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All Gold in the Ground is Not Created Equal

A Review of Gold Industry Valuation Fundamentals

About Twenty years ago Bill Brown, CEO of Goldfields, wrote an analysis with the Engineering Mining Journal magazine, (E.M.J.), of the gold business. He documented the fact that it was not an economically viable business. This conclusion was based upon the total cost to find, capitalize and produce an ounce, at that time. Recent bankruptcies in the industry, and others that are technically gone, but clinging to life, Cambior, and others, confirm that this case can regrettably still be made for a good portion of the industry.

The recent articles here comparing share valuations of gold companies needs a bit of sunlight on a few of the dark corners. One can argue that the market is efficient and effective in the proper allocation of value to shares, and all there is to know is known, as there is full disclosure by proper and professional management, with audit committees, etc. One can then recall all the analysts at the big brokers who pushed Bre-X.

I happen to fall into the camp of the esteemed Reg Howe and agree with his piece posted here, and at his site, that the management of most resource companies leaves much to be desired. Cambior, and Ashanti to only point out the obvious. One also has to be prudent of looking at the glass being half empty, or half full. Is there a place for proper hedging or not? What is proper hedging?

It must be understood that a share of stock in a gold company is an option on a future ounce. One would pay more for an ounce that was produced at an all in cost of $100 than for an ounce that had an all in cost of $300 – 350 . Especially if the current sale price is $275. If there were no more ounces after five years, pay less than if it lasted Ten or Fifteen years. If one company has 50 – 100 M. Oz. that will be produced at a loss or at a marginal profit, what are they worth? If the high cost producer had a lot of debt and demonstrated the inability to find or buy new low cost ounces one would be even more stingy on the buy. Say avoid like the plague?


What does this mean to the investing public today? Just this. Does the corporate entity have any net free, after tax, cash flow to grow the business? Earnings, and how about a dividend perhaps.

The truly extra ordinary opportunity afforded by the oversold condition of the current gold market needs some qualification of the quantification of the merits for the available choices that are out there.

The Industry's Four cost components to consider are:

  1. Finding cost. The total cost of drilling and other ancillary necessities to put an ounce into the proven, mineable, diluted, recoverable category, produce a bankable final feasibility, and get the government permits to develop the project.

  2. Development / capital cost. The total cost to build the process facilities for the deposit. How much cash flow for the ongoing capital costs. Very significant. S. Africa 's are huge. (50% of pre tax profits) New shafts for deep underground deposits, additional pre production stripping.

  3. Cash cost. The total of mining, processing, royalties, taxes, refining, etc. Thankfully recently better defined by an industry standard.

  4. Closing costs. Environmental reclamation to meet government regulations.

  • Finding cost. This varies from $5 to as much as $100 per ounce. The best people in the business are under $10. The old Goldfields group were at $5, Newmont is at $7. The average is in a range of $20 - $50. My estimates are that the industry was been spending about $100,000,000 a year in Nevada, until recently, and has not found much. Placer and Kennecott have the Pipeline deposit, but after the discovery of Paradise Peak, Chimney Creek and Sleeper ten years ago, there have been very few discoveries. Franco's Ken Snyder is it. Barrick has it's first ever in the history of the company discovery, Pascua. All other reserves were bought. The Meridian folks once boasted of having spent about $350 M. on exploration, and essentially found nothing, prior to the discovery in Chile. El Pinon. 2.0 M. Oz for about $78 M. of exploration from 1994 – 1999. ($34 / Oz.). The juniors that find quality ounces for $5 and sell them for $40-70 such as Mar West, Arequipa, and now Pacific Rim are great horses to ride if one can identify them early on. Francisco has been trying to sell their deposit for years, to no avail.

  • Development / Capital cost. The next big ticket item. $40 - $100 per ounce. Most preferred deposit is warm climate, open pit heap leach. The lowest capital cost. About $5-7,000 per daily ton of through put, vs. $10-15,000 for a milling operation. Thus a 5,000 Ton per day heap leach would be $25,000,000 vs. $50,000,000 for a mill. High grade (+3 gm) small milling of 1-3,000 tpd is also most attractive. The cost for the typical underground operation is about $20,000 per daily ton. Old, deep, underground, low grade operations can consume all profits, if there are any, with ongoing capital. That is most of Canada, and S. Africa. Exceptions are very few, i.e., the new Agnico Eagle higher grade deeper reserve, the old Campbell Red Lake, and now the new Goldcorp reserve. Meridian had almost $100 M. of capital out from 1995>1999 on old mines, with no increase in production. No surprise they reported negative earnings totaling $120 M. for those years. El Pinon capital of $77 M. or $33. Barricks Pierina had initial capital of $260 M., about $12,000/ daily tonne, double normal Nevada heap leach capital costs, that was recovered in less than a year from high grade hedged ounces yielding $285 M. cash flow. People do not realize that Barrick had $100 per Oz Pre Production Capital in Nevada and without a fwd sale @ $360 they would just be trading dollars. Not what they do.

  • Cash cost. The average cash cost of the industry has been falling in the last two years as the higher cost projects have been closed, and or the companies with them have gone into bankruptcy, and off the averages. Royal Oak, Pegasus, Rea Gold, Cornucopia, Greenstone, and Alta Gold in the U.S.A. the companies have also been cutting exploration, development, and G. & A. If exploration and development are cut to much you can pick the day when the doors close quite accurately. With the elimination of the higher cost production, the North American average has fallen from $250 - $260 down to about $220. Barrick is 3.7 M. Oz @ $134, Newmont and Placer are about $150 - $170. Coopers and Lybrand did an industry survey years ago, and found wide variations in the reporting of cash costs. Fifty percent of companies did not include royalties and local taxes in cash cost, and frequently equipment is leased or contracted, and not counted either. South African production is about $280 - $300 as the mines are two to three miles deep, and absolutely nothing can be done but to close them, which has been happening slowly.

  • Closing costs / Reclamation. This is a largely ignored but very significant item. Both Barrick and Newmont have $5 – 10 per ounce in the annual reports. A realistic estimate must be done and a sinking fund established, even if it is not required by the governments. The government agencies in North America have gone from hysterical to reasonable on this in the last few years, as the industry is so depressed. The management skills of the company on the environmental issues of a project are equally as important as on any of the other engineering management issues. If the management is perceived by the government as not trust worthy, the reclamation can be a very expensive nightmare. Anyone remember Summitville?

South Africa Mines

One can have nothing but the highest possible admiration for the S. African miners. The skills developed to work tens of thousands of people down 2 – 3 miles on the narrow reefs at 130 degrees Fahrenheit, or hotter, literally boggle the mind. BUT, the reality of the operations is that the grade is dropping as ongoing capital increases, cash costs increase, and profits drop. That they are increasing tonnage mined in this environment is a monumental testimony to engineering management skills.

These highlights are for all mines, comparison from 1998 > 1999:
Dollars are USD, 1898 Rand = 5.316 /// 1999 Rand = 6.1131

Tonnes Milled = 82.8 M. > 86.55 M.
Grade, grams = 5.09 > 4.62
Kg of Gold = 464,391,200 > 449,472,200
Cost / Tonne = $42 > $44.51
Gross Profit = $947 M. > $763.6
Cap. Costs = $376 M. > $385.7
Dividends = $345.5 > $367.7

Not a pretty picture at all, but no surprise to anyone. Capital costs as a percent of profit increase from 40 > 50%. They are miraculously increasing tonnage as grade falls, costs go up, therefore profits drop. Why would they increase the dividend in this environment? Methinks only to keep the shares attractive, and of course to keep the cash flow up to the parent companies. One has to wonder how much capital is needed to access the 50 M. or 75 M. or 100 M. Oz of reserves down another mile or two. Think of the air conditioning costs alone, and starting new shafts from 10,000 – 12,000 ft. Mind boggling. Harmony's once a quarter shaft failures are expensive. The other companies closing of the low grade shafts and layoff of tens of thousands of miners continues. Thankfully the government cut taxes a bit.

The phrase "All gold in the ground is not created equal", can now be understood. For the companies that have not been able to find the replacement for their depleting reserves, they have no choice but to try to buy reserves found by the junior exploration companies. When FMC Gold (Meridian) ran out of reserves at Paradise Peak in Nevada their production went from 425,000 Oz/yr to 180,000, and cash cost increased about 25%. The parent company FMC tried to sell them to industry, and with no takers it took a year and a sharp gold rally for Wood Gundy to sell them to the institutions. They boasted of spending $350,000,000 on exploration for 12 years, and have finally found a viable deposit in Chile. Many similar others.

If a company is unable to find low cost high quality deposits, they must buy them. If, a very big IF, management is entrepreneurial and has the business skills for acquisitions. Many, in fact most, are not capable, or when buying, pay to much. Placer is notoriously famous for this. (1.) Mt. Milligan @ $200 M. Write off. (2.) Getchell $1.0 Billion for 10 M. Oz. Underground, Autoclaves. $300 cash costs. (3.) Las Christinas, start construction then stop on a $500 M. project that already has $100 M sunk and a title dispute! Since Cambior has an all in cost of +$340 or so and $214 M. of debt, with no cash and no free cash flow, do they have any ore reserves, and how will they avoid receivership?? Ashanti at least had assets.

I am not addressing any of the Aussie companies due to time and space limitations.

Industry Acquisition Costs, or what is an ounce in the ground worth

There are sufficient examples of majors buying proven, and producing properties, that acquisition costs per ounce are well known. For medium to average cash cost reserves, proven ounces have been selling for $10 - $60. Mar West to Glamis @ $40. Placer paid $100 for Getchell, a $300 / Oz producer now shut down to upgrade for $230 M. Incomprehensible. Teck paid $140 M. for the producer Tarmoola in Australia, 2.5 M. Oz. $56 per Oz. An average deal.

Barrick was sneered at for paying $70 (shares, not Cash), for Arequipa's Pierina heap leach deposit in Peru. Initial cash cost of only $48 per ounce, capital cost of $250 Million, for 8-10 M. Oz., 800,000 Oz/yr. sold forward at $380. Operating cash flow of $317 / Oz! This deal warped the greed factor way up in the whole industry, as at the time no one understood the technical details of why the project commanded such a price. "We will just drill ten holes and sell to Barrick for a Billion." Heard it several times. Barrick also bought the Bulyhuluan underground deal in Tanzania. $350 M. for 3.6 M. Oz. They were sneered at again, but the reserve is now 7 M. and going to 10 M. Oz, or more. Production going ramping from 250,000 > 500,000 Oz/yr, cash costs going from $160 > $100 / Oz.

We sincerely hope the very brief overview of the industry here helps explain why one would happily pay so much more for Barricks and Newmonts Ounces than others. However, when the gold price lifts off, we expect that the South African shares will move exponentially to the moon, as putting some money to the bottom line with increased metal prices is a major positive for their shares. The volatility will again be incredible.

On the next level down to the juniors that have proven reserves, some with mills, some with other production and no debt, the opportunity to control proven reserves that are priced in this market at $1 - $10 per ounce with the junior companies that have proven reserves some of and need finance, has not been seen since gold dropped from $800 to $280 in the 1981 –82 and 84-86 years. It is apparent that 10-20 times multiples have, and can be had from here. It is also apparent that this window of opportunity can close in a couple of months.

It is both possible and probable to repeat the twelve months price jump from $296>$500 in 1983, and $300 > $500 in 1986. How many people can recall $500 gold much less recall when and how long it took to happen? If Ian Gordon and J. Hathaway are correct, that we can then see four digit prices, after clearing the old high of $800, then any position that is not well selected with the above in mind will be astonishing.


One other large misconception must be cleared up once and for all. Mining is NOT Risky! Grass roots exploration to send a geologist out to look for someplace to look for a deposit is risky. Drilling wildcat oil wells (more than a mile from existing production), is risky! 90% failure. Opening new restaurants is risky. 90% failure rate. Starting new DotCom companies is risky.

Developing and producing proven ore bodies is NOT RISKY! It is, however unremittingly unforgiving of any carelessness, incapacity or neglect by management that lacks the requisite knowledge, experience, wisdom, and judgement to develop and mine the Ore Reserve. Choose your management and the reserves for your investments carefully!

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