Ounce for Ounce

Dave Forest
Pierce Points
Jun 19, 2009

In this issue:

Refilling the Tank
The Hidden Tax
Not Enough Gold to Go Round
BP's Big Book of Oil
Return to Asia

Where will the world get its gold? This week we look at some fascinating new research on what it costs gold producers to keep up their supply of in-ground reserves. The numbers suggest that producers are having a tough time finding new gold at a reasonable price. Which is causing a "sea change" in the philosophy amongst majors. We'll examine how the approach to exploration is changing, using the example of one of the largest new discoveries of this decade.

We'll also dig into some of the data from the recently released BP annual statistical review of world energy. The review is the "bible" for the energy industry, and its yearly publication is the closest thing to a gala event the petroleum sector has. This year's review was startling on a number of fronts. Trends that have been in motion for the last 15 years in the energy sector are reversing before our eyes. This is a must-read for anyone involved with the energy business. Let's get to it!

Refilling the Tank

Analyzing major mining companies is both complex and simple. When looking at a major, there's a lot more to consider than with a junior. A junior company may have only one project. The deposit may not even be in production yet. It's a fairly straight-forward process to analyze the grade, tonnage and strip ratio and come up with an approximate net present value.

But with a major the picture gets a lot more complicated. Most majors have several operating mines, often on different continents. They have a portfolio of development-stage projects getting ready to go to production. They may have an exploration portfolio as well. Breaking down each of these projects individually is extremely time consuming. And big companies often don't report detailed information on all of their projects, the way a junior does for its one, key deposit. It's just not easy to dig into the "nuts and bolts" of a major.

To analyze major companies with large, complex property portfolios, analysts come up with short cuts. Easily-measured metrics that can be used to gauge the overall performance of a company across all of its mines. Often when it comes to large companies, these metrics are financial. Revenue growth, cash flow, after-tax earnings. But there are a number of geological indicators that analysts can use as well. One of the most popular is the "reserves replacement ratio".

Reserves replacement is a fairly simple concept on the surface. Just take a company's reserve additions in a given year and divide by the company's annual production. Let's take a quick example. Suppose Pierce Gold is a mid-tier producer. Over the past year, Pierce produced 2 million ounces of gold. During that same period, Pierce's exploration programs discovered a new, 2 million ounce gold deposit. Pierce also bought a junior company that owned a 2 million ounce deposit. The net result: during the year Pierce Gold added a total of 4 million ounces in new reserves (2 million discovered plus 2 million acquired). So Pierce's reserves replacement ratio equals 4 million ounces in reserves additions divided by 2 million ounces of production (reserves depletion). Pierce thus has a reserves replacement ratio of 2, meaning it replaced 200% of the reserves it produced. This is a very good figure. Any ratio above 1 indicates the company is growing reserves. A ratio below 1 implies shrinking reserves. And shrinking reserves do not bode well for the future of a producer.

Large companies (both in the mining and oil and gas sectors) often live or die by their reserves replacement metrics. Analysts are fanatic about this statistic. A good reserves replacement year is often rewarded by favorable coverage and good stock price performance. But if a company slips in replacing reserves, punishment in the stock market can be severe. Company managers therefore put a lot of time and energy into figuring out how to replace reserves.

Those managers got some help this week when Canada's Metals Economics Group (MEG) released one of the most comprehensive studies ever completed on reserves replacement strategies amongst the world's largest gold producing companies. MEG analyzed production and reserves additions for major gold producers during the decade from 1999 to 2008. The group came to some startling conclusions, with important implications for the future of the gold sector. Some of these findings also tie into themes we've been discussing in this letter over the past several months. Most notably, majors increasingly pursuing large deposits that are low-grade or engineering-challenged. It's critical that investors stay on the leading edge of these trends.

The Hidden Tax

One of the main findings of the MEG report is that replacing reserves is getting increasingly more difficult for major producers. A couple of key statistics reflect the problems majors are having finding more gold.

First is cost of replacing reserves. MEG found that over the past decade majors have paid an average $83 in combined exploration and production costs to replace one ounce of gold. This "replacement cost" more than doubled during the study period. This means majors are paying considerably more to add an ounce of reserves to their project portfolio than they were in the late 1990s. This "finding" cost represents a hidden tax on production, one that gets overlooked by many analysts. This is a critical concept that we've discussed a number of times in relation to other industries. Let's take a look at what it means for the gold sector.

Remember our previous example of Pierce Gold. We said that during the past year, Pierce discovered 2 million ounces of gold through exploration, and also acquired an additional 2 million ounces by purchasing a junior company. Now, suppose Pierce paid $100 million in exploration costs to discover the former 2 million ounces. That equates to $50 per ounce in finding cost. And Pierce paid $300 million to acquire the junior company with the 2 million ounce deposit. An acquisition cost of $150 per ounce. Averaging the discovery and acquisition costs, Pierce has an overall replacement cost of $100 per ounce of gold. Generally in line with the MEG findings ($83 per ounce average replacement cost across the industry).

Pierce now must make up for this cost when they produce the ounces. Suppose the company has operating costs of $450 per ounce, for labor, chemicals and electricity at its various mines. If the company is selling gold for $900 per ounce, the balance sheet would show cash flow of $450 per ounce. Relatively healthy. But in order to calculate the overall return on investment we have to add the $100 in costs paid to acquire the ounce in the first place. Bringing our "all-in" costs to $550 per ounce. Our "after-capital" profit has been reduced to $350 per ounce, a 20% reduction.

Usually, corporate financial statements don't account for finding costs. They simply show direct operating costs, and then subtract these from revenues in order to get cash flow. To torture our example just a little more, Pierce Gold's financial statements would show the company selling 2 million ounces of gold in a year, for revenue of $18 million (at a sale price of $900 per ounce). Cost of sale would be $9 million ($450 per ounce times 2 million ounces production). For a profit of $9 million.

But Pierce's return on investment is less than this. If we factor in the $100 per ounce in costs paid to acquire gold in the ground, Pierce is only making $7 million in profit. That's a $2 million reduction. This is a significant "hidden tax" on cash flows, one that does not show up when looking at conventional metrics. But it is crucial. If replacement costs for an ounce of gold rise too much, they could wipe out a significant portion of a producer's profits (more on that in a moment). If producers stop making an adequate return on capital, they will eventually go bankrupt as the money they're spending fails to generate productive returns.

Not Enough Gold to Go Round

Perhaps the most significant finding from the MEG study is that the gold industry as a whole is doing a poor job of replacing reserves. During the study period, 62 discoveries were made containing more than 2 million ounces. As a whole, these deposits contain an estimated 377 million ounces of recoverable reserves. Here's the bad news. Those reserve additions are less than half of the gold industry's total production during the same period. Exploration alone is generating a reserves replacement ratio of less than 50%. This is obviously not sustainable.

In fact, the picture is even bleaker. Of the new reserves discovered through exploration, more than 90% were reserves additions at existing mines or known deposits. Not true grassroots discoveries. With a rising gold price over the last decade, in-ground ounces that were low-grade or deep or had other engineering challenges became economic to produce. (With a high sale price, companies can afford to pay more to extract on ounce of gold.) This allowed companies to book millions of ounces in "new" reserves that had previously been booked as "resources" (that is, known but uneconomic). With the gold price now having "stalled out" around $900, the industry is running out of ounces to upgrade. This source of reserves additions will soon be tapped out (barring another significant rise in the gold price).

This leaves producers even more desperate to replace reserves. One option for replacement is through greenfields exploration in new areas. But this is a business that the majors are increasingly unfamiliar with. Over the last few years, majors have moved away from the expensive and risky business of exploration. In the last few months alone, there have been a number of layoffs of high-profile exploration staff at large gold companies. The message is, exploration is out. Companies are looking elsewhere for reserves additions. But where?

The answer seems to be better engineering. Gold producers are looking to regions and deposits that offer big in-ground reserves, but have been previously overlooked because of engineering challenges. In fact, this trend has been going on for some time in the gold sector. The development of heap leach processing unlocked huge, low-grade gold reserves that had previously been uneconomic. An engineering solution (sprinkling cyanide on massive ore piles) made it possible to process what would have been a money-losing deposit under conventional technology at the time.

Today, producers are being forced to look for new and more innovative engineering solutions in order to replace their produced reserves. One of the most interesting recent examples is AngloGold. Anglo traditionally focused on production in South Africa. However, the South African mines are old, and keeping them running meant going deep underground, at high capital and operating costs. Remember we discussed the idea of "all-in" costs, the amount a company pays in capital costs to access an ounce of gold (through exploration or acquisition), plus the operating cost required to extract the ounce. In 2008, AngloGold was paying $239 per ounce in capital costs to sustain and expand its mines in order to access new ounces. Combine this with relatively high operating costs of $444 per ounce, and the company was barely making a profit on each ounce produced.

Management realized this situation had to change. They could no longer afford to replace reserves by paying $239 (or more as time goes on) to deepen existing mines. The company set a goal of adding new reserves for less than $40 per ounce (less than half of the industry average of $83 that MEG found). Sounds great, but where in the world can you add ounces for such low cost? The solution was to go to a new area, Colombia.

One of the attractive things about Colombia is the country is a known gold producer. For a company like AngloGold, it was easy to spot regions likely to contain large gold deposits. One of these is the Tolima district, about 150 kilometers west of Bogota. For decades, everyone knew that gold occurred here. Exploration was of course limited by the Colombian political situation. But another reason that Tolima didn't have mining companies crawling over it was that gold mineralization here is generally porphyry-type. These deposits tend to be low-grade in terms of gold, relative to gold mines in the rest of the world. Not exactly the target most gold companies are seeking.

But this was exactly the type of opportunity AngloGold needed. By pursuing low-grade porphyry deposits that few other companies wanted, Anglo made it easy on themselves. They were able to acquire a huge package of exploration lands (at one point, the company had the rights to 7.5% of the entire country of Colombia!). And these lands had much better odds of discovery than other, more picked-over plays. This meant Anglo didn't have to spend as much on exploration in order to make a discovery. In 2006, the company had a worldwide exploration budget of $100 million. By contrast, Newmont spent $155 million on exploration that year, while Barrick spent $170 million. And Anglo came up with the biggest discovery amongst the three companies: La Colosa.

The La Colosa discovery has been a major success for AngloGold in terms of replacing ounces. The deposit now contains 13 million ounces of inferred gold resource. This is a huge deposit. (The company's next biggest development project is only 7.7 million ounces.) And La Colosa cost less than $50 per ounce to delineate. This is less than one-fifth the price Anglo was paying to add new ounces to its balance sheet at the old mines in South Africa. A major boost to the company's reserves replacement ratio.

That's the good news. The challenge is grade. The majority of Anglogold's mines in South Africa grade between 4 and 8 grams per ton gold. The grade at La Colosa is 0.86 grams per ton. That grade would be very manageable for an oxide gold deposit that could be processed by low-cost heap leaching. However, it doesn't appear that the gold at La Colosa is oxidized. The heap leach option is off the table. Instead, Anglo will have to build a conventional processing plant. At much higher capital and operating costs. Making this deposit work economically will require some skillful engineering in order to cut costs wherever possible. But this is a challenge Anglo is willing to accept in order to be able to book ounces in the ground and keep their reserves replacement ratio looking good.

This is the world we live in. With good gold deposits increasingly difficult to find, producers are going to continue moving toward low-grade (or otherwise challenged) deposits that offer significant scale. The drive to replace reserves is just too ingrained in executives.

BP's Big Book of Oil

This month saw one of the gala events in the petroleum sector. The release of BP's annual statistical review of world energy. Despite the dry-sounding title, the review is one of the most fascinating and comprehensive looks we get at the oil and gas sector (as well as renewable energy). It always contains some intriguing revelations. And this year was no exception.

One of the big "stunners" from the report was the fact that energy use in non-OECD countries overtook OECD energy use for the first time in history. The driver behind non-OECD use is of course China. Chinese energy demand was up 7.2% in 2008, accounting for 75% (!) of the overall global increase in energy consumption. For anyone who still doesn't believe that China is a force to be reckoned with in the energy markets, this was a major wake-up call.

The rise of non-OECD energy use isn't a huge surprise to anyone who's been following the data closely. Energy use in the developed OECD countries is extremely sensitive to economic conditions. It always declines during recessions. Non-OECD use, however, continued to rise during both of the last two recessions. The current recession is stronger than either of the last two, so non-OECD use has declined slightly, by perhaps a million barrels of oil per day since Q4 2008. But the fall in OECD energy use has been much more dramatic, about 4 million barrels per day.

Of this, about 2 million barrels per day of consumption has been lost in the U.S. alone. Western Europe has dived by half a million daily barrels (Europe has in fact been cutting back on its energy use for some time, with consumption running more or less flat since 1998). Energy use in Japan is also down half a million barrels, continuing a decline in the country's consumption that's been going on for the last 15 years.

Perhaps the most interesting question raised by the BP report is: where will growing demand centers like China get their oil from? World oil production simply isn't keeping pace with demand. And production is increasingly being concentrated in the hands of a few, key countries. Namely, OPEC.

OPEC nations were able to boost their production by almost a million barrels per day in 2008 (although they've since curtailed output in the face of falling oil prices). The worrisome news is what's happening throughout the rest of the world. Non-OPEC production fell by 610,000 barrels per day in 2008. This is the biggest decline since 1992.

More than half of the drop in non-OPEC output came from Mexico. Mexican production fell by 310,000 daily barrels in 2008. The country's output is down almost a million barrels over the last five years. Elsewhere, the story isn't much better. The only non-OPEC countries showing significant increases in production over the last five years are Canada, Brazil, China and Russia. And even Russian production has been relatively stagnant over the last few years as the country increasingly struggles to attract foreign capital and expertise. There just aren't a lot of places outside the Middle East with excess oil to pump.

The oil industry is at a crossroads. Much like the gold producers who are moving toward lower-grade resources, oil producers are going to have to increasingly turn to engineering to make up for lower discovery rates worldwide. Enhanced oil recovery through water and carbon dioxide flooding is one technology that could make a difference (a conventional well only recovers 20 to 30% of the total oil in place in a formation). As well as large-scale development of unconventional resources like Canada's oil sands.

Of course, all of this engineering costs money. It's going to take structurally higher oil prices in order to encourage development of these necessary technologies. The caveat being that some oil producing regions simply need better access to free markets. If state-of-the-art American technology was fully brought to bear on Russia, Venezuela and Mexico, a lot of new oil (and gas) could be unlocked. None of these countries will be opening up anytime soon, however. Leaving the industry to look for new solutions in the sandboxes it already owns.

Return to Asia

What a week! I'm settling in Vancouver after a 1200 kilometer drive last weekend. It also felt like I had 1200 boxes to unpack after the moving truck arrived (okay, not quite that many), but the work seems to be getting done and the new house is starting to feel like a home. It's simply great to be here. Vancouver is one of the world's premier cities, whether in terms of food, views or culture. There's always something going on.

Of course, Vancouver's other attraction is its proximity to the rest of the Pacific Rim. I'm soon going to be making use of this amenity, as my associates and I are planning a trip back to Asia in the next couple of months. The itinerary is already filling up, but if you're interested in meeting us while we're in Hong Kong, Tokyo, Shanghai or Singapore, drop me a note. We always try to be as flexible as possible.

We're also working on a number of other projects that have slowed over the last few weeks due to vacations, moves, etc. These will soon be "ready for prime-time", and I look forward to sharing more details with you as soon as I can. Judging from what I've heard from many of you, these services should be useful.

Once again, thanks to all of you for reading and making this letter what it is with all of your feedback. Your questions and comments always make my week more interesting. Keep them coming. In the meantime, have a great weekend and I'll see you next Friday.

Here's to replacing reserves sensibly.

Jun 19, 2009
Dave Forest
email: dforest@piercepoints.com

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