Consolidation affects exploration

You don’t need hyperspectral imaging or the latest in magnetotellurics to figure out that the impact of consolidation on exploration has been substantial. The last half-decade has been one of the harshest stretches for exploration that I’ve seen. The culprits are obvious: low base and precious metal prices and the flight of speculative capital, and along with it, investor confidence.

But these alone don’t account for all the changes we’ve been through. Consolidation is changing the exploration picture, both in combination with low prices and apart from them. These factors have contributed to a decline in exploration spending that promises to have a long-term effect on production supply.

While low metal prices may have helped start the consolidation wave, rising prices don’t mean an end to consolidation, or its effects on exploration.

This recent wave of consolidation started in 2000, and it started mainly with the base metal companies: Billiton bought Rio Algom, Phelps Dodge swallowed Cyprus Amax, Grupo Mexico acquired Asarco, and Rio Tinto took over North.

The wave gained momentum in 2001 with the BHP Billiton merger, and then the gold companies got on board. Since mid-2001 there have been more than 14 company mergers/acquisitions and more than 10 mine transactions in the precious metals industry.

What are the forces driving the consolidation wave in the first place, and will they continue?

First, consolidation has been driven by investor demands for scale. Getting on the radar screens of the investment community (the big fund managers, the analysts) is what it’s all about. Investors are demanding large, profitable companies with continual growth. How big is enough? Is US$8 billion in market capitalization enough? US$20 billion? The market cap of the entire gold industry — roughly US$55 billion — is less than a quarter of Microsoft’s US$255-billion market cap. The total market cap of the four largest diversified miners is only about US$80 billion.

Second, consolidation has been driven by investor demands for improving rates of return from existing assets, rather than by exploration and development of new ones. Low prices caused the focus to shift to reducing operating costs, improving margins, and operating smarter, cheaper and more productively. This focus on achieving synergies through consolidation isn’t likely to diminish, because the pressure remains on miners to achieve rates of return that are competitive with other sectors.

Consolidation is driven by companies seeking to replace or increase production without the inherent risks in time and money of exploring for and developing new assets. The flight of speculative capital resulted in significantly decreased exploration activity by junior mining companies that were part of the lifeblood of the exploration industry and significant contributors to the exploration pipeline.

There have been just two significant gold discoveries over the past three years, forcing companies to merge to show production and reserve growth. The result is a reshaped gold mining industry with fewer companies — and a widening of the gap between the major and small companies.

From a select group of 40 gold-mining companies in 1998, there were 14 intermediate producers controlling 24% of production and 20% of the market cap. By 2002, that same group had been reduced to 22 through consolidation, and there were only six intermediate producers controlling 10% of the production and 11% of the market cap.

In contrast, in 1998 the top eight gold producers in the group controlled 66% of the production and 65% of the market cap. And in 2002, nine senior gold producers controlled 86% of the production and 80% of the market cap. Thus we saw a decrease in intermediate producers’ share and an increase in the seniors’ share.

The net effect of consolidation on the industry is potentially positive insofar as it makes the industry better-qualified to compete for investor capital. But that’s not the whole picture.

We’re seeing fewer players at the top, and they are spending a larger percentage of shrinking global exploration expenditures.

Take gold mining, for example: In 1997, the three largest gold companies, Barrick, Newmont and AngloGold, accounted for 8%, or US$267 million, of total exploration spending of US$3.3 billion. By 2001, the big three accounted for 21%, or US$185 million, of a smaller pie of US$900 million. What’s equally striking here is the decline in gold exploration spending over the 5-year period to around US$900 million from US$3.3 billion. We see a similar decline throughout mining.

The Minerals Economic Group reports that exploration budgets for 2002 stood at US$1.9 billion, a drop of 14% from 2001. That followed a decline of 15% in 2001 and 7% in 2000. In total, exploration budgets have slid 63% since their peak of US$5.2 billion in 1997.

Without a doubt, low metal prices have been mainly responsible for the shrinking exploration expenditures in the gold industry, as elsewhere. Lest we forget the grisly details: nickel hit a low of US$1.69 per lb. in 1998; copper dipped to US61 per lb. in March 1999; and the gold price was US$250 per oz. in mid-1999.

Two additional factors — lack of risk capital, owing to the lack of investor confidence in the speculative side of the market, and the Asian crisis — resulted in decreased exploration spending by junior companies. But consolidation has played a role in the exploration spending cutbacks as well.

The Metals Economic Group reports that, in 2001 alone, the mining industry lost eight significant mining and exploration companies to consolidation. With them, a combined exploration budget of about US$166 million disappeared.

In 2000, before their merger, Newmont and Normandy had a combined exploration budget of US$111 million; in 2002, post-merger, the total budget was US$73 million. Before their merger, BHP and Billiton had a combined exploration budget of more than US$200 million; after the merger, it slipped to US$136 million. Pre-merger, Barrick and Homestake had a combined exploration budget of US$149 million; afterwards, it was US$104 million.

In my early years in this business, 1-million-oz. deposits filled the bill quite nicely back at head office, but today new finds must be both large enough to make a difference and offer rates of return that well exceed the cost of capital. And there have not been many 5-million-oz. deposits lately.

Since 1999, we’ve only seen two large gold discoveries: Goldcorp’s Red Lake deposit, which grew to more than 5 million oz., and Barrick’s grassroots discovery at Alto Chicama in 2001. Two in four years for the whole industry. By comparison, there were 10 between 1994 and 1998.

Another effect on exploration is the upheaval consolidation causes in terms of job losses and career moves in exploration. Job redundancy or downsizing is an unavoidable part of the process. A decrease in the number of companies translates into fewer jobs. Newmont for example, closed five exploration offices following the Battle Mountain merger, and Barrick closed three exploration offices following its merger with Homestake. Some people find themselves out of work, or leave the industry altogether.

Consolidation in mining also has a ripple effect on the investment industry. Consolidation means fewer companies, and there has been a similar consolidation under way in the investment industry. In short, there are fewer analysts paying less attention to fewer stocks.

Consolidation also leads to declining research and development spending in exploration. In Australia, for example, R&D funding dipped by 60% over three years, according to a 2001 report by the Australian Institute of Geoscientists. Less spending on R&D means fewer innovations and fewer improvements in exploration equipment.

I would argue that the cost of not funding new research far outweighs the short-term savings. And besides, with most of the low-hanging fruit already picked in exploration, new technological advances will prove crucial to improving our success rate.

The question is: Will consolidation cont
inue?

Apart from historically low prices, the same forces that sparked consolidation are likely to remain unabated. In fact, for the gold industry, the falloff in exploration over recent years has led to a shortage of new discoveries that could result in declines in industry production over the next 10 years — even at US$325-per-oz. gold or better.

This expected falloff in production comes at a time when rising gold prices are likely to focus investor interest on companies with the best prospects for production growth. This, in turn, will increase the heat on companies lacking good organic growth prospects to hit the acquisition trail.

Consolidation is also likely to continue at the level of individual assets, with companies swapping or re-shuffling contiguous assets or joint-venture properties amongst themselves in order to boost returns.

Where will all this activity be centred? Among the majors, the mid-caps, or the juniors? I think a good deal of the “urge to merge” will be played out in a mid-cap tier of companies seeking to get on the big-fund radar screens, as well as among juniors — for example, through mergers to unite a cash-rich junior with a project-rich junior.

But there is far more at stake here, and the long-term cost to the industry of the disappearance of exploration dollars is sobering. One thing is certain: the current state of affairs in exploration spending is untenable for the health of the industry.

Big companies need to spend more on exploration; otherwise, at current annual production rates, reserves will be depleted in 10 years. Given that most projects require on average of five to eight years from discovery to production, we are not currently funding exploration at a level required to replace reserves. We also need to attract more speculative capital back to the industry for the sake of junior exploration companies, which historically have provided a pipeline of new projects.

Fortunately, positive supply-demand fundamentals in the gold market bode well for the gold price. We need gold at US$350 per oz. and even higher, for five to six years, to put the economics in place to sustain exploration that will bring us the best discoveries — the low-cost, long-life properties that sustain the industry.

— The preceding is an edited version of a speech presented at the annual convention of the Prospectors & Developers Association of Canada in March. The author is the senior vice-president of exploration of Barrick Gold.