first majestic silver

A Peek at Smaller Golds - Part 3

Blood in the Streets

December 6, 1999

Just when gold stock investors thought they were dealt a winning hand, we get blood in the streets instead. As of this December 3rd writing we find POG at around $282, still up from the $255 area of last summer. But, THE UNDERLYING GOLD STOCK INDEXES ARE NOW BELOW WHERE THEY WERE BEFORE THE EUROPEAN C.B. ANNOUNCEMENT. The large cap index XAU moved from around 65 in early September, peaked at over 90, has retraced to 65. Similar action occurred in the Toronto gold index, trading from the 5000 area to a brief peak at 7334, back to 4991 on the 3rd. The price action seems heavily influenced by tax loss selling and a lack of bids.

The defining attribute of this recent action has been the perplexing and disturbing need for gold stock investors to have to become overnight experts on complex derivatives markets. Even worse these investors entered into a twilight zone of not even being sure if they wanted POG up, down or flat. I found myself (no doubt like you the reader on your own holdings) going back over obscure footnotes in my Ashanti file (recommended in Peek, part I), finally exclaiming, "Eureka, I see it now, I didn't take into account the delta factor on that May/Oct, 2000 butterfly spread. How could I have been so stupid!".

The natural and understandable reaction of many investors has been to proclaim "who needs this", and throw the baby out with the bath water. No doubt some have moved on to internut stocks where the requirements for individuals to do their homework isn't nearly so strict and demanding. That said I take a deep breath (no, I freely admit that was actually a sigh), and smelling a great opportunity, reaccess the landscape. To do so we will take a simplified peek at the economics of gold mining and at the business approach being applied by the industry.

It my assertion that the current thinking of gold companies and investors stems from the after shocks of a long bear market in gold and commodities. This old sentiment operates on the thesis that improvements in commodity prices and especially gold are temporary, and will be reversed before the projects favored by the juniors can come to fruition. This attitude is very risk adverse, as companies ask the fiduciary question, "If we do X project, will the company be severely jeopardized if POG goes back to $250 or even $200?

If you read interviews with leading gold execs, they seem focused on the "great gold asset" philosophy. The great assets are typically defined as world class monster mines producing very low cost gold (well under $150/oz production costs, and maybe closer to $100). The thinking is that if cash costs are $100, capital costs are $50, exploration costs are $50= $200/oz total, then even at $250 POG, you have a viable profit. Add some hedges and bingo you have the magic formula.

These great gold assets (and to some extent hedging) have been the company builders during the gold bear market, with the most successful models being Barrick (producing 800,000/oz a year at about $50 at Pierina, Peru), and Newmont's Yanacocha, Peru (producing a million a year at $100). The five leading producers in the world (ANGLY, Barrick, Placer Dome, Newmont, with the possible exception of Goldfields) and most of the next tier are either disciples of or wannabee practitioners of this approach. The problem is that with the dearth of exploration, these deposits are rare, and when discovered take time and considerable expense ($260 million for Pierina, and $396 million for Yanacocha) to get into production. I contend that this strategic philosophy is like fighting the last war, and unless changes are made the industry faces a self inflicted shortage of gold. I sense that gold stock investors also will need to shift their focus away from this "tooth fairy strategy" and towards what I call the "quest (for basic gold supply)" philosophy.

Projects in the next cycle will not be based on sheer size, but by deposit profit. It is in this scenario that juniors with established small and medium size, moderate cost deposits will reemerge as an investment class. The prototype of this might be a digestible deposit or existing small mine with a total cash and capital cost of $225/oz or less. Historically exploration costs have been stated at about $50. The reality is that resources today are capitalized at $2 to $5/oz, and reserves at $10 to $15, or less. Investors at this stage would no doubt willingly depart with these exploration assets (defined as through the feasibility phase) for say $25, and less ripened projects for $15. So the buyer gets a project with a total cost of $250, and a $50 profit margin at $300 POG. With a viable profit, mining companies won't have to engage in hedging strategies as a finance tool. Good profits attract capital, and great profits (as when POG goes even higher) will attract even more capital.

Given the prevailing bear market sentiment that $300 POG might not last, companies employing the quest philosophy probably are going to go for bite size pieces rather than big gulps. Medium size, high grade deposits not involving enormous project cost will be the targets. These are manageable, and the quest company would not be bankrupted if POG dipped and stayed below $250. The other variable is location. It is unlikely that much $200 total cost gold will be found in first world countries like the U.S., Canada or Australia. Of course, going for projects in the third world involves greater political and supply shock risk. This risk could be dealt with through proper geographic diversification combined with more modest sized projects.

The gold industry is also crying out to be consolidated, including at the exploration level. Where is the next "gold" Boone Pickens when we need him? Perhaps gold mutual funds could take the lead on establishing this new trend. The industry should start addressing the issue of shareholder value. To win investors back to the sector, new combinations are necessary that give investors greater value. Examples would be companies working on the same regional trend who could realize economies of scale, pooled knowledge and capital, project diversification and greater negotiating power. The stock market on a net present value basis will value these aggregated parts higher than isolated ones.

It appears that too many smaller companies are little fiefdoms run for management. The formula employed is spend every last dime, maybe find some gold, and leave. If investors ever got interested enough in this sector they could use the power of the INTERNET and communication to totally dominant the process, particularly in small cap golds. The end result could create great wealth opportunities for small gold investors.

FOLLOW-UPS ON PREVIOUS SELECTION (initial writeups available on Peek, part I and II) AND A NEW NAME:

Pangea (PGD.TO): Trading at $3.90, has been the big winner among my picks. I think because maybe PGD represents the best of two worlds. First, there may be a tooth fairy (Tulawaka?) in it's project portfolio. But the best reason for owning PGD is the potential for a slew of quest projects in Tanzania and Peru. ABX's apparently sees it that way, having just picked up 10% ownership at current prices. PGD is now very well financed and ready to go.

St. Jude (SJD.V): An example of the fiefdom management approach referred to above. Here's a company with a good deposit (in Ghana) and plenty of cash ($8 million US) and what do they do: invest a million into a computer furniture company. Let's see, first we have to analyze gold deposits, then complex derivative strategies, now ergonomics. Give me a break! The end result is fairly predictable: stock languishing at huge discount to cash value (50 cents versus cash of 70 cents/share after the million "invested'). If Boone were around he would know what to do with this sitting duck. And I would gladly sell him my stock.

Birim (BGI.TO): Classic quest company! Very well focused on their corporate strategy of developing medium sized high grade deposits, selling ore for cash and moving the chess pieces over to the next good drill site. Strategically placed in Ghana to play this scenario, feeding several majors operating in the region. In the high 20's, still selling below cash on hand. Take advantage of tax selling to accumulate.

Nevsun (NSU.TO): What else is there for NSU to do? Their Kubi project is set up as a royalty collector ($15 an oz plus 20% of uplift over $325), and the Tabakoto, Mali with 1,877,000 indicated and inferred ounce is at an advanced stage. The plan is a high grade operation with $200 cash and capital cost. NSU at 44 cents CDN has a mkt cap of 7.3 million (US) minus $3.8 million US cash= $3.5 net mkt cap. So if we analyze just Tabakoto alone, the exploration side of this equation is capitalized at $2 an ounce. I don't think so. It's time to maximize shareholder value.

One likely purchaser is the new Semafo/Managem partnership (the later is the mining subsidiary of Morocco's largest conglomerate). They have public announced an aggressive acquisition program of up to $100 million, targeting West Africa.. At these prices, that buys a lot in this neck of the woods. In quick order they have already picked up the Segala project immediately adjacent to Tabakota, and the Samira Hill project also in Mali. Nevsun has got to be in their sights.

Greystar (GSL.TO): Where does GSL's Angostura fit in the quest for gold supply puzzle? It may be a world class deposit but in risky Columbia, instead of stable Peru. If so, the buyer would have to be a major to offset that risk. ANGLY just entered Columbia for the first time. The aforementioned ABX and NEM have experience with this type of mining. Normandy/TVX still haven't made a move In Latin America. Kinross owns 21% so they will have a say, but are likely to want a more modest quest project.Production and capital costs are likely to be under $200, so the economics should be excellent.

Despite "the fit" questions, GSL arguably may be the best gold stock value in the world right now. At 58 cents, the US mkt cap is a mere $18.7 million and with $4.7 US working capital substracted, the net net is only $14.0 million. That's less than $3/oz for GSL's 5.2 million oz.indicated and inferred resources, and there is little doubt there is more to come.

Golden Reserve (GLDR): GLDR's Brisas project in Venezuela is far advanced (165,000 meters of drilling) and pretty much a known entity. The deposit contains proven and probable reserves of 6.05 million oz gold, and 732 million copper. The problem is the estimated project cost is $339 million and total production and capital cost are $262 an ounce. Obviously no one is going to run out tomorrow and start developing Brisas. So what's the attraction? With a mkt cap of $16.3 million (stock at 72 cents), and cash of $20 million this deposit is valued by the market at zero, indeed less than zero.

Here's a modest scenario: suppose gold traded to $350 and stayed. If the property were purchased in a quest transaction for a mere $15 an ounce ($4.88 per GLDR share including cash, or 675% profit), then total project costs would be $272, and profits at $350 gold would be a solid $78/oz.

Madison Enterprises (MNP.V): at 68 cents is in a buy range. A lot happens next year, as the company updates the resource estimate of it's prolific Mt. Kare project. New drilling targets five new nearby zones including the promising Pinuni Creek area. And finally a feasibility report is issued. By way of comparison, cash costs at PDG's Porgera are $166/oz, and metallurgical recovery rates were superior at Mt. Kare. MNP is fast approaching the stage where it will show up on a quest radar screen, if it hasn't already.

Romarco (R.TO): R has an established exploration track record already, having sold part of the Midas (Nevada) property to Franco-Nevada. If that wasn't enough they assembled (no small feat) 15,000 acres of land at Goldfields, Nevada and have produced some excellent initial drill results. Other very promising projects in Nevada include Jake Creek, Red Rock and Converse.

R has the capital firepower to carry out it's plans as there are 738,000 Franco-Nevada shares left in the till, with a value of $12.8 million. There's also $1.1 million cash and $1.4 million in "other securities" bringing the total to $15.3 million US. And now that you all know the punch lines on these recommendations, the market at $0.90 CDN values THE COMPANY AT ONLY $12.8 MILLION US.

According to the Talmud you should keep one-third of your assets each in land, business interests, and gold.
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