Gold plan points to price pain

Investors keen on gold were disappointed by the failure of the attempt to merge Newmont Mining and Barrick Gold, but what they should have been more disappointed about was the original proposal and the negative message it contained about the gold-price outlook.

When the complex deal surfaced two weeks ago, some people saw it as a way to generate synergy benefits in the world’s two biggest gold producers that would maximise profits.

As always the devil was in the detail, because merging Newmont and Barrick into a $US30 billion business, and then splitting it apart into two new companies with specific geographic focus, would effectively have created a “good” company centred on North America and a “bad” company with assets spread around the world.

Essentially, the best and lowest-cost mines would be housed in the North American business. Most of the other mines, earmarked for the “Rest of the World” company, are old and high-cost, including one of Australia’s stalwarts, the financially struggling Superpit in Kalgoorlie.

Some observers saw the deal as a way to “spin” assets off Newmont and Barrick, creating two new businesses owning mines that could be worked more efficiently by focused management teams.

In theory that might have happened, with the spin-off able to develop as a rival to the parent. As Karl Siegling explained in the February 7 edition of Eureka Report (Spin-offs beat IPOs), there can be benefits from giving a business independence and a motivated management team.

There is a problem with that theory when it comes to mining, however, because the only factor management can effectively control in a mine is its costs. There is little opportunity to add value to the end product, especially when that end product is a single element such as gold.

All miners are price-takers, forced to accept what the market if offering. There can be one-off synergy benefits from combining adjacent mines, but once that’s done the business reverts to price-taking.

The Newmont/Barrick merger proposal would have achieved some synergy benefits, but mainly in one part of what was being created; the North American business where the costs are already lowest and the synergy benefits greatest.

It was never explained in these terms but it can be argued that management at Newmont and Barrick were seeking to merge in order to create a world-beating gold producer, while the higher-cost assets were discarded.

The numbers tell part of the story. Between them, Newmont and Barrick currently produce 12.3 million ounces of gold, with output roughly the same at a little more than 6 million ounces each.

After the proposed merger, two businesses would emerge – still producing 6 million ounces each, but in different parts of the world, and at a significantly different cost.

The North American business, centred on the US state of Nevada where Newmont and Barrick operate adjacent mines, would be the world-beater, able to ride out any future fall in the gold price.

The other company, probably containing the Australian assets, would have a higher cost structure.

The deal would have created one business able to survive a gold-price collapse, and another business that would probably struggle if the price-collapsed.

The North America business would probably have emerged with an ongoing cost structure below $US600 an ounce, well able to prosper in a lower gold-price environment such as that forecast in my April 11 story (A gold mirage) and more recently by a number banks, including Morgan Stanley and the ANZ.

Earlier this week, Morgan Stanley joined another investment bank, Goldman Sachs, in forecasting a future gold price of less than $US1150/oz, down $US134/oz on the overnight price of $US1284/oz.

Click to enlarge

That latest price is itself down $US36/oz since that April 11 story despite rising tensions in the relationship between Ukraine and Russia, an event which might once have triggered an upward surge in the gold price.

The problem for gold is that the world economy, despite the odd trouble spot, is improving. The US economy is slowly gaining strength and money is being rotated out of safe havens into conventional investment destinations such as industrial equities. Even Europe is showing signs of slow improvement.

Specifically why the Newmont/Barrick deal was abandoned has not been explained, with outsiders left to assume that it was a personality clash at board level, or a disagreement over what assets went into which company.

It could even have been about which managers went to which company, because there the division of assets would have created two significantly different businesses – one guaranteed to be profitable at all times, and the other not.

One of the better comments made during the merger process was from a Canadian fund manager, Norman MacDonald, who manages about $US1.5 billion in funds including Invesco’s Gold and Precious Metals Fund.

MacDonald told the Bloomberg news service on April 24 that an earlier de-merger conducted by Barrick had not been a success. That deal involved the spin-off of gold assets in Tanzania to create African Barrick Gold – a company which has halved in value since it was created.

“They didn’t spin those assets into a public vehicle because they wanted other shareholders to reap huge rewards,” MacDonald said. “They created an entity because the assets were dogs and hoped someone would take them off their hands”.