The Gold Report: Dave, tell us a little bit about PI Financial.
David Goguen: PI Financial Corp. (PI) is one of Canada's largest, independent, employee-owned full service investment dealers. PI has been advising and financing the mining sector for the past 30 years and I have been providing resource sales coverage to institutional clients for over 15 years.
TGR: It's been a tumultuous year in the mining space. Maybe gold prices haven't hit the highs that we saw in 2011, but with prices hovering around $1,700/oz, most gold producers can make a profit. On the other hand, equities—particularly the mid caps, small caps and micro caps—have been decimated by summer doldrums or investor disinterest. PI Financial obviously sees opportunity in the mining sector.
DG: A very good proxy for the senior gold companies is the Van Eck Market Vectors Gold Miners ETF (GDX). Going back 12 months from today, this ETF is down 23%. Over the same period, the Market Vectors Junior Miners ETF (GDXJ) is down considerably more, by 39%.
I think a key reason for the underperformance is due to the recent challenges that juniors have had to face in raising capital to fund continuing exploration and development. Historically, smaller and less liquid mining companies are hardest hit in a risk-averse, "risk-off" market. The junior mining sector is delivering a lot of technical studies that have been underway for the last year. These studies will provide the insights by which investors will choose certain development projects over others as they assess capital cost of construction and project rates of return. This process will see investors supporting companies that they expect will lead the way in the next cycle.
TGR: You've predicted that some of these junior miners will have a recovery in the fall. Could senior producers that need to replace reserves be shopping for mid-size junior companies with promising projects to acquire? Do you see merger and acquisition (M&A) activity in the fall and going into 2013?
DG: I agree that there will be mergers and acquisitions, driven by poor returns on some senior gold producers' larger capital development projects. Looking back on the second quarter reporting season, which just ended, commentary reflects management and shareholder displeasure with the rate of return on some of the larger capital development projects.
"The majors will likely look at smaller projects, instead of the larger ones previously targeted."
Unanticipated project cost escalation due to increased capital expenditures (capex), schedule extensions and geopolitical risk has meant that the cost of executing on these construction programs exceeded what was originally factored into budgets by a very wide margin. Barrick Gold Corp.'s (ABX:TSX; ABX:NYSE) statement that "returns drive production instead of production driving returns" has become a new mantra echoing among senior gold companies. Projects are going to be assessed with a more critical evaluation of risk-adjusted returns, and capital allocation discipline is really going to be stressed.
We would expect greater scrutiny of some of the more marginal projects in the development pipeline, some of which may be put on hold or even canceled. A prime example from the base metal space is BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) putting $63 billion of capital programs on hold. Barrick Gold has suspended projects as well.
TGR: If senior companies use more fiscal discipline and scrutinize potential acquisitions more carefully, won't margins improve and financials look correspondingly better? Couldn't this be a positive thing for shareholders?
DG: Fewer projects will satisfy the decision criteria for development and construction. With fewer projects launched and fewer marginal ounces coming onstream, there is going to be reduced supply in the global gold market. As development projects idle and the effects are felt in future production and global supply numbers, there will be a resulting reduction in gold supply or at minimum a reduction in future supply growth. This, in turn, should mean higher gold prices in the intermediate and longer term and should be positive for the junior gold companies.
TGR: What else will that mean?
DG: In the past, the capital requirements and capital risk of developing larger projects—especially larger projects in remote locations—has been underestimated. As a result, the majors will likely look at smaller projects, instead of the larger ones previously targeted. These projects are potential producers of, perhaps, 200,000 to 400,000 ounces (oz)/year, instead of 500,000+ oz/year. Their development cycle is shorter and their ultimate capital costs can be contained. These are the smaller projects held by some of the junior companies that we follow. Investors should focus on companies with projects that are amenable to phased development and can be scaled up offering smaller initial capital outlays and future expansions funded out of project level cash flows.
TGR: So the majors are going to be looking at smaller projects with lower capex requirements and higher margins, as opposed to pursuing larger development programs in more remote places with smaller margins?
DG: Exactly.
TGR: Given that backdrop, in what parts of the world are majors going to be sniffing around?
DG: We would focus on Latin American-based projects. Latin America has historically had one the highest allocations of exploration capital. PI Financial produces a quantitative research piece called "Select Golds" that focuses on Latin American precious metal companies. We examine advanced explorers, emerging producers and junior producers. We track their evolution and progression through each of those categories and into production.
TGR: In what countries?
DG: We specifically like Mexico. The geology is excellent and continues to yield new discoveries both in precious metals and in base metals. Mining has a long history in Mexico. There is an ample skilled labor force and a strong network of technical suppliers and technical services. Permitting and mining laws are transparent, with a record of fair treatment. Technical submissions and permit applications are responded to and processed by the various ministries in a timely manner.
"Latin America has historically had one the highest allocations of exploration capital."
Mining is socially accepted in Mexico. A good example of a locale that provides technical services to mines and to development projects within the Sierra Madre is Hermosillo. Mexico has proven its ability to cater to companies that are developing assets there.
Brazil is also well regarded for supporting mining exploration and development. Processes for getting approvals are both well laid out and well understood. Brazil also has the bureaucratic infrastructure to approve permits. So, the path from development to production in Brazil is a relatively straightforward one.
TGR: What are some particularly promising companies and projects in Brazil?
DG: In Brazil, the Volta Grande project is being developed and advanced by Belo Sun Mining Corp. (BSX:TSX.V). This project has a lot going for it. It has attractive size, with over 5 million ounces (Moz) Measured and Indicated and Inferred. It has attractive grade, at 1.7 grams per ton (g/t) gold. The resource should support a meaningful production profile, likely 250,000 to 350,000 oz/year. And, the deposit sits in a prospective greenstone belt that is 100% controlled by Belo Sun. So, if a major were to come in and acquire Belo Sun for the Volta Grande project, that major would also expect the benefit of an entire greenstone belt package on which to fund continued exploration, while maximizing purchase value through additional discovery within the prospective belt.
TGR: What other Latin American companies that might be not as well developed as Belo Sun offer potential for M&A?
DG: Considering the new criteria for M&A interest that we've discussed, in Mexico, Torex Gold Resources Inc. (TXG:TSX) would certainly be a company the majors could be looking at. Torex has 4.8 Moz in the Measured and Indicated category with a grade of 2.79 g/t. This open-pit development is expected to be ready to begin construction in mid-2013, with production by early 2015. And, Torex is due to deliver a feasibility study shortly. It is my belief that this study will further validate the project and show that it has sufficient resource to merit interest from intermediates and majors.
TGR: Is this in the Hermosillo area you mentioned? It looks as if it's actually relatively close to Mexico City.
DG: Torex is in the state of Guerrero, within the Guerrero Gold Belt. Torex has features that make it an attractive acquisition candidate, with a project located in a productive gold belt that has geological exploration upside potential and future optionality on discovery. Any prospective buyer of Torex is ultimately going to enjoy the benefits of any subsequent discoveries in the belt.
TGR: Torex is also an unusual company because it has a sizeable treasury at this point.
DG: Yes. Torex has $69 million (M) in cash as of July 31, 2012. But, with delivery of a feasibility study expected soon, this capital will be needed for long lead-time expenditures. The capex on this project is going to be somewhere in the $500–700M range, and that means equity and debt financing will be needed.
TGR: What other names are there in Mexico?
DG: Timmins Gold Corp. (TMM:TSX.V; TGD:NYSE.A) is in Sonora, Mexico. Timmins started production approximately two years ago and is on track to produce 100,000 oz in 2012.
The company has made good progress in its revitalization of the San Francisco mine. Expansion plans currently underway target a production level of 130,000 oz/year.
"We specifically like Mexico. The geology is excellent and continues to yield new discoveries both in precious metals and in base metals."
Improvements in throughput rates have raised monthly gold production. After a period of spending cash flow on capital development and mine optimization, Timmins is turning the corner and is expected to generate coveted free cash flow.
For intermediate gold companies looking to grow and for investors looking to position themselves in real value, Timmins is also especially attractive. When we look at other junior developers that are attempting to build mines of the same scale as Timmins' San Francisco, it becomes very clear that Timmins is trading well below replacement value.
TGR: What other companies do you like in Mexico?
DG: On the development side I would be looking at Esperanza Resources Corp. (EPZ:TSX.V). Esperanza looks like a good value in the junior gold space.
Esperanza has the Cerro Jumil project. This time last year, Esperanza delivered a preliminary economic assessment (PEA) that called for just over 100,000 oz/year of production, for an initial capex of approximately $114M to construct a heap-leach operation mining 35 million tons (Mt.) of material grading 0.83 g/t gold. They've achieved surface land and made submissions for water permits. At present gold prices, the Cerro Jumil project has an internal rate of return in excess of 50%. Esperanza is expected to deliver a prefeasibility study shortly, along with a revision in resource expectations. I think that resource could see the project mine life expand from six years to upward of 10 years, and further define the ability to scale up the size of the annual production profile.
Importantly, Esperanza also benefits from a new management team. The development, construction and operation team comes from Minefinders Corporation Ltd., which was recently taken over by Pan American Silver Corp. (PAAS:NASDAQ; PAA:TSX).
I'm quite confident that Esperanza is going to be able to move the Cerro Jumil project from prefeasability to production. The Esperanza team is experienced in Mexico and is very experienced with this particular kind of ore body and with this type of process flow sheet.
TGR: It also looks as if Esperanza has other projects in the pipeline.
DG: Esperanza is doing regional exploration. When the time comes, there are both local and regional exploration targets that will be of interest.
TGR: We've spoken about four companies in Mexico on the development side and four on the production side. Which explorers or project generators in Mexico do you like?
DG: Almaden Minerals Ltd. (AMM:TSX; AAU:NYSE) is a very well-disciplined, well-managed project generator with a very good track record of making discoveries, and from either joint-venturing or advancing them further. Its present flagship asset is the 100%-owned Ixtaca property, which is a discovery Almaden made in August 2010. The original discovery hole was 300 meters of 1 g/t gold and 48 g/t silver.
Almaden has four drills operating and has now drilled over 200 holes on the project. Mineralization has been traced for over a kilometer, and a parallel zone has been discovered, which has also been yielding some good results. Almaden is expected to publish its maiden resource in December.
TGR: Almaden's Duane Poliquin invented the whole model of the resource generator, didn't he?
DG: Almaden is a classic example of the project generation model. After 26 years in the exploration business, Almaden still has only 59.2M shares outstanding. Almaden has shown that it can fund the company through joint ventures and by monetizing assets and projects that have been developed and sold to other companies.
TGR: Other than Mexico, what other countries do you particularly like in Latin America?
DG: Nicaragua fits that description perfectly, although those taking a cursory glance might conclude otherwise. The operating experience of B2Gold Corp. (BTO:TSX; BGLPF:OTCQX) in Nicaragua has been exceptionally good. It has no doubt benefited from the quality management team it brought to Nicaragua.
But the country, through its government and permitting processes, has been refreshingly responsive to this junior gold company's needs. As a result, B2Gold has been successfully operating the Limon mine, a 40,000 oz/year producer. The La Libertad mine was developed and is now a 100,000 oz/year producer.
Cash costs for B2Gold were $583/oz in the last quarter. The company has recently raised its production forecast, anticipating the development of what's called the Jabali zone. This zone exists in a 15+ kilometer-long corridor of prolific rocks that are host to some higher-grade mineralization that will be put through the La Libertad Mill.
TGR: Based on its success, is B2Gold more of an acquisitor or an acquisitee?
DG: I think B2Gold is more of an acquisitor. It has exhibited the bench strength and the management capacity to operate a company three times its size.
TGR: B2Gold has successfully negotiated and navigated the Latin American political waters. The fact that it can have such a successful project in Nicaragua suggests that it can also be successful in Peru. And perhaps it can be successful in other areas, like Argentina or maybe even Chile.
DG: B2Gold's management has a long history in Chile, having formerly been with Bema Gold Corp. [acquired by Kinross Gold Corp. (K:TSX; KGC:NYSE)] on the Cerro Casale project and others.
TGR: Moving to a more macro discussion, do you see a general and continuing recovery in the precious metals equities? What other macro indicators, in your view, portend continued recovery of the space?
DG: High levels of global, unsustainable debt continue to support the upward trend in gold prices. Unfunded debt impairs the ability of countries to grow and erodes confidence in currency, whether that currency is the euro or the U.S. dollar or something else. All the moves by the various central banks to effectively print money through bond purchase programs to keep the yields and the interest rates low just further debase currency. Many smart observers in the marketplace have recognized that gold offers protection from those activities. As it becomes increasingly evident that central banks have no intention of stopping the printing of currency, gold should continue to rise again.
This is a process that is not going to sort itself out in weeks or even in months. It's going to take years. While some of this pain is discounted in present valuations already, volatility will continue as the global central banks work their way out of this mess.
TGR: What a great summary by which to end our conversation. What else would you like to add?
DG: Perhaps more than any other time in the recent past, the Q2/12 reporting season has cleaned the slate with respect to disclosures among senior mining companies, intermediates and even junior companies. This fundamental reconciliation of the challenges gold companies have had with their associated assets paves the way for better news going forward as these challenges are overcome. The prospect of better news is what we're starting to see get discounted in share prices, hence the sector is in the early stages of moving higher.
TGR: What new interest is there in the junior gold space from institutional investors? Considering that we have a cleanly set table, what different people are at the table than you've seen before?
DG: The past six months have brought a kind of cleansing process to institutional portfolios. The shares of companies that did not meet expectations and projects that did not evolve as hoped are being sold. And the resulting proceeds are being reinvested in some of the better companies that remain. It is those better companies that we see now leading the market higher in junior golds.
TGR: Excellent. We and our readers value your comments.
David Goguen is PI Financial's director of institutional mining sales, where he focuses on the mining sector. Goguen's focus includes Select Golds—advanced, exploration, emerging producers and junior producers. Goguen earned a Bachelor of Arts degree in economics from Carleton University and holds the Chartered Financial Analyst designation.
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DISCLOSURE:
1) Sally Lowder of The Gold Report conducted this interview. She personally and/or her family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Timmins Gold Corp., Almaden Minerals Ltd. and B2Gold Corp. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) David Goguen: I personally and/or my family own shares of the following companies mentioned in this interview: Esperenza Resource Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.
