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Paolo Lostritto: Don't Retreat, Reload Your Gold
Source: Brian Sylvester of The Gold Report (1/31/11)
When it comes to the 2011 gold price correction, Wellington West Senior Analyst Paolo Lostritto says he's seen worse. In this exclusive interview with The Gold Report, Paolo counsels investors to "use this opportunity," if they haven't already, to rebuild gold positions because he foresees upside by the second half of 2011.
Paolo Lostritto: We've seen a reaction in the gold price over the course of the last several weeks in response to these tightening measures. Historically, North American players have experienced inflation pressure in the form of labor inflation, like during the 1970s. This time around, we're seeing inflation problems in the developing economies such as Asia and Brazil. However, these inflation pressures are starting to get exported around the globe. An example would be the recent focus on food price inflation. The reserve requirement adjustments are in response to these types of issues. Should the velocity of money accelerate to more traditional levels, this problem is only going to get worse.
TGR: We're continuing to see some significant downward movement in the gold price this week. What's Wellington West's position on the ongoing volatility in the gold market?
PL: In the last 10 years, there's been a slow and steady progression of the gold price in response to the amount of fiat currency that has been issued; this is an attempt to stimulate economies around the globe. During that progression, there have been many examples of much more volatile corrections than the recent one. Wellington West still believes this is just a short-term blip in a long-term secular trend, and that weakness should be looked at as a buying opportunity.
A perfect example is Sprott Asset Management's recent efforts to buy silver for the Sprott Physical Silver Trust (NYSE.A:PSLV). Sprott has been purchasing silver for the past 2.5 months, and they're still trying to take delivery of that physical silver. Silver prices have corrected despite a tight physical market. There's a severe disconnect between the fundamentals and the price action. The one silver name that I cover is South American Silver Corp. (TSX:SAC; OTCBB:SOHAF), which is in the exploration and development phase and has only tested 30% of its exploration target and yet has yielded a resource of over 330 million ounces of silver.
TGR: Is the same thing happening with exchange traded funds (ETFs) and gold? Are they having trouble taking delivery, too, or is this strictly about tightness in the silver market?
PL: The one advantage of having eyes and ears on the ground in terms of the physical market is that you're able to see the ebb and flow of true physical demand. We have contacts in the industry that we tap every once in awhile, and this is pretty fresh data on a large scale. That's hard to ignore.
TGR: How much does gold have to fall before you and the Street become worried about high cash-cost gold producers and their margins?
PL: We look at it on a case-by-case basis. At Wellington, we are using $1,400/oz. gold for 2011 and 2012, and use a long-term gold price thereafter of $1,000/oz. Gold equities have been in a sweet spot since 2008 whereby costs have been somewhat contained while commodity prices have improved. The time to make serious money in the equity markets is during phases when you have margin expansion, similar to the 2001 to 2004 period. However, during the 2004 to 2007 period, margin compression despite higher commodity prices was a bit of an issue, which was reflected in the lack of equity performance. We are starting to see signs that costs are creeping up again. Consequently, one is more inclined to lean toward producers that have the majority of their capital expenditures behind them, or alternatively, royalty companies such as Franco-Nevada Corp. (TSX:FNV) that give you exposure to the commodity but not to potential cost inflation.
TGR: Franco-Nevada recently took over Gold Wheaton Corp. (TSX.V:GLW). What do you make of that move?
PL: I thought it was a brilliant move by Franco-Nevada Chairman Pierre Lassonde, President and CEO David Harquail and their entire team to add value through an asset that was underappreciated by the market. After that deal, we changed our rating from a market perform to a buy. This recent correction is starting to look very, very interesting from a valuation perspective.
TGR: Let's go back to the creeping cost escalation that you talked about. What factors are behind those rising costs?
PL: We're starting to see a little bit of cost inflation in steel and oil prices, but the majority of cost inflation is coming from the shift in labor and currencies. This is effectively the same problem that we had in the 1930s, when every nation was trying to entice economic growth through competitive currency devaluation. But if everybody is doing it, it's a race to the bottom, and who really wins? That economic backdrop presents some difficulties to investors trying to preserve wealth, and that's why some are turning to gold as a means of protecting themselves.
TGR: One high-cost producer that you follow is Avion Gold Corp. (TSX:AVR; OTCQX:AVGCF). Avion is mining gold from several deposits in Mali. That company had a remarkable run in late 2010, going from less than a dollar in early November to above $2 by the end of the year, made possible by the impressive cash flow numbers from its gold production. You have a market perform rating on that stock now. What needs to happen to get Avion to the next level?
PL: Avion has been a great turnaround story and that speaks to the high level of professionalism within that organization, from the production guys to the geologists. Their attention to detail has allowed them to unlock the value of those assets. In the next six months, Avion is going to have impressive cash flows from their existing operations. It has a market perform rating because, from our perspective, the current market capitalization has already priced in a significant portion of those expected better results that should occur over the course of the next three to six months. In order to get to the next level, we believe the company has to have another significant, near-surface discovery that will allow them to access relatively high-grade, inexpensive ore to keep those cash flows going.
Now, Avion is accessing some underground mineralization, and we think there's a real opportunity to demonstrate further value by extending those mineralized zones at depth. But traditionally, underground operations take a bit more time and have a tendency to run into dilution issues; hence, our cautious approach to valuing this company. But the team there has done a tremendous job in unlocking value. We were pounding the table on Avion back when it was around $0.45–$0.50.
TGR: Well, they recently completed 22 holes of drilling in the cross-structure part of the Kofi deposit, and one hole hit 27 meters running 6.1 g/t gold. Is this something that the Street was looking for, or is this part of the expectation that you talked about before?
PL: No. This is an asset that Avion recently acquired, and the company tested a cross-structure theory and confirmed it in drilling. Those assays prove that the theory, in fact, holds together. There's a lot of value yet to be unlocked in some of these peripheral assets. The difference, of course, is that some of these other assets are farther away from the Tabakoto mill. The ounces found near a mill are worth more than ounces that are farther away. Kofi is roughly 35 km away as the crow flies, but from a road and infrastructure standpoint, it's about 55 km away. We tabulate that to be about $6–$8/ton in costs, so you would have to look at maybe mining some of the higher-grade material before you started trucking it. Alternatively, if it's big enough, you build its own stand-alone operation. We're still in the early days of trying to unlock additional value from Kofi. Avion's team is planning to do about 22,000 meters of drilling there. It will be an interesting year from an exploration standpoint.
TGR: What's Avion's cost per ton from operations near the Tabakoto mill?
PL: It's an open pit area called Dioulafoundou, and their costs—hauling costs, mining and milling—are something on the order of $50-$60/ton. That's a function of being in the early stages of the open pit. However, we would suspect that the strip ratio is going to increase as they get a little bit deeper. Probably by the end of this year, costs will shift closer to $85, maybe $90/ton at that deposit. But offsetting that, you're dealing with some phenomenal grades for an open pit; you're talking 4–6 g/t, and any time you can mine open-pit material at between 4–6 grams a ton with that cost base, it's a license to print money. We think that the next three to six months are going to be pretty special.
TGR: Let's head in a slightly different direction. Wellington West recently published its top stock picks for 2011.The companies on Wellington West's 2010 Top Ten Picks list averaged a return of 72%. Not bad.
PL: Not bad at all.
TGR: Indeed. I won't ask you about all the names on that 2011 list because some of them aren't gold or base metals names, but there are three companies with gold properties among the 2011 picks. Can you tell us about those?
PL: The two names that I covered in last year's Top Ten report were Anatolia Minerals (TSX:ANO) and Kirkland Lake Gold Inc. (TSX:KGI). Anatolia was a 111% performer last year, and Kirkland Lake was up about 78%. Anatolia has gone from being an emerging producer to being in the process of merging with an Australian group called Avoca, to form a new company called Alacer Gold. Assuming that the merger happens as planned, Alacer could soon be producing more than 400,000 oz. per year and become a significant player in the mid-tier space.
TGR: And Kirkland Lake?
PL: It was a hell of year for them . They went from being an obscure, under-followed, under-appreciated company producing roughly 50,000 oz. per year to being covered by several analysts; their market capitalization went from roughly $300 million to close to $1 billion. I think Kirkland Lake is just getting started in terms of being able to demonstrate production and cash flow growth over the coming two or three years.
TGR: Well, getting that kind of coverage certainly helps. But let's get back to Wellington's 2011 picks. Please tell us about those.
PL: I've only submitted one pick this year, and it's a company that exited 2010 with some challenges. And it's in light of those challenges that I think there's tremendous value and opportunity going forward. My top pick was Victoria Gold Corp. (TSX.V:VIT). At the tail end of last year, Victoria had to retract a portion of its resource statement in Nevada. Data was incorrectly entered into the database by their consultants. Unfortunately, the error was caught after it was published. It was a bit embarrassing, but we are not too concerned.
We think there's an opportunity because the drilling at the Cove Project in Nevada was never tight enough to suggest that we had a great understanding of the mineralized system at depth. Victoria really had only enough information to justify constructing an exploration ramp. Victoria Gold's plan of operations has been approved by the Bureau of Land Management. Consequently, the company is now in the short strokes of finalizing their required permits before driving the ramp in the first quarter of this year, with the hope of getting first pre-production by the third quarter.
In addition to that, there is Victoria's Eagle Project in the Yukon. The prefeasibility study on Eagle was less than well received, but what most people don't realize is that the pit walls were designed using a 30-degree slope. The rock qualities have since been tested and may justify using a pit slope of 40 or maybe even 50 degrees. Under that scenario, significantly more mineralization would fall in the pit design, and that would have a huge positive impact on the project's internal rate of return.
Those are two big value drivers and there are several "blue sky" exploration targets that are not priced into the stock.
TGR: You're saying Victoria is going to build this underground ramp at Cove to get to the mineralized ore at depth and that we could see some gold production in the third quarter?
PL: It will take roughly six months to get there, and the company will do two things once it gets underground. One, it will conduct advanced exploration drilling in order to understand the deposit dimensions and ideally expand the resource. Secondly, it will be able to "teaspoon" some of that material, roughly 400 tons per day, and ship it to one of the local smelters. There are three smelters in the area; one is owned by Barrick Gold Corporation (NYSE:ABX; TSX:ABX), one by Newmont Mining Corp. (NYSE:NEM), and another by Yukon-Nevada Gold Corp. (TSX:YNG). I think there's enough competition there for 19-gram gold material to suggest that Victoria has a pretty good chance of securing an off-take agreement. As a result, we believe Victoria Gold should be ready to snap back in 2011.
TGR: There are two other mining companies on Wellington's list that are covered by another analyst in your shop, Steve Parsons. I know analysts don't usually comment on companies covered by other analysts, so, Steve, would you like to comment on those names?
Steve Parsons: Sure. One is Sulliden Gold Corp. (TSX:SUE; OTCQX:SDDDF). Sulliden is focused on developing its Shahuindo gold-silver project in Peru, near Barrick Gold's Lagunas Norte mine and Newmont/Buenaventura's Yanacocha mine. It really does fit the bill for a two-part theme I've been talking about for a while. The first part involves my expectation that building cash balances in the mid-cap producer space will spur a pick-up in M&A activity. The second part of the thesis is that the glut of development projects planned for 2013–2016 will undoubtedly create a very tight market for qualified labor and input cost inflation. With this market dynamic in mind, I look to mid-size deposits as probable targets. In particular those projects offering low capex intensity that are relatively easy to build and easy to operate. Shahuindo fits the bill given the open pit, heap leach configuration. As this theme plays out (and it is still early days), I expect the merits of Shahuindo to crystallize and drive Sulliden shares substantially higher. My target price is $3.90.
The other one is Aura Minerals Inc. (TSX:ORA). Aura is a gold producer and operator of the San Andres Mine in Honduras, and the São Francisco and São Vicente mines in Brazil. Aura also has material base metal exposure with the 100% owned Aranzazu Cu-Au-Ag mine in Mexico and the Arapiraca copper-iron-gold development project in Brazil. At 0.7x P/NAV, ORA shares are the cheapest in our gold producer universe and by a wide margin; average of peers is closer to 1.2x. The opportunity is that I expect Aura to be in a state of abundant positive news flow starting in Q1/11 led by a step-change improvement in production and cash costs at the company's flagship San Andres mine. I also view as positive the potential for Aura to surface value from the large Arapiraca copper project in 2011.
TGR: What are some other names you're following in the gold space, Paolo?
PL: I cover 19 companies, and other than Victoria Gold, I only have two strong buys in my space. One is Kirkland Lake, which we talked about. I expect their growth, both in cash flow and in resource, to continue over the next two to three years. I've also got a strong buy recommendation on Lake Shore Gold Corp. (TSX:LSG). It's the same story as Kirkland Lake; there's enough critical mass and production that through expanding the resource through the drill bit, and through future cash flow, those valuations—Kirkland Lake and Lake Shore—should move up over the next two or three years on a relative basis. A comparison would be something like Alamos Gold Inc. (TSX:AGI), which is producing between 150–170 Koz. per year with a market capitalization of roughly $2.2 billion. With Kirkland Lake and Lake Shore, you've got two companies that are roughly $1–$1.3 billion that are going to produce that amount of gold in the next 12–18 months.
TGR: One more for the road?
PL: Sure, Aurizon Mines Ltd. (TSX:ARZ; NYSE.A:AZK). Aurizon is set to have a banner year in 2011. They've moved from mining at a faster rate in 2010, but at mildly lower grades, to being in an area in the Casa Berardi mine where they're aiming to have higher grades; closer to 8-grams per ton. This company could be set up to produce record cash flow and earnings in 2011. Aurizon is poised to do well. Their balance sheet is rock-solid and should benefit from improved grades during 2011. The company is positioned to either develop existing assets or use that war chest to expand their asset base.
TGR: That's something the Street's been expecting for awhile, and it hasn't happened. Is there a particular reason for that?
PL: David Hall is a very prudent president and CEO. As part of the construction and ramp-up of Casa Berardi, he went through a period of repairing a balance sheet that had some debt on it. After demonstrating that the mine would work, generating some cash flow, and paying off that debt, Aurizon has built up not only a substantial cash balance, but several other projects to which it can deploy that capital in order to advance both growth in production and growth in cash flow. Aurizon has had a fairly robust move over the last couple of years because it's heavily sensitive to the gold price. It's gone from roughly $0.50/share back in 2002 to about $6.50/share now.
TGR: Before we part ways, what's your outlook for the gold market in 2011?
PL: We exited 2010 with a lot of fervor. There were a few generalists who would not normally participate in the space who entered it, and it was a bit frothy there for a time. We are currently experiencing a little bit of retracement, which is shaking out some fast money. But we've seen this before, over the course of the last 10 years. I still have faith in the investment thesis, especially given that some Central Banks have gone from net sellers to net buyers of gold. There continues to be examples of large pension funds looking for a means to protect their wealth. And there are numerous examples of oil-producing nations quickly converting their oil cash into gold as a means to protect that wealth.
I look at what's going on now as a short-term correction; I am not quite sure how long it will last, but I would use this opportunity, if you haven't already, to rebuild your gold position, because I believe the second half of 2011 is going to be a lot of fun.
TGR: Paolo, thank you for your time.
Paolo Lostritto currently serves as a mining analyst for Wellington West Capital Markets Inc. He has formerly worked with Scotia Capital and MGI Securities. Paolo holds a B.A.Sc. in geological and mineral engineering (Toronto), P.Eng.
Senior Research Analyst Steve Parsons, P.Eng., has been a member of Wellington West Capital Markets' equity research team since April 2008. After earning his bachelors of engineering degree in mining at Queen's University, Steve worked as a metallurgical engineer for Placer Dome, and then moved on to a metallurgical consulting firm. Shifting to the investment side of the business after that, he signed up as a research associate with GMP Securities, concentrating on base metals initially and later joined MGI Securities as a research analyst.
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1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his 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: Franco-Nevada, Avion, Sulliden and Aurizon.
3) Paolo Lostritto: I personally and/or my family own shares of the following companies mentioned in this interview: South American Silver Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None.
4) Steve Parsons: I personally and/or my family own shares of the following companies mentioned in this interview: Sulliden. I personally and/or my family am paid by the following companies mentioned in this interview: None.