South African Gold Mining

The South African gold and platinum deposits are among the vastest and richest in the world.

Even after a persistent drop in annual production since the 1970s that has driven output down to an 85-year low, the country is still the second largest gold producer in the world. With gold and platinum prices breaching record levels every other day now, especially in terms of the struggling South African currency, you would think that investing in South African miners would prove to be a winning formula.

Yet many of the South African gold shares have all but sat out the bull market in gold so far.

Smaller producers are trading near their worst levels since 2000. Harmony is up only 100 percent since 2001. Same with Anglogold, which has been diluting their South African investments by investing overseas. Gold Fields is up a little better (200 percent) since 2001.

Still, these gains pale in comparison to the HUI (AMEX Gold Bugs Index), which is up some 600 percent; let alone some of the leaders of that group, such as Goldcorp or Agnico Eagle, which are up 800 and 1,300 percent respectively, since 2001. Or even compared to the gold price, which has more than tripled, and hence outperformed all of the South African producers.

Cue the South Africa Blackouts…

South Africa started experiencing “rolling blackouts” in late 2007 — due to an overloaded grid. The power shortage prompted the South African government utility, Eskom, which provides 95 percent of South Africa’s electricity supply, to halt all exports on Jan. 20. It didn’t help.

Five days later, the South African mining industry reported an emergency power outage that lasted several days — where all production was lost. The utility “indicated that the current quota of 90 percent of average historic electricity consumption will remain in force for at least five years, through to 2012.”

The problem of course is underinvestment, thanks to government planning.

Privatization of the utilities was warded off in the late ‘90s. The crisis was predicted as far back as 1998.

The move to rectify the situation has only begun, and 2012 is when additional power is expected to come on stream. In the meantime, businesses have begun to factor this into their long-term plans.

For One Company, There Was No More Postponing

On Feb. 25, after prepping the market for months, Gold Fields (GFI: NYSE) announced the impact of this crisis on its South African operations, which make up two thirds of its group production profile.

It expects production declines of as much as 25 percent this quarter, then 10-15 percent on a “steady state” basis thereafter. After considering its international operations, this translates into a 15 percent production shortfall this quarter, and afterwards management expects growth in its international assets to offset the decline and fill the void altogether. The company expects operating costs to increase by up to 25 percent this fiscal year, but gold prices are already up 50 percent on GFI averaged realized FY2007 prices.

Gold Fields is mothballing some capital expenditures, and shutting down six of 21 shafts at three of four mines in South Africa — and plans on shedding 6,900 jobs (10-15 percent of their work force).

In a teleconference, management said power has been tight for three years already, but Eskom’s latest announcements have acted like a catalyst, forcing the company to deal with their problems more or less immediately.

However, this news isn’t likely to have a significantly bearish impact on share values from current levels.

In fact these expectations have already been baked into the share price — and from here early investors could stand to see a 200 percent gain in the next two to five years.

The Bad News Is Already In

This is just the latest in a series of short straws that the South African miners have drawn, and that have worked to depress valuations in the segment. The first blow occurred in 2003 when mining companies in South Africa were required to give up 26 percent of their interests (over 10 years) to the locals — under the Black Economic Empowerment (BEE) charter. Since then the industry has faced several obstacles, from a strong Rand (2002-2004) to soaring labor costs, to safety problems at some mines.

Technically, the climax in bearish sentiment occurred in 2005. The current crisis is anticlimactic. Some pure South African players climbed right through the news.

That’s where I see a potential buying opportunity in Gold Fields…

The market is paying $110 dollars for each proven and probable ounce of gold in the ground owned by Gold Fields (GFI). That is less than half of what the market is paying for Newmont’s reserves — which boast lower grades and less potential to convert resources into reserves.

Just Comparing Values…

In terms of its overall “measured and indicated resource,” Gold Fields is trading at one-fifth of Newmont’s value.

At a $10 billion market capitalization the market values Gold Fields roughly equal to the intermediate producer Agnico Eagle, a Canadian company with about one fifth of the reserves, one tenth of the resource, and which will be producing at a quarter of the annual output that Gold Fields is producing, even after Agnico’s expansion program. In fact, Agnico Eagle is roughly the size of Gold Fields’ international assets.

At these prices, that’s like getting Gold Field’s South African operations free!

Lesson or Opportunity?

On the one hand, this situation demonstrates the difference between investing in gold and investing in gold shares. Buying gold possesses no risk other than the possibility that the government might take it away from you, or that the central banks might abandon their inflation policies. It is the ultimate risk-free investment, particularly in today’s ideological climate — with respect to monetary/banking policy.

Investors in gold shares are investing in a business, not a commodity. There are added risks.

So, if your gold shares are not outperforming gold, you are taking too much unnecessary risk.

On the other hand, this situation may well represent a small window of opportunity to buy some of the best quality mining assets in the world on the cheap.

Now, here’s a secret…

The gold shares that have outperformed gold to date are unlikely to outperform it from here on. You can mark my words.

The operating environment in South Africa may not be conducive to growth until 2012, when the new power generation plants are expected to be up and running. But given how tight supplies are already, it is likely that the price of gold will rise fast enough to make up for the lower level of output.

Moreover, the circumstances may finally provoke Gold Fields into an acquisition spree, as it has abandoned its focus and capital expenditure plans on some of its mines in South Africa.

I could think of two companies instantly that would make a good fit for their international portfolio.

Then again, its shares are so cheap it may represent a takeover target itself…

Ed Bugos
March 11, 2008

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