Lihir's Success Comes At A Cost29/10/2008 7:51:14 PM By Greg...

Lihir's Success Comes At A Cost
29/10/2008 7:51:14 PM

By Greg Peel

Lihir Gold (LGL.AX) has managed to become the "other" of Australia's two locally-owned world class producers despite having all its fortunes once tied to a remote and fickle Papua New Guinean island. Disappointments, delays and disasters at Lihir Island have been par for the course throughout its history leaving gold analysts with a sense of ennui rivalled only by Newcrest's (NCM.AX) much vaunted and highly disappointing Telfer mine.

It was thus a pleasant surprise that Lihir managed to put in a record 41% increase in quarterly production including a 27% increase at the said island. The balance was achieved from having acquired Ivory Coast gold miner Equigold earlier in the year. Lihir also lays claim to the Ballarat Gold eponymously named gold mine, but the previous owners couldn't get much out of it and Lihir is struggling as well.

The production figure managed to surprise most but not all brokers, but digging into the numbers it was hard to be overly excited. Lihir Island has moved to a more efficient level of production but the truth is the record level owes as much to hitting a new, higher grade seam of gold than anything else. As a result, management has not made any change to its previous annual production target of 700-770koz but at least analysts are more convinced the final tally will be more toward the middle than the lower end.

Nevertheless such an achievement, or better, lies very much with the island's fortunes rather than Lihir's attempts at geographical expansion. The Bonikro mine in the Ivory Coast has reached "nameplate" capacity but management has been forced to downgrade production guidance for 2008 by 10koz to 40koz given inevitable delays. Commissioning guidance was for 60koz. There is also that lingering uneasiness that the Ivory Coast does not rate up there in the world list of extremely safe places to do business.

Ballarat is simply a case of analysts starting with no expectations and being prepared to be happily surprised, but not losing any sleep over it. Ballarat, too, has been beset with delays but as any production is to be capitalised at this stage it makes no difference to the P&L.

While analysts may have taken the 250koz of production from Lihir as a positive, the cost of producing that gold has left most feeling somewhat deflated. The average cash cost of US$412/oz was more than most analysts expected, given most analysts expected costs to have come down by now.

Out on remote Lihir Island, the company is reliant on two sources of energy. One is your common or garden heavy fuel oil (HFO), while the other is a more recent compensatory source that taps the volcanic outcrop's geothermal energy. One would assume that getting heat out of a volcano was no mind-bending challenge, but it seems a shortfall in expected geothermal power for the quarter was one reason why production costs remained elevated. Lihir was forced to use more HFO than it would have liked.

On the subject of HFO, the dramatic drop in the oil price would suggest production costs should now be on the downward spiral, but it has not yet been the case. One could never blame management for attempting to alleviate uncertainties, but it appears it went and locked up supply of a good deal of HFO at August prices believing it was perhaps finding a temporary bottom in price moves. August had seen blessed relief as the crude oil price fell from US$147 back to US$100/bbl and that would have looked like a great place to lock in prices to anyone. Unfortunately, we're now at US$62/bbl.

I doubt this will be the last we hear of resources companies having to wait some time before lower input spot prices actually convert into cost savings.

All in all, it looks like Lihir Gold may have turned the corner with regard to the reliability of its Lihir Island operation. This is the first quarter of relatively good news for a long time. The simple fact is that most brokers remain bullish on the medium term price of gold, although there have been some hasty downward adjustments to 2008 average forecasts. Hence seven out of nine FNArena database brokers grant Lihir a Buy rating, with JP Morgan more circumspect at Neutral.

Merrill Lynch is the non-believer and the analysts still think annual production will be at the low end of guidance. They also predicted the cost problems, although not an increased depreciation charge. Merrills clearly needs more than one quarter of relative success to join the faithful, and is happy to maintain an Underperform rating despite the stock trading at a discount to net present value since the Big Sell-Off.

Other analysts point out that the stock's discount only adds to its charm, given in good times a premium of up to 50% above NPV is the norm. One lingering doubt is, however, funding of further expansion. Lihir needs about $400m to see its plans through and has secured $250m, although given the current credit climate management will wait before trying to attract the remainder.

Forecast earnings changes have varied from broker to broker depending on their earlier assumptions. The average target price has nevertheless fallen to accommodate higher cost assumptions and some tweaking of shorter term gold price assumptions, not to mention a general lowering of multiple expectations in this new, risk-averse world. The average target in the FNArena database has fallen from $3.12 to $2.69.

Put a bunch of Australian gold analysts in a room and they will likely not disagree on the direction of the price of gold, nor the fact that every Australian stock portfolio should include a world class local goldminer. What they will argue about, however, is whether if you had to pick one, should it be Lihir or Newcrest. The former is more highly levered to the gold price but is a riskier proposition. The latter is somewhat undermined by its copper exposure, but has the more stable track record, Telfer notwithstanding.