Category Archives: Mining

more on gold

July 31, 2015 By in Gold, Industry Analysis, Mining Tags: , , , , , , 1 Comment

just to clear the air

I was interviewing a prominent tycoon in Hong Kong  in the mid-1980s when the topic turned to gold.  He told me that he had long since sold all the gold bars he had once used to store his wealth.  He was now holding currency and currency derivatives instead.  I soon found that this was the norm among the rich and powerful in what had once been the center of gold bug-dom.

This was akin to travelling to southern California and seeing budding cultural trends in the US.  That’s when I began to realize that gold that had lost its function universal function as a store of wealth.  Yes, gold retains this function in third world countries like India, where people don’t trust or can’t afford banks, but–in my view–nowhere else.

As fun as it might be to elaborate on this theme, I want to write more about the mechanics/quirks of the gold market–mostly about production–than about popular delusions.

about supply

–Inventories, held either as gold bars or in jewelry, dwarf production.  As decision of holders in the three biggest markets–India, China and central banks– to liquidate can have a significant effect on price.

–Gold mines typically have pockets of ore that are very rich in gold and others that are relatively thin.  Industry practice is to aim for maximum sustainable mine life.  This means mining larger amounts of relatively poor ore are when prices are high and shifting the mix toward richer ore  when prices are low.  One practical consequence of this practice is that actual production cost figures from the past few years of high prices are going to overstate the cost of production in today’s lower price world. Another is that production amounts tend at least initially to expand when prices fall.

–When mines get in financial trouble they begin to “high grade,” meaning they produce exclusively from their richest ore deposits and they cut the amount they usually spend on maintenance and on developing newer areas to mine.  This is ultimately destructive of a mine’s long-term prospects, but it ups near-term cash flow–and it can go on for an extended period.

–When I began studying gold mining companies in the late 1970s – early 1980s, gold miners were very financially conservative because they understood clearly that their industry was subject to violent ups and downs in price.  Their number one rule was to have no debt and a large cash reserve.  That’s no longer the case.  Heavy borrowing urged by CFOs with academic finance training but little industry experience has meant that mines need to generate enough cash to service debt as well as pay operating costs.  This intensifies the need to generate maximum cash flow, even at the expense of diminishing long-term mine viability.

–Bankruptcies may help the orebodies.  But because they remove the burden of debt service, they make the near-term supply situation worse, not better.

my conclusions

The gold price can go lower, and stay depressed for a longer period, than I think most people expect.

oil and gold: finding the commodity cycle bottom

July 30, 2015 By in Capital-intensive firms, contribution margin, Energy, Gold, Industry Analysis, Mining Tags: , , , , 2 Comments

I got my first couple of portfolio manager jobs in the 1980s because one of my industry specializations as  a securities analyst was natural resources.  Back then, there were an enormous number of mining analysts in an information industry based in London.  The large size and vitality of the analyst community were partly because there had been an enormous spike in the prices of gold and oil in the late 1970s-early 1980s. So investors were willing to pay handsomely for information and interpretation.  Also, the prevalent economic theory of the day, since proved to be woefully incorrect, held that a necessary condition for global economic growth was a continuously expanding supply of mineral resources.

When the Chinese economic expansion-driven commodities boom began a decade and a half later, I found that, unsurprisingly after 15 years of no one being interested, the entire stock market information infrastructure for metals had disappeared.  There were still the odd steel or oil analyst around eking out a living and staggering toward retirement, but little else, either in London or New York.

As far as I can see, from an information perspective the situation is at least as bad today.  In the perverse way that Wall Street works, however, that lack itself is the basis of the positive thesis for mining in general.

industry characteristics

Mineral extraction industries are very capital-intensive.  This means that projects typically require large amounts of up-front money. But they can often continue, once up and running, for long periods without new funds being put in.

Mining projects often have very long lives.

Very often, projects are also huge.  This is partly the nature of the beast, partly a function of the temperament of the people who run minerals companies.  This means that new supply is often added in gigantic chunks.  New supply almost invariably arrives in amounts way above the increase in demand and typically, therefore, marks the high water mark in terms of price.  Boom and bust, boom and bust–the rhythm of these markets.

finding the bottom

Falling prices indicates that there’s more supply than demand.  In theory, that situation can be reversed either by demand expanding or by supply contracting.  In practice, the first rarely happens.

What establishes the bottom for these markets, in my experience, is a price decline that’s deep enough to force high-cost capacity to close.  This does not mean the price at which companies stop earning a financial reporting profit.  That price is too high.  That’s because it includes as an expense a non-cash allowance for recovering the money spent to open the project.  A company can also be compelled to sell at unfavorable prices by creditors.

What actually matters is the point at which the out-of-pocket cash cost of getting output out of the ground is less than what it can be sold for.  That’s the point at which projects begin to shut themselves down.  They may not do so immediately.  They may continue to bleed in the hope of an imminent turnaround.

For gold, the relevant figure is around $850 an ounce, I think.  Oil is a bit more complicated, but the magic number is likely about $40 a barrel.

More tomorrow.

 

 

sorting out oil-related stocks

February 9, 2015 By in Energy, Industry Analysis, Mining, offshore contract drilling, oil and natural gas, Refining, shale oil, shale oil and gas Tags: , , , , , 1 Comment

The very large drop in oil prices over the past eight months has had negative effects on all oil-related firms.  The amount of suffering varies considerably, however, based on how a given firm is involved in the hydrocarbon business.  Here’s my take on the various sub-industries:

1.  oilfield services companies.   It’s a general rule in business that when a manufacturer slows down, its suppliers feel more pain than the manufacturer itself.  This is true in the oilfields, as well.

–Lower output prices mean some new drilling projects are cancelled.  This is bad for the contract drillers who supply and operate the rigs that do the actual drilling.  Offshore, where projects are typically larger and more expensive–therefore riskier, is a worse place to be than onshore.  Worst hit of all are the suppliers of the oilfield services firms, like the companies that manufacture new drilling rigs.

–Suppliers of goods and services, from seismic analyses of prospective acreage to drilling mud, are hurt as well.  Being in support for development of existing projects is better than being involved in new exploration.

2.  high-cost alternatives   …like liquefied natural gas (LNG) or tar sands.  Projects may no longer be economically viable.  I think LNG is more at risk.  Transporting natural gas from, say, the US to the EU or from Australia to Japan requires a multi-billion dollar investment in plant and equipment to liquefy and ship the gas to market (the alternative would be an underwater pipeline).  Because of this, I think new projects are non-starters in today’s world.  As for projects already up and running, we have no way of knowing how contracts are structured–that is, how the selling price of the gas is affected by the oil price drop.  This determines whether the pain of the oil price decline is borne by the LLNG project or by the utility customers who ultimately use the gas.

The situation for green alternatives, like solar and wind, is less clear.

3.  reserve valuations     The asset value of any oil exploration/production company depends heavily on the size and value of its oil reserves.  The lower oil price clearly hurts the value of reserves.  What’s less obvious is that reserves are defined as barrels of oil that can be brought to the surface and sold at a profit at the current price.  Some barrels that are economically viable at $100 a barrel may not be at $50.  If so, the size of reserves will also shrink.  In an extreme case, a company with a million barrels of reserves worth $50 million at an oil price of $100 might have 0 barrels worth $0 at a $50 oil price.

4.   US-based exploration companies     Smaller firms have been the leaders in shale oil production.  Generally speaking, they are hurt worse  by shrinkage in cash flow and downward revisions in reserve value than the big international firms.  To the extent they’ve borrowed to finance drilling, their problems may be magnified.  As a practical matter, however, there’s probably less scope for creditors to take action against a firm if it has issued junk bonds than if it has bank loans.

5.  international majors    The profits of these firms are more insulated against the price drop than their smaller rivals.  How so?

–They have petrochemicals and refining/marketing businesses that benefit from the lower price because they’re users of crude oil.

–They have fields they own that may have been operating for decades, and which therefore are still profitable at today’s prices.

–Also, in their deals to develop fields with national oil companies in foreign countries, they typically are paid a return on invested capital.  In other words, they don’t gain or lose much (if anything) as the oil price rises and falls.

No, they don’t escape unscathed.  They do lose from the lower price they get from production they own in the US and Europe, but their losses are much less than the pure domestic exploration and production companies.

6.   I haven’t looked at refining and marketing companies.  I assume that they aren’t fully passing along to their customers the benefits of lower crude oil costs, but I haven’t checked.

Of course, if/when the oil price begins to rise again (I don’t expect that to be any time soon), the most responsive stocks will likely be those of the oilfield services firms, with those of the international majors moving the least.

effects of lower oil prices

February 5, 2015 By in Energy, Industry Analysis, Mining, oil and natural gas, shale oil, shale oil and gas, Strategy Tags: , , , , , , , 2 Comments

At $50 a barrel oil vs. $100 a barrel:

1.  High-cost alternatives hydrocarbon like liquefied natural gas (LNG), where projects require billions of dollars in spending on infrastructure–cryogenics at the wellhead, special refrigerator ships for transport–become much less compelling.  Tar sands, too.

2.  Green energy substitutes like wind and solar, which already require heavy government subsidy to encourage adoption, are less attractive, as well

3.  The real asset value of oil companies is in their proved reserves.  A lower price hurts this value in two ways.  The first is the obvious one, that the selling price of output is lower.  But there is a second.  In order to be counted as reserves, barrels of oil must be economically recoverable at present prices.  So quantities may shrink, too, as the price declines.  One can imagine, say, a tar sands company that has one hundred million barrels of reserves worth $20 billion at a $100/bbl price   …but 0 barrels worth $0 at a $40 price.

4.  The natural gas price in the US has fallen, but not by a much as oil.  This puts US petrochemical plants, which use natural gas as a raw material, at a relative disadvantage vs. their European and Asian counterparts that use naphtha, a petroleum product.  In absolute terms, the US companies are still in better shape, but to the extent that their historical price advantage has long ago been factored into stock prices, their equities have been relative underperformers.

5.  I spent six years as an oil analyst, covering both the big internationals and domestic explorers, and another while managing an Australian portfolio at a time when over half the market consisted of natural resources stocks.

Admittedly, my expertise is dated.  Nevertheless, some things don’t change.  Hearing and reading Wall Street “experts” on oil publicizing their opinions, I’m struck by how much loss of basic knowledge about the oil industry there has been within the investment community over the years.  This really shouldn’t be so surprising.  I’ve seen the same phenomenon in the mining industry.  In both cases, there have been very long stretches of time when the relevant stocks have been dormant and, consequently, it has been very hard for a sector specialist to make a living selling his analysis.

More on industry sub-sectors tomorrow.

 

the view from Canada

January 22, 2015 By in Current Market Thoughts, Energy, Industry Analysis, Mining, oil and natural gas, Strategy Tags: , , , , Leave a comment

Yesterday the Governor of the Bank of Canada, that country’s central bank, announced it was lowering short-term interest rates from 1% to .75% as an “insurance” measure to help the Canadian economy adjust to lower oil and gas prices.  The move doesn’t come as a huge surprise, given that the oil and gas industry is close to 10% of the Canadian economy and has been accounting for about a third of its GDP growth.

In the words of Governor Stephen Poloz, “The drop in oil prices is unambiguously negative for the Canadian economy.  Canada’s income from oil exports will be reduced, and investment and employment in the energy sector are already being cut.”

To me, more interesting is the bank’s quarterly Monetary Policy Report, released at the same time, which deals with the global effects of lower oil.  It says:

1.  the Bank is assuming the oil price ultimately recovers to US$60 a barrel–no $100 oil anywhere in sight

2.  Canada gradually shifts focus to non-energy industries of the type which have been in decline during the energy boom years

3.  the net effect on world GDP growth of the oil price fall is zero, both in 2015 and 2016.  On an area by area basis, however:

–the US is a net winner.  It grows at a real rate of  +3.2% in 2015 (rather than the previously projected +2.9%) and +2.8% )+2.7%) in 2016

–China is, too.  It expands at +7.2% (+7.0%) and +7.0% (+6.9%)

–the EU, as well.  It advances at +0.9% (+0.8%) and +1.2% (+1.0%)

–Japan is up by +0.6% (+0.7%) and +1.6% (+0.8%)

–the rest of the world is a mild net loser, growing at +3.1% (+3.2%) in 2015 and reounding to +3.4% (+3.4%) the following year.

In the last category, Canada grows at +2.1% (+2.4%) this year before rebounding in mid-2015.