Monday, 10 December 2012

The hard life of a mining investor

Mining Shares versus Precious Metals

The precious metal side

Investing in precious metal bullion is relatively easy: you have only two (or three including platinum) metals to choose from. Coins or bars makes little difference: the premium is higher the smaller the item.
Precious metals investing in the larger sense may turn out to be more difficult or treacherous.
  • Bullion ETF's are the more obvious alternative and fluctuate in lock step with bullion. There is however a small yearly fee, part of which is paid to the custodian holding the gold (or other precious metal). Investors cannot be sure their gold-paper isn't leased out to provide an extra income for either of the parties involved.
  • Investors depositing their gold in a bank may turn out to have unallocated gold, which will be leased or sold if the bank is placing a short bet. Recovery will take persuasion to convince the bank and patience to allow them for taking delivery on a future contract and return physical gold bullion. 
  • Leverage kicks in on futures and investors need to be aware of contango and backwardation. Finally the cash on your futures account is only as safe as your broker is reliable; future investors with MFGlobal have experienced this most vividly.

The mining side

All of the above seems a piece of cake when compared to the more difficult way to get rewarded for your faith in the precious metal bull market. To make it in the hornets nest of mining investments requires insight, strategic vision, conviction, nerve, tenacity ... and luck. You will need all of those to deal with the risks inherent to the world of mining.

Location issues

You may find Precious Metal Mining on all continents and throughout many countries. Some areas have been scoured for precious metals since centuries, other (more hostile environments) have been left relatively aside. All precious metal ore bearing areas have one thing in common: a past of volcanic activity is necessary to potentially enable the concentration of precious metals. As continents shift, prior volcanoes may move away from the hotspot that created them. The mountain ranges erode and precious metals may be found at much shallower depth than where they were deposited in the first place. As an investor you don't need to deal with these geologic issues, pertaining to the world of mineralogy. Yet while investing in gold explorers, you will need have faith in the competence of the team who should know all of this in much more detail.

"Location risk" is determining whether a project can be viable or not. Remote areas without electric power, roads, all season accessibility are a considerable drawback. In desert areas, the need for a sufficient water supply to operate a mine may be problematic. On the other hand, proximity of existing mining operations is an asset, since invariably most of the above will have been dealt with. As an investor these can be factored in  easily when checking out where the miners develop their next generation exploitations.

"Political risk" is a different type of "location risk". It may have many appearances, going from ever lasting permitting procedures, starting with genuine environmental concerns, local pressure groups invoking environment reasons to object against a project, hostile behaviour of locals with a tradition of illegal small scale mining, changes in taxation (federal or local) to bribery or outright extorsion and nationalisation. There are no mining areas absolutely free from all of the above. It's up to the diplomatic talents of the mining company management to figure out whether the political hazard is a surmountable hurdle in building an economicly sustainable mine and if so to carry it through in the best possible way.

The MMM's

In prior paragraphs, management skills already came up several times. That's why Management is the first of the MMM's. Mines only come next and are of a similar importance as Money. Good managament will carry on only with mines offering the outlook of several years, preferably decades worth of profitable production. Their mining plan will include a realistic budget and they will be able to stick to it. They will not sketch a too rosy estimate concerning the scaling up of production and the time necessary to become cash-flow positive.
Management of precious metal mining majors will need to provide for replacement of the quantity of reserves exploited. Mineral reserves are a "wasting asset". Postponing the development of resources available into new reserves and/or delaying the acquisition of such resources will inevitably lead to existing mines nearing exhaustion, resulting in cash costs per ounce escalating.
During past periods with high explorer valuation, mining companies often overpaid to acquire new resources. More recently, several explorers have been bought out at the cheap: think of Extorre, bought by Yamana or Silvermex bought by First Majestic, just to name a few.

Mines come in different forms and sizes, much of which is related to the geologically determined form of mineralisation. It is now generally acknowledged that every new generation of mines contains lower average gold grades than their predecessors. While problematic in the long run, this does not create a competititve disadvantage to starting up new exploitations. Many of the mines having been operating since a decade or less are of the open pit type, where low grade gold bearing porphyry is exploited. Grades allow a profitable exploitation because digging a tonne of ore is fairly cheap and because secondary metals (often copper) may provide an extra revenue covering most of the operational cash costs.
All gold isn't created equal either: when present in sulphide layers, gold particles may be extremely tiny, preventing the more common metal extraction techniques of milling and sedimentation or centrifugation to be effective. Chemical leaching using cyanide solutions may dissolve gold from the ore, provided it is milled down fine enough. In some cases an autoclave method will need to be applied on an ore concentrate to free up the gold inside stubbornly hard sulphides. One needs to be aware that the gold recovery rate and the ore treatment cost balancing one another, depend significantly on the chemistry involved. Exploiting ores below several grammes per tonne may be prohibitive if this complex chemistry is involved.
Stripping ratio is another issue to consider. This is the amount of ore, when compared to the quantity of waste rock that needs to be removed to get at the ore layer. Evacuating ore and rock through a set of horizontal tunnels leading to a valley also is cheaper than lifting everything through a vertical shaft, yet topography doesn't always allow a cost effective alternative.

Money is less of a problem for larger mining corporations with several profitable operations. They have a more easy access to capital markets allowing them to take on more debt when considered useful. Smaller miners will need to address their banker(s) and borrow on less favourable terms or look for alternative financing through forward selling of production or selling a stream of secondary metals to a royalty company. All of the above need to be balanced against raising new capital. Until few years ago this has been relatively easy, yet capital markets seem to have dried up and at least have turned very risk averse.
Despite gold around $1700/Oz, mine developers calculate in much lower future gold prices (ranging between $1100 and $1300) for determining the economic potential of their future mine. This "better safe than sorry" approach prevents marginal depostis from entering into production.
The upper decile of gold mining costs mainly consists of older mines, nearing the end of their economic lifecycle. Mining costs are escalating as ore needs to be transported from ever deeper and further veins. Eventually stockpiles of low grade ore left aside when treatment was not economicly viable are also sent through the production chain whenever spare capacity is available. Marginal pits only survive by the grace of sustainably high gold prices.

In terms of supply response to a prolonged negative price shock for precious metals, the situation now is fundamentally different than the one in the last two decades of the 20th century. The 'discovery cycle' has just begun to bear fruit and a considerable number of resources are yet to be developed. The capital expenditure needed is considerable and rising investment costs entail high risks of budget overruns. It is clear that these extensions of production capacity are likely to be 'mothballed' should we face a lasting decline of gold prices. At the opposite end, there are but few recent mines that may recur to 'high grading' to temporarily boost the gold quantity produced, thus keeping up the revenues necessary to compensate for fixed asset depreciation and to pay down debt (the way it happened during the late 1990's). On the contrary, written down mines with high and escalating cash costs would most likely close down much sooner than anticipated. This may send the gold producton capacity into a decline which is difficult to reverse.

The tactical issues

No doubt there have been periods when mining investors were richly rewarded for their bravery. When carefully choosing the time horizon, mining shares have outperformed bullion dramatically as I've shown before. See: Miners relative to precious metal prices: a tactical approach. Unfortunately this all comes to timing: being in too early ruined your outperformance, likewise holding on too long. The HUI index relative to Gold shows how mining shares fare and when they outperform or underperform gold bullion. The long term figure (1996-2012) in the above article shows that the major HUI outperformance is in fact concentrated in the first few years of the gold bull market, running till December 2003, with HUI/Gold peaking at 0.638.
On a regular basis, a 6 month graph with daily observations is shown on the gold miner pulse blog page. You will notice that on Dec 7, this ratio stands at 0.254. For a long term investor, the message is clear: December 2003 was the time to switch from mining shares to bullion without looking back.

Traders will tell you a different story: for over four years, it was possible to trade the HUI/Gold ratio, switching from bullion to mining shares and back as either one seemed relatively overvalued. The 2008 financial crisis brutally ruined this game, driving gold mining valuations back to those of the turn of the century. Mining investors ultimately were left holding shares worth only a few dimes on the dollar.

Almost predictably, this created a major opportunity for the brave mining investors during late autumn 2008. The story ran to end 2010, with HUI/Gold peaking at 0.425 long before the HUI index topped out early September 2011. In vain, investors hoped for the previous HUI/Gold trading range to establish itself. Instead mining shares have grossly been underperforming bullion.

Mining investors should have been gladly locking in a decent gain on their holdings, as gold bullion rallied from around $1350 in November 2010 to its peak early September 2011. They certainly have leveraged down the loss incurred by bullion sliding towards end 2011. Unfortunately 2012 brought more misfortune. Despite the September recovery, miner valuation is once more abysmal.

Doing better than the HUI index over the last two years has been possible. It's been a winning game for the few astute investors intelligently allocating their capital to the market outperformers. Unfortunately the odds are against you. Taking the set of Canadian miners and explorers in the Gold Miner Pulse database as a reference, this is easy to check: on the Miners news page, the top graph shows the quintile of best performers. These best 20% miners and explorers have at least realized a gain since November 2010, if not outperformed precious metals. Unfortunately, there are only few and tiny gains in the second quintile; in the third quintile the median loss currently amounts to about 40%. It illustrates the dire situation miners have gotten into, despite high precious metal prices.

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