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Companies Seek Lower Costs in Hope of Commodities Rebound

Some things never change in the gold mining industry which often leads the market in terms of making bad investment decisions. Inevitably, however, management does come to its senses, realizing that the grass is often greener in their own backyard than farther afield.

That cautionary tale would seem to apply to Goldcorp’s recent takeover offer for Quebec-based Osisko Mining which at the time of the offer traded at approximately 40% of its all time high of $15 in 2010. Goldcorp’s offer of shares and cash (valued at $5.95 per share) represented a 15% premium to Osisko’s closing price the previous trading day which is definitely at the low end by historical standards for any gold acquisition. Whether that hostile bid holds up will no doubt be determined by various legal challenges that are currently underway.

Osisko has been one of the great home-based success stories in the Canadian mining industry, developing a profitable low grade gold asset in the historic mining camp of Val d’Or-Malartic. The company also boasts one of the lowest cash costs in the industry – around $750 per ounce – which is obviously why it’s such an attractive takeover candidate for Goldcorp.

More than anything, Osisko’s success speaks to the ability of well managed companies to develop quality assets in highly regulated environments where the rules are generally unambiguous and the politics are predictable. You only have to look at Argentina, Mexico, Mongolia and several emerging countries to see the other side of the coin as many mining companies have learned to their detriment.

I’m probably not the only person that believes we are entering a critical phase in the minerals industry that will see ongoing consolidation (i.e. mergers and acquisitions) and a focus on political certainty, not to mention access to critical infrastructure that has a direct impact on mine development costs and, ultimately, unit production costs. Clearly, quality over quantity is becoming the order of the day.

That being said, it’s ironic to note that Canadian mining companies in particular sought to increase production through expensive acquisitions and large scale development projects, the majority of them offshore. Most of the gold deposits were low grade and predictably came on line well over budget. Their production costs also escalated, effectively offsetting higher gold prices.

What these companies were betting on was a continuation of the gold bull market which peaked at $1,913.50 in 2011 and spiraled downward thereafter. Perhaps the real irony lies in the fact that their desire to get more profit leverage to projected higher gold prices by boosting gold output had the opposite effect: they ended up with more leverage to lower gold prices which was compounded further by higher production costs. As stock market investors know all too well, leverage is very much a two way street!

Rather than continuing to destroy shareholder value through poor business practices, it appears we are finally seeing a return to business with a clear view of bottom line economics. What’s ahead for the industry? Well perhaps a look in the rearview mirror might provide some insights.

In actual fact, what the industry is going through today is nothing compared to the great recession in the early 1980s when the U.S. Federal Reserve drove the prime interest rate to 21.5%. Not surprisingly that policy tanked the global economy and decimated commodity demand, along with prices, to depression era levels. Stock prices also plunged. Eventually, the global economy stabilized and demand for mineral commodities returned to normal levels.

The situation is much different today. For one thing we are in a low interest environment which could last for years. While that’s generally bad for gold, which is an inflation hedge among other things, the monetary instability this policy creates should support higher gold prices in the future. Indeed, that’s the principal reason why gold producers in particular are focused on reducing production costs from existing operations, a fact the stock market is slowly beginning to recognize. Copper, a major industrial metal, is holding its own and so are iron ore prices which has come as a surprise to many. Both of these are bellwethers of global economic activity.

A more serious issue for the broader metals market is the health of the junior exploration sector which is heavily weighted to the gold sector. Companies are finding it difficult or impossible to secure venture capital; and what money is available undervalues their assets in most cases. High administration costs, much of it due to over regulation, means less money is going into the ground, reducing the potential for discovery.

One has to wonder if we will see any significant grassroots discoveries in the near future, the kind that produced real wealth for  countries in years past. That would be a pity indeed!

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