A Brazilian Gold Mine

Earlier this year, The Motley Fool's Bill Mann and Andy Cross spoke with Peter Marrone, CEO ofYamanaGold (AMEX: AUY  ) . Small-cap specialist David Nierenberg, whom weinterviewed recently, first brought this Motley Fool Hidden Gems Tiny Gems selection to our attention. Following are excerpts of our conversation with Marrone.

Bill Mann: Peter, I'll start with this: A lot of American investors -- North American investors -- have some misconceptions about the business climate in Brazil. Tell me: What it is like operating there for Yamana?

Peter Marrone: It is easy for us to forget, as North Americans, that Brazil is an industrialized country. Brazil is [among] the 10 largest economies in the world and has exceptional infrastructure. If one were to drive in the areas of Sao Paulo or any other major center ... one would find paved two-lane, four-lane, and six-lane roadways with overpasses. It would not be different from what you would find in North America.

It has abundant power [and] a diversified industry, and 95% of power in Brazil comes from hydroelectric power. It has an established mining culture. It has an economy that tailors itself, in some respects, to mining. Mining accounts for about 5% of Brazilian GDP, but if you include the collateral businesses that tailor to mining, it comes to close to 17% to 20% of GDP.

Add to that, though, a cost structure that is the equivalent [of that in] a developing nation, because power is inexpensive and because much of the equipment -- trucking fleets and the like -- is locally manufactured. ... Labor is inexpensive. It is a country, after all, of 175 or 180 million people. So it is an exceptional platform that is great from an industry and business point of view.

Then from a mining point of view, add to that the fact that the industry does tailor to mining, and the fact that you have a mining culture that has been here for hundreds of years.

BM: Perhaps this would be a good platform to discuss Yamana and how it fits within the gold-mining business. But gold mining is extraordinarily energy-intensive. One of the things I wanted to talk about was the economics of the gold-mining industry and what differentiates, in your mind, the mining companies themselves, in terms of ore in the ground or cost of production.

PM: Well, the starting premise is the gold price. The gold price, as you are probably aware, has been in a steady climb for a number of years. I believe that it continues to get stronger from here, but right now we are in an environment of about $570 per ounce for gold, and the marketplace is a very liquid marketplace, so a gold miner, such as ourselves, would be selling into the marketplace and would be selling at spot price, normally. So the spot price is only for the day that you are selling the gold -- and it is usually very competitive. There are at least a couple of quotes and, often, more than a couple of quotes. One would be getting very close to what the spot price is for gold.

The revenue is driven [from] the commodity price. We do not produce anything other than gold at this point, but later this year we will be bringing a mine into production that produces copper as well. We will be selling that as a concentrate, so effectively it is a powdery substance that contains gold and copper. We will be selling it to smelters. Again, it is a worldwide marketplace, and the contracts that we have in place are international contracts -- European, South American, and Asian. These are contracts for the purchase of the concentrate, but the price that we will get for copper and gold is the spot price at the time.

Then the margin between that price and what would be our cash flow would be our operating expenses. The operating expenses are what you would normally find in a business -- everything from the cost of extracting the ore from the ground to transportation costs to costs for the continuing development of other ore bodies, labor costs, fuel costs, power costs, and the like. The lower one can produce the product per ounce, the greater the margin, and so the more cash flow and ultimately more profitable that mine is and, ultimately, the more profitable that mining company is. So by and large, our larger cost components would be labor, power, and consumables.

BM: OK, wonderful. One fairly big piece of news for people who do follow the gold market is that in the past 18 months or so, BarrickGold (NYSE: ABX  ) announced that it was removing its hedges from production. Again, maybe to go back to Gold Mining and Gold Management 101, why would you hedge production? Is this something that you do at Yamana?

PM: Well, we would not hedge our gold production. The reason for this is that we believe gold continues to have a significant upside. I believe that we are in this "perfect storm" of events that leads to higher gold prices -- certainly sustainable gold prices at these levels.

But mining companies about a decade ago turned to financial instruments hedging their gold production, and now they are finding that those who did that are experiencing losses by comparison to the spot market, because they have hedged to prices that are lower than the current spot market. So that is why I think a lot of these companies are de-levering themselves from hedges. We have not hedged any of our gold production and do not intend to hedge any of our gold production.

Bill, the other thing is that shareholders who invest in our companies like to see leverage to the commodity price and to the gold price, so eliminating some of that leverage by hedging our gold production would be a mistake from a shareholder point of view as well.

Now having said that, copper is a bit different. We do see copper, at least in some respects, as the equivalent of cash, so we are not reluctant to hedge some of our copper production. We have hedged 50 million pounds of our copper production [for] 2007. That is the first full year of operations for that mine that produces copper, the Shapata Mine. That, as I said, represents about 50% of our production.

We have hedged that copper production at $1.37 per pound, but what we have done is taken long calls at $1.67, which means that anything above $1.67 we share in the upside and we have this protection below $1.37. So it is the equivalent of cash at $1.37, and we still share a lot of the upside.

I believe that we are in a marketplace today where copper prices and gold prices and other commodity prices continue to go up, but since we are predominantly a gold company, my view is that hedging some of our copper production -- to apply that as, effectively, cash toward our gold-production costs -- is a prudent thing to do.

BM: OK. Well, let's play global macroeconomic prognosticator for a moment. What do you suppose is driving gold prices? And even if you believe that the long-term trend is in place, could there be a temporary bubble?

PM: You know, if I could predict the gold price, I would probably be in a very warm, tropical place ... and I would have a sweet drink in my hand. It is difficult to predict where gold prices will go. However, in late 2004 and early 2005, I thought that the gold price would go to $500 an ounce by the end of 2005. My prediction was right. I think it will go higher than $600, and my view is that there is this perfect storm of events that could take it to $800 an ounce this year. I think it certainly can average $600 per ounce this year.

The drivers for gold prices are counter currency, [which] trades as an opposite to the U.S. dollar and then, ultimately, as an opposite to a basket of currencies. It has been trading as the U.S. dollar has weakened relative to other currencies. Gold prices have been improving.

We then saw a movement in the pattern where as the U.S. dollar and the euro and some of the other currencies in the world weakened [while] we saw gold continue to strengthen. Add to that the fact that we do have some economic concerns in many parts of the world -- that there are significant budget deficits and trade deficits. And consumer debt is at an all-time high in many parts of the world, including the United States, Canada, and many parts of Europe.

And then, finally, add to that the geopolitical circumstances that we find ourselves in, with conflicts in various parts of the world -- what is happening in Iran with its nuclear policy, for example -- and I think those things have a natural tendency to create concern. People turn normally to harder assets and turn normally to things like gold as a protection against these types of geopolitical events. So it is this perfect storm of events that seems to be concentrating itself within this period of time that I think marks for a higher gold price.

BM: In terms of looking at an investment in gold versus an investment in "Gold-Mining Company X," what would be the difference?

PM: As a starting point, what I would look for in Yamana -- and I think what your readers would be interested in -- is growth. Growth is important. This is a company, as an example, that will have gone from one mine with [fewer] than 100,000 ounces of production in 2003 to more than four mines with a production level in 2006 of about 400,000 ounces. And in 2007, I project about 550,000 ounces increasing to 650,000 ounces of gold production by 2008.

So I think growth is important, and the next thing that one should look at is value. What is the cost of production of that gold by comparison to other companies? What is the margin, in other words, between the cost of production and the gold price?

In 2007, with our first full year of operations on our Shabata Copper Gold Project and with by-product credits, we would be producing gold at less than $100 per ounce, and so you can imagine that in a gold environment similar to today, that is a very large margin to the gold price. And so that makes for a very, very strong cash flow and good profit position for a company like ours. So those are the things that I think one would look at.

I like the idea of multiple assets. While it is always interesting to have a large, very long-life mine, I like the idea of a portfolio of assets that get to the same result. Again, Yamana is an interesting example of that, because we have a portfolio of a number of different assets that take us to that ultimate 650,000-ounce level by 2008.

BM: Including $220 million in cash.

PM: Including cash, yes, and including copper production, which by 2007 will be more than 100 million pounds of copper. And, in 2008, close to 190 million pounds of copper.

BM: Peter, do you think that the increase in gold prices attracts additional capital -- in other words, additional competition to the industry?

Current Hidden Gems subscribers can access the rest of our interview of Peter Marrone in text or audio format.Not yet part of the Hidden Gems community? Come and check it out -- a one-month guest pass is free and gives you access to all of our small-cap stock recommendations, plus interviews, analysis, and our online community.

Bill Mann, co-advisor of Hidden Gems, does not own shares of any company mentioned in this article.Nor does Hidden Gems research analyst Andy Cross. The Motley Fool has a disclosure policy.


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