For David Baker, managing partner at Baker Steel, the gold market is at a watershed and miners need to change soon if they are to stay afloat. An interview with the Gold Report.
Author: Brian Sylvester
PETALUMA, CA (THE GOLD REPORT) -
The Gold Report: The major gold producers have ceded market share to gold exchange-traded funds and royalty companies and are vastly underperforming those investment vehicles. If you were running a major gold producer, how would you go about restoring the appeal of your company's shares?
David Baker: Mining companies need to restore trust and give more clarity. They are confusing investors because on the one hand they tell us they have so many ounces of gold in reserves and are producing so many ounces of gold, and then they confuse us by benchmarking all this to dollars—a depreciating asset. We believe the mining companies should be consistent and report in gold; this would then give investors a clearer picture on how much gold it is costing to mine the resource and how many ounces of gold are added to the shareholder vault.
There are a number of challenges out there; first is the issue of the dollar cost inflation. When measured in dollars, the capital and operating costs of a mine have gone up, but when measured in gold, costs are fairly stable. Back in 2008 when gold was $800/ounce ($800/oz), a 100,000/oz per annum gold mine would typically cost $80 million ($80M) or 100,000 oz, today that same mine will cost around $170M, again around 100,000 oz. In dollars, costs are up by over 100% but in gold ounces they are steady.
We are using the wrong measure of costs; we are using a depreciating asset—dollars—to measure costs instead of a real asset, gold. So by mixing dollars and gold we are confusing investors. Now if costs in ounces had risen, we would have a serious problem! To compound the issue, analysts are forecasting higher dollar costs and lower future gold prices. Put these together and this spells a potential margin squeeze. Under this scenario, a new gold project has little value, and the shares get de-rated.
Second, the gold exchange-traded fund (EFT) has outperformed the gold equities; how do we reverse this trend and convince investors to sell some of their EFTs to buy a gold share? As it stands today, if you sell your gold ETF to buy a gold share, what you get is a company who digs gold out of the ground, brings it to surface and then converts it back to dollars, which when you think about it, is not what the EFT holder wants. We believe gold miners need to give investors gold, not dollars, and they could start doing this by reporting in gold, holding gold on their balance sheet instead of dollars and paying a gold royalty or gold dividend.
TGR: Even if companies do put their gold production on the books, they're still going to need to liquidate some of that gold in order to meet day-to-day expenses.
DB: That is exactly right, but the balance should be held in gold. When we analyze a typical gold mine, it takes about 10% of the deposit to build the mine, 40–45% of the deposit to mine it, about 15% to pay government taxes and maybe 5% for sustaining capital. The balance, 20–25%, is the return and instead of selling this for dollars, the mining company should hold these gold ounces on its balance sheet.
Why is this a good idea? First, it makes no sense to sell an appreciating asset for a depreciating one; second, holding gold instead of dollars will also preserve the purchasing power of the company. A mining company with gold in its vault and lucky enough to discover a new gold project will no longer face a problem of capital cost inflation. As explained, capital costs are fairly stable in ounces and account for around 10% of reserves. Holding gold on the balance sheet will also act as a new source of demand, keeping more gold off the market. Gold producers should then start to emulate the ETF.
Companies should review their mission statements; they should change it ''to build and grow shareholder value expressed in ounces of gold.'' This will give management more focus and investors greater clarity.
TGR: When you bring up this idea to boards of gold companies, what's their response?
DB: I would say that overall we are getting a very positive response; they like the logic and it is certainly stimulating debate.
There is clearly an appetite for gold projects. We can conclude there is a market for this model. Unfortunately, when gold companies sell a royalty to the royalty companies, they have been giving real margin to the royalty companies, and shareholders have ended up with less. Just look at the difference in share price performance of the royalty companies and the gold miners—it says it all. The gold companies don't give away much and they hope shareholders hardly miss the 1.75–2% of the gold they sell, but the royalty companies have made a great business out of this.
There is an understanding that something has to change, that the business model isn't exactly working for gold equity investors—we are giving our margin to others. We argue that royalties should also be paid to current shareholders of the mines. It doesn't have to be much, say 2–2.5% of the gold mined, but this will link the gold in the ground to what the shareholders get; there is then a tangible way to define what an increase in reserves means to the value of the company. After all, I tell the mining companies, "When you're going down to your pit and you do 20 shovels to put to the mill, all you have to do is one-half to one shovel to shareholders. It's not too much to ask."
TGR: How far off is that?
DB: We're starting small. We have confirmations that the strategy will be discussed at board level for a number of companies with the view that they will adopt these policies, so we are getting traction. They are listening, but it is hard being the first mover. Our aim is to allocate funds to those companies who adopt our strategies.
In a nutshell we need to restore the trust between the mining companies and investors and we believe our strategies are one way to do just that. The miners have to be held to account.
TGR: There's precedence for this. After gold reached its all-time high in early 1981, a number of companies started forward-selling their gold so they could better control their costs. Shareholders ultimately were the benefactors of that. They've done it once before, so it can be done again.
DB: In the 1980s and 1990s, the gold price was falling and the dollar was rising. It made every sense that once you dug your gold out of the ground, you converted it straight into dollars. It was such a convincing trade that people were selling gold they had yet to mine to convert into dollars, and that was the advent of forward selling. It took about 10 years to get it entrenched that the gold price was falling, and the dollar was rising. We then took 10 years, from 1990 to 2000, for everyone to get on the trade and forward sell. At the bottom of the market, there were well over 3,300 tons gold forward sold.
TGR: Practically all production.
DB: It was over one year's annual production. Now the situation has reversed; the gold price is rising and the dollar is depreciating, and this should continue as long as the central banks carry on printing more and more money. Over the last 10 years, gold has been rising at around 15% per annum, so we are now just getting the hang of this trend. We have to become gold centric; the miners need to be forward buying gold (holding gold on the balance sheet) instead of forward selling gold. The dollar period was the 1980s to the 2000s; now we're in a gold period.
TGR: Some countries are doing that. China has dramatically increased its gold imports from Hong Kong, putting it ahead of India as the world's largest gold consumer.
DB: Many central banks are printing money. They're trying to get their currencies cheaper than others so they can capture market share and generate growth, the so-called currency wars, but they all know that if everyone is printing money, they cannot all devalue against each other. They have to devalue against something, and gold is a currency that can't be printed. So these central banks are starting to see the writing on the wall, and they're buying physical gold, converting dollars and buying gold. That's a positive. That's going to carry on. But nothing goes up in a straight line. At the moment, we're going through this consolidation, which has felt as if it's lasted forever. It's probably been about two years. Hopefully, we're coming to an end of it.
In the last 10–12 years, we've seen cost inflation of 12–15% and the gold price running up at a similar rate. If you forward sell $300M of gold, and gold continues to rise at the same pace it has over the past 10 years, then in a couple of years, the cost of this debt is going to be greater than 100%, simply in the lost opportunity cost of not being able to sell gold at market. A disproportionate share of our projected returns will either end up in money heaven through the lost opportunity of forward selling or to the bank through fees—again shareholders are short changed. Investors have cottoned on to this and are deserting the developers in droves.
TGR: Baker Steel funds have underperformed in lockstep with gold equities. What approaches are you employing to offset the recent dismal performance in gold equities?
DB: The market is very cheap. A lot of resource companies are trading on single-digit multiples, whereas the market as a whole is trading at 15–20 times multiples. Gold equities used to trade at a premium to the general market but are now trading at a significant discount. That's the opportunity. We're looking for well-managed companies and companies that are diversified and well capitalized.
Our focus is the mid-cap, 400,000–600,000 oz (400–600 Koz) gold producers that have two or three operations, with potentially a growth asset as well. We've built up a nice portfolio of these. Unfortunately they still haven't caught traction in the market; you can buy these companies for around 6–8 times price-earnings ratio. They're very cheap.
TGR: Do you visit the companies?
DB: Yes, last year I went to Chile, Sudan and the Democratic Republic of the Congo (DRC) and others in our investment team travelled to Papua New Guinea, Africa, Indonesia and other sites. We do a lot of due diligence.
TGR: You have investments in what would be classified as safer jurisdictions, like Canada, Mexico and Australia, but you also have investments in places with greater risk, like South Africa, Eritrea and Zimbabwe. Would it be fair to say that when Baker Steel is evaluating a potential asset, it doesn't put as much emphasis on jurisdiction risk as it does on potential return?
DB: We risk adjust all of our investments; we are interested in risk-adjusted returns. For example, we would place a higher discount rate on a mine in Zimbabwe. Zimbabwe producers have been completely de-rated by the market, to the point it probably couldn't really get much worse. In an effort to survive, many of the Zimbabwean companies have had to modify the way they do business in an effort to make their model work. They're starting to produce gold at relatively good costs. There are still some political issues, but you can buy these assets for 10 cents on the dollar. We're putting in just enough money that if we get it right, investors will be glad. And if it doesn't go right, it's not going to be so big a deal for us.
TGR: Are you bullish on platinum?
DB: You have to be positive on platinum, given the problems in South Africa and the challenges that the platinum producers have there. I don't think there can be a lot of downside in the platinum price. If there's not a lot of downside, presumably there's some good upside.
TGR: Thank you for your insights.
David Baker is a managing partner at Baker Steel and heads the company's Sydney, Australia, office. Prior to founding Baker Steel in 2001, Baker was part of the award-winning Merrill Lynch Investment Management natural resources team, successfully managing the Mercury Gold Metal Open Fund, the largest precious metals fund in Japan, from its launch in 1995 until his departure in 2001. Prior to joining MLIM in 1992, Baker was a gold and mining analyst for James Capel Stockbrokers in London from 1988 and held a similar role at Capel Court Powell in Sydney from 1986 to 1988. Baker started his career in 1981 as a metallurgist at CRA Broken Hill, Australia. He holds a degree in mineral processing and a master's in mineral production management from Imperial College, London.
This article is an edited version of the original and is published here courtesy of The Gold Report ~ http://www.mineweb.com/