Description

I see these warrants as a way to get at least 3X leverage to gold, through Sept. 7, 2011.  This leverage is non-recourse and carries no counterparty risk – good things to have when you’re buying insurance against economic disaster.  I’m interested in gold because it’s one of a very few assets that has tended to perform well during both inflation and deflation.  I have no grand predictions here – but I do worry about both and I’ll buy insurance if the price is right.

(Notes: all security prices in CAD.  Trading volume YTD has averaged 35,000 warrants per day.)

Let’s consider the alternatives for getting exposure to gold:

Buy Physical – I don’t dislike this one, but I’m wary of committing lots of capital to a non-interest bearing asset which is so difficult to value.  I would want any long exposure if gold seemed wildly expensive, but I don’t think that’s the case.  We’re not far from the marginal cost of production (probably mid-$700s/oz versus $876 spot), and supply growth is constrained, at least for a while.  That said, I can’t tell you exactly why the price couldn’t be 30% lower in a year.

Buy options on physical – at-the-money options are really expensive, plus you’ve got counterparty risk.

Go long a futures/forward contract – the problem here is that the forward curve is in steep contango (last I checked the 12 month future was over $1,000/oz).  This is the futures market’s way of charging you a steep price.  The margin debt used will magnify any losses.  Plus, you’ve obviously got counterparty risk with forwards.

Buy gold miners – I don’t necessarily dislike this one, but I do have two concerns: first, I think the number of companies that qualify as “insurance” is fairly limited.  Basically, I’d look for:

• Producing gold now or in the near future
• Minimal net debt
• Self-funding (for development of existing properties)
• Below average costs
• Long reserve life (i.e. less risk of an overpriced acquisition to replace reserves)
• Majority of value in politically safe countries

Don’t get me wrong:  stocks not on this list could still have a good risk/reward.  There could be plenty of names with overly discounted exploration/ political/ financing/ etc. risk.  I just don’t think they qualify as disaster insurance.  You’ve got to have production to have leverage to gold.

My second concern is that I don’t know just how much leverage to gold I’m going to get.  Gold stocks are often viewed as levered plays on the metal, since production costs shouldn’t rise as much as the gold price.  That’s true to some extent, but I see three factors that create a drag on earnings growth: 

• Cost pressure - labor, equipment, and energy each make up about 1/3 of costs, and have all been a big drag on earnings growth this decade. 
• Miners have a tendency to go after their higher cost reserves when the price jumps significantly, which is also a drag on earnings (the idea is to make decent margins on your crappy reserves and save the good stuff for a rainy day). 
• Let’s face it: this is a commodity business that has traditionally over-invested.  Gold stocks that fit my above criteria are almost always priced as if the discount rate ought to be 0% (which it shouldn’t).  Eventually, people tend to get what they pay for.

All that said, if gold goes up from here, most producers probably will see some earnings leverage.  And maybe valuation multiples will expand for a while regardless.  All I know is that I’d want some decent leverage to compensate me for all the risks the come with mining versus just owning the metal, and I’m not sure how much leverage I’ll get.  Perhaps an expert could figure this one out, but I’m a generalist.

Buy calls/ warrants on gold miners – I like this one best.  Specifically, I like these Kinross warrants because:

• Kinross qualifies as “insurance” in my book.  It’s roughly the fourth largest gold miner in the world, has almost no net debt, long reserve life, low cost, etc.
• Longer dated – these go out to Sept. 7, 2011, versus January 21, 2011 for the longest dated options.
• Zero counterparty risk – Kinross can always issue another share.  Admittedly, counterparty risk for an exchange traded option is probably tiny, even with $2,000 gold.  But why not avoid this risk if you can do it for free (or better)?
• Relatively cheap – the warrant market is something of a backwater, thus less efficient than the equity option market.  For example, these warrants currently trade at an implied volatility of 53%.  Their nearest cousin on the Toronto exchange - the $22 strike warrants maturing 1/21/2011, trade at 71%.

Interestingly, of the 100+ gold stocks in the world with publicly traded warrants, Kinross was the only name that came even close to meeting my criteria.  Warrants are typically issued as a sweetener in higher-risk IPOs, secondaries, etc. – which included Bema Gold back in the day.

Kinross assumed these warrants when it acquired Bema gold in a stock swap valued at 0.4447 Kinross shares per share of Bema.  The strike price is $10, thus it will effectively cost you 1/0.4447 * $10 = $22.49 to buy one share should you exercise the warrants.  (Fractional shares are settled in cash.)

To be conservative, I’m assuming that Kinross shares will rise 1:1 with the price of gold (note that Kinross is the only large producer with no base metals exposure).  Kinross is trading at about 1.4 to 3X NAV, depending on how realistic a discount rate you use.  It may not be logical, but these shares are well within the range of NAV multiples that gold stocks like this trade at.  Given my limited capital outlay (thanks to the leverage), I’m willing to bet that goldbugs won’t change their ways in the next 885 days.

A few extra words on Kinross:

The biggest risk here, by far, is probably just the price of gold.  But I’ve taken a look at a couple other sources of risk and come away feeling OK.

• Growing pains – production growth is forecast at about 20% for 2009, owing to the startup of the Buckhorn mine, a major expansion at the Paracatu mine, and the first full year of production at the Kupol mine, which has been producing since mid-2008.  Of these, Paracatu likely has the biggest potential for delays since the expansion has tripled throughput of its low grade ore, making it one of the largest operating gold mines in the world.  Fortunately, Paracatu is open-pit (much easier than underground) and otherwise low cost.

• Political risk – calculating NAV as conservatively as I can, Kinross has about 70% of its property value in the U.S., Chile and Brasil – all of which are fairly safe places to mine.  A firm called Behre Dolbear (www.dolbear.com) ranks the top producing mining countries by political risk each year.  For 2009, the highest marks went to:

1.      Australia

2.      Canada

3.      Chile

4.      U.S.

5.      Mexico

6.      Brazil

About that other 30%...  About 20% is found at the Kupol mine in Russia, a country which Dolbear lists as tied with Bolivia for second to last place out of 25 (hey, at least it’s not the Congo!).  So, yes, it’s risky.  But since the negatives are obvious, let me point out a few positives:

• Kinross has owned two other gold mines in this same part of Russia over the past 12 years (Julietta and Kubaka).  While Kubaka did run into some political hassles, I calculate that the project eventually returned a roughly 15% IRR.  The biggest drag on returns by far were the low gold prices of 1998 – 2001, not politics. 
• As far as I can tell, the Julietta mine did not experience any political problems worth noting, and returned an IRR north of 25%.
• The partnership structure is good: Kinross 75%, local government 25%
• Most of the horror stories amongst Western gold miners occurred in the late 1990s and early 2000s, when commercial law was less well defined.  It’s still risky, but the legal environment is significantly better today.
• The Kupol mine is located in an extremely remote area, which helps to keep out the bad guys.
• CEO Tye Burt has extensive experience with Russia

The remaining 10% is at the Fruta Del Norte site in Ecuador.  Again, it’s risky, but:

• The government is already getting most of the economics in the deal
• The mine will likely not commence production before the expiry of these warrants anyway.  Were Ecuador to renege on this deal, it’s unlikely to happen while Kinross is still spending money to bring FDN to production.
• The history of similar deposits (Yanacocha, Goldstrike) suggests a good chance that the deposit could be much larger than the current 13 million ounce estimate (which is already huge).

Catalyst

Money printing, deflation, etc.

Expansion of reserves at FDN