In Spite of Rising Gold Price, Credibility of Junior Gold Miners is in Question

Many resource investors had expected they would be able to retire when gold reaches its all-time high of $850. It appears that few, if any, were able to do that in November when gold finally touched that level. While gold reached an all-time high, few gold stock names managed to do the same. Smaller juniors mining companies, in particular, failed to live up to the expectations priced in by investors and remained laggards.

We see several reasons for this: rising production costs; aggressive feasibility study assumptions; a worrisome number of start-up productions problems; and even resource data falsification. Unfortunately, these negatives are not happening to the small and unnoticeable companies, but the sector “blue chips” (those companies with over one billion dollars in market capitalization).

Production costs are rising for a vast majority of producers. Only a few companies have been able to stabilize or reduce their production costs in the past year. To add to that, recent events in the mining sector undermined management credibility and weakened investor confidence in the whole sector.

First, Southwestern Resources (SWG) announced that it had determined that there were errors in previously reported assay results for its Boka Project and as a result, it withdrew all of its previously announced results for the project. Southwestern Resources was covered by many respected analysts and newsletter writers. When the stock crashed from $15 in 2006 to most recently $0.59, this caused the first crack in investor confidence. Can resource companies be trusted when assay results may be false or misleading?

The second hit came from a number of junior producers, and especially, the famous multi-bullion Gammon Gold.(GRS) The company started production in 2007 and the cash costs were beyond disappointing. In fact, they were losing money on mining gold and silver. This was in some ways justifiable as start-up production can be challenging. Yet the company continued to promise improvements with every press release but none have come to date even after a change in management. The feasibility study promised the project to be highly economic at lower metal prices. But so far, the Ocampo project has been anything but profitable and the Gammon Gold stock fell from over $18 in early 2007 to under $8 today. The result: investor confidence in many junior producers has been shattered.

Novagold (NG) is the most recent disaster. The blue chip development stage copper-gold focused company announced a suspension of construction at Galore Creek since it had determined that the project was uneconomic at current consensus long-term metal prices. The 2006 feasibility study estimated $1.74B in capital costs and called for production to begin in 2012. The new estimate projects $5B in capital costs and 18-24 months longer in construction time. Could costs rise almost three fold in just one year or were assumptions used in the feasibility aggressive or misleading? The company’s explanation does not sound reasonable, which is a contributing factor to why the stock price was halved in just one day.

As a result, the RSG Gold Exploration II Index, which consists of 26 companies with established resources having demonstrated economic viability, a performance leader until recently, has now become a laggard. The index is flat for the year, while gold is up 23%.

click to enlarge

A noticeable underperformance of the Exploration II index when compared to the Gold Bugs Index (HUI) began in August, as is clear from the chart below. The first leg down was reasonably explained by a lack of liquidity and flight to safety. In September, the index staged a strong rebound before getting hammered on the Novagold news.

A sharp second leg down occurred mostly due to Novagold, which had the largest market capitalization in the index and was therefore, the largest component in the Exploration II Index. But even excluding Novagold from the index, similar Exploration II companies got hammered by association.

There is a striking similarity between the recent events in the mortgage/banking industry and the developments in the junior mining industry.

Despite the fact that the two industries are positioned on completely different ends of the investment spectrum, both are highly dependent on their ability to effectively raise large amount of capital and therefore, on the integrity of their collateral. For the mortgage/banking industry, collateral is financial paper (Mortgage Backed Securities and Asset Backed Securities) backed by underlying properties and creditworthiness of the homeowners. For the junior mining industry, “collateral” is the in-ground resource supported only by technical documentation (technical reports, feasibility studies, etc.), the quality and reliability of which is essential.

When the integrity of the paper-documented underlying assets is suspect, it is very difficult for either industry to raise capital and continue operations. For the junior exploration and development stage companies, the ability to raise capital through debt or equity offerings is absolutely essential for financing their expensive exploration programs as well as for mine development and construction.

The reputation of the whole junior mining industry has come under question following the events described above. As a result, credibility and the track record of the companies’ management are now more important than ever. Greater transparency and better communication with investors are the first two steps that need to be taken in order to start rebuilding trust in the industry. The recent announcement by Gammon Gold that the company will issue ongoing monthly key performance indicator updates is a step in the right direction. We hope others will follow suit and help restore investor confidence.

Comments

[cheapybob:]

Ok, try again in Q4 with gold averaging $100/oz higher. It won't fix the problems of NG or GRS, but that and increased production will fix the HUI dog GSS, or any other producing gold miner.

2007 Dec 06 05:56 AM

[cheapybob:]

Gold is $100 higher in Q4. It won't solve problems for miners like DROOY, NG, or GRS, but it will turn lemons into lemonaide for the likes of GSS or any other laggard that has improving costs and production.

2007 Dec 06 05:59 AM

[SHARKTOOTH:]

Excessive stock options for management have ruined many a business--and today have ruined the objectivity of many, many managers in zillions of companies, including mining!

2007 Dec 06 07:13 PM

[MrSaito:]

The author's analogy of "recent events in the mortgage/banking industry" and the junior gold mining sector is flawed because even if one concedes the similarity in the method for raising capital, the scope and magnitude of the mortgage/banking situation is far deeper, more widespread, and insidious. SIV's and CDO's are off-balance sheet assets floating around out there, who knows where until a bank absorbs them into their balance sheet. Mining companies assets and liabilities are there for the investor to examine. The strength of their management team is easily assessed, as is the political and environmental environment in which the mining company operates - I don't see bailouts from governmnet making their way to mining. I don't see contract law being ignored. This is article is at best poorly researched and at worst alarmist and irresponsible.

2007 Dec 24 06:30 PM