why there will be more m&a in au sector

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Posted to the web on: 28 December 2005
Soaring gold price no boon for producers
Bernard Simon

Financial Times

The price of gold has doubled over the past five years, so it stands to reason that companies that dig the precious metal out of the ground must be laughing all the way to the bank.

They are not. Even with gold at more than $500 an ounce, “the margins are not great”, says Bruce Alway, a senior analyst at GFMS, a London-based research group.

That paradox helps explain Barrick Gold’s pursuit of its Vancouver-based rival Placer Dome, and a drive throughout the industry to grow in ways that improve profitability and replenish reserves.

Placer agreed to an improved $10,4bn offer last week, setting the stage for Barrick to overtake Newmont Mining of Denver as the world’s largest gold producer.

While Barrick CE Greg Wilkins exudes confidence on the gold price, he says that the challenges facing the industry “are only going to get harder, not easier”.

Wilkins says building a new mine costs at least $500m, with most projects now in the pipeline running at $1bn-$1,5bn.

Regulatory approvals have become more complex and time-consuming. Environmental safeguards are more costly.

“We need to have a company that has the strength, breadth and scale to capitalise on the opportunities,” Wilkins says.

But strength requires more than sheer size. Even the industry’s giants are struggling to lift profits at a pace close to the gold price.

Newmont reported virtually unchanged third-quarter earnings. Profit at AngloGold Ashanti, the number-two producer, were almost 40% lower in the first nine months, measured in US dollars.

The same inflationary pressures that have helped lift the gold price are also pushing up costs. Newmont blamed a shortage of underground labour and higher diesel and other commodity prices for a 24% jump in third-quarter costs at its Nevada operations.

“There’s a limit to what you can achieve by synergies,” says Alway. “You’ve still got to drive trucks and shift soil.”

The strength of the Australian, Canadian and South African currencies has eroded margins of mines in those countries, eating into local currency revenues.

Hedging, popular when gold was in the doldrums in the 1990s, has now become a drag on profits.

According to GFMS, Barrick and Placer combined would have the largest hedge book in the industry, accounting for about 40% of the global hedged position. Both companies have significantly reduced their positions this year.

Perhaps the biggest benefit of mergers and acquisitions is the ability to replenish reserves, a crucial measure of a gold producer’s long-term growth prospects. As one executive puts it: “The bigger you get, the more you need to replenish reserves.”

Barrick mined 5-million ounces last year, but expanded its reserves by only 3-million ounces. While Placer has increased reserves 60% over the past five years, Barrick’s reserves have expanded only 8%.

The soaring gold price has fuelled a global exploration boom.

Metals Economics Group, a Nova Scotia-based consultancy, estimates that spending on gold exploration has trebled in the past three years, with gold making up 47% of the $4,9bn spent on mineral exploration this year.

But Jason Goulden, a Metal Economics analyst, notes that “when you take over a junior exploration company without proven resources, you’re taking over a fair amount of risk”.

By acquiring Placer, Barrick will boost its reserves from 89-million to 150-million ounces. As Barrick sees it, the Vancouver company will give it “an unrivalled pipeline” of projects on four continents and exploration holdings in 16 states.

Given the importance of reserve replenishment, one of the toughest decisions facing Barrick will be whether or not to hold on to Placer’s 50% stake in the South Deep mine in SA. South Deep accounts for a 10th of Placer’s proven reserves and more than a half of its ”probable” reserves.

Barrick’s founder and chairman, Peter Munk, has been lukewarm towards investing in SA. South Deep has barely broken even this year due to high costs and lower-than-expected output.

Some analysts believe that South Deep’s performance could be enhanced by merging it with Gold Fields’ adjoining Kloof mine. South Deep’s shareholder “could sell the reserves to someone who could do a better job at developing them”, says one industry executive.

Wilkins says that Barrick needs time to consider its options: “We’ll be approaching that with an open mind,” he said.