The Nearly Free South African Opportunity Made of Gold

Mar 12th, 2008 | By Ed Bugos | Category: Commodities, International

South Africa’s gold and platinum deposits are among the largest and richest in the world. But you’d never know it from watching the lackluster price action of most South African gold stocks. In general, these stocks have lagged far behind their North American counterparts. But there’s good reason to believe that these laggards might soon become leaders.

Despite a persistent drop in annual gold production since the 1970s that has reduced output to an 85-year low, South Africa is still the second largest gold producer in the world. With gold and platinum prices breaching record levels every other day now, especially in terms of the struggling South African currency, you would think that investing in South African miners would prove to be a winning formula.

Yet many of the South African gold shares have all but sat out the bull market of the last eight years.

Smaller producers are trading near their worst levels since 2000. Harmony Gold Mining (HMY: NYSE) is up only 100% since 2001. Same with Anglogold. Gold Fields is up a little better (200%) since 2001. A 200% gain sounds pretty good, until you realize that gold itself has gained nearly twice as much over the same timeframe.

What’s more, the modest of gains of the South African mining stocks pale in comparison to the Gold Bugs Index (^HUI: AMEX), which is up some 600%; let alone some of the leaders of that group, such as Goldcorp or Agnico Eagle, which are up 800% and 1,300% respectively, since 2001.

Then, just when a soaring gold price started to breathe fresh life into the South African mining stocks, a severe electricity crisis struck the country. In late 2007, South Africa’s electricity utility, Eskom, started imposing “rolling blackouts,” due to an overloaded grid. The power shortage prompted Eskom, which provides 95% of South Africa’s electricity supply, to halt all electricity exports to neighboring countries. The crisis worsened nevertheless. South African mining stocks tumbled.

Five days later, the South African mining industry reported an emergency power outage that lasted several days — where all production was lost. The utility “indicated that the current quota of 90% of average historic electricity consumption will remain in force for at least five years, through to 2012.”

The problem of course is underinvestment, thanks to poor government planning. And unfortunately, no easy solution is in sight. Although Eskom and the South African government are trying to rectify the situation, no new power supplies are due to come on stream until 2012. In the meantime, the mining companies must simply put up and shut up.

Like many other South African mining stocks, Gold Fields (GFI: NYSE) has slumped badly since the electricity crisis became a front-page story. But the truth is that this story has been on the back pages for quite a while, and Gold Fields has already been adapting to it.

South African operations comprise approximately two-thirds of the company’s operating mines. The rest lie outside the country. Obviously, the blackouts do not affect the foreign operations.

In a teleconference, management said power has been tight for three years already, but Eskom’s latest announcements have acted like a catalyst, forcing the company to prepare for the worst going forward. But the worst is not that bad for Gold Fields, which is why its stock seems unjustifiably cheap.

Gold Fields expects its South Africa production to fall as much as 25% this quarter, then 10% to 15% on a “steady state” basis thereafter. After considering its international operations, this translates into a 15% production shortfall this quarter, and afterwards management expects growth in its international assets to offset the domestic decline and fill the void altogether. The company expects operating costs to increase by up to 25% this fiscal year, but gold prices are already up 50% on GFI’s averaged realized FY2007 prices. So these rising costs should not reduce profit margins.

The South African electricity crisis is just the latest in a series of short straws that the South African miners have drawn, and that have worked to depress valuations in the segment. The first blow occurred in 2003 when mining companies in South Africa were required to give up 26% of their interests (over 10 years) to the locals — under the Black Economic Empowerment (BEE) charter. Since then, the industry has faced several obstacles, from a strong Rand (2002-2004) to soaring labor costs, to safety problems at some mines.

Technically, the climax in bearish sentiment occurred in 2005. The current crisis is anticlimactic. That’s where I see a potential buying opportunity in Gold Fields…

The stock market is valuing each of Gold Field’s proven and probable gold ounces in the ground at only U.S. $110. That valuation is less than half the market valuation of Newmont’s reserves — which boast lower grades and less exploration potential.

But just comparing raw values…

In terms of its overall “measured and indicated resource,” Gold Fields is trading at one-fifth of Newmont’s value.

At a $10 billion market capitalization, the market values Gold Fields roughly equal to the intermediate producer Agnico Eagle, a Canadian company with only 20% of the proven reserves that Gold Fields controls, and only 10% of the probable reserves, and only 25% of the annual production. In other words, Agnico Eagle is roughly the size of Gold Fields’ international assets. At these prices, that’s like getting Gold Field’s South African operations free!

This comparison demonstrates the dramatic difference between investing in gold shares and investing in gold itself. The investor who buys gold does not worry about operational risks, or rolling blackouts or the valuation differences between various types of mining companies. The investor who buys gold, owns gold…pure and simple.

But the investors who buys gold shares assumes a variety of risks…and potential rewards. Now that the South African mining stocks have lagged behind the gold price for so many years, and have also suffered from the recent electricity crisis, they probably offer a lot more reward than risk.

The electricity crisis in South Africa may well represent a small window of opportunity to buy some of the best quality mining assets in the world on the cheap.

Regards,

Ed Bugos
March 12, 2008

Editor’s Note: As always, send any questions or concerns to us at jim@pennysleuth.com

Ed Bugos

Ed is a former Howe Street broker. During the late ’90s, while many Wall Street firms were abandoning commodities altogether, Ed toiled for his clients on the Vancouver Stock Exchange. He was able to make his clients money even during the most vicious bear market for gold in the past two generations. Ed is now excited to take his skills and knowledge of precious metals and apply them to one of the biggest bull markets history has ever seen.

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