Why senior producers will look to acquire juniors...
SENIOR Gold Mining producers needing to replenish depleted reserves will be looking to promising juniors to provide needed ounces, suggests Dave Goguen, director of institutional sales for PI Financial Corp. In this interview with The Gold Report, Goguen shares his views on where senior gold producers will be hunting in the risk-averse but increasingly gold-hungry world marketplace of today—and tomorrow.
The Gold Report: It's been a tumultuous year in the Gold Mining space. Maybe Gold Prices haven't hit the highs that we saw in 2011, but with prices currently hovering around $1,700/oz, most gold producers can make a profit. On the other hand, equities—particularly the mid caps, small caps and micro caps—have been decimated by summer doldrums or investor disinterest. PI Financial obviously sees opportunity in the mining sector.
David Goguen: A very good proxy for the senior gold companies is the Van Eck Market Vectors Gold Miners ETF (GDX). Going back 12 months from today, this ETF is down 23%. Over the same period, the Market Vectors Junior Miners ETF (GDXJ) is down considerably more, by 39%.
I think a key reason for the underperformance is due to the recent challenges that juniors have had to face in raising capital to fund continuing exploration and development. Historically, smaller and less liquid mining companies are hardest hit in a risk-averse, "risk off" market. The junior mining sector is delivering a lot of technical studies that have been underway for the last year. These studies will provide the insights by which investors will choose certain development projects over others as they assess capital cost of construction and project rates of return. This process will see investors supporting companies that they expect will lead the way in the next cycle.
TGR: You've predicted that some of these junior miners will have a recovery in the fall. Could senior producers that need to replace reserves be shopping for mid-size junior companies with promising projects to acquire? Do you see merger and acquisition (M&A) activity in the fall and going into 2013?
David Goguen: I agree that there will be mergers and acquisitions, driven by poor returns on some senior gold producers' larger capital development projects. Looking back on the second quarter reporting season that just ended, commentary reflects management and shareholder displeasure with the rate of return on some of the larger capital development projects.
Unanticipated project cost escalation due to increased capital expenditures (capex), schedule extensions, geopolitical risk has meant that the cost of executing on these construction programs exceeded what was originally factored into budgets by a very wide margin. The statement that "returns drive production instead of production driving returns" has become a new mantra echoing among senior gold companies. Projects are going to be assessed with a more critical evaluation of risk-adjusted returns, and capital allocation discipline is really going to be stressed.
We would expect greater scrutiny of some of the more marginal projects in the development pipeline, some of which may be put on hold or even canceled.
TGR: If senior companies use more fiscal discipline and scrutinize potential acquisitions more carefully, won't margins improve and financials look correspondingly better? Couldn't this be a positive thing for shareholders?
David Goguen: Fewer projects will satisfy the decision criteria for development and construction. With fewer projects launched and fewer marginal ounces coming on stream, there is going to be reduced supply in the global gold market. As development projects idle and the effects are felt in future production and global supply numbers, there will be a resulting reduction in gold supply or at minimum a reduction in future supply growth. This in turn should mean higher Gold Prices in the intermediate and longer term and should be positive for the junior gold companies.
TGR: What else will that mean?
David Goguen: In the past, the capital requirements and capital risk of developing larger projects—especially larger projects in remote locations—has been underestimated. As a result, the majors will likely look at smaller projects, instead of the larger ones previously targeted. These projects are potential producers of, perhaps, 200,000 to 400,000 ounces (oz)/year, instead of 500,000+ oz/year.
Their development cycle is shorter and their ultimate capital cost can be contained. These are the smaller projects held by some of the junior companies that we follow. Investors should focus on companies with projects that are amenable to phased development and can be scaled up offering smaller initial capital outlays and future expansions funded out of project level cash flows.
TGR: So the majors are going to be looking at smaller projects with lower capex requirements and higher margins, as opposed to pursuing larger development programs in more remote places with smaller margins?
David Goguen: Exactly.
TGR: Given that backdrop, in what parts of the world are majors going to be sniffing around?
David Goguen: We would focus on Latin American-based projects. Latin America has historically had one the highest allocations of exploration capital. PI Financial produces a quantitative research piece called "Select Golds" that focuses on Latin American precious metal companies. We examine advanced explorers, emerging producers and junior producers. We track their evolution and progression through each of those categories and into production.
TGR: In what countries?
David Goguen: We specifically like Mexico. The geology is excellent and continues to yield new discoveries both in precious metals and in base metals. Mining has a long history in Mexico. There is an ample skilled labor force and a strong network of technical suppliers and technical services. Permitting and mining laws are transparent with a record of fair treatment. Technical submissions and permit applications are responded to and processed by the various ministries in a timely manner.
Mining is socially accepted in Mexico. A good example of a city and a locale that provides technical services to mines and to development projects within the Sierra Madre is Hermosillo. Mexico has proven its ability to cater to companies that are developing assets there.
Brazil is also well regarded for supporting mining exploration and development. Processes for getting approvals are both well laid out and well understood. Brazil also has the bureaucratic infrastructure to approve permits. So, the path from development to production in Brazil is a relatively straightforward one.
TGR: Other than Mexico, what other countries do you particularly like in Latin America?
David Goguen: Nicaragua fits that description perfectly although those taking a cursory glance might conclude otherwise. The country, through its government and permitting processes, has been refreshingly responsive to junior gold companies' needs.
TGR: Moving to a more macro discussion, do you see a general and continuing recovery in the precious metals equities? What other macro indicators in your view portend continued recovery of the space?
David Goguen: High levels of global, unsustainable debt continue to support the upward trend in Gold Prices. Unfunded debt impairs the ability of countries to grow and erodes confidence in currency, whether that currency is the Euro or the US Dollar or something else. All the moves by the various central banks to effectively print money through bond purchase programs to keep the yields and the interest rates low just further debase currency. Many smart observers in the marketplace have recognized that gold offers protection from those activities. As it becomes increasingly evident that central banks have no intention of stopping the printing of currency, gold should continue to rise again.
This is a process that is not going to sort itself out in weeks or even in months. It's going to take years. While some of this pain is discounted in present valuations already, volatility will continue as the global central banks work their way out of this mess.
TGR: What a great summary by which to end our conversation. What else would you like to add?
David Goguen: Perhaps more than any other time in the recent past, the Q2/12 reporting season has cleaned the slate with respect to disclosures among senior mining companies, intermediates and even junior companies. This fundamental reconciliation of the challenges gold companies have had with their associated assets paves the way for better news going forward as these challenges are overcome. The prospect of better news is what we're starting to see get discounted in share prices, hence the sector is in the early stages of a move higher.
TGR: What new interest is there in the junior gold space from institutional investors? Considering that we have a cleanly set table, what different people are at the table than you've seen before?
David Goguen: The past six months have brought a kind of cleansing process to institutional portfolios. The shares of companies that did not meet expectations and projects that did not evolve as hoped are being sold. And the resulting proceeds are being reinvested in some of the better companies that remain. It is those better companies that we see now leading the market higher in junior golds.
TGR: Excellent. We and our readers value your comments.
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