description?
TP: Yes, but first I want to comment on that thesis. There's no doubt that exploration is a tremendous driver of shareholder value for emerging companies. What we're seeing is that a lot of the Australian companies in West Africa are having excellent exploration success. In fact, they're getting huge gains on their share prices—200 to 300%—due to exploration success. That's happening because they are discovering gold at a discovery cost of around $10–$15 an ounce.
Equity markets, doing simplistic valuation multiples on gold resources and reserves, value them typically at $50–$100 an ounce once you've got a significant gold resource established, maybe 500,000 ounces or more. If your discovery cost is $10–$15 an ounce and you're being valued by the market at $50–$100 an ounce, there are tremendous gains to be made through exploration success. You're getting very high leverage on those exploration multiples. That's the game at the moment.
I'll run through a few companies we've been following in our gold sector reviews that we feel are stand-out companies. Typically the companies we cover in this sector are $200 million capitalization or less. One is Morning Star Gold NL (ASX:MCO), and there's a bit of romance to this story. Morningstar is restarting gold fields whose history goes back 150 years to the original gold rush in southern Australia.
Morningstar owns the Woods Point Gold Project. About 70 million ounces of gold has come from that area in the last 150 years. Morningstar is trying to re-establish underground mines that were last operated half a century ago. These were gold-rich mines operating at grades of around 1 ounce per ton; so, there's some tremendous potential.
TGR: Morningstar is commissioning the mill, right?
TP: That's right; and we'll see first production in the December quarter. Woods Point will produce around 20–25,000 ounces per annum at grades of around 10-15 grams per ton.
Morningstar sees themselves as a central hub in that historic Woods Point gold field. Once they establish a production plant, they will develop a number of other operations alongside Woods Point to grow production from that region.
TGR: It looks like they're going to be mining some more of the gold-rich portions of their property in order to boost cash flow at the beginning. Am I reading that correctly?
TP: That's right. Some of the ore that's been coming up in the development of the mine has been around 55 grams per ton, simply some fantastic grades. It will be very interesting to see what the first production is with those sorts of grades.
There's no doubt that they're into a couple of the more attractive veins. But I think the inference that the grades may not be sustained at those levels shouldn't be made, because this ore body could continue to yield grades at that sort of level from the other areas of the mine as well.
TGR: What kind of mineralized systems are we looking at here? Are these epithermal?
TP: It's not an epithermal system; it's high-grade quartz vein. You've got this sort of nuggety vein effect in quartz, so it's difficult to know what grades you're going to get until you start mining and get it out on the deck and treat it. That's always been one of the challenges with these types of mining operations.
But we've got production projections now and done a valuation on Morningstar based on their cash flow. We're running a model at $900 an ounce and getting a net present value of AUD$0.79 per share, which is roughly double the current share price. On top of that, there's a lot of exploration potential on the 240 square kilometers that Morningstar tied up in those historic goldfields. And they have a Chinese partner coming in to join them in exploration.
TGR: What are some other companies you're following that present some good value?
TP: Allied Gold is an Australian-based company with operations in Papua New Guinea and the Solomon Islands. It's in what is known as the Pacific Rim of Fire, a ring around the Western Pacific that has some very large scale multi-million ounce epithermal gold deposits.
Allied has traditionally had a Papua New Guinea production base, which is starting to grow quite strongly. They've been about a 70–80,000 ounce per annum producer. But the headline for Allied Gold is that within three years they're looking at production of 320,000 ounces annually through the expansion of their existing Papua-New Guinea operations and bringing their Gold Ridge operation the Solomon Islands into production. It's a plant that stopped operating about 10 years ago when there was political turmoil in the Solomon Islands, which has since settled down.
TGR: That's fairly dramatic growth.
TP: A very dramatic growth profile. They're forecasting about 80,000 ounces in the year ending June 2011. The market is probably not fully cognizant of the exciting growth potential of this company.
We have them on a projected six-times multiple for 2012, which for a mid-tier producer looks extremely low.
We have a valuation on them based on $900 an ounce gold of around AUD$0.73 a share. Allied was recently trading around the low fifties.
TGR: One thing the market might be factoring into its valuation on Allied would be jurisdiction. While it's an Australian company, its operations are obviously in somewhat more risky areas. What are your thoughts on where Allied operates?
TP: It's a good question. If you look at the two countries involved—Papua-New Guinea and the Solomon Islands — PNG has a long association with Australian mining companies and mining is very important to the economy there. Even though you sometimes read slightly disturbing headlines about the status of PNG in terms of the crime rate, etc., we haven't seen any recent problems at major operations. I am fairly comfortable with PNG.
If you look at the Solomon Islands, it was one of the trouble spots a decade ago that has now settled down. The Australian government is working with the Solomon Islands in terms of peacekeeping and policing. We're seeing quite a stable political and social environment established there. Allied's restart of this mine has been very much welcomed by the Solomon Islands government, which knows it needs this type of investment. Basically, we're comfortable with the political risk issues in those two countries.
TGR: But Allied has 3.4 million ounces in reserves, the least risky resource category, and then another 8.3 million ounces in resources. It's not often that you see a company with those kinds of proven resources trading at such a low price.
TP: That's a very good point. I think it's fair to say that there's still not full recognition in the market of what's happening with Allied Gold. And those reserves and resources are likely to keep growing with the excellent ground they have in those two countries.
TGR: How about a couple more?
TP: Alright. Silver has outperformed gold in the last three months, and it now has crossed in excess of USD $21.50 an ounce, which is quite near a 30-year high.
We've been looking at a silver company called Cobar Consolidated Resources Ltd. (ASX:CCU), and they're looking at bringing a silver mine into production in New South Wales. We see some excellent prospects for this company; they've established a silver resource of 51 million ounces. That's similar to one million ounces of gold. It's not going to set the world on fire, but it's quite significant and there is potential to significantly expand their resources and reserves. At the moment, reserves at the Wonawinta silver project are 14 million ounces. They're looking at getting into production by the end of 2011; they're in the financing stage now.
There are not many silver mines in Australia. If they can work out financing, Cobar will turn out 3 million ounces silver a year. The cap cost is only about AUD$30 million to get into production with operating costs of around USD $10 per ounce of silver. But there is lead in the ore too, which could be recovered as by-product credit. If they choose to recover the lead, their operating costs would slip to USD $6 per ounce silver. We see this as a quite interesting operation.
We currently have a target price of $0.46 a share, and it's trading at around AUD$0.30 a share.
TGR: We don't talk with analysts in Australia very often, so it would be great if you could give us one more.
TP: I do have another company, Eleckra Mines Ltd. (ASX:EKM).
This company is only a minnow. It's capitalized at AUD$30 million but they've tied up a whole greenstone belt east of the Western Australia's major greenstone belts like Kalgoorlie and Leonora. They've got over 4,000 square kilometers in this belt. They started drilling and found some pretty high grade gold in its discovery called Central Bore; it started to uncover some quite significant resources. And if they're right, and it looks increasingly like they might be right, this is a significantly mineralized belt.
They've already established a 750,000-ounce resource. That resource is likely to grow quite significantly if they continue with their exploration success. The grades are coming out quite high now; the original resource was only 1.8 grams per ton, but now they're picking up resources that are more in the 10 grams per ton category.
Keep an eye on it because it could be a real flyer if Eleckra continues with their exploration success.
The company is trading at AUD$0.13, but could trade up to $0.20 cents in the next six months when it publishes a new resource statement.
TGR: Sounds promising. Do you have some parting thoughts on the precious metals sector in Australia?
TP: Yes, obviously, the gold price is up 31%, in U.S. dollar terms, in the last 12 months. But the gold prices in producing countries haven't been nearly as strong because of the appreciation of currencies. The Canadian gold price is up 23% in that 12-month period, as opposed to 31% for gold prices in U.S. dollars. And in Australia, the gold price is only up 19%.
But if you look at the performance of the indices over the same 12-month period, the U.S.-based gold stocks, with the S&P gold index, are up 49% in that 12-month period. That's performing better than the gold price, and that's to be expected as there are no currency issues there.
In Canada, the gold index is up 18%; so, it's actually underperformed the gold price. You'd have been better off holding gold rather than Canadian gold stocks in that period. That's partly due to the fact that the Canadian dollar gold price was up just over 20%.
But the Australian gold index in that 12-month period is up 43%, even though Australian gold price was up only 19%; so, Australian gold shares have been fantastic performers. And I am sort of bragging.
Tony is a metallurgist who began his career working in metallurgical process development with Xstrata (then MIM Holdings Limited) at Mt Isa, Queensland. He subsequently moved to London, where he took up a position as a mining equities analyst with James Capel Limited, (now HSBC). Tony also worked in equity sales and mining corporate finance, where he marketed to institutional clients in the U.K. and Europe. He later returned to Australia and took up a role in the corporate finance sector. In 1993, Tony established his own consultancy and has been engaged extensively as a strategic planning consultant to many small-medium enterprises. He currently serves as a Senior Resource Analyst for Resource Capital Research. He holds a BSc (Hons) in Metallurgy and a PhD in Metallurgy from the University of NSW.
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DISCLOSURE:
1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his family own the following companies mentioned in this interview: None.
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