STRAIGHT TALK ON MINING
No. 24
The Squeeze
Dr. Keith M Barron
May 23, 2005
You have to choose (as a
voter) between trusting to the natural ability of gold and the
natural stability and intelligence of the government. And with
due respect to these gentlemen, I advise you, as long as the
capitalist system lasts, to vote for gold. -George Bernard Shaw
The Squeeze
You can take your pick of reasons
to explain the current malaise in the gold share market. Among
the culprits named have been: investors exiting all equity markets
(not just gold), the annual "sell in May and go away,"
tax deadline selling of shares with flow-through benefits, and
the lack luster recent results of Newmont Gold - the list goes
on. Take heart, we have seen such things many times before in
this cycle and there's no reason to turn Chicken Little over
it.... I did a back issue search of the National Post
newspaper for the period of 2001 through today and the gold bull
was declared dead no less than six times! (June 26, 2001;
July 11, 2001; October 9, 2002; April 29, 2004; November 30,
2004 and April 18, 2005). Judging by the web traffic to Straight
Talk and new sign-ups to the email alert list, the interest
in matters golden is healthy and I suspect there are many people
out there contemplating some spring "bottom fishing."
Anyone remember that Donald
Sutherland movie, Invasion of the Body Snatchers? Where
at first everything looked right, but you had an ever more unsettling
sense that things were wrong? It's one of those devices of the
horror genre we have come to expect when we walk into a movie
house. One website described the movie thus: "The atmosphere
of dread and paranoia grows increasingly intense as the complexity
of the alien invasion is gradually revealed, until nobody can
be trusted to be who they appear." It's all good fun.
Headlines like "GM and
Ford bonds reduced to junk," "Congressional
budget office forecasts costs of Iraq war to top $80 billion
in 2005," and "UAL defaults on pension obligations,"
are in fact real horror. Folks ought to be outraged. However,
in this unfolding economic scenario, complacency is the order
of the day. We are all inured against headlines.
But... little personal signs
do indeed pop up regularly that all is not right with the real
world and I sense a growing pervasive feeling of foreboding...
in my case one of my latest was indeed a very little sign...
by the cash register at my morning coffee and muffin shop, which
apologized for the need to raise prices for the entire contents
of the store, in order to ensure continuing quality. We
adults all know that that's code for "the store is feeling
the squeeze" and so have passed higher costs on to the consumer.
In ancient Rome, religious
officials foretold events by observing and interpreting signs
and omens, often from nature. My favorite was the haruspex,
who foretold the future through "reading" the entrails
of various animals (some stock market analysts arguably use methods
not much more technologically advanced to forecast the market).
When the signs of trouble become more numerous and intrude on
everyday life it is time to start paying attention.
My public transit fare has
gone to $2.50 from $2.25. My morning paper is now 75¢ versus
25¢ last year. The cost to mail a local letter is up to
50 cents from 49. Every tiny mundane part of my existence is
becoming more expensive. Individually, these are minor annoyances,
but collectively they are starting to bite... not to mention
the bigger ticket items like a tank of gasoline, my utilities
bills, I could go on and on. Some clown came to my door last
night with dire apocalyptic warnings that I would freeze this
coming winter if I didn't sign up to his company's scheme and
"lock in" the price I pay for natural gas. All these
forces on the consumer I call the "little squeeze."
The little squeeze is important
to appreciate, because all those little squeezes compounded together
are causing people to make lifestyle changes and cut out those
little luxuries like a coffee and muffin each morning. Revenue
from movies is down 6% over this time last year. Notwithstanding
the Academy performance Paris Hilton no doubt put in (I have
not see her film) attendance has fallen off the table. Such omens
bode ill for elective spending and Christmas retail. The consumer
cannot ride to the rescue unless it's on a bicycle.
Everybody is in the squeeze.
Manufacturers pay more money for power, fuel and raw materials.
Already shaved to the bone, they can only absorb so much and
need to pass those costs on to consumers who have to incrementally
pay more for everything.
Gold Miners and The Squeeze
A look at recent headlines
makes it clear that gold producers too are in the Squeeze - BIG
TIME. Gold producers should be making boatloads of money and
they're not. How can this be so? Hasn't the gold price risen
from $US260 a few years ago to its present $US420 per ounce?
Why yes. So we have an apparent paradox. The factors affecting
the profitability of gold mining operations are not simply down
to the price paid by the refiners for each ounce of gold delivered.
Here's why:
Local Currency Fluctuations
The gold price miners receive
is dictated by the international market, and individual producers
can't tell the refineries they want more money for their product
- they have no price control, so unlike my coffee and muffin
shop, if their costs go up they have no way to pass expenses
on to purchasers. Moreover, the international price is quoted
in U.S. bucks, which is fine if you are a company with all your
operations (and costs) in the U.S., however if your mines are
in a country where the currency has been appreciating in U.S.
dollars you face a double whammy. Gold may be going sideways
or even down in terms of local currency while your costs are
inching upwards. A mine is a fixed asset; you can't cut your
costs by setting up elsewhere cheaper, like the numerous call
centers sprouting up in India, for instance.
If you look at the new crop
of annual reports you'll see most mining companies with operations
in several countries will make reference to "sensitivity
to local currency fluctuations." This is an analysis
of the impact of significant changes in currency exchange rates.
For instance, say the rand appreciates against the dollar, then
mining an ounce of gold in South Africa - in dollar terms - becomes
more expensive and your profit shrinks. If the rand drops against
the dollar, mining costs in dollar terms decline and your margins
improve. This is always important to understand because the amount
you will be paid by the refinery for your gold will be in US
dollars. Currency fluctuations by themselves are not going to
make a mine profitable or unprofitable, and there are other factors
at play (see below), but it has been perhaps the single most
important factor why gold miners have not been making big bucks.
Energy Costs
Mining operations are huge
consumers of electricity and diesel fuel, as well as significant
consumers of natural gas and propane. Everyone is acutely aware
how energy costs have gone up over the last calendar year.
If you are mining underground,
you probably have substantial costs to run the fans and blowers
that ventilate the mine. You may be using refrigerated air to
lower the temperature in the working stopes (especially in the
South African deep mines). You will be using electricity to haul
your ore and people up the shaft. You might have diesel scoop
trams moving the ore and waste around underground, or you may
have an electric car system. Your electric pumps work constantly
to keep the workings from flooding. In the South African goldfields
many of the underground workings are interconnected; meaning
that if your neighbor goes bust and pulls his pumps you will
probably have to increase your own pumping capacity to deal with
the excess.
If you are mining by open pit,
your haul trucks and shovels will be diesel or electric. It will
be costing you more to strip waste in the pit as fuel costs go
up. Most open pit mines like underground operations need to be
pumped to keep them free of water.
Almost all the mill equipment
is probably electric powered. We're usually talking here about
huge buildings stuffed full of crushers, agitators, thickeners,
ball mills, conveyors, cyclones, screening plants and other vital
equipment. If processing by heap leach, the ore needs to be crushed,
and pads stacked with broken ore either by truck, conveyor, or
combination of the two. Barrick Gold Corp. consumes between 1.3
and 1.5 billion kilowatts at their mines worldwide.
Rather than be at the mercy
of high fuel costs, Placer Dome, Barrick and Newmont are all
looking at becoming power producers themselves. Placer is considering
a 125 Megawatt coal fired plant at Pueblo Viejo. Barrick is building
a 115 Megawatt natural gas-fired plant at Goldstrike, Nevada.
They also have fuel and propane hedge (ewww there's that word
again) programs. Newmont has "advanced plans" for a
coal-fired power plant in Nevada and has invested in Canadian
Oil Sands Trust as a hedge against rising fuel costs. We can
debate the wisdom of gold miners entering the electricity generation
business.
Commodity Costs and Availability
of Materials
All the Senior Gold Companies
discuss supply chain management and sourcing of materials in
their recent literature. "Cost saving initiatives"
often figure prominently. In a typical mining operation there
will be considerable consumables, such as lubricants, reagents,
lime, acid, grinding media, and... rubber tires! Mining operations
consume huge numbers of rubber tires because the wear and tear
in the mine environment is considerable. The days of tapping
rubber trees are mostly over; tires have long been made synthetically.
Like anything petroleum-based they are becoming more expensive.
China's modernization has been
sucking up worldwide stocks of commodities like steel and metallurgical
coal. On the minesite, every piece of equipment made from sheet
steel, and every mine vehicle and piece of heavy equipment is
becoming more expensive, due to higher purchasing costs of steel
for fabrication. Structural steel and concrete figure prominently
in all mine and mill construction, as well as tailings dams and
impoundments. I have recently heard of situations where millsite
construction went way over time and budget due to skyrocketing
structural steel costs and simple unavailability. 2004 was a
year of tight supplies and inventory. February 2004 prices were
$432/tonne versus $740/tonne February 2005 for hot rolled steel
plate.
Concrete has become more expensive
because it is pricier to produce the aggregate and cement raw
materials. The kilns that calcine the lime used in cement are
often natural gas fired. US Concrete Inc. reported their first
quarter 2005 average selling price was 12.7% higher than the
same quarter last year.
I read a press release recently
where a company had announced that it had secured a long term
source of rubber tires for their mining equipment. Good for them!
(It almost sounds like WWII rationing is back.)
Increasing Costs of Labor
Downsizing is never popular
with workforces and as senior producers attempt to mothball or
close marginal mines and retrench miners they run into conflict
with labor groups made up of people who themselves are in the
squeeze. Harmony Gold has already been affected by a strike in
late March, and Gold Fields narrowly averted one.
Declining Grades
In the face of shrinking margins
Bobby Godsell of AngloGold-Ashanti has scheduled the company
for aggressive liposuction. I am not singling him out, but his
company has admitted to falling grade profiles. Many of the world's
gold mines and districts are simply getting old and tired. A
mine is a wasting asset that gets depleted over time. You can
do as much cost-cutting as you care to do, but there is only
a finite amount of gold in any mine.
For the period 1997-2002 there
was little exploration expenditure by the gold industry, especially
by junior companies, because venture capital was siphoned away
by the dotcom boom. The seedbed for new projects that is usually
provided by juniors simply was not there, and so the industry
is now playing catch-up, with worldwide gold production levels
still forecasted to fall. In addition, the M&A flurry we
saw worldwide extended into the gold mining sector and some companies
have been justly accused of robbing their orebodies to temporarily
get their production profiles up. High grading an orebody may
look great on paper to investment bankers but it can lead to
premature death of the mine. There are a number of new mining
projects in the pipeline, but we haven't seen many open in the
last two years.
The Bottom Line
As production costs increase
without a concomitant increase in the price of the metal, marginal
gold reserves become uneconomic. If the situation becomes serious
enough it can make a gold mine an unpaying proposition. To persist
in mining would be to throw money down a hole... literally. As
costs begin to take hold they can push ore out of the "reserve"
category back in the "resource" category, necessitating
companies revise their reserves downward. As one of my old professors
used to say, "if it can't be mined at profit, it's not ore."
The bottom line is that the
gold price needs to move higher to give miners a decent return
on investment. Nobody ever downsizes their way to success. Eventually,
mine closures would force the supply of new gold downwards and
drive up the bullion price, but that's not the route the industry
wants to go. Senior executives of mining companies need to focus
not on cost-cutting, closing down unprofitable mines, and building
power plants, but on marketing their product, maybe withholding
gold from the market, getting the World Gold Council to grow
a spine, and perhaps uniting with other producers in a cartel
- if that's what it takes. One thing that immediately comes to
mind is to loose the pit bulls on every politician who talks
about selling IMF gold. The public relations departments should
be hammering away relentlessly at these guys. This is becoming
a high stakes game of Survivor: Outwit, Outplay, Outlast - and
we may see mergers and acquisitions of distressed companies before
long.
Blue Skies for Miners, Storm
Clouds for Everyone Else
What I've laid out above sounds
pretty bleak, but I think that there are macroeconomic factors
that are just about to rescue the miners and propel gold prices
forwards. Just in the last few days we have seen evidence that
foreign governments are beginning to jettison dollar-denominated
debt from their currency reserves. Back in February a shudder
went through financial markets when South Korea merely mooted
the idea of scaling back their US dollar investments and diversifying
their foreign reserves. They quickly backtracked if you remember.
The big shocker in the last few days is release of data showing
that purchases of Treasuries by China have skidded to a halt.
http://www.ustreas.gov/tic/mfh.txt
A precipitous drop in the value
of the US dollar will cause trouble for miners if gold fails
to rise in other currencies, but this drop may be so deep and
profound to start a panic that will force other countries to
massage their own currencies downward. According to the German
Federal Statistics Office, March unemployment was a whopping
12.5% of the workforce. A huge spike in the Euro against the
dollar will only make this problem worse as it would choke off
the flow of European exports to the US.
The US is virtually powerless
to stop the bleed of investment cash elsewhere. Hikes in domestic
interest rates to protect the dollar would tank the economy.
There has been much table thumping by the US about the value
of the Yuan, but China has so far not been compliant and revalued
its currency upwards. Bush is still agitating for this to happen
but the Chinese certainly are not going to voluntarily shoot
themselves in the foot and make their own exports less saleable.
Bush has decided to turn this into a domestic issue and has taken
the predictable course of introducing protectionism. States like
North Carolina stand to lose 10,000 to 20,000 more textile industry
jobs this year says the Charlotte Observer, and so May
18th's announcement of new import quotas on Chinese-made apparel
raises no eyebrows. It remains to be seen if this is just the
start of a whole slew of new tariffs and trade barriers designed
to halt the flood of cheap goods from China.
So where is all this cash that
would otherwise be in Treasuries going to go? If you want to
clear out of the dollar and storm-proof your holdings the best
choice is to increase your bullion reserves.
The haruspex has his hands
full these days. No amount of chicken gizzard reading or crystal
ball gazing is going to accurately call this one, but it's clearly
time to start paying attention to the signs.
Geology 101
You may have seen an annotation
in tables of released assay results of "assays cut to 20
g/t Au" or something like that. What does it mean?
The distribution of gold in
a mineralized body, especially in veins is often not uniform.
The gold can occur in fractures, seams, masses, or small globs.
It can also be partially or fully encapsulated in other minerals
like pyrite. Sometimes gold can be in particles or nuggets that
are big enough to be seen with the naked eye. I've taken a photo
of a piece of high grade I found as a student on a field trip
underground at the Dome Mine in the early 1980's. The white material
is quartz and the black is the wall rock from the edge of the
vein. You can see some yellow gold in the quartz at the top of
the picture.
The non-uniform distribution
of gold you see is called the Nugget Effect. Large grains
or nuggets may contribute much of the contained metal in a vein.
A Problem arises when you want to properly extrapolate the gold
contained in a small sample volume, say a drill core, to a much
larger volume in a resource calculation. A second problem comes
from the sample itself and reproducibility of the result. You
could reassay the sample in my hand here and get results that
differ by perhaps 200%, depending on whether or not a coarse
gold particle ended up in the assay crucible. To get around this
second problem, explorationists will often ask the laboratory
to provide a "metallic screen analysis." Because
gold is malleable and soft it tends to get pounded into little
pancakes or smeared out in the crushing and milling equipment
labs use. When the material is then sieved and the finer fraction
sent to the assay furnace the gold particles could stay on the
screen and be left out. In a metallic screen analysis the coarse
gold is segregated from the fines and assayed separately. What
you get are two assay results: one for the coarse fraction and
one for the fine. This will give you a much better idea of what's
going on and how to further consider the results. The assay lab
I use has a great downloadable summary of coarse gold problems.
http://www.alschemex.com/downloads/newsletters/course%20gold%20problems.pdf
When it comes to reporting
the results in a press release, say in a drill intersection,
promoters are often loathe to take out or minimize high assays.
High assays after all attract market interest. Often high assay
spikes will be due to the erratic gold distribution in a vein
system. That's just the way nature does these things. However,
the high assay may not be representative of the vein that is
being sampled. In many scenarios it is desirable to use a "cutting
factor" or "top cut" to reduce individual high
assays before any grade averaging is performed. At the start
of an exploration program, or when doing regional work it is
inappropriate to cut the assays because not enough is known about
the gold distribution. However, if working in the vicinity of
a mine or in an established camp, there may be an arbitrary cutting
factor based on a traditional value used for the type of deposit
in the area. In a new area, when 1000's of samples have been
taken and a data base of values has been compiled a cutting factor
can be determined from statistical calculations. It's important
to use a cutting factor if your mineralization is prone to assay
spikes from high grade so that you conservatively estimate how
much gold you have in the ground; otherwise, production decisions
can be made on orebodies that do not contain enough gold to be
profitable. When an orebody is in production, the cut-off grades
will be fine tuned and adjusted to reconcile with the gold being
recovered in the mill.
Prior to mining of the HGZ
zone at the Goldcorp Red Lake Mine, over 85% of the drill intercepts
displayed visible gold. The historical cutting factor for the
mine was used on initial reserve models, but later when reconciled
against production figures was found to be underestimating the
contained gold. The cutting factor had to be revised upwards
not once but twice! Refinement of the cutting factor resulted
in the ore reserve grade increasing 20% from year-end 2000 (Sept
12, 2001 news release).
I've been doing some research
on some OTC:BB junior exploration companies lately and found
many disquieting things. I wouldn't want to condemn everyone
on the bulletin board, but I do find it a bit like the old Wild
West, with lots of factual inaccuracies, many outrageous statements,
and what appears to be a sad lack of market vigilance by regulators.
The offenders tend to be companies with their sole listing on
OTC:BB, not cross-listed juniors.
The annual spring gold
show in New York is just about upon us, and last year
I entered the main conference hall on one of the days to find
brochures placed on the rows of many chairs advertising an OTC:BB
company which claimed to be exploring for diamonds in eastern
Canada. I want to stress that this company was not registered
at the conference, did not have a booth, and had placed literature
in the hall in strict violation of the conference rules. The
brochure was astounding. There were photos of mining machinery
working in open pit mines (the company did not in fact own a
mine) and there was a beautiful scenic shot from Jasper National
Park in Alberta (which is in WESTERN Canada). No captions to
these photos, which led me to wonder what they were doing there.
Also no mention in the brochure of officers or directors of the
company, nor a corporate address - just the ticker symbol. The
worst offence was a shot on the front page of a handful of Herkimer
Diamonds.
Herkimer "diamonds"
are in fact ultra-pure doubly terminated quartz crystals which
are found in dolomite rock in upstate New York. They look like
facetted gems. When they were first discovered back around the
time of the American Revolution there was actually a plan to
use them to fund the Continental Congress. Wishful thinking.
The crystals are NOT real diamonds and have value only to collectors.
I've been to the Herkimer quarries a couple of times and here's
one from my collection. If you want something fun to do with
the kids this summer I highly suggest you make a visit if you
are in the area. But bring safety glasses and don't use claw
hammers from home to break up rock - they are too soft and the
steel will splinter! I've got a link to the Herkimer quarry below.
http://www.herkimerdiamond.com/hdmstart.htm
Now, the exploration company
never made any claims that these were diamonds, nor that they
came from their property; but gosh, what the heck were they doing
in a brochure in the first place??! Do yourself a favor and do
some investigation. A simple look at the SEC filings of many
OTC:BB companies will enlighten you. If they were in the food
services business last month and now in the gold exploration
business, with the same officers, directors, and principals,
I'd steer clear.
http://www.sec.gov/edgar.shtml
*****************************
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May 20, 2005
©2005 Keith M. Barron Ph.D.
kmbarron@straighttalkonmining.com
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