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By Julian Murdoch

Barrick Gold's (NYSE:ABX) bid to acquire Cadence Energy (OTC:CDSFF) surprised me at first. After all, Barrick is a gold miner, right?

The nature of the bid was surprisingly local. Cadence is a small oil driller; we're talking tiny. They produce 3,600 barrels of oil a day. I mean, why bother? The short answer is this: Barrick is thinking globally, and acting locally.

With this deal, Cadence becomes a captive producer of oil - the nominal barrel of oil flowing from Cadence's wells goes directly to Barrick. Absorbing all of Cadence's production would replace some 25% of Barrick's energy needs.

Interestingly, Barrick didn't stop with this one deal. Yesterday, Barrick took things a step further, announcing it would buy ALL of the adjacent oilfield assets from Daylight (OTC:DAYYF), one of the competitive bidders for Cadence. This puts another 900 barrels of theoretical oil per day at its disposal. Barrick now owns its own little corner of Alberta, Canada, spewing 4,500 barrels a day of oil for at least the next decade. It's the equivalent of a home owner, fed up with oil prices, converting to a wood furnace and buying 200 acres of forest to get off the grid.

Here's how the admittedly simplistic math works. Cadence sat on 18.2 million barrels of oil, with an expected cost of extraction of $20/barrel. Assuming the new acquisition has similar scale, we can do some simple math.

Let's say production stays flat at 4,500 barrels a day, and nobody takes Christmas off. Barrick can now count on 1.6 million barrels of oil per year, at a cost of $33 million. At spot (or even a year out, given the current long-horizon flat futures curve), Barrick would have to spend about $120 per barrel to hedge a future oil spike, or a fully collateralized $192 million. That's a whopping $160 million economic argument in favor of owning your own cow to forgo all that milk. Even if these hypothetical extraction costs are off by a few hundred percent, it's still a compelling argument.

Understand that these are back-of-the-envelope calculations with all sorts of problems. For one, the oil field has more than just light sweet crude (70% of the field) - it's got natural gas and ugly oil too. It's also the case that this raw production won't end up in trucks and literally get transported for Barrick's use. Instead, the production from Barrick's new Canadian energy operation will go out into the open market, and those proceeds will let Barrick purchase actual energy in the form it needs it, where it needs it.

But it remains interesting as a true economic hedge. Barrick (and many commodities players) is rolling in cash. It just reported quarterly cash flow in excess of $500 million, a 58% increase over last year. The real question management and investors face is what to do with it. They can't just magically get more gold out of the ground, so controlling their costs for the future is a smart move - after all, the whole reason their cash flow is so high right now is because their current costs for extraction haven't gone up in lockstep with the price of gold.

There's a good chance that this is the tip of the iceberg. Commodities companies have much in common. Whether they're extracting ore, oil or crops from the earth, they are fundamentally in the same business - they make big investments, they deal with big governments and complex policies, and they run massive hedging operations. While the cost for actually producing some commodities has gone up, the fundamental drivers for higher prices has been demand, so we've seen most producers trade in line with increases in underlying commodities prices.

 

Chart: Barrick Gold

 

Which puts many commodities producers in the same boat as Barrick. We've just witnessed a rash of exceptional quarters from oil producers. Even turbulent lovers Rio Tinto (RTP) and BHP Billiton (NYSE:BHP) have had tremendous profits - tens of billions of dollars in free cash (even if that hasn't been enough to keep their share prices up). If the major producers' share prices become depressed compared with their underlying resources, there's an incentive to buy back shares - something Exxon's  (NYSE:XOM) been getting a lot of heat for, as they dumped $8 billion back into their own stock last quarter.

 

Chart: Exxon and Crude Oil

 

If, by contrast, we see share prices relatively high compared with the underlying, there's incentive to do something better with the cash - make acquisitions.

 

 

Chart: Barrick Gold

 

Those acquisitions make the most sense when they leverage internal expertise (like hedging and infrastructure management).

So how do you play it? If you're willing to do the homework, the challenge is finding small-cap resource companies who may be undervalued relative to their reserves. That's what Barrick's doing. The trick is getting there first. There's some evidence that those smaller firms may have a hard time raising new capital for expansion, despite the boom in prices, meaning they'll need to merge or seek investment from the big boys to play in the game.

And energy is probably the smartest place to look. The Barrick investments are fundamentally about hedging energy - something big aluminum producers have been doing for ages, co-locating their facilities near big electrical utilities. It is an increasing consideration in ethanol plant development. The longer oil stays expensive, the more this kind of deeply vertical integration will make sense.

Source: Barrick Gold's Move Into Oil: Precursor to Commodities Consolidation?