Market volatility sets the stage for price upswings as well as downswings, according to Michael Gray, equities analyst of Macquarie Capital Markets, and the recent gold price drop should be seen as a "pause" in the bull market. Management teams are pausing as well, to focus on earnings and shareholder return, rather than growth. In this interview with The Gold Report, Gray says this is the time to buy the best companies you can while they are discounted to fire sale prices, and he offers several names in jurisdictions from South America in the junior explorer space.
The Gold Report: On April 15, gold dropped to a two-year low as panic selling set in across many mined commodities. Was this the larger players showing the retail market who is in control or was it inevitable?
Michael Gray: Several firms have been predicting a mid-cycle correction for gold; it just happened faster and with more volatility than expected. It also seems to be a very well-timed short-selling trade, especially on the back of the positive gold price correlation with quantitative easing [QE] breaking down and reversing post-QE3. In addition, there was no response in the gold price to the debt crisis in Cyprus or political concerns with North Korea. This was an opportunistic time for the shorts to come in, and they did, forcefully.
TGR: Does this indicate that investors prefer equities to gold?
MG: Not necessarily. The gold equities have moved sharply down and most are now pricing gold at an implied gold price of $1,000-1,200/ounce [$1,000-1,200/oz] or less. There is some fear that the gold bull run is over, which explains why many institutional investors have been abandoning their gold equity positions.
TGR: Gold equities fell in lockstep with the fall in the gold price. Why?
MG: Gold equities have had an inverse correlation of share price: net asset value [P/NAV] versus the gold price since late 2009. Historically the senior gold equities have traded +1.2x P/NAV. Now we are looking at an average of 0.65x P/NAV among our senior gold producers. Essentially, investors are pricing in a much lower gold price on the forward curve.
As the gold price goes down, we believe investors will expect that the future gold price will drop as well. That is why the equities are trading in lockstep with the decline and have a much weaker response on the upside.
TGR: Has the drop in precious metals prices fundamentally changed the market?
MG: We have not seen this magnitude of volatility in this bull market up until now. It sets the stage for other big moves and for a more volatile market, perhaps including price upswings of similar magnitude. We think this volatility is ultimately good for the bull market.
TGR: Will it result in less gold being produced?
MG: The deferral of major capital projects and the number of projects that will be shelved because they cannot stand up to the stress test of a $1,200/oz gold price will limit growth among the senior companies. As that happens, we expect significantly less growth in the gold sector over the next five years if prices continue to lag or go sideways.
TGR: A JPMorgan Chase report dated April 16 said 10 years remain in the commodity supercycle and that the April 15 price drop was only a pause in the overall cycle. Do you agree, and what positives do you see as a result of the price drop?
MG: In general, we concur that this is a pause in the supercycle for metals in general, including base and bulk metals. China's growth being lower than expected shocked the market, at least in the short term.
The positives are that management teams are now less focused on growth and more focused on earnings and returns to shareholders-this could instill more investor confidence. It will take a few years, but having CEOs whose interests are more aligned with shareholders will impose more discipline among the producers.
TGR: In early April, Barrick Gold Corp. (ABX) once again delayed development of its Pascua Lama gold project in Chile. What are the likely ripple effects for Barrick and the sector?
MG: This is one of those situations where a company believed it had earned its social license after a long dialogue with the government and various nongovernmental organizations [NGOs]. Barrick likely felt it was crossing the finish line. Barrick is not alone in this situation.
For the gold sector it means management teams will have to look at large capital expense [capex] projects through a lens that captures extreme capex creep risk, in the case of Pascua Lama from less than $3 billion [$3B] to north of $8B. Going forward, project scale and social license risk will be key issues-only the best projects will be built.
TGR: Is Chile still on your list of preferred mining jurisdictions?
MG: It was until recently. Canada, Mexico and the U.S. are at the top. Recent developments in Chile and elsewhere in South America with community relations and NGO protests are cause for concern.
TGR: If Mexico, Canada and the U.S. are your top jurisdictions, what is the next tier?
MG: The next tier would include Chile, Peru and Turkey. In particular, Turkey is embracing foreign investment, has attracted a significant amount of capital and has a successful track record of mines being permitted and put into production.
In South America, Brazil can be also be an attractive jurisdiction, depending on the state. In Central America, we like Nicaragua. Nicaragua has been very politically stable in the past decade and is one of the few countries in Central America that has a stable mining policy and royalty regime. In Africa, Namibia, Tanzania and Botswana would lead our list.
TGR: Let's look at management teams. Cash is king for junior mining equities right now, yet some junior mining executives are collecting big cash salaries. Some shareholders think the C-suite is overcompensated. What do you consider a reasonable salary for a junior mining CEO?
MG: Management compensation has been a blind spot for investors in the exploration sector during this bull market, given that many management teams have created tremendous value for shareholders. The compensation matrices among peer groups have been driven by market capitalization: The more you could grow your company, the more you could convince your compensation committee to pay you.
The problem is that juniors with undeveloped resources trading at $1B market caps in 2011 paid dearly to attract talent or retain talent. Their base salaries in some cases exceeded $400,000 [$400K] plus similar size annual cash bonuses. Now those same companies have market caps of $200-300 million [$200-300M], yet the compensation levels have not changed. The G&A burn rate related to these salaries is significant.
To evaluate compensation, we look at where the company is in the exploration cycle and how much skin management has in the game. The $80-150K/year salary range has the right ring for a very early-stage explorer with no assets of retained value. Companies that have more advanced assets probably need to pay in the $200-250K range, plus bonus.
TGR: How do people find out that information?
MG: It is all disclosed in the annual financial statements and in the Management Information Circular on www.SEDAR.com [System for Electronic Document Analysis and Retrieval].
TGR: A story in Canada's National Post reported that CEOs and company presidents are more often fired in good times than in tough times because expectations are higher. Does that apply in mining?
MG: That comes back to investors focusing on returns and punishing the senior mining companies for poor leadership, including overpaying to acquire assets and the inability to control operating and capital costs. In the gold space, three CEOs have been fired in relatively good times for focusing too much on growth. The trend is now toward CEOs trying to focus on earnings, provide realistic guidance and, if possible, pay a dividend. Those are the leaders who will keep their jobs.
TGR: A recent Macquarie research report said, "The producers will rapidly pursue M&A of new 'grade A discoveries' if they emerge but are unlikely to pursue the large, capex-intensive B- and C-quality discoveries. In the meantime, the price will get lower and favor the producers that are patient and seeking smaller, strategic tuck-in acquisitions." What is a tuck-in acquisition?
MG: I would like to start by making it clear that "rapidly pursuing 'grade A discoveries'" means that if a junior has found another Kupol or Eleonore deposit, the type of precious metal high grade/high margin deposits coveted by the seniors, it will garner a tremendous amount of attention and probably attract a takeover bid before a resource is defined. This is what happened with Virginia Gold Mines' Eleonore discovery.
That is what I mean by a rapid move on what are clearly high-grade/high-margin assets because they are so rare right now.
TGR: And now, what is a tuck-in acquisition?
MG: A tuck-in acquisition is one that the market views as a relatively small deal, say, under $500M. It either fills a gap in the producer's pipeline down the line, or is strategic in consolidating a district in which the producer is already active.
TGR: If Kupol and Eleonore were grade-A discoveries, what are examples of tuck-in acquisitions? Would it be something like Grayd Resource Corp. [GYD-TSX.V] and Agnico-Eagle Mines Ltd. (AEM)?
MG: Yes, Grayd with Agnico in Mexico would qualify as a tuck-in acquisition. Extorre Gold Mines Ltd.'s acquisition by Yamana Gold Inc. (AUY) was a relatively small acquisition but meaningful to Yamana's growth pipeline.
TGR: Are other juniors developing candidates for tuck-in acquisitions?
MG: In that category, we like Midas Gold Corp. [MAX-TSX]. The company's Golden Meadows project in Idaho has more than 7 Moz gold in resources and a significant antimony credit. The company has issued a preliminary economic assessment [PEA] on the project. It is only trading with a market capitalization of $100M or so.
This would be an excellent tuck-in acquisition for producers looking for a +400,000 oz/year production profile, starting in 2018 or 2019.
We see Midas's Golden Meadows project as a Donlin Creek-type of setting, and published our belief that the potential endowment could ultimately exceed 20 Moz gold. Thus, in our view it is potentially a Tier 1 asset that already has 7 Moz documented, in a historic mining district, making it a brownfield site. The company is heavily discounted in value right now.
TGR: What progress has Midas made since you started covering it 18 months ago?
MG: The company has executed well the mandate to infill and expand the near-pit resources and establish resources that could be put into a PEA and eventually into a preliminary feasibility study. It has also conducted a lot of pragmatic consulting with the community and the NGOs.
Stephen Quin, Midas's CEO, has the perfect skill set for permitting and advancing the economics of this project given his past experience with similar projects.
The overhang is the perception that it will be tough to permit in Idaho and that production is a long way out in 2018. As a result, the stock has lagged over the last 12 months.
TGR: How much does the antimony credit play in the project economics?
MG: At the front end, the antimony credit is fairly important. I believe about 80% of the antimony currently documented will be produced in the first four years. This allows Midas to achieve gold equivalent grades that exceed 2.4 g/t, whereas the average grade in the first pit to be mined is closer to 2.0 g/t for the gold only. Therefore, the antimony credit is fairly important.
During World War II, Golden Meadows was mined for antimony needed to harden shell casings. Now antimony is used mainly as a fire retardant. About a year ago, antimony led the British Geological Survey list as the #1 commodity at risk. That is a compelling twist to the Midas story.
TGR: Where does permitting stand?
MG: The formal permitting process is called the Joint Review Process [JRP], which harmonizes the review activities of the state and federal governments. This process has not started yet; however, because Midas has completed a PEA study, it is able to start the informal process right now and consult with various stakeholders. We expect Midas may be in a position toward the end of 2013 to formally enter the JRP.
On a separate front, it is unfortunate that the U.S. Forest Service pulled back some of its drill permits on non-patented lands. Having to re-apply for those will delay exploration on the outer reaches of the property. There is no question that permitting in Idaho can take time, but in our view it is a question of when, not if, providing responsible plans are put forward and the process is closely adhered to.
We believe management has the right skill set to persist and earn the social license to permit Golden Meadows. This is a state with high unemployment and mining the brownfield site would actually clean it up. It is a good news story.
TGR: To value companies, you use a sum-of-parts NAV valuation system based on a 5% discounted cash-flow model. Using this system, what companies are among your top picks?
MG: We also use the forward curve and long-term commodity prices to value the companies where we are able to establish a discounted cash-flow model. When we see this much market volatility in the commodity prices, we tend to make more frequent adjustments to the forward curve we are using and to reset target prices accordingly.
Mirasol Resources Ltd. [MRZ-TSX.V] is one of our top picks among the companies we cover. [For more of Michael's top picks, click here]
Mirasol Resources is a cash-rich junior that has emerged in a very strong position through discovery and monetizing its assets. We estimate it has approximately $50M in cash and investments.
We like Mirasol because it has shifted its exploration focus to Chile and has identified what appears to be a large, high-sulphidation system. If Mirasol succeeds, this potentially large gold system will attract the seniors' interest. The project is very early and only trenched so far-we expect drilling in May and June-but the markers suggest that Mirasol could be onto a fairly significant new belt in Chile.
The company also has significant assets in Argentina, although they do not yet have resources.
TGR: Is there less pressure in Chile on smaller companies?
MG: As long as their programs are not huge, smaller companies are likely better able to fly under the radar. In the early stages, they do not have to negotiate for water rights or consult with the communities on a formal basis. That makes it easier.
At the same time, they have to pave the way for the ultimate developers to earn their social licenses. It is important that they execute on the ground at an extremely early stage by developing good relationships and respecting the community.
TGR: Access to water is one of the biggest issues in Chile. Does Mirasol have a clear path to water?
MG: The company has been somewhat cryptic as to the exact project location and has yet to conduct an analyst site visit. Our understanding is that Mirasol is still acquiring strategic land positions within this new belt.
TGR: When will that information be available?
MG: We are confident in the management team's ability to conduct generative research using satellite and Advanced Spaceborne Thermal Emission and Reflection Radiometer [ASTER] imagery to identify large alteration signatures. The company has homed in on a specific area with nine targets. As it goes forward to drill the initial targets in the next few months, I expect more visibility on the actual location and setting.
TGR: If you were a grief counselor for retail investors with positions in gold, how would you assuage them after the recent dramatic market events?
MG: Being one of those investors who feel the pain, I can empathize. It comes back to volatility. If you are convinced that the best companies will come out of this, when they are deeply discounted and you can buy them at what seem to be fire sale prices, you will be rewarded down the line. It also comes back to the potential swings in volatility we could see to the upside. That is why you want exposure to the gold sector, especially in equities, despite its downtrodden reputation.
TGR: Thank you for your insights.
This interview was conducted by Brian Sylvester of The Gold Report and can be read in its entirety here.
Michael Gray is a mining equity analyst with Macquarie Capital Markets and covers a range of precious metal explorers and producers with an emphasis on North and South America. He is an exploration geologist and holds a Bachelor of Science in geology from University of British Columbia and Master of Science in economic geology from Laurentian University. His career of over 25 years in the mineral exploration business started with senior mining companies including Falconbridge, Lac Minerals, Cominco and Minnova where he worked throughout Canada and the USA. He co-founded Rubicon Minerals in 1996 and helped navigate the company through a series of joint ventures and an asset portfolio build that was eventually centered on the Red Lake gold district in Canada. During this period, Gray was president of the 5,000 member British Columbia and Yukon Chamber of Mines for one year and on the executive committee for six years. Gray then joined the mining analyst world in 2005 where he brought to bear his technical skills to identify new precious metal opportunities at an early stage with outstanding exploration potential; he has covered a number of these opportunities that were subsequently taken over by gold producers.
1) Brian Sylvester conducted this interview for The Gold Report and provides services to The Gold Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
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3) Michael Gray: I or my family own shares of the following companies mentioned in this interview: Barrick Gold Corp. I personally or my family am paid by the following companies mentioned in this interview: None. Macquarie Capital Markets disclosures are available here. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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