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Can-The-Gold-Industry-Return-To-The Can the gold industry return to the golden age? Digging for a solution to the gold mining reserve crisis Can the gold industry return to the golden age? Digging for a solution to the gold mining reserve crisis Authors Greg Callaway Oliver Ramsbottom 4 Can the gold industry return to the golden age? Executive summary The gold industry finds itself at an inflection point between the recent era of cost out initiatives and balance sheet deleveraging, and an increasing need to focus on growth and the replenishment of depleting gold reserves. However, after a period of impairments, write-downs, and value destruction following the M&A frenzy of the last gold price boom, shareholders in search of improved returns and greater management accountability are unlikely to support significant M&A programs, which have been the traditional mainstay of production growth and gold reserve expansion for major gold companies. The future strategic options to drive growth will differ across industry players, but all players will need to consider a mix of organic and inorganic approaches if they want to return to growth in an economic and sustainable way. Since the turn of the century, the gold industry has experienced a roller-coaster ride, with prices rising from USD 255/oz in 2001 to highs of USD 1,906/oz a decade later, before falling to USD 1,056/oz by December 2015. This reversal of fortune led debt-heavy gold companies, which had engaged in aggressive M&A programs before the peak, to initiate dramatic cost out programs, resulting in all-in sustaining costs (AISC) declining 20 percent to USD 879/oz between 2012 and 2017, and significant impairments totaling USD 129 billion since 2011. The impact of these initiatives coupled with current higher gold prices has restored the health of large gold companies, evidenced by stronger cash flows, leaner cost structures and deleveraged balance sheets. However, this recovery has come at a cost as gold reserves have declined by approximately 26 percent to 713 MOZ, due in part to an approximate 70 percent reduction in exploration expenditure as companies sought to preserve cash. This raises the uncomfortable prospect of a looming reserve crisis. During the last boom, gold companies sought to bolster reserves by launching acquisitions, with annual acquisitions peaking at USD 38 billion in 2011, while the average price paid per ounce reserve in this peak period was often more than 300 percent higher than deals executed a decade earlier. In recent years, shareholders and activist investors have become increasingly vocal about value destruction resulting from aggressive M&A strategies and – despite transaction multiples being at decade lows – management teams are cautious about resorting to this approach to replenish depleted reserves. This challenge is being exacerbated as greenfield exploration programs have failed to deliver but a handful of significant gold discoveries above 6 MOZ since 2006, and there are also long lead times between discovery and first production. As a result, relying on traditional greenfield strategies alone will likely be insufficient for many companies with aspirations to capture growth in this new era. The strategic response required will differ by company depending on the current strength of gold reserves and project pipeline, internal exploration and project development capabilities, financial balance sheet strength, and the M&A execution track record. Whatever approach is taken, management teams will need to pursue a multi focus approach, i.e., driving growth via selective exploration and acquisitions while using new methods and technologies offered by digital and advanced analytics. Can the gold industry return to the golden age? 5 What goes up must come down A popular investment anecdote relates how Sir Isaac Newton – a proponent behind the British government’s move from silver to gold as its monetary standard – suffered significant losses in the South Sea Bubble. In early 1720, Newton cashed out with profits of GBP 20,000, doubling his investment, but as the share price continued to rise, Newton lost his nerve and not only invested once, but twice. He supposedly lost most of his investment in the crash that followed and is claimed to have said “[he could] calculate the motions of the heavenly bodies, but not the madness of people.” Thus was born the First Law of Financial Gravity: what goes up must come down, and what goes up the most will come down the hardest – a lesson not lost on the gold industry. The gold industry has been on a roller-coaster ride since prices peaked at USD 1,906/oz in September 2011, and companies have undergone a rapid transition from debt-fueled, acquisition-driven expansion and a “production-at-all-costs” mindset, to a period of aggressive downsizing to reduce bloated cost structures and – for some – to avoid potential insolvency. After five years of restructuring, impairments, and write-downs, the industry is recovering and cash flows and profit margins are improving. Many commentators are increasingly confident that the industry cycle has finally turned and is entering an upswing; however, many companies remain cautious about initiating growth strategies – especially those requiring large M&A programs – as activist investors continue to berate management teams and boards alike for significant value destruction during the last boom and bust cycle. Exhibit 1 Gold prices peaked above USD 1,700/oz during the 1980s energy crisis and 2003-11 commodity boom, only to sharply decline thereafter Gold price, 19702017, USD/oz, 2015 real 2,000 Commodity 2nd oil crisis boom 1,600 1,200 Black Monday China 1st oil crisis equity 800 crash/ Dot-com Brexit bubble 400 Sale of UK gold reserves 1970 75 80 85 90 95 2000 05 10 2015 Source: World Bank; McKinsey Global Institute 6 Can the gold industry return to the golden age? Prices moving ever skyward Between March 2000 and October 2002, the NASDAQ Composite lost approximately 80 percent of its value, dropping from 5,047 to 1,114 and, in the process, representing a USD 5 trillion to 7 trillion loss in value. This represented the fallout of the dot-com bubble, which began in the late 1990s and witnessed soaring US equity valuations fueled by speculative investments in internet-based companies. The end of the dot-com bubble and subsequent events were the catalyst for the decade-long rally in gold prices from lows of USD 255/oz in April 2001 to a peak of USD 1,906/oz in September 2011. The gold price rally in the 2000s. Gold price forecasts follow two schools of thought: one of supply-demand cost-curve fundamentals; the other of macroeconomic factors such as interest rates and exchange rates. McKinsey’s assessment suggests that gold price-setting mechanisms reflect a combination of supply-demand and macroeconomics – in particular oil prices, US inflation, US real interest rates, and US dollar exchange rates. Together, these factors enable us to understand the increase in gold prices from 2006 to 2011, during which time stock market returns were close to flat compared to gold price returns of approximately 120 percent. From a fundamentals perspective, this period was characterized by increased demand for gold from emerging markets, with Indian and Chinese jewelry, physical bars, and official coins increasing more than 1,100 tons between 2003 and 2011. At the same time, a number of macroeconomic factors were at play – first, fears of global inflation stimulating gold consumption as a hedge against inflation and economic uncertainty, especially during the 2007 to 2010 global financial crisis; second, increasing concern over debt levels and quantitative easing dampening the investment appeal of US treasury securities and municipal bonds; third, investor belief that China would significantly diversify its foreign currency reserves into precious metals, including gold and silver. Accelerating M&A, capital spend, and shareholder value destruction. After two decades of declining gold prices, the rally of the 2000s provided management teams with an environment in which to focus on growth strategies, in many cases fueled by aggressive acquisitions and poorly managed capital projects. From 2000 to 2010, the industry saw over 1,000 acquisitions with a combined value of USD 121 billion, compared to only USD 27 billion from 1990 to 2000; indeed, at the peak in 2011, in a single year there were over USD 38 billion in acquisitions. Many of these deals were predicated on gold prices continuing to increase, with some industry experts predicting prices to rise above USD 5,000/oz. This drove CEOs to pay premiums of 30 percent and more; for example, in 2009, Goldcorp’s USD 229 million acquisition of Canplats was offered at a 41 percent premium to the then share price, while in 2010 Newcrest also offered a 41 percent premium to shareholders in the USD 8.5 billion acquisition of Lihir Gold. Simultaneously, annual capital expenditure by large gold companies increased tenfold between 2000 and 2012, with aggregate spend exceeding USD 125 billion. Our research shows that two-thirds of projects exceeded budgets by 60 percent compared to initial estimates, and half of capital projects experienced delays between one and three years. Factors leading to cost overruns and delays include rising contractor spend, owner and EPCM cost growth, scope change, industrial retaliation, domestic currency appreciation, and the logistics challenges of remote regions. For example, the South Deep gold mine in South Africa has persistently fallen short of production targets, even after investments starting in 2006 totaling approximately USD 2.5 billion. In 2017, South Deep produced 281 KOZ of gold instead of the expected 315 KOZ. In mid-2018, after two labor restructurings at the end of 2017, it was reported that it was unable to quantify the impact of the large-scale restructuring on production in 2019 and later.
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