Silent Bulls and Bloated Costs

By David Forest       Jul 13 2009 10:18AM www.piercepoints.com

The Gold-Haired Stepchild
A Silent Bull Market
U.K. Oil: Rock or Hard Place
Big Brother, Where Art Thou?
"Bells and Whistles" Contracts
The Summer Heats Up

Investors often complain about summer being the "quiet season". As I look daily through six iGoogle tabs stuffed with RSS feeds from financial and commodities data sources around the world, it indeed seems that news flow has grown skinnier over the last few weeks. Great events, it seems, just don't happen when the beach is baking and the patio beer gardens are open.

But I find the summer a good time to really listen to the markets, and to the broader economic world. With much of the "noise" of daily events muted for a couple of months, we have time to contemplate what's going on below the economic surface we see on MSNBC or MarketWatch. As Robert Frost wrote, "We dance round in a ring and suppose, but the secret sits in the middle and knows." There are a few secrets sitting at the heart of our current economic hubbub right now. And during this quiet season we can settle our thoughts enough to start drawing a bead on some of the seismic changes going on in the subsurface of the natural resources sector (and in the wider economy).

This week, we look at a few issues that you won't hear about on the daily financial news. There are very serious changes afoot in the cost structures for both the mining and petroleum industries. The gold sector in particular is undergoing some big shifts, even as most investors are ignoring gold producers in favor of "hotter" stories like base metals and coal. These are silent but crucial changes in the industry with the potential to have a huge impact on investment returns for years to come. We'll cock our ear a little to hear some of these whisperings.

We'll also look at some of the measures that governments around the world are (and should be) taking to aid the oil and gas industry. Petroleum producers are having a tough go lately with high costs eating away profit margins to razor-thin proportions. And governments are responding with some extraordinary measures.

And speaking of extraordinary, we'll also travel to the outer reaches of resource project finance and look at some very unusual new strategies metals producers are developing to protect themselves from price volatility. These are "leading edge" concepts, the kind that could set the tone for an industry that has seen its profits decimated over the last year. We'll see what the future might look like.

As a final note, I want to welcome the many readers who've joined us recently. As I've said in the past, it is my hope and mission that you all get as much enjoyment out of reading this letter as I get from writing it. A tall order, given how much fascinating material I have to go chew through these days. But we'll do our best. Let's get to it!

The Gold-Haired Stepchild

Citigroup commodities analysts raised their price targets this week. Across the board. Citi now predicts copper will average $2.50/lb in 2010. Previously they had been forecasting $1.65 copper. That's a 50% increase. The analysts have also become more bullish on zinc, raising their 2010 forecast 45%, from $0.475 to $0.70. Targets for aluminum and nickel were upped by 20%.

Citi have also grown more positive on coal. The group's forecast coking coal price rose from $120 to $140. The thermal coal forecast rose 15% to $80. Good times are back in the industrial commodities!

Investors have been equally optimistic recently. Share prices of base metals producers rose fast in the second quarter. Between March and June, Xstrata was up 100%. CVRD gained 65%. Likewise Rio Tinto. Some smaller base metals producers have enjoyed more spectacular appreciation. Canada's Teck Cominco is up 450% since March! Investors have moved back into the base metals in a big way.

But one commodity has been left by the wayside. Gold. In what amounted to a footnote to its price forecasts, Citigroup noted it is leaving its prediction for the gold price unchanged at $925/oz. Not particularly inspiring. Investors seem to feel the same way. Gold producers were all the rage at the beginning of 2009. Share prices of most producers doubled or better between November 2008 and February of this year. But since then, the performance has been less inspiring. Most gold companies have seesawed through the last five months, staying more or less flat. Gold it seems, has had its day in the sun.

Share price isn't the only metric by which gold companies are flagging. P/E ratios for the sector are also falling. The average P/E across the gold sector staged a dramatic recovery at the end of 2008, rising from a crisis-induced low around 12 to as high as 23 by early 2009. But since then P/Es have declined, to around 18 as of June.

A big part of the reason is gloomy analyst forecasts for the sector. Estimates of average forward earnings for gold producers have fallen by 20% since mid-2008. Earnings estimates have turned up slightly over the last few months. But they're still below the levels seen even in mid-2006. Back then the gold price was at $650. Today, analysts are predicting companies will make less money, despite the fact that gold is $250 higher.

A Silent Bull Market

The relative underperformance of gold over the last two quarters looks like a classic case of sector rotation. After the initial excitement of gold companies rebounding out of last fall's crash, attention quickly shifted to the "next big thing". Investors have found the next thing in the form of base metals, coal, oil and a wider array of stocks and bonds. All of which have been appreciating since March. And looking a lot more interesting than gold, which has been bumping along between $875 and $975 with no real direction.

But the calm in the gold price belies some seismic changes in the sector's profitability. I've discussed several times during the last few months the idea of gold's "silent bull market". During deflationary periods, gold wins by not losing. The gold price stays relatively constant, while prices for most other goods fall. The result being that gold producers' sales revenues stay the same, but their cost of production falls dramatically as input costs like diesel fuel, mine labor and electricity all get cheaper. Making it less expensive to operate a mine and produce an ounce of gold.

A steady gold price plus falling costs should translate into higher profit margins for gold producers. That has indeed been the case lately. In fact, the first quarter of 2009 saw the highest average profit margins for gold producers in the last 15 years. And yet, as these results were reported in April and May, share prices of gold producers continued to trade sideways. And analysts maintained earnings forecasts for the gold sector significantly below those of 2008, when profit margins were lower. The industry's good news fell on deaf ears.

Indications are that Q2 will be even better. The London morning gold fix averaged $923 in the second quarter, up from the Q1 average of $907. At the same time, mine labor costs (which can account for up to 50% of a mine's operating costs) at U.S. mines fell 3.6% quarter-on-quarter according to the Bureau of Labor Statistics. Other important mining input costs also came down. Industrial chemicals fell 2%. And iron and steel costs were down 9%. On the downside, oil rose 50% in the quarter, making fuel more expensive. Overall, Notela Resource Advisors' mine cost index was nearly flat in Q2, rising by just 0.3% quarter-on-quarter. As noted above, the gold price was up almost 2% in the quarter, meaning that revenues rose faster than costs. Which should equal higher profits for gold producers, on average.

The chart below of the mining cost index versus the gold price shows that something unusual is afoot in the gold sector. For the first time in over 20 years, the cost index and the gold price have stopped moving in parallel. During the gold bull market of the last eight years, the two series tracked each other almost exactly. As the gold price rose to new heights, so did costs. Inflationary pressures drove up all goods and services. The average quarterly gold price peaked in Q1 2008 at $923.27 (just pennies above the average price from the past quarter). The cost index peaked two quarters later in Q3 2008. But since that time, the two series have gone in opposite directions. The cost index has fallen by 20%. While the gold price has held even.

The last time the two trends diverged was 1985 to 1988. At that time, the gold price rose (from $300 to $475) while the cost index fell. This was a period of high profitability for the gold sector. Return on capital invested in gold mines during this time averaged over 40%. When the trend reversed after 1988 (with the gold price falling and costs staying level) returns on capital fell to below 10%.

Interestingly, the recent 20% drop in the cost index is by far the largest in its measured history (the series goes back to 1968). The index has only fallen significantly two other times. In 1982 and 1985. Both times by 10% over two or three quarters. The current cost deflation in the mining sector is unprecedented in the last forty years. Amid such a drop in costs, Citigroup's forecast of a steady $925 gold price means increased profitability ahead for gold miners. It may not be sexy, but making money is making money. Whether you do it through rising revenues or shrinking expenses.

U.K. Oil: Rock or Hard Place

The gold sector isn't the only one where costs and revenues are re-adjusting. Oil and gas producers are also seeing their margins change. But in the wrong direction.

In the gold sector, the commodity price has stayed level while costs declined. In the petroleum business the situation is opposite. Commodity prices have fallen but costs have stayed stubbornly high. This week British industry group Oil & Gas UK released its annual economic report, detailing how high costs are becoming a major barrier for North Sea petroleum producers. The major problem is that day rates for drilling rigs are still near record highs. Rates for semi-submersible rigs are currently running between $400,000 and $515,000 per day. That's 15% higher than summer 2008. Prices for jack-up rigs have declined slightly, but only by about 5%.

By contrast, U.K. gas prices are down 75% from their highs of last summer. Brent crude oil is down 50%, despite having recently strengthened to $60/bbl. This is extremely problematic for the industry. High rig costs mean that a company drilling a new well is making a huge "up front" capital investment to get oil or gas flowing. In order for the company to make a positive return on capital, the cash flow from this production has to pay back the cost of the well and deliver enough additional revenue to generate an acceptable profit for the company.

Suppose for example, that Pierce Oil drills a well in the Central North Sea at a cost of $20 million. The well finds oil and produces at a rate of 1,000 barrels per day. If Pierce makes a profit of $20 on each barrel it sells, the company is getting $20,000 per day in cash flow. At this rate, the well must produce for 1,000 days (about 3 years) just to pay back the initial $20 million drilling investment. Simply to break even. If Pierce wants to obtain a return on capital of 30% (that is, make a 30% return on the $20 million invested in drilling) they need to get an additional $6 million in cash flow out of the well. Requiring an additional year of production. And this is a simplified example, assuming that production stays level. In reality, the well's production rate will not hold at 1,000 barrels. By year two, the well might only be producing 500 barrels. By year four, the rate could fall as low as 200 barrels. At which point it takes much longer to pay back the capital cost of the well and book a profit.

The other problem for producers is that operating costs are staying high. In the U.K. North Sea, operating costs this year are averaging over $14 per barrel of oil produced. That's up slightly from 2008 and is considerably higher than the $12 per barrel producers were paying in 2007. Operating costs are also critical for the economics of an oil and gas project. In the example above, we assumed that Pierce Oil makes a profit of $20 on each barrel of oil it produces. But if operating costs rise (or commodity prices fall) that profit might be squeezed to $15 per barrel. At that rate, it will now take nearly four years to pay back the $20 million in drilling costs. The timeline for profit is drawn out further.

This is a "rock and a hard place" situation for petroleum producers. With costs high and commodity prices low, it's extremely difficult to turn a profit. Add to that the credit crisis, which is making it difficult for companies to secure equity or debt financing for drilling and operating. Because of all this, Oil & Gas UK expects new drilling in 2009 to drop off significantly. The U.K. North Sea saw 105 exploration and appraisal wells drilled in 2008. Projections for 2009 are as low as 30. This is a significant decrease in activity, and would represent the lowest level of drilling since 1999.

Big Brother, Where Art Thou?

With costs in the petroleum sector remaining high while oil and gas prices fall, something has to give. There are a few possibilities. Commodity prices could rise. If profitability gets squeezed too much, production should fall off and the lack of supply would cause prices to rise. (This logic doesn't always hold true. In the southern U.S., gas producers are continuing to drill new wells despite record-low gas prices, either because they have hedged production at higher prices or because they need to drill wells in order to hold ownership of key acreage.) Or service prices could fall so that companies can make a decent profit margin even at low commodity prices.

There is also a third option. Government can get involved. In addition to operating costs, a large part of the expenses for an oil and gas producer come in the form of taxes. Globally, there are numerous different kinds of taxes on petroleum. More traditional forms include corporate taxes where producing companies pay a portion of their profits to the government. Or royalties, where producers pay a percentage of revenues "off the top". There are also "hidden taxes" like production sharing, where a company must surrender a certain percentage of its oil or gas to the government. Or bonus and transfer payments, where a company must pay a fee to the government upon being granted the rights to a field or exploration concession (these fees can run as high as hundreds of millions of dollars) or making ongoing payments to the government for things like training local workers.

Obviously all of these expenses make a huge difference to a company's bottom line. In times where corporate profits are being squeezed by low oil and gas prices and high operating costs, the government can provide some relief in the form of reduced taxes. Helping producers weather the tough times and stay in operation.

Such aid from "big brother" is controversial. The public often sees this as a handout to "big oil", transferring funds from social programs to corporations. Rarely a popular move. Some capitalist purists also dislike this kind of aid, arguing that in tough times business should simply be allowed to fail. The problem for countries like the U.K. is that oil and gas production is not a simply an academic or philosophic matter. British oil and gas production peaked in 1999 near 4.5 million barrels of oil equivalent per day and has been in decline since. The country became a net importer of oil and gas for the first time in 2004. In 2008, the U.K. produced 2.64 million boe per day, meeting two-thirds of its energy demand. A further fall in production would mean greater dependence on imports. From countries like Russia and Algeria, whose dependability is dubious. Thus, U.K. oil and gas investment is matter of economic security.

Because of this, the government has been pulling out stops over the last several years to encourage new drilling and production adds. Marginal tax rates on oil and gas fields have been dropped from 75% to 50%. The government has also introduced new types of licensing to encouraging exploration. E&P companies can now apply for "promote licenses". These come at 10% of the upfront cost of traditional oil and gas leases in the region. They also allow the operator up to two years to assess the lease before having to sink the big bucks to drill a well. This gives the company a lot of time to decide whether it's worth drilling on a particular target. If not, they can simply walk away having spent only a minimal amount. Over the last few years, the government has awarded 293 promote licenses, a number of which have already resulted in commercial discoveries.

These initiatives have helped slow the decline of U.K. production. Between 1999 and 2006, U.K. North Sea output fell by over 1.5 million boe/d. A decline of about 200,000 boe/d yearly. In 2007 and 2008, the decline slowed to 100,000 boe/d. Still falling, but not as quickly.

But the success of the "production push" led to renewed calls for the government to take a bigger piece of petroleum profits. In late 2005, the government passed an act to increase its "supplementary charge" on petroleum profits from 10% to 20%. Combined with a 30% corporate tax, this brings total taxes for petroleum producers to 50%. In 2007, the government decided to exclude the oil and gas industry from a provision lowering corporate taxes to 28% for most other businesses in Britain.

The pendulum is now swinging the other way. With oil and gas companies seeing profits pinched, the industry is looking for the government to provide some relief. What might the government do? Repealing some of the supplementary charge tax is one option. Providing accelerated depreciation of capital costs is another possibility. This would allow producers to write off their drilling costs against taxes sooner, saving money up front. Remember in our example, Pierce Oil paid $20 million to drill a well producing about $7.5 million a year in cash flow. If 50% of this cash flow goes to tax, the company pockets only $3.75 million yearly. But suppose the company is allowed to write off the entirety of its capital costs immediately against cash flow. In the first year, Pierce would claim $7.5 million in capital cost allowance, sheltering all of its cash flow from tax. This would leave $12.5 million in capital cost claims ($20 million in drilling costs minus $7.5 million in tax claims). In year two, the company could once again shelter all $7.5 million of its cash flow, leaving $5 million in allowances that could be applied against most of year-three cash flow as well. A tremendous savings.

Most oil and gas jurisdictions allow for some recovery of capital costs. But often the yearly amount is capped. If a government imposes a 20% cap on capital recovery, the company can only claim 20% of its original capital expense in any given year. In Pierce Oil's case, the company would be allowed to claim only $4 million yearly (20% of the $20 million drilling cost). Claiming $4 million, the company would be left with $3.5 million in unsheltered yearly cash flow. They would pay 50% tax on this, draining $1.75 million from the company. In a time of low margins, that extra tax could make the difference between profit and loss.

Some jurisdictions even go beyond 100% capital recovery. These governments allow companies to claim an extra "uplift" on capital write-offs. If the government allowed an uplift of 25%, Pierce Oil would be able to claim 125% of its capital costs for drilling against taxes. After spending $20 million on drilling, the company would generate $25 million in tax pools. Enough to shelter three and a half years of cash flow. In fact, the U.K. government allows a 35% uplift for capital expenditures on fields commissioned before 1993 (with some limitations). Applying this kind of tax break to new fields would certainly help producers turn a profit.

Governments around the world are facing these issues. Outside the U.K., India is also looking for ways to stimulate its domestic production. The Indian government announced this week that it will re-instate a tax holiday for new natural gas fields. The policy allows gas field operators to avoid paying taxes for the first seven years of a field's producing life. Starting in 1999, the government had promised this tax holiday to bidders in its oil and gas licensing rounds. But the country then did an about-face in 2008, abruptly announcing that the tax break would be cancelled retroactively. Leaving every company that had acquired a field over the last decade suddenly facing reduced cash flows. Perhaps because of falling gas prices lately, the government recanted and said it will allow the tax holiday on new licenses awarded from this point forward. Producers who received licenses previously are still out of luck, but the move should help attract bidders for upcoming licensing rounds. Every little bit of saving helps these days.

"Bells and Whistles" Contracts

With commodities prices and operating costs having come "unglued" across much of the natural resources sector, companies are getting creative in protecting their profit margins.

One solution is to link revenues and costs together. This can be done by signing contracts with service providers that index costs to the price of a company's sales product. These are very unusual deals, but some interesting examples have emerged recently. U.S. aluminum producer Ormet is one company facing this dilemma. With aluminum prices having fallen from $1.50/lb to $0.70/lb over the last year, the company has seen its profit margins dwindle. The major cost for an aluminum-maker is electricity, with power accounting for an average one-third of production expenses. So, Ormet wants to make the price it pays for its electricity indexed to the price of the aluminum it sells.

The company has applied to the Public Utilities Commission of Ohio to adjust power rates for its production facility in the town of Hannibal. Under Ormet's proposed scheme, its power price would be set in relation to the London Metal Exchange price of aluminum. The price would be set at a level that allows the company to make a guaranteed minimum profit margin at the prevailing aluminum price. So if aluminum falls, so does the power price. If aluminum prices rise substantially, the utility is allowed to raise prices in order to recover some of the profits it lost while selling discounted power to Ormet.

There are of course criticisms that this plan amounts to a subsidy for the company at the expense of other power users. The key question will be whether Ohio is willing to give Ormet a break in order to keep the facility running and save jobs. But at the very least, this is an interesting example of "thinking outside the box" in order to preserve profit margins in a time of volatile commodity prices and production costs.

This kind of thinking is also being applied to financing costs. Some mining companies have recently experimented with bond issues where the bond coupon is linked to metals prices. A zinc producer, for example, might issue bonds indexed to the zinc price. At high zinc prices, bondholders would receive higher interest payments, maybe 10%. The extra payments are fine for the company because if zinc prices are high, corporate cash flows will also be high. But if zinc prices fall, and cash flows shrink, bondholders might only receive 3% on their investment. Allowing the company to pay less and conserve cash through the "lean times".

These kinds of "bells and whistles" are not as far out as they sound. The idea of adjusting taxes to commodity prices has long been accepted in the petroleum sector, resulting in the creation of sliding-scale royalties. It's common around the world for petroleum producers to pay higher taxes at higher oil and gas prices, or reduced rates when prices fall. Governments recognize that profitability is not static, and that adjustments need to be made as the pricing environment changes. Given the rapidly fluctuating cost structure of most natural resource sectors today, this thinking may become more common across the entire industry.

The Summer Heats Up

Another week has flown by. So much for the lazy days of summer! The Japanese say that the greatest blessing a person can have is to constantly face challenges and then delight in overcoming them. On the first count, I've certainly been blessed of late. Despite the summer lull, there has been a constant stream of new resource projects coming across my desk. And certainly a few that have proved, upon deeper analysis, delightful and worthy of financing. I suppose the greatest blessing a resource financier can have is to find worthwhile pieces of ground into which to stick money.

One point of business. I've mentioned before that reader feedback is one of the things that really makes my job fun. This week was no exception, and I owe a tip of the hat to Neil Adshead for writing in with an important caveat on a news item I mentioned last week regarding a new iron ore discovery in China. As Neil correctly points out, news about the "world class" nature of this deposit needs to be taken with a grain of salt as the ore is located at over a kilometer's depth. The deposit may be large, but it will be high-cost to produce.

The next few weeks are shaping up to be even busier than the last. I will almost certainly need to return to Colombia at some point soon to have a "boots on rocks" look at our latest property acquisition there. My partner at Notela Resource Advisors, Phil O'Neill, is headed to Asia this week to discuss financing on the project (and perhaps enjoy just a little beach time in Thailand). More on that soon.

And if the summer is quiet on the markets, it certainly isn't on the technical conference circuit. There are a number of great-looking events coming up in both mining and petroleum over the next couple of months. I plan to include at least a couple on my travel slate. They will undoubtedly provide some intriguing views on leading edge developments in these industries. And some musings for future letters.

As always, enjoy your weekend and thanks for reading. Meet you here same time, same place next Friday!

Here's to the wisdom in summer silence, 

Dave Forest
Pierce Points Weekly Newsletter

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Note: The information provided in this newsletter is based on the independent research of Dave Forest and Notela Resource Advisors Ltd. and is intended solely for informative purposes and is not to be construed, under any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy or trade any securities or commodities named herein. Information contained in this newsletter is obtained from sources believed to be reliable, but is in no way assured. All materials and related graphics provided in this newsletter and any other materials which are referenced herein are provided "as is" without warranty of any kind, either express or implied.  No assurance of any kind is implied or possible where projections of future conditions are attempted.  Readers using the information contained herein are solely responsible for verifying the accuracy thereof and for their own actions and investment decisions. Neither Dave Forest nor Notela Resource Advisors Ltd., make any representations about the suitability of the information delivered in this newsletter or any other materials that are referenced herein for any purpose whatsoever.  

The information contained in this newsletter does not constitute investment advice and neither Dave Forest nor Notela Resource Advisors Ltd. are registered with any securities regulatory authority to provide investment advice. Readers are cautioned to consult with a qualified registered securities adviser prior to making any investment decisions.

The information contained in this newsletter has not been reviewed or authorized by any of the companies mentioned herein.

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