Stress-testing junior gold miners

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Interview by Brian Sylvester of The Gold Report

The Gold Report: We last talked in April 2012. What has happened in the junior mining market since then and where is it headed?

Barry Allan: Defining junior mining as single-mine producers and exploration companies, the sector has been decimated over the last 12 to 18 months. We’re still in a period of skepticism and suppressed valuations. That will continue for the balance of 2013 and perhaps into 2014.

However, in spite of this general malaise, the entire sector isn’t going to hell in a handbasket. Good companies can still conduct business, raise money and advance their projects. We suspect that in 2014 the market will be a bit more palatable, but not offer a dramatic shift.

TGR: In 1999, you watched the gold price hit a low of $252.80/ounce ($252.80/oz) and until 2004, struggle to rise above $300/oz. How is today’s market for precious metals equities different?

BA: The protracted bear market that led to the bottom of the gold price was a steady grind down from the end of 1997.

That is not the case now. We remain in a bear market, but the price drop has been rather moderate. That is not a very bad gold price environment compared to where we were back then.

There’s more optimism, in that gold — the amount of bullion held in exchange-traded funds (ETFs) — remains at a very good level. Bullion has reasserted itself as a legitimate asset class.

TGR: The Federal Open Market Committee meeting showed strong support for tapering quantitative easing due to an improving U.S. economy. Can a steadily growing U.S. economy and a rising gold price coexist?

BA: It should be entirely possible. One of the big concerns about the future of the bullion price has been what happens in the event of sharply higher interest rates in the U.S.

We expect bullion to show better resilience in this environment because of the emergence of other world economies — China being the primary example, but also India — that have stated the importance of bullion to their currency holdings.

I anticipate that while a higher U.S. interest rate and a stronger dollar will have an impact, it won’t be of the magnitude that it would have been 10 years ago.

TGR: What will be the key price drivers for gold over the next 12 months?

BA: In North America, real interest rates and the performance of the dollar will be the drivers.

But the caveat is how the China sovereign entities respond. Their stated goal is to diversify out of currencies and into bullion. If we see this transition of money out of gold ETFs, it is likely to move into the hands of the world’s sovereign funds to diversify their currency risks. As a result, we anticipate a more balanced market overall.

TGR: And silver?

BA: When you correlate silver with gold, you get an R-square of 0.94 over the very long term. Short term, the only thing you can say about silver is that it sometimes lags or overreacts to the gold price. Fundamentally, if you’re positive on gold, you should be positive on silver in the short term. By short term, I mean up to six or nine months.

TGR: Will silver’s run carry into the fall?

BA: Most probably, yes. If history repeats itself, as it often does, silver will lag and then overreact. Silver is like a sign-wave around the long-term gold price, but overall the two are very closely aligned. I fully anticipate silver will overreact, then come into line.

TGR: Intierra Raw Metals Group reported that only $2.28 billion ($2.28B) in mining finance was received in Q2/13 compared with $6.12B in Q2/12. Another $5.16B was raised in Q1/13. How is Q3/13 shaping up?

BA: The gold price has shown some life; the equities have shown more life than commodities. We fully anticipate that Q4/13 will be better than Q3/13. The current quarter will be consistent with Q2/13. Getting into Q1/14, we anticipate another uptick.

TGR: If you weren’t optimistic about the fall and 2014, would you be doing this interview at all?

BA: Probably not. We’ve done our analysis and we see some light in bullion. The gold industry doesn’t work at a $1,000/oz gold price. In 2000, the industry didn’t work in a below-$275/oz gold price environment.

In the shorter term, this is a period of seasonal strength, and the gold price is following a very consistent, seasonal pattern.

Through to Q1/14 we have at least a short-term trade in a market that has been otherwise negative. In the longer term, we are pretty comfortable that we will not be in a sub-$1,000/oz gold price environment.

TGR: Yet you and your team at Mackie have published a no-nonsense report, evaluating precious metals companies using $1,000/oz gold and $18/oz silver. The report put companies into three categories: Thrive, Survive and Die. What sort of response has the report generated?

BA: We did the report as a direct response to the investment community. Everyone was concerned about which companies could survive a sharp downturn in the bullion price. We wanted to be succinct, hence the rather dramatic categories and the title, “Thrive, Survive or Die.”

“In spite of this general malaise, the entire sector isn’t going to hell in a handbasket. Good companies can still conduct business, raise money and advance their projects.”

We’ve heard from a number of third-party information distributors, such as Bloomberg, that the report had the highest readership for the week in which it was released. Our own website shows that to be the case. From the investment side, it was well received.

People on the company side were very mindful of what we were saying. We received direct responses from each company in the Survive and the Die categories, recognizing our comments and addressing the issues, explaining what they are doing in response to the questions that the report posed. The companies were reasonably open in recognizing that they have issues and are addressing them.

TGR: It must be nice to be relevant in the conversation.

BA: No doubt about it. The renewed interest in the investment community compared to 12 months ago is gratifying.

Average investors are severely underweight in gold stocks. They’re very sensitive about it; they recognize that gold equities have come off a bottom, and they’re concerned about being underweight.

TGR: Let’s get to some of those companies starting with the Thrivers. It’s a short list.

BA: It is a short list, and the macro point to be taken from its brevity is that the industry can’t stay intact at $1,000/oz gold and $18/oz silver. The industry will need to restructure to be functional in the longer term.

The companies categorized as Thrives will stay intact. Their balance sheets are comparatively strong. They have mines that work at lower commodity prices. They can generate positive free cash flow even after capital expenditures, which means they won’t have to shut down mines or defer development expenditures.

TGR: And what are those names?

BA: In the senior category, the most dominant is Goldcorp Inc. (G:TSX; GG:NYSE). Goldcorp has stayed in there, not completely unscathed by a lower gold price environment, but in Q2/13 nothing shifted fundamentally for Goldcorp compared to its competitors. It also has some development projects that have positive rates of return, projects you’d still build at $1,000/oz gold.

TGR: Those projects being Cerro Negro in Argentina, Éléonore in northern Quebec and the Cochenour expansion at Red Lake in northern Ontario. Which excites you most?

BA: I didn’t really rate them in terms of excitement. Cerro Negro in Argentina has more political risk than Eleanore or the Cochenour expansion, both in Canada. Cerro Negro is a good quality project, which is needed because of the 30% inflation rate in Argentina today.

In addition, El Sauzal in Mexico is coming to the end of its mine life, as is the Porcupine operation in Ontario, both of which would be on care and maintenance at $1,000/oz. Goldcorp is not without certain mines it needs to deal with, but that doesn’t fundamentally alter the company overall.

TGR: Other Thrivers?

BA: In the senior category, we felt that Kinross Gold Corp. (K:TSX; KGC:NYSE) would survive reasonably intact. This is more of a judgment call because the company will have to face issues such as the probable need to close Maricunga in Chile — a fairly low-grade operation. It also will probably have to defer Tasiast; it just doesn’t work.

Those strategic calls aside, Kinross’ balance sheet is in pretty good shape. Its operations are performing reasonably well, and, with the exception of Maricunga, it can continue to operate at $1,000/oz gold. It isn’t as strong as Goldcorp, but compared to its compatriots, the changes at Kinross aren’t as dramatic for the overall corporation structure.

“The rays of hope are already evident in the marketplace. While it feels like a bear market in gold and gold equities, it’s not.”

We also flagged Eldorado Gold Corp. (ELD:TSX; EGO:NYSE), with the recognition that it would have to defer capital programs on its development projects, a move it has already announced. Eldorado realized it couldn’t develop all of its assets simultaneously, that it needed to be more scheduled in planning its forward operations.

AuRico Gold Inc. (AUQ:TSX; AUQ:NYSE) is a much stronger Thriver. The company has a lovely balance sheet. Its assets work at $1,000/oz. There is nothing it really needs to do. It can thrive intact without really any major issues.

You can make a similar argument for Argonaut Gold Inc. (AR:TSX), with the slight caveat that it needs to sort out its new acquisition, the Magino mine, from the Prodigy Gold Inc. (PDG:TSX.V) merger. We don’t know what Argonaut intends to do there. At $1,000/oz gold, the easiest and most logical thing is to defer it.

TGR: Does Argonaut have the management team in place to figure out Magino?

BA: It certainly has the operating history and the personnel in place. Argonaut hasn’t said anything publicly about its plans for Prodigy.

One of the themes that came out of our $1,000/oz assessment is if you’re talking about a hard-rock, 1-gram deposit in Canada, you are likely to have a hard time at $1,000/oz gold.

TGR: In Q2/13, Argonaut’s El Castillo mine produced 4,000 oz more gold than your forecast. That is obviously good for Argonaut, but does Mackie prefer to underestimate or overestimate?

BA: We prefer to be more conservative in our forecasts.

Argonaut tends to optimize and to be on the higher side of our expectations. That reflects the company’s conservative approach to communicating production guidance. That’s a good thing. The market will always give you kudos for achieving or exceeding expectations. If you continue to underperform your guidance, the markets will discount you.

TGR: Where will Argonaut’s growth come from?

BA: Right now, we’re testing the models for survival at $1,000/oz. We’re not even talking about growth in this scenario.

Argonaut has consistently optimized its existing operations, and it continues to do its business well. It has an open issue related to permitting at San Antonio to resolve, but overall we anticipate more optimization of existing assets. If Argonaut does take on something else, as it has done with the Prodigy asset, we would look for it to have a methodology or strategy.

TGR: Any more in the Thrive category?

BA: Among the smaller companies, we included Klondex Mines Ltd. (KDX:TSX; KLNDF:OTCBB), an operation in Nevada that is not yet in production. It is in a situation with spectacularly good-grade material.

TGR: What do you make of the grades the company is reporting at Fire Creek?

BA: Grade was the biggest overhang on the Fire Creek property. If I go back two years, when we first started talking about Klondex, the concerns were about whether the asset was as high a grade as it drilled out to be and whether it could be mined as an underground operation.

Klondex had to address both concerns. The first bulk sampling targeted the better areas of the resource, where the material extracted exceeds 2 ounces/ton. The grade seems to be there. The question now is what will it show on a higher-volume basis?

TGR: Klondex is trucking gold-silver mineralized ore to Newmont Mining Corp.’s (NEM:NYSE) facility. What do you think of that model?

BA: It is not ideal. Custom milling is never the preferred way to go because trucking adds to the cost base and it is a more expensive way of processing ore.

However, the presence of surplus milling capacity near Fire Creek underscores that Klondex may never have to build a mill. While using someone else’s mill increases operating costs, it diminishes capital costs. The sole capital cost is in the underground mining.

We will have to wait for an updated resource to know if this asset justifies building a mill. Is there enough material to justify the upfront capital costs to build or buy and transport a new mill relative to the operating cost? If the answer is no, milling capacity nearby makes it possible to generate positive cash flow without building a mill. That’s the unusual aspect of the Fire Creek property’s central location in an established mining area. The company really has options.

TGR: What other companies are you following?

BA: We’ve been involved with Probe Mines Limited (PRB:TSX.V) for some time. What started off as something that looked like a better-quality 1 grams/tonne (1 g/t) bulk mining, open-pit deposit has morphed into what is likely to become a high-grade underground mine that will grade somewhere between 6 and 15 g/t. As subsequent drill results have confirmed, there is a very high-quality component to the resource — better than 10 g/t — that allows Probe the flexibility of investigating a smaller-scale, higher-grade development scenario. It would have a smaller footprint and a more affordable up-front capital cost. And interestingly, mineralization remains open. It has been one of the better gold discoveries in years.

TGR: What characterizes a company in your Survivor category?

BA: The Survivors are companies that will need to make material changes to endure at a $1,000/oz gold price. That means some hard choices: restructuring the balance sheet, deferring or cancelling development projects and/or closing existing mines that contribute to the production profile.

TGR: A couple of those names?

BA: The most high-profile is Barrick Gold Corp. (ABX:TSX; ABX:NYSE). Recently, the company has talked about removing its debt-repayment burden in the short term where its balance sheet was a bit stretched. The bigger issue is understanding what certain assets really do contribute to the bottom line. In our research, we identified assets in Australia and Africa, along with some copper assets. The biggest hurdle for Barrick right now is its Pascua Lama project in Chile and Argentina.

These are major structural elements. It probably will be another six to nine months before we really know how Barrick will get through this transition phase. Pascua Lama is unlikely to be addressed before 2014.

TGR: Is it time for Barrick Chairman Peter Munk to go?

BA: I don’t know how much of the current decision-making process he influences. Has he not been closely enough involved? Was the board not as attuned to what was going on as it should have been? I don’t know, but clearly there has been fault.

TGR: Can you give us some names in the Survivor category with market caps in the $200M range?

BA: We don’t have many at that market cap. The closest would be Teranga Gold Corp. (TGZ:TSX; TGZ:ASX).

TGR: Teranga recently acquired Oromin Explorations Ltd. (OLE:TSX; OLEPF:OTCBB). What are your thoughts on that merger?

BA: It was long overdue. At a $1,000/oz gold price, Oromin’s project should not proceed on a standalone basis. It makes good sense for Oromin to blend with Teranga and use its infrastructure to process the Oromin ounces. The merger is accretive by any measure and is a good move by Teranga and Oromin.

Of course, there will be issues to deal with, including the other joint venture partners in the Oromin joint venture group.

TGR: What are the cash costs?

BA: We haven’t seen those yet, post-merger. The whole dynamic will change.

All upfront capital costs will be avoided, in the range of $350 million. There is no need to build a mill, so upfront capital costs will trade off against the costs of transporting the material to the Teranga mill. Overall it will be positive.

If I were to speculate, it might mean slightly higher than average operating costs compared to the Oromin feasibility study, but upfront capital costs will be limited. No matter how you cut it, the overall economics should be substantively better.

TGR: How about with Survivors with a market cap below $1 billion?

BA: Primero Mining Corp. (PPP:NYSE; P:TSX) is an example. Its rate of return on the newly acquired Cerro del Gallo project drops below 10% on an internal rate of return basis. Primero would have to restructure and/or rethink its project development at Cerro del Gallo. Its San Dimas mine would operate fairly well at $1,000/oz gold, but developing Cerro del Gallo would stretch the balance sheet in the short term.

TGR: Would the Cerro del Gallo project have similar cash costs to San Dimas?

BA: Unfortunately not. That’s part of the issue. San Dimas is largely under control and operating quite well. But the capital burden of a new project at a low rate of return is on the cusp at $1,000/oz gold price. Ten percent is not enough to go forward. That’s a heart-wrenching decision.

TGR: Goldcorp owns about 31% of Cerro del Gallo. How does that stake play in all of this?

BA: I can’t speak for Goldcorp, but the relationship between Primero and Goldcorp has been fairly close. There will probably be some restructuring of Goldcorp’s interest in Primero or perhaps outright monetization, although the capital markets would not allow that right now.

TGR: The Royal Bank of Canada recently rerated Primero from a Sector Perform to an Outperform rating. What do you make of that?

BA: I suspect it has everything to do with the good performance of the San Dimas mine.

For a company of this size, Primero has done a good job of taking an asset that initially had a low profile to come out into the public market as a standalone entity. After the IPO there were a few bumps and grinds before the mine started to live up to market expectations. It also has silver, which is sold through to Silver Wheaton Corp. (SLW:TSX; SLW:NYSE). Overall, Primero has done very well and ultimately rewarded shareholders.

TGR: Can you give us a couple of names that did not survive the $1,000/oz gold and $18/oz silver stress test?

BA: The one we’ve been focused on for some time is Lake Shore Gold Corp. (LSG:TSX). The company has a heavy capital program that will end in December. But it also has debt obligations with some fairly lofty covenants, which it is starting to repay. Using our forecast of $1,000/oz gold, come December, the company will be out of cash. Indeed, even with a gold price between $1,300–1,400/oz, it will have limited cash at year end.

Its debt obligations mean the company will need additional financing as a bridge. But if you already have a pretty aggressive debt structure in place, short term and long term, how do the secured lenders approach this?

TGR: It’s not the only name having similar issues.

BA: Yes, other companies of similar size operating in the area face similar issues. Their assets are not generating positive free cash flow and they have very little latitude in what they can do without additional financing.

TGR: Aside from Thrivers, Survivors and the Dead, do you have any wisdom for gold investors looking for a few rays of hope?

BA: The rays of hope are already evident in the marketplace. While it feels like a bear market in gold and gold equities, it’s not. It is has been a fairly aggressive correction, but it’s not the doom-and-gloom type of bear market of the past.

The market has accepted physical bullion as a legitimate asset class. While there are some “challenging” gold equities, others have conducted their business well and are in good shape.

Longer term, we will need to see bullion show a positive investment environment in a higher interest rate environment and a higher dollar environment, but that’s a fight we’ll take on late next year. For now, we are happy to enjoy seasonal strength.

TGR: Barry, thanks for your time and your insights.

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COMPANIES MENTIONED: ARGONAUT GOLD INC. : AURICO GOLD INC. : BARRICK GOLD CORP. : ELDORADO GOLD CORP. :GOLDCORP INC. : KINROSS GOLD CORP. :KLONDEX MINES LTD. : PRIMERO MINING CORP. : PROBE MINES LIMITED : TERANGA GOLD CORP.