I have noticed that volumes are drying up and a number of precious metals stocks are suffering due to a lack of enthusiasm, and a shortage of new participants to take the ball up. Many gold bugs would be nearing the stage of being "fully invested", and until there is further evidence of the uptrend resuming with gusto we are unfortunately going to experience some lean times.

This is the period where many will throw in the towel, and feel that gold has failed them for not skyrocketing to $350 within a short timeframe. Investors must be mindful of the fact that bull markets tend to give you reasons to stay out, whilst the dreaded bear tends to suck investors in like a vacuum. We are all faced with serious decisions once the excitement subsides, and I guess those that no longer believe gold will ever rally still have a reasonable window of opportunity in which to exit.

My timeframe for precious metals has been pushed out somewhat, and I am resigned to the fact that it will be a buyers market for the immediate term. This period could extend for weeks, even months however there is enough short-term spikes in the junior end upon the release of drilling results with plenty to follow to keep some interest alive. Investors are becoming far more discerning, however there still appears to be interest from the daytraders, which has allowed some juniors to overshoot on the upside due to the sheer weight of volume. With increasing volatility, the risks of short-term trading after announcements have been exacerbated somewhat based on the evidence thus far of day two and three corrections.

The precious metals bus was over the legally allowed limit, and until we see some disembark, it is similar to a horse lugging 70kg in a sprint event.

Whilst the "noise has subsided" I have provided a basic overview of investing in the Australian gold sector.

The major discoveries of gold in the United States and Australia were made in the mid-19th century. The California gold rush started in January 1848 when gold was discovered in the tall-race of Sutter's Mill in Sacramento Valley. It is estimated that around 500,000 prospectors flocked to the region and the rush was accredited with opening up America's west. The first gold discovered in Australia was in 1851 near Bathurst, New South Wales and resulted in the areas transformation from what was essentially a penal colony. The great gold boom of the 1980's transformed Kalgoorlie and the region was affectively labeled the "Golden Mile".

Gold mining was carried out by the Egyptians around 2000 BC, however it is estimated that the production was no more than 1 tonne per annum. In the 15th century gold production in the region now known as Ghana provided a supply, which was estimated at 5-8 tonnes per annum. Russian gold production in the late 18th century was estimated to have reached 30-35 tonnes per annum, in 1847 (one year before the Californian gold rush).

Australian output peaked in 1903 at 119 tonnes per annum, and this level of production was not surpassed until 1988. During the majority of the 20th century gold production in many countries was in a period of decline, although the onset of the great depression brought higher prices in the early 1930's. The price rise of 1980 rejuvenated the industry and as a result a number of old mines were revisited and further exploration carried out.

In terms of investment appeal gold is often highly regarded as a source of diversification based on its negative correlation with other asset classes. The gold price is prone to supply/demand factors, the $US, interest rates, inflation and in some cases has been viewed as a safe haven in times of social unrest. The price of gold has tended to move in the opposite direction to stocks, treasury bills and bonds. With the US stock market experiencing a very strong period of growth over the last 20 years the price of gold has been effectively in decline, although there have been some powerful rallies during the "bear market".

One of the features of gold is its liquidity, and the fact it can be traded 24 hours a day in one or more gold markets on a global basis. It is easily convertible to cash, with transactions on the gold market similar to those in equities and bond markets.

Key Investment Considerations

• In terms of investor appeal it has been estimated that for every 100 stock market participants only 1 could be considered a gold enthusiast.
• Gold companies receive limited press in comparison to their industrial counterparts. Often price rises will lead to further publicity, however during periods of prolonged weakness both the financial press and Internet forums will rarely feature gold enthusiasts. The gold sector has long been considered speculative, however apart from the explorers there are a number of companies that have consistently returned money to shareholders in the form of dividends and capital returns.
• Rising lease rates often lead to a rally in the gold price. One- month lease rates in September 1999 rose to 10%, and the spot price reacted accordingly. Lease rates refer to the interest charge on borrowing gold, and there has been considerable debate on the explosion in gold- based derivatives and the role of Central Banks.
• There have been a number of excellent gold discoveries in Australia recently and these include the Raleigh Deposit (Goldfields, Tribune and Rand Resources), Thunderbox (Dalrymple and Lion Ore). The discovery of gold in the Gawler Craton in South Australia in 1996-1997 resulted in strong price movements in a number of juniors led by Helix Resources.
• One of the most infamous cases of a gold discovery that was later proven to be false involved a Canadian junior Bre-X Minerals in 1996-1997. The Busang gold discovery was rumored to contain up to 100 million ounces, but no economic gold was located. The issue caused considerable damage to the mining industry both in Canada and on a global basis.
• Investors should have an understanding of the implications of native title and how they can affect the progress of the company they have invested in.
• Gold stocks have shown their ability to appreciate rapidly during periods of speculative boom. The rallies in 1980, 1986, 1994,1996 and 1999 clearly indicate the potential windfalls that exist to investors who are well positioned when the yellow metal climbs off the canvas. The medias attitude quickly changes, and Internet forums become cluttered with questions relating to finding producers and or explorers that are well positioned in terms of resources and hedging.
• Many companies sell their production forward locking in potential profits. Those with sound hedging principles benefit in difficult times through assured income, however those that are hedged excessively and are faced with a rising spot gold price are forced to deliver their gold at much lower prices. Investors tend to concentrate on those companies that are lightly or have no hedging in place. It has been argued a number of rallies have been thwarted by Australian producers forward selling into any price strength.
• The advent of the so- called "new economy" has led many to state that gold is no longer a viable investment. No doubt this attitude has moved to the technology/Internet stocks after the April 2000 meltdown and subsequent failure of a number of listed companies in Australia and throughout the world.

What to look for in a gold stock

• A company that has a resource base that will support their market capitalisation. When valuing a gold company I often apply a value for in-situ resources of around $15-$25 per resource ounce.
• Assess the level of hedging in the case of gold producers. A mixture of assured income and exposure to a gold rally price can complement each other throughout the various investment cycles.
• Exploration companies that are surrounded by majors, and a producing mine can provide a windfall if a discovery in the region is made. This can be through either direct or indirect exploration success combined with the potential for corporate activity. The low gold price has forced many South African high cost producers to seek cheaper ounces and production abroad. Examples include Durban Roodeport Deeps and Harmony. Mining maps are useful and are often contained in annual reports, on the company's website or are normally freely available from the company and in mining publications.
• Those that have sufficient cash reserves available and the ability to mobilise drilling rigs in the advent of a gold price rally will stand to benefit from reporting exploration results when speculators are looking for the next major discovery. The forward work programs of companies are contained within quarterly reports and usually detailed in the company's website where applicable.
• Kalgoorlie has a rich tradition in gold mining and exploration and no doubt during the next upswing the rumors and discussion in the local bars will reach fever point. Watch out for stories on companies on Internet forums, and have a working knowledge of which juniors are carrying out exploration or have further worked planned.

Understanding company reports

Due to rising exploration expenditure as a result of renewed interest in the gold sector, investors are more likely to be faced with the daunting task of deciphering company reports in terms of the exploration success/failure. Whilst a high-grade hit may cause a speculative frenzy, it may be at a shallow depth and may not be an accurate reflection of the potential resource. In other cases a relatively low-grade result might be at an excellent depth and indicate that a low cost mine could move into production.

Drilling

There are three main types of drilling, and a brief description is provided below.

Rotary Air Blast (RAB)

• Often the cheapest form of drilling but also the least accurate.
• Operates in a similar fashion to a hammer drill, where drill cuttings are collected as they reach the surface.
• Potential exists for contamination from other drill holes.

Reverse Circulation (RC)

• The drill cuttings are effectively forced into the hollow drill bit, which is achieved through compressed air or fluid.
• More expensive form of drilling than RAB.
• More accurate than RAB based on the method of retaining drill cuttings.

Diamond Core Drilling

• Next step taken from RC drilling.
• Diamond drill bit rotates to cut a sample of the rock rather than grind it.
• Solid core of the rock collected through drill bit.
• Most expensive form of drilling, but the most accurate.
• The rock sample effectively provides geologists with a clear picture of the nature of the mineralisation. The samples can also be used for metallurgical tests.

Companies in their reports will usually state that they are conducting for example a 5000 metre RC drilling program, after conducting Geophysics which can include both airborne and ground studies. This will provide a very rough estimation of the costs involved, not allowing for the mobilising of rigs and staff.

Resource Definition

• Inferred resources are where the data is insufficient to confirm the resources continuity.
• Indicated resources also contain insufficient data, however they can give what is considered a more reasonable indication of the continuity of the resource.
• Measured Resources contain sufficient data that are able to confirm the continuity of the resource.
• Probable relates to the confidence level contained within the indicated category.
• Proven is similar to the confidence in the measured resource category.

Open cut or underground

Open pit refers to surface mining where the ore is removed from a pit. Underground mining results from access to the orebody achieved by a decline and as further ore is sourced the depth increases. The cost factors will involve underground power, water and essential services to facilitate the mining of the orebody.

Mine Infrastructure

In some cases where a significant discovery is made in a remote location, the ultimate costs will be affected by the need to develop roads, water and power supplies, living quarters for staff and access to air travel for staff which are normally required to work on a fly in -fly out basis.

Exploration Results

Once a company releases exploration results, many investors who have little or no working knowledge of geology will often ask for various opinions on the grades achieved at certain depths. From my experience the higher the grade and the depth, the more excited investors become. Whilst 1m hits at 230 grams per tonne (g/t) may seem attractive in comparison to other results, it is often the shallow nature that may result in some apprehension over the continuity of the resource. Contained within results are the location of each hole, the type of drilling undertaken and a range of results received. For reporting purposes many companies elect to report "significant results" in summary before providing a more detailed review of the assay results. It is often one or two drill holes that fuel the initial speculative wave.

Solid results at depth such as 15m at 8 g/t that flow throughout a report will indicate that there is a greater likelihood of a continuous resource with impressive grades that may ultimately have an impact on production costs.

A resource may be reported as being 3.0 million tonnes at 6.2 g/t (Indicated) for 600,000 ounces of gold. A rough market capitalisation of this company will be based on the level of ownership of the project, access to infrastructure, the price of gold in both $US and $A. A back of the envelope calculation would result in a market capitalisation of around $9m, without including value for further exploration potential. If the company has 150m shares on issue, the valuation per share is 6c, however it should be noted that the liquidity of the company, location of the project and any external factors will result in wide ranging pricing discrepancies across the sector. If another company finds the resource attractive and also the regional aspect they may be willing to pay a much higher price per resource ounce to takeover the company in question. In Australia this has ranged from $20-$50 per resource ounce, with much higher valuations applied to resources in the gold producing regions in countries such as Tanzania.

Sources

The Green Room, A Guide To Speculating On The Australian Stock Market by Tony Locantro (2001)

The Mining Valuation Handbook, Victor Rudenno 1998.

Tony Locantro
locantro@iinet.net.au

18 July 2002

Tony Locantro is a client advisor in Perth, Australia, and the author of "The Green Room", A Guide To Speculating on the Australian Stock Market. Tony was previously a major contributor to Australian Internet forums under the nick "Budfox" from 1998-2001. Stocks mentioned in this article are for illustration purposes only and do not represent investment advice. The author has both direct and indirect interests in stocks mentioned in the article and these may change without notice.