Gold Mining: Royalties and Jurisdictions

A look at gold royalty companies...

DIRECTOR and research analyst with CIBC in Toronto, Cosmos Chiu focuses on midtier Gold Mining producers, but his coverage gives him a leg up on truly understanding royalty companies' assets. In this interview with The Gold Report Chiu talks about how much longer royalty companies could continue to outperform the rest of the market, while also discussing some of his favorite jurisdictions. 

The Gold Report: Gold spiked to nearly $1800/ounce (oz) after the latest round of quantitative easing was announced. It has since fallen substantially. What's responsible for gold's recent price weakness?

Cosmos Chiu: If you look back, the month of October is usually the weakest month of the year. Because investors look at it as a seasonably weaker month, there's less demand. That has held true this year as well.

TGR: Could gold finish the year higher than where it is now?

Cosmos Chiu: Different factors that could drive bullion higher in November and December, including the restocking of jewelry for the winter holidays in the West and in India, the rethinking of the role for gold following traditionally weaker markets in October, and continued bailout concerns for Spain and Greece. It has also been a favorable monsoon season in India as well. That should also help increase demand coming from the Indian population.

TGR: Do you forecast strengthening investment demand, too? 

Cosmos Chiu: Investment demand was lower for the first half, but there's been strong central bank buying, which certainly helps. Demand isn't just composed of exchange-traded funds. 

TGR: What's your investment thesis for midtier producers predicated on higher Gold Prices?

Cosmos Chiu: They're in the industry of producing gold so higher Gold Prices don't hurt. Even though they're in production, they're small enough to have meaningful growth ahead. It's not that hard to grow a company by 20–30% during the next year if a company has a starting base of 200,000 oz (200 Koz).

Some of the midtier companies benefit from dealing more with pure gold instead of base metal byproduct credits, base metal contracts and smelter contracts. There's sometimes less complexity in running these companies as well. 

I just got back from traveling to a road show in Europe—I go about twice a year. Investors are still very bullish on the gold and Silver Prices. One key question that's been unanswered in North America and across the pond is why have equities underperformed the commodity and will that continue? 

Costs, more or less, are not stable—they're not going down, but they're not increasing at the same rate they did before. Earlier, they were increasing at a faster rate than the increase in the Gold Price. There has been some margin deterioration. We don't have any concrete evidence that this has reversed, but we certainly have seen some of the input costs moderate a little. That's going to be a key driver for some share price catch-up to the underlying commodity.

Companies' multiples will start to move more consistently as investor confidence continues to come back. 

TGR: What about jurisdiction?

Cosmos Chiu: People always like to bring up political risk. But what is political risk? Is it higher taxes? The risk of expropriation? The risk of war? To understand political risk, investors have to understand all these different types of risks. And don't ever forget about permitting challenges and issues like that. Investors need to understand that there's a wider scope to political issues than what's highlighted in newspapers.

TGR: What's the first thing you would tell an investor interested in African gold plays?

Cosmos Chiu: Africa is one of the fastest growing areas in the world. While mining in South Africa is well developed, a lot of opportunities are still currently available to investors in other parts of the continent. I quite like Burkina Faso, Ghana, Sierra Leone. They provide good value for investors. 

I'd also say it's a mistake to lump together all countries in the entire region. There might be issues in Mali, for example, but that doesn't mean all the other countries are impacted. 

TGR: Which countries in West Africa are you most bullish on?

Cosmos Chiu: I look for stability in the government and exploration upside. The three that I like the most are Burkina Faso, Côte d'Ivoire and Ghana.

TGR: Where will the next wave of producers come from? What are some development-stage projects in West Africa that you're keeping an eye on?

Cosmos Chiu: West Africa is the most favorable jurisdiction. There's a greenstone belt that goes through all these different countries. It's quite simple. The more greenstone belt, the more exploration potential for a country. 

Mali has been a historic producer of gold, but given the recent instability in the country, exploration and production have been more muted of late. 

One up and comer, although it doesn't hold as much of the greenstone belt, is Sierra Leone. It has several projects under development. Given the civil war that devastated the country more than 10 years ago, it is looking forward to and very supportive of foreign investment.

TGR: How would you compare Turkey to West Africa in terms of gold exploration potential?

Cosmos Chiu: They are very different. I was actually in Turkey two weeks ago on a mine tour. The mineralization is different in Turkey because there is a larger silver component. The mining is somewhat different in that there is more heap leaching. The infrastructure is better.

However, Gold Mining is not yet a huge component of Turkey's economy. There's a culture behind gold production, of course, given the history of the country. That said, at this time, it's not as well developed yet as Canada, Australia or other jurisdictions with a longer, modern mining history. 

TGR: Royalty companies have been the sector's star performers over the last few years. How do you decide which royalty companies to cover?

Cosmos Chiu: To analyze royalty companies well, you need to understand the underlying contracts and the underlying mines. We have an advantage because we cover most of these underlying mines that actually pay a royalty to companies. 

You need to look at the composition of these royalty streams. Where are they coming from? Is gold a byproduct of these streams, are the economics driven by gold or is it driven by silver or some other precious metals? How big of a component is each stream of the total net asset value (NAV)? You never want a single stream to dominate the NAV of a royalty company because part of the royalty attraction is the diversification of risk. 

I always say they're one of the easier types of companies to cover—they tend to meet my earnings and cash-flow targets quarter over quarter. 

TGR: Do you expect royalty companies to perform as well over the next three years as they did over the last three years?

Cosmos Chiu: It's certainly been a good environment for royalty acquisitions. We've seen accretive deals within the last two months. The favorable conditions for royalty acquisitions should continue for the next two to three years.

TGR: Will royalty companies pay larger dividends?

Cosmos Chiu: It's a double-edged sword. They want to return investment to investors, but, at the same time, why would they if they have opportunities out there where they can continue to generate positive alpha for the company itself? 

We've seen over and over again how these royalty acquisitions have increased the NAV of the company. I believe companies will keep it at a certain point, say more than a 1% yield, to make sure that there is some return to investors, but they will want to make sure that they also are able to capitalize on opportunities.

TGR: There aren't a lot of royalty companies, but do you see further consolidation among them?

Cosmos Chiu: I wouldn't be surprised. I've covered them for a long time. It's much easier for a larger royalty company—some of these companies have been around for a long time and it takes a long time to build up a good portfolio. The diversification benefits are not as clear for some of the smaller companies. I wouldn't be surprised if there's more consolidation knowing that it's actually quite a small space in the end.

Royalty company financing has become more mainstream. Many of these mining companies are looking at it from the perspective that they want to have a royalty financing component as part of a more integrated financing package. They want to do some type of equity financing, a portion debt financing, a portion project financing and also a portion of the royalty financing.

TGR: What are some investable themes that our readers should watch for in the precious metals space throughout the remainder of this year and into 2013?

Cosmos Chiu: I've been telling clients to look for the companies that will deliver on their promises. Look for companies that have the ability to capitalize on some of this cost abatement that we might see in some parts of the industry. From my perspective, I favor companies that are more pure gold than the ones with a significant base metals component.

TGR: I've appreciated speaking with you today. Thanks, Cosmos.

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