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(Kitco News) - Mining companies have their work cut out finding and developing new deposits of gold, especially those with high ore grades, said Dan Denbow, portfolio co-manager of the USAA Precious Metals and Minerals Fund (USAGX).

Furthermore, once operations are up and running, companies face increasing costs of production, such as energy, labor and others.

Denbow addressed some of the challenges facing the mining industry during an interview with Kitco News Thursday. The USAGX fund, based in San Antonio, invests in equities of precious-metals companies. Morningstar said the fund has assets of $2.2 billion and gives USAGX a four-star rating in the category of equity precious metals.

"The long-term challenges (for producers) are growing the resources and finding new deposits to grow the earnings in the companies," Denbow said.

As a result, global gold-supply growth has been relatively stagnant in recent years even as prices rose, although gold-mining output grew modestly last year, he said.

Conversely, money supply of paper currencies is increasing many times faster, not only in the U.S. but other nations, he said. "The base of gold itself is not growing very fast," he said.

'Increasingly Difficult' To Find Large Deposits, Especially With High Ore Grades

"It's increasingly difficult to find large deposits," Denbow said. Furthermore, it's hard for companies to find those with high grades of ore, which are the most profitable. "Grade is the key to profitability. More and more, you're seeing big, low-grade large tonnage."

Sometimes, newer operations might only get a gram of gold per ton of mined material.

"So you have to be good on (controlling) your costs," Denbow said. "You have to move a lot of rock to be able to make those operate."

Many of the world's high-grade deposits are already in production. Meanwhile, as gold prices rose in recent years, companies often turned to lower-grade projects that have higher per-ounce operating costs.

"That's where a lot of the growth is coming from today—deposits that were not profitable at $250-$350," he said. "Now, at these prices, they're more economic, so people are going back and opening up old geologist books, finding where discoveries were that just weren't profitable (at lower gold prices)."

However, these discoveries often are regions not very hospitable, such as an Arctic climate or areas with a high political risk. As an example, Denbow cited discoveries of a number of different minerals in war-torn Afghanistan.

"Not a lot of miners are going to be lining up to go over to Afghanistan and mine those projects," Denbow suggested.

Other areas with political uncertainty include the Democratic Republic of Congo and Ivory Coast.

"In the Ivory Coast, there is a lot of good, prospective ground. But with the civil wars, it was basically ignored for over a decade, in terms of exploration," he said. "People started moving back in there several years ago. They know there's good rock there….Then we had the issues there following the elections. It basically put all exploration on hold for a while."

Violence broke out in the Ivory Coast following elections late last year.

In other nations, there are worries about government taking back control over mining operations, making companies hesitant to spend money there.

"There's been stories out of Bolivia and other places that tend to sneak up occasionally about taking assets back because they see they are very profitable now," Denbow said. "The more profitable mines get, the more the local or national governments want to take those."

Another challenge, Denbow said, is that when companies find higher ore-grade deposits, they are often far under the ground, making them more difficult and more dangerous to mine.

"That's why South Africa's production is falling. The grade is down at incredible depths and they're having huge safety issues," Denbow said. Much of the mining is occurring more than a mile below the surface.

Yet another challenge is permit issues, since denizens of many regions do not want a mine next door.

Labor, Commodity Costs Rising For Mining Companies

In their day-to-day operations, mining companies have had to deal with rising labor and commodity costs. Energy is one of the big ones.

"Oil prices, depending on the type of mine, can have a significant impact," Denbow said. "If you are remote enough and not near power lines, you are operating on diesel or heavy fuel-oil generators. So energy prices can not only impact the trucks and your mining equipment, but also electricity. For some mines, it could be up to 40% of operating costs."

A few years ago, when platinum was hitting its record highs, some of the support came from rolling power blackouts due to electricity shortages in the South Africa, the world's main supply source. "South Africa is still dealing with that, although they've been very good at shedding demand," Denbow said.

The marginal cost of gold production is around $1,000 an ounce or more, including capital costs, he said. But while increasing expenses cut into the profit of mining companies, they are nevertheless supportive for gold prices, since they could constrain supply growth, he explained.

"As costs rise, the marginal production will have to come off," said Denbow. "It will become uneconomic."

This happened in base metals such as copper when prices initially tumbled after the global financial crisis of 2008, Denbow said. A number of companies cut back mining at their marginally profitable operations.

Denbow Remains 'Positive' On Gold's Long-Term Outlook

While gold has fallen back lately, Denbow said his fund remains "positive" on the longer-term outlook.

"We believe the issues are still out there that make it a good investment—the budget deficits, entitlement problems, the European debt issues that still need to be resolved, and the global currency devaluations taking place in developed countries," he said.

Denbow said the fund recently reduced its silver position on ideas that silver prices had risen too quickly before the recent pullback.

"We have been long-term fans of platinum…," he said. "Most platinum comes out of South Africa. The production problems they've been having—because of the depths of the mine, energy availability and labor issues—we thought would be supportive for platinum long term."

 

By Allen Sykora of Kitco News; asykora@kitco.com

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Dan Denbow
Dan Denbow