High grade gold deposits in politically safe jurisdictions with supportive local governments, educated work forces, and convenient access to developed capital markets are often difficult to find today when everything that was easy to pull out of the ground has already been pulled out. Luckily, with gold prices reaching record highs, or at least a support level above $1500/oz, miners are feeling confident enough to venture into the outside world.
To boldly go where others have feared may not always yield the most promising results, as recent history has shown. Trading on the Toronto Stock Exchange are plenty of junior miners operating in politically risky areas of Latin America, Africa, and former Soviet Union states. These areas are often underdeveloped, and thus high-grade deposits can be found with relative ease after moderate infrastructure investments. Comparable deposits in North America would have been claimed long ago in with significant premiums. Management at these companies feel that they are able to work together with these local regimes better those who have failed. Financial incentives to ailing governments also help, whether they are lucrative royalties, infrastructure investments, or simply employing local workers. But sometimes, things do not go as planned; one only needs to look to the examples of Centerra Gold’s (OTCPK:CAGDF) instability during the political upheaval in Kyrgyzstan in 2010 or Rosia Montana Gold’s uncertainty in obtaining an environmental permit in Romania due to protests against construction on a historical tourist attraction.
The most recent and prominent example of the risks for mining companies investing in developing markets came from Mongolia, where the Mongolian government expressed an interest in increasing its stake in the massive southern copper and gold deposit Oyu Tolgoi. Two-thirds of the project is owned by Ivanhoe Mines (IVN), a Canadian company with a market capitalization of over $11 billion. The government owns the other third, and has an option to increase it to 50% in 30 years. However, its plan to prematurely increase its stake through negotiations sent a chill down the spines of Ivanhoe investors, forcing a sharp sell-off of Ivanhoe shares and shaking Mongolia’s reputation as an attractive emerging market for investors.
On October 6, 2011, the Mongolian government released a statement renouncing its previous intentions, allowing Ivanhoe shares to rally 20% in early trading that day and temporarily keeping Mongolia off the list of resource-rich developing nations wanting a higher share of the profits from foreign operators. However, other stories have not ended so happily.
A developing nation’s natural resources are both a source of pride and an important economic asset. Resource nationalism is the term used to describe the policy of governments to assert greater control over its natural resources, mostly from foreign companies that have made the significant and desperately needed investments to make those resources extractable. Once the facilities are complete and extractions are about to begin, governments step in to take a greater share of the cash flow, whether it is through new taxes, export quotas, enlargement of ownership, or outright seizure.
The windfall tax is a particularly popular tactic. It is levied by governments against specific industries during times when those industries experience record profits, such as now for miners when the prices of metals are rising, or for oil companies back when oil peaked.
In Peru, a major mining jurisdiction and the largest gold producer in Latin America, the election of leftist nationalist and former army rebel Ollanta Humala as president in June 2011, shook the confidence of investors due to expectations that he will shift business-friendly policies toward ones of greater government control. Things began falling apart immediately, when Bear Creek Mining saw its Santa Ana silver project, halted by the outgoing President Alan Garcia, after violent protests by locals in June 2011. The $382 million market cap company saw its shares drop 27% that day, after a nearly 50% sell-off earlier in the spring when protests first began. Bear Creek threatened legal actions against the Peruvian government, but this junior miner is unlikely to have significant sway in a region where even giants such as BHP Billiton and Freeport-McMoRan (NYSE:FCX) tread with caution. Other junior miners, such as Duran Ventures ($33.9 million) and Fortuna Silver Mines ($689 million) also took hits due to reminders of the geopolitical risk of operating in that region.
Another example from Peru is the new tax on profits on the mining sector that will bring about $1.1 billion a year in revenue. This is after extensive negotiations with foreign companies, who feared measures that would cost them collectively up to $3 billion, punitive enough to make their investments uneconomical. Even in Australia, a country many reasonably perceive to be as safe as Canada, the government contemplated a 40% mining tax in 2010. Luckily, the government reached a compromise with miners, softening the damage in ways such as raising the trigger point to 12% of the return on capital from the initial 5%.
Bear Creek was in crisis mode, as it had to assure investors that its main Corani project in southeastern Peru was not in equal danger. The company is almost a pure play on Peru, and thus after losing nearly 20% of its reserves in Santa Ana, it must convince investors that it will not lose everything else.
Junior mining companies accept that they must take on the heavy risks of operating in such a region in order to find new reserve needed to grow production in order to take advantage of the rising prices of commodities as well as to compensate for dwindling reserves in developed countries. Yet at the same time, these companies must command a significant valuation discount of 3%-10%due to the undiversified geopolitical risk. Investors are prudent to stay away from risky junior miners, especially ones that do not have extremely high-grade reserves and a record of local government cooperation with management.
For a junior miner to grow into a major like Goldcorp (NYSE:GG), it needs to have a lucrative flagship mine capable of providing stable cash flows to fund risky yet ambitious exploration projects and takeovers. Goldcorp had its Red Lake mine in Canada that was stable enough to support its expansion. Bear Creek’s Corani in Peru, may not do the same. For conservative investors, venturing into politically risky areas should be left to senior producers with portfolios diversified enough so that the failure of one project will leave only a small temporary dent on the company’s reserves. If a junior must venture out, it should partner with a senior through joint ventures or joint stakes in order to leverage the bargaining power of multinational firms. After all, one new tax, protest, or accident can end it all. In regions where the rule of law is subjective and free market principles are not upheld, seemingly air-tight contracts with governments may not be perfectly binding during regime changes or times when governments want to cover for budget deficits through tax revenue increases. Barrick Gold, even with its controversial North Mara mine in Tanzania, on the front page of the Globe and Mail’s Report on Business Magazine, will not face bankruptcy any time soon. But for a junior miner acting as a pure play on a geopolitically risky region like Africa, investors should not be so sure.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.