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China matters to LatAm, but Deutsche Bank forecasts don't

Scanning through Bloomberg this morning I came across this scary report. Deutsche Bank AG (DB) is calling China as a big risk for LatAm, bigger than the US and its well-reported slowdown. Check out the article yourself, but basically DB says that rising inflation in China means the gov't there will shut down the economy by tightening the financial screws and cutting down on capex projects. This will cause a massive drop in commodities demand and we'll all be royally screwed as prices plummet for copper, soybeans, zinc, iron ore, coal, you-name-it.

Sounds like bad news for LatAm, and I can imagine a lot of nervous longs poring over their mining exposure right now and thinking about paring down holdings. Well I'm here to give you the good news that will bring immediate and permanent relief to you nailbiting longs;


Really. They way suck. Here's how DB has predicted on China for the last five years, adjusted its forecast and then watched as China whips its forecasting trasero time after time.
The first column in grey is DB's original forecast on China's GDP growth for the year in question. The second column in that odd peachy-orangy Excel colour is DB's mid-year adjusted forecast (in fact they adjust their forecast all through the year, but I've tried to choose one that falls as close as possible to the end of each second quarter). The final red column is the actual GDP growth result of each year.

So yeah, they way suck. I mean, last year they called 9% growth for China, and it came in 2.4% higher! That's a 26.6% miss on a country, guys, which represents about 900 billion dollars (yep, that's a "B") of biz they failed to see. That's....errrr....a And they miss without fail every year.

But you don't notice it, because for one thing they adjust and adjust and adjust their guesses...OOOPS sorry!...their detailed forecasts until the one published in late November of each year nails the number and suddenly these guys are damn smart on China. And it's Deutsche Bank making these wild-ass guesses, not some damnfool with a blog in the middle of South America. Y'know....Deutsche Bank! Supposed to be smart, earning big money for this stuff etc.

So Otto sez; stop taking these clowns seriously just cos they wear a decent cut of suit and use all that impressive financial spiel. DB's China track record is laughable,and when you read reports like this on Bloomie you should have a really big contrary indicator lightbulb going beserk in your cranium.


Fitch Ratings breaks the big news on Chilean energy crisis...

...that was broken a month ago.

But still, it's interesting to see a kickbutt heavyweight office full of smart people say that Chile really does have a doozy problem with its energy sector, and it's not just a figment of this joker's imagination. Fitch did a more detailed job on supply breakdown and its PDF report is worth a read (that's on the first link above), but the message is basically the same as the report published February 11th by Hallgarten (gotta pay there) and available freebie at RGEmonitor (hooray):

*Chile's energy supply is very tight
*Generation costs are soaring
*GDP projections are now out the window
* Brownouts and blackouts are in the cards
*Copper production will be affected
*etc (read the links if you still care)

Also up today was this report from Reuters (in Spanish only so far, but zap it through the Google translator if your Castellano is a bit rusty these days) from Chilean power generation company Colbún. The President of Colbún told reporters that supply conditions were "critical" and "at absolute limits" amongst other gems, and made it clear that the day demand went over the limits is the same day Chile gets its first round of blackouts. Oh, it's critical 'til June, too.

Which is all well and good, but unless you live in Chile you need a decent reason to know all this, right? Well, there's a trade or two staring us in the face here.

1) Play the copper supply squeeze that's on the way (you can trade the metal futures, or perhaps a non-Chile exposed Cu producer like PCU would work well). This has the downside of running against the bearish grain of the broad markets right now, so maybe the next one is better.

2) ECH. This ticker is the iShares MSCI Chile Index, an ETF chock full of Mapuche exposure (23% in utilities for one thing). It's a pretty new vehicle, having opened for business late last year. The chart here ....(gracias, your charts rock)

.....shows that right here right now ECH is at a new high, and we think the energy crisis now made 'official' by an international ratings agency and explained by a Chilean energy bigwig in no uncertain terms makes our recommendation you're about to read a pretty good trade for the next few weeks, especially when you factor in the drought in Chile that doesn't just leave hydro reservoirs empty, but means the agro sector there is in bad shape, according to all sources.

Our reco on ECH? Short that sucker. Our reco for residents of Santiago? Buy candles.

Breaking News: Reporter In Venezuela Writes Facts about Economy

Benedict Mander writes for the Financial Times of London, and since he was posted to Venezuela last year has been one of the few fair voices covering the country's economy (and politics, for that matter). He does what a good reporter should do; reports on what's going on. Period.

His latest FT missive points out something which has seemed obvious for quite a while if you don't swallow the hype and find out what's really going on: Chávez isn't a dumbass, Venezuelan oil is still drooled over by BigWorldOil Ltd. and the partial nationalization of the country's oilfields last year (the state now controlling 60% of the business, and oil companies get 40%) did not live up to the Coup d'Etat-making wet dreams of the kneejerk anti-Chávez establishment.

Sorry (IESA) boys, it looks like greed is winning out over fear again. Oil companies are now lining up to do business in the Venezuelan oilfields on Chávez's terms, and the money Venezuela makes is actually getting spent on radical lefty things like 'schools' and 'hospitals' and 'roads' and.....errr.....stuff......dude.

Gold about to have its own little "Scotty from Star Trek" moment


I propose the following motto for the reverse side of South America's single currency (coming to a jingly pocket near you January 1st 2018):

"We got loads of commodities down here."


Argentina's new forex policy in three words: STUPID STUPID STUPID

Here are a few two year charts that map how some local currencies have done against the dollar.

Here's the Brazilian Real (approx 20% appreciation)

The Chilean Peso (approx 18% appreciation)
Here's the Colombian Peso (approx 10% in two years, but 23% from that peak)
Now the Peruvian Nuevo Sol (approx 16% appreciation)
And to give some global context, here's the Euro's perf against the greenback in the same two year period (approx 21% appreciation)
Meanwhile, Argentina's Peso has done...well..this;
While the vast majority of world currencies have appreciated considerably against the US Dollar, the Peso in Argentina has actually lost ground against the greenback to the tune of around 2%.

I've been through the "whys" of this monetary policy before, but in a nutshell Argentina wants to keep its currency artificially weak so that its exports remain competitive. The fact that it doesn't necessarily change anything (I've previously argued that one as well) doesn't seem to worry be it.

I've also argued in other places that Argentina is setting itself up for a speculative attack on its currency from overseas investors. Peru is the latest regional state to have made the complaint that foreign hot money has been washing in and overcooking its forex market. Well, it looks like Argentina has not just ignored this threat but has just thrown the door wide open to the speculators and pinned a sign saying "please take my money" on its back.

Bloomberg reported today that Martin Lousteau, Argentina's minister of the economy, plans to sell ArgP$40Bn into the foreign currency markets this year to keep the Peso weak. But this time they aren't just going to emit Peso debt but use tax revenue pesos to buy the dollars, the idea being that they can artificially weaken the currency without printing more currency and adding to the country's inflation problem (and hey, it's a problem).

Sounds fine, no? You get to 1) up your dollar reserves, 2) keep your currency nice and weak and where you want it and 3) don't add to M2 in pesos, thus lessening monetary inflation pressures.

Well, apart from the obvious inflation problem a weak currency causes to a country with a strongly growing GDP (country gets richer, country likes that 42" flatscreen digital TV they make in Japan, country starts importing shiploads of stuff, country pays through the nose for foreign goods in its local currency cos the damnfool gov't won't let the Peso go from 3.15 to 2.80 vs the dollar etc etc), the chances of being openly gang-raped and left with sore nether regions are multiplied tenfold when you start playing forex games in the big leagues instead of just pumping out the pesos to the unsuspecting locals and sterilizing the transaction.

How it happens is like this: Argentina wants to sell ArgP$40Bn in a year...that's ArgP$3.33 a month...let's call it a billion dollars' worth to round up a bit. So Argentina trots over to the open forex market and finds a buyer for its pesos. Ka-ching, dollars change into pesos at 3.15/1, and everybody's happy.

But hold on a minute; if you were the buyer, what would be the attraction in buying a currency that wasn't planning on going up in value? Surely you'd be a buyer in the Peso for a reason, no? You'd like the Peso and happily sell your dollars if you thought it would get more valuable later.

So what happens if you, as Señor buyer, decide that you don't just like the Peso but you REALLY like the Peso? The Argentina government goes to market and sells its ArgP$3.33Bn for the month, and you go, "Hey! wait up dudes!! I haven't finished buying those yet! Don't run away, sell me another 3 billion, yeah?"

Argentina says, "Sorry dude, ain't got no more right now....I'll sell you a few next month ok?"
Señor Buyer, "Hey dude, that's bogus. Anyone else wanna sell me some?"
Private bank #1; "Yeah, I got 500 million of them, but I won't sell 'em so cheap. I'll give you 3.1 of them for a buck."
Señor Buyer, "Yeah ok, it's a deal."
Private bank #2; "Dude, you can have half a billion of my Pesos at 3.05 if you like, yeah?"
Señor Buyer; "Cool,'s the moolah."

Now all this time Señor Buyer's feeling happy, cos he bought 3.3Bn pesos at 3.15, then managed to bring down the exchange rate by buying a few more at lower prices. So if he cashes in his original buy at the latest deal price of 3.05 he makes 10c on every Peso he bought from the gov't. And when your talking 10c X 3.3Bn, that's a tasty profit.

But the gov't aren't so happy, they see what's been going on since they left the market and go,
"WHOAAAA! Bad karma, maaaaaan! This whole thing was supposed to keep the Peso weak, and now look what's happening...SheeeYIT! We're gonna have to sell some more Pesos."

So the gov't goes back to market and sells another 3 billion or so. But Señor buyer isn't just any old buyer with a deep pocket. He's a hedge fund with REALLY deep pockets, and he smells serious profits here.

Señor Buyer; "Hey, this is SOOOO cool. These dudes are selling me lumps of cheap currency, but not only that, they've already told me how much they're going to throw at me in the whole year. They have ArgP$40Bn to sell. Hold on, let me check how much I've got here. Okaaaay! Way cool. I've got TWO HUNDRED AND FIFTY BILLION DOLLARS HANGING ROUND HERE! All I have to do is buy every single cheap Peso the Argentine gov't offers me, then buy more and more and more until they can't defend it any more! Sweet! Then it goes to 2.80 or so, up 10% more or less, and I cash in my chips....They sell me 40 billion chips and i make 4 billion profit without breaking sweat."


Moral: Argentina is now officially playing with fire. It doesn't take Einstein to work out that the Peso is lagging behind all other regional currencies (check those charts again), and by going to the open foreign exchange market with a fixed amount of Pesos to sell they are making a huge tactical mistake. The big rumour a couple of weeks ago was that economy minister Lousteau was very close to resigning. When the forex market has finished with him and his half-baked plan, he might just get fired first.

Ssssh! Venezuela is being responsible..for heaven's sake don't tell anyone

The graph above shows how Venezuela's currency, the Bolivar (previously known as the VEB, now called the Bolivar Fuerte, aka 'VEF' since Jan 1st when three zeroes were lopped off the rate) has performed versus the US dollar in the semi-official parallel market since May 2006. (click on the chart to get a better look). From a rate that fiddled around 2.65 to the dollar for years, the parallel rate started moving up in 2006 and really picked up steam in 2007 to peak at 6.80 to the dollar on Nov 1st '07, which was over three times the official rate. (remember, the VEF is pegged at 2.15 to the dollar for most transactions, with estimates of how how of the total traffic is carried by the official CADIVI body ranging from 80% to 90%).

But since that peak, the VEF has reversed course and has moved back pretty sharply, with today's parallel rate at 4.0 the bid and 4.2 the ask. That's one helluva downward move, but strangely enough the good news hasn't been picked up much by the English speaking press.

Amazingly, press coverage was much more intense when the VEF parallel was losing all that ground against the dollar last year. Headlines on Venezuela with words like falls, plummets and loser were common. Comparisons with the Zimbabwean dollar made it to (supposedly) serious newswire services, and still do the rounds of the less informed blogchatterers today. The Miami Herald and the stupendously biased media inside Venezuela had its own little field day.

So what happened? What stopped the prophets-of-doom merchants in their tracks and forced them to change tack and make up stories about Chávez and cocaine trafficking or Chávez and terrorism or Chávez and babyeating (joke...I think) instead?

Well, basically the Venezuelan money guys (the economy ministry, the central bank etc) have started implementing sensible monetary and fiscal policies. This chart shows the big change; it shows M2 money supply in U$ dollars.
We can see that money supply more than doubled in the 18 month period to November 2007 (which makes Bernanke's helicopter look like a paper plane, it's that bad). But it just might be that those in power have recognized the error, because since the end of last year and through to now, the gov't has stopped printing money like the clappers and has actually shrunk the amount of VEFs in circulation. The fact that this chart and the parallel rate chart look similar is not a coincidence, by the way. There is a direct relationship between the amount of money a country prints and what that money is worth...just ask Alan Greenspan, Ben Bernanke, or Nick Sarkozy (poor guy can't sell his goods'n'services to 'les yankees' any more).

This last chart shows how badly the Venezuelan reserves have sunk since that crazed Chávez got his sweaty palms on power....I mean, just look at how that line tails irresponsible...spending a whole country's reserves like that.

Oops!! Forgot!! I put the dates on backwards, so 2008 is actually on the LEFT hand side (1997 on the RIGHT hand side) and reserves have been climbing all this silly of me (*cackling laughter in background*).

Yes, as we can see Venezuelan international currency reserves have climbed significantly through the period, from around the U$15Bn mark of 10 years ago to the U$30bn+ figures of today that also includes the U$8Bn or so Chávez siphoned off in early 2007 to pay for social program funding (see that quick dip there?...that was the withdrawal).

When it comes to forex rates for developing nations, the amount of reserves tucked away in the central bank is pretty important, as it gives a ballpark idea to how much each unit of local currency is worth. In Venezuela's case, there's currently 151.9 billion VEFs in circulation in the country. There's U$31.7Bn in the Banco Central reserves. This means each dollar held by the state backs up 4.78VEFs*.

That the parallel rate came down from the highs of November isn't so surprising, given the new dose of pragmatism recently seen (no more printing press mania), and the VEF moved back into the 4s range. It has also been helped along by another new policy, that of the bank selling reserve dollars directly to banks to cut down parallel market demand (you can see that in the last part of the currency reserves chart; so far this year reserves are down U$2.8Bn as the central bank buys up the VEFs and hands out the dollars). This has pushed the VEF past the reserve equilibrium and down to the 4.0 exchange of today. The forex might fluctuate round this point for a while, but the longer-term tendencies now are likely to be dictated by changes in reserves holdings and VEF M2 rates more than doom'n'gloom reporting. Venezuela has got its currency under control again, and a further outbreak of responsibility will see the country get on an economically firmer footing. The ball's in your court now, guys.........make those petrodollars work for you.

There's plenty more to say about today's Venezuela and its economy, and not all of it is good. But the thing that really pisses me off is how you only get to hear about the bad stuff in English, and anything that the country does well is never reported by western media. Tell it like it is, that's what I say.

*If you like, imagine that all of a sudden the whole population of Venezuela decided to knock on the central bank's door and demand they swapped VEFs for dollars...the central bank would have enough to give 1 US dollar for every 4.78 VEF that were handed to them).

It's evolution, baby

How to measure a country's progress? Beer! Yep, yesterday Alan Garcia stood up in front of the presidential palace and told us all that the progress made by Peru is obvious 'cos beer sales were up 11.5% YoY.

You can't make this shit up, I'm telling you. For one thing, only Alan could do this and keep a straight face at the same time. For another, only in Peru would you get a press corps that actually take these kind of comments seriously. Alan even admitted that higher prices for frivolities like 'bread' were causing consternation, but BEER! won the day.

The journalistic lapdogs also seemed to have forgotten a bit of basic supply and demand law, too. Sure beer sales are up 11.5% YoY, but nobody mentioned that in 2007 the virtual monopoly that local brewer 'Bacchus' had over the local beer market was finally broken, thanks to Brazil giant Ambev getting serious about selling its 'Brahma' brand (LatAm's top selling brew, even if it is a bit like making love in a boat*), as well as new brands such as 'Franca' and 'Barena' hitting the market and new efforts to market traditional one-town brands all over the country (best example being the 'Trujillo' brand).

The result of all this competition? Yes Victoria, prices have dropped. The unbeatable "3x10" price of a couple of years ago (meaning that you got 3 bottles of 620cc beer for 10 soles) is now down to "4x9" "4x9.50" etc depending on the brand involved...and that's retail price in the smallest of corner stores. What happens when prices drop? Yes Victoria, sales tend to increase.

Garcia trumpeting beer sales as proof of economic well-being in Peru? Laughable. Reporters taking him seriously? Even worse.

* f___ing close to water


Before you meet your prince….

…you gotta kiss a lot of frogs (or "trying to find a junior miner bargain")

Every so often, friends, clients, IR people and even complete strangers will tip me a junior mining stock, usually cos they operate somewhere inside LatAm. So over time I’ve developed a scanning system that lets me check out the company quickly…if it passes these tests then I’ll look at it more deeply. Today someone gave me a name to look at, and after running down the system I’ll try and sum up how it worked today

So in rough chronological order, here’s the scanning system. Practical comes after.

Who gave the stocktip?
I tend to trust some people more than others…normal, no? If one of the wiser stockpals passes me a name to look at with a bare minimum of info, I’ll look it over no doubts. If it’s the “psst, wanna buy a goldmine” variety, goodbye. Between those two poles there are a lot of colour shades, and it often depends if I’m busy

Where does the stock trade?
If it’s one of the established markets like the NYSE, Nasdaq, Amex, LondonSE, Toronto, then good. I don’t really have a problem with the Toronto Venture exchange or London AIM either. The red flags get waved at OTC (.OB) stocks. That does of course mean there might be a real bargain hiding there, but you should hear alarm bells when you’re looking at .OB stocks, and don’t turn the alarm system off.

Website time
If I’m still interested, I’ll go to the company website. I first look for transparency. Go to the financials page and see if the share count is up to date and the latest quarterly report is available on a link. Once that’s done, there are three important things to look at, firstly….

Management team
This is the most important, and particularly true in the case of a small junior miner. I want to see DECADES of experience in the top jobs, and also the top guys must have experience in first-rate companies. If the management and directors also sit on the boards of other companies, that’s not necessarily good or bad, but the active head of the company (be it the CEO, the Chair, the Prez or the COO) should be dedicated to the business your looking at right now and not one of his or her other seats.

This is the second most important. Get the latest quarterly financial and the management’s discussion (at the SEC they come as one, at SEDAR for example they’ll often get presented as separate documents). Once in the financials, I’m looking for “a lack of red flags”, rather than actively good things. Do the assets add up? Are they hiding a bootload of warrants and options behind that small ‘shares outstanding’ number? Does the debt look correct and serviceable? If it’s already producing, how are gross revenues/costs/stuff like that progressing (by then, I’ll have a second, earlier financial open to compare number evolution etc). If I still like what I see I’ll then go to..

What are these guys doing right now? If it’s a junior miner, do they have the cash to do what they want to do or will they need to raise cash via dilution or debt? How far along the development timeline is the project? Things of that style, but this part of the DD process isn’t as empirical as the previous parts, and ‘getting the feel’ is important.

So after all that (which shouldn’t take more than 15 minutes), if I’m still interested in the stock I’ll sit down and do a SWAG (stupid wild-ass guess, if you didn’t know already) on how much money I’d expect them to make and when they should start making it. Another 10 minutes, perhaps

And if I still like the stock after all that, it’ll be worth my time dedicating a few hours to learning about the stock more seriously.


So now to the practical: Today, I was told about a company called ‘Nilam Resources’, so here’s how it fared down the filtering system.

Who gave the stocktip
A friend who knows what a mine needs to look like. Smart guy, successful investor and a junior aficionado. If he says it’s worth a look, it’s worth a look. Respect given automatically

Where does the stock trade?
Ticker is NILR.OB, and OTC stock. Ugh! Not a case of outright rejection, but red flags.

Website time
Not a bad site. User-friendly, and well laid out.

Very good-looking management team, and this scores big points. My pal had told me in his original mail that someone called Len de Melt was on the board, and that had already caught my eye. Mr. de Melt has a top CV and has a good reputation in Peru mining circles. When I checked the management roster there was plenty of good quality experience on board, including a couple of names I know and like from other places (particularly a guy named Carlos Ortiz, who has worked in the right kind of mine here in Peru).

No red flags. Short on ready cash, and their main project is in the acquisition process right now, so they’re going to have to raise money to pay the bills.

Not bad. The flagship property already has a small 50 tonnes per day (tpd) processing plant on site, and Nilam plans to put a 500tpd facility on site. Good reported gold grades of 1/2oz per tonne of rock, and apparently plenty of reserves left to be proved up on the site.

So all in all, it was worth spending a few more minutes on the numbers. So the quarterly report gets pored over more carefully and the SWAG calculation comes out. In a SWAG, I always try to be conservative but realistic. Rather than step-by-step the SWAG, here’s what I wrote back to my pal (edited slightly to protect the innocent)

The terms of the deal to buy the new mine mean they pay 250k on the 25th March, $500k in July 2008 and $750k in February 2009. Right now they have $176k at bank. So you can bet your sweet bippy they are diluting to pay for the purchase.

They have a 50tpd operation there. That may be true, but betcha the cash costs are way high too (i know these piddly peru mines). The plan is obviously to pump capex in to bring machinery up to 500tpd. That'll cost at least $15m these days.

So let's assume there's a placement at discount to market PPS...say 10m shares at $1.50 with half a warrant attached. That would add about 15m to the full dilution. That's not bad. What they aren't telling you is that it'll take 12 to 18 months to ramp the 500tpd operation up. Meanwhile they will be nickel'n'diming the 50tpd operation for sure. They will need more cash to get through that period...i'm going to play safe and say another 10m share placement with 5m warrants attached. So i'm going to ballpark the full share dilution at 87.5m (57.5m out now)

Let's fast forward and get to them running a 500tpd gold operation at a little under 1/2oz per tonne (they say they're running 1/2 oz per tonne right now, but it's easier to pick and choose the ore thruput when it's a 50tpd operation)...let's go for 10g/tonne 500tpd = 5000g gold = 160.77oz per day x 365 days = 58681 oz per year

gross sales at POG $950 = U$55.7m

They have to pay 4% in royalties on this number: 3% to the mine vendors as part of the sales agreement, and 1% to the govt (that's the rule down here) total gross after royalties = $53.5m

It's now time to "guess the cash cost". Let's start at U$650/oz, cos a new operation always has glitches...then it drops to $550/oz in the 2nd 6 months of the year...avg $600/oz gives net revs at $18.3m

keeping it simple, let's just extract a cupla million for SGA (ballpark, then take away the obligatory 8% workers profit sharing (peru law) then tax the profits at 30% (peru rate)

minus $2m = $16.3m

minus 8% workers = $15.8m

after tax earnings = $11.06m

Now, IF i'm guessing right on the share count, the cash cost, the price of gold they get at market and all the others, my estimated EPS is 12.6 cents a share. Right now the stock is at $2.16. So, what i'm saying here is that you buy right now and you will see your company diluted quite a lot (if they're an honest bunch, which i think they are), the you'll have to wait about 18 months for the new machinery to come on line to get the project to 500tpd, then after 1 year you'll have a PE ratio of 17X

Not my idea of a bargain. To be honest, the company looks good. Good mgmt, good ideas etc etc. But i'd bet a full United States Dollar (1932 silver variety) that this is not the right time to buy. I suggest you keep it on your radar and think about it in a year's time. There are plenty of other miners down here that are further along the development timeline and at cheaper and more predictable multiples

More on Ecuador's windfall tax

After publishing the note today, I got a mail from a friend who is very wise to numbers (much wiser than me, in fact) but doesn't follow the inner workings of mining companies very much. He said the analysis didn't stand up because we don't know that mining costs have risen by the same amount as gold.

Firstly, here's the context: a chart showing the gold price in 2007 (courtesy The first price of the year was U$639.50, and the last was U$833.75, representing an increase of 30.37%

Thing is, the rise in costs is so well-known in mining these days that I didn't really expand on the subject to my original audience (who were mostly miners and Ecuadorian businesspeople). But the observation from my friend was valid as my original note didn't go into much detail about the costs rise, only mentioning the example of Barrick (ABX) to give a bit of context. So here's a bit more.

The fact is that the ABX costs situation is repeated all over. Here are three excepts from three other 4q07 or year-end reports:

At Yanacocha (LatAm's biggest gold mine) BVN reports:

"...For 2007, cash cost was US$356/oz, a 67% increase when compared to 2006...."

At Goldcorp (GG):

"...Gold sales for the quarter increased to 638,500 ounces at a total cash cost of $195 per ounce, compared with 599,500 ounces at a total cash cost of $160 per ounce in 2006...." (Otto's note: 21.88% rise)

At Newmont (NEM):

Costs applicable to sales ($/ounce)
$ 406 (2007)

303 (2006)
(Otto's note: 33.99% rise)

And so it goes on and on. Barrick, Newmont, Buenaventura and Goldcorp are some of the biggest and most established gold miners out there, so they give a good yardstick for gold cash costs. But the same is also true for junior mining companies that want to construct a new mine on their project sites. The famous one for 2007 is Galore Creek, way out in the yonders of Canada and run as a JV between Teck Cominco and Novagold. In 2006, construction costs were estimated at U$1.8Bn in a 43-101 report. Then in late 2007, that capex estimate jumped to U$5Bn, an enormous jump that spread bad kudos over the companies involved as well as the engineering company who submitted the first report, Hatch. Take a look at the 1 year chart of Novagold and take a wild guess about when the announcement was made:

But Galore Creek is not the only example. Inca Pacific's (IPR.v) 'Magistral' project in northern Peru saw its estimated capex bill jump U$128m, or 48%, in the space of 10 months; U$265m being quoted by the pre-feasibility study of January 2007 and U$402m quoted in the final feasibility study of November 2007. Petaquilla Copper's ( project in Panama just saw capex cost estimates double to U$3.5Bn, which has cast serious doubt over whether the project should go ahead.

Again, I can spend a long while knocking out plenty of other examples of the same ilk, but the message will be the same. The price of gold does not go up all by itself and has a direct relation to the prices of other things, especially the price of things needed to get the gold out of the ground and into the marketplace. It's straight out of the Austrian economics school playbook, in fact.

Final note; I'd normally add sources to all the data found at third partes, but as it's a blog and not an academic or professional note, I can't be bothered. Go look for yourself at the ABX, NEM, GG, BVN, PTC, IPR, NG websites if you'll see the same as I did, though.

Why a Windfall Tax Would Be Bad for Both Ecuador and its Mining Industry

This is a paper presented to a conference in Ecuador earlier this month. It's still a relevant topic, because Ecuador's constitutional assembly has not yet published its findings and how they expect to burden the mining sector in the country. I sure hope they don't go the windfall way, because it's likely to kill the industry before it gets off the ground. The charts Fig2 to 4 and pretty small, but click on them and you'll see the detail.


is going through a period of wide-ranging political and social that goes far beyond one sector of economic activity. However the mining industry is certainly part of the process, and the changes proposed to Ecuador’s nascent mining sector have made many headlines over the past few months in both English and Spanish. Some of those changes have been seen as either good or bad inside the industry, the view often depending on personal opinion. However, one proposal that has caused concern from virtually all quarters of the mining community is that of the proposed 70% windfall tax that may be levied on miners when prices at market for its precious metals, base metals or non-metallic goods rises above a certain level.

This short paper uses the example of a gold miner operating in Ecuador and examines why a windfall tax would cast a dark cloud on the mining sector and could in fact scare away any further investment in Ecuadorian mining.

Windfall tax is not welcomed by miners

Ecuador’s government has made it clear to the mining sector that it wants to increase the total tax burden on producing miners, and has recently been in talks with at least two of the companies behind large mining projects currently in development stage in the country. While there is a consensus that while prices for the metals at market remain high there is certainly room for these private companies to hand more revenues over to the state, the proposed 70% windfall tax is not viewed as a progressive and industry-friendly option. Mining companies are businesses after all, and would prefer to pay the least burden possible, but if they have to pay extra to the state in which they operate preference is for royalty payments on gross revenues

The misconception of guaranteed profits

At first sight, it may seem that as the price of gold (our example metal in this note) rises it would be good news for a miner, even if a windfall tax took away much of the potential profit. Many people assume that if gold moved up from U$1000 to U$1500 an ounce, even though the government would pocket U$350 of the extra U$500 the mining company would still benefit by U$150. Unfortunately that is not the case.

Our example metal of gold is traditionally a good barometer to how inflation affects currencies. Gold (and other commodities) does not suddenly “get expensive” all by itself; gold gets expensive because everything else gets expensive in relation to the currencies we use to buy them, in our case the US dollar. We normally call this phenomenon ‘inflation’. We therefore expect gold to rise as the price of everything else rises in real terms. This theory has proved good recently, as Fig. 1 illustrates.

In the chart below we see that as gold rose approximately 30% in dollar terms through 2007 and so did costs in dollar terms at the established and large gold miner Barrick (ABX). As another example of cost creep, the projected capex needed to build new mines has risen dramatically in this last year, with examples such as the Galore Creek project in Canada (run as a joint venture between Teck Cominco and Novagold), whose projected capex costs rose from under U$2Bn to a whopping U$5Bn in less than 18 months, a cost increase that has halted development at the site completely.

Fig. 1

Price of Gold Influences Production Costs

Barrick 4q06 total gold production costs


Barrick 4q07 total gold production costs


percentage change


Gold price per oz 1st January 2007


Gold price per oz 31st December 2007


percentage change


source: barrick filings, london gold fix

As the price of gold rises, so do the costs of mining the gold (in everything needed to run a mine, including labour, fuel, infrastructure, vehicles etc). We can therefore assume that if gold reached a U$1500/oz, the cost of mining that ounce of gold will not be the same as they would be if gold were at U$1000/oz.

Our model

In the simplified model that follows, we examine how a windfall tax of 70% might affect a gold mining operation. Ecuador has not publicly mentioned any base reference prices that mark when the windfall tax might begin to take effect for gold or for any other commodity for that matter, but for the purposes of our model we will use U$1000/oz as the start point.


Therefore, in our model we assume the following:

1) Ecuador sets a 70% windfall tax on gold, with a reference base price of U$1000/oz

2) As gold rises, costs rise accordingly. In our model the percentage cost of producing gold remains constant to the percentage rise in the price of gold. In the real world there may of course be differences in the comparative price rises, but we are keeping this model simple for the sake of clear illustration.

3) The price of gold rises steadily in the next few years to approach U$2000/oz. The windfall tax therefore kicks in when gold passes U$1000/oz and the burden becomes progressively greater as the price rises.

In the charts below, the blue line represents a company that has low relative costs, and we assume that 50% of gross revenues covers its total production costs (which includes cash cost and other costs not included in the normal cash cost calculation such as sales, admin etc) The green line represents a company with average relative costs, with 60% gross revenues covering its break even point. The black line is a company with relatively high costs and needs 70% of gross revenues to get to break even.

Fig. 2

We see that as the price of gold rises from U$900 to U$2000, the amount of windfall tax due to the government rises accordingly. However costs also rise, and little by little company profitability is crimped between the rise in costs and the rise in windfall payments. In the case of the company with relatively low production costs (blue line), when gold is U$1400/oz or more the company would be less profitable than when it was priced at U$900/oz! A similar but even more depressing story is told by the company with average total production costs (green line). Perhaps the most dramatic is the high total production cost company (black line), who would actually make a loss as gold climbs past U$1700/oz!

The contrast to royalty payments

Now let us examine the same three companies that are obliged to pay a large royalty to the government instead of a windfall tax. In Fig. 3 the royalty is 5% of gross revenues

Fig. 3

In Fig. 4 the royalty is a very large 10% of gross revenues.

Fig. 4

It is clear that, even though a mining company would have to pay more to the state under a royalty agreement as the price of its commodity rose, the company would still benefit from rising profits as the market price increased. This is true even for a 10% royalty on gross revenues, a percentage that would be higher than any other country royalty in the world. As a comparison, Ecuador’s neighbour, Peru, levies a 1% to 3% royalty on gross revenues to operating miners depending on the size of the operation. The conclusion we can draw from the three charts above is that even a large royalty is better than the current windfall tax proposal put forward by the government of Ecuador.

Fig. 5 below compares the three methods of payment outlined in the above charts. We see that until our hypothetical base reference price of U$1000/oz for gold, the windfall tax would bring in no extra revenues while the model royalty system would pay between U$45 and U$100 per ounce of gold. In the U$1200 to U$1400 range, the windfall would produce greater benefits for the state. But as the price of gold passed U$1600 note we have put the windfall charge figures in italics, because from this point onwards it is feasible that some miners will close down operations rather and walk away from a business that offered them an ever diminishing, marginal or even negative return.

Fig. 5

Gold Price per Oz (U$)








Gov't Revenue 70% windfall tax (U$)








Gov't Revenue 5% royalty (U$)








Gov't Revenue 10% royalty (U$)








This is the first significant risk with a windfall tax system. If the price of the commodity produced rose to a ‘choke point’, miners start closing up shop. If that happens, everybody loses. The mining company loses revenue and has an idle asset. The employees lose their jobs. The state loses valuable income.

The second significant risk is the lack of investment appeal it makes for those not already in the country. If a mining company wanted to set up a new operation in a foreign land, a potentially inhibitive burden on future earnings such as Ecuador’s proposed 70% windfall tax would greatly discourage it from setting up in a country operating such a system. The miner would simply go somewhere else to do business. Again, the loss would be felt by the state, but this time the mining company would not be affected as it set up its business elsewhere.


Although Ecuador’s government may believe a windfall tax would be a good way to bring in extra revenues from the mining sector, it would be a serious mistake on their part to take this proposal and make it law. Gold and other commodities may or may not rise to new heights in the years ahead, but the windfall tax will always appear as a major stumbling block for any mining company looking continue operations or to invest in the Ecuador’s future. On the other hand, a royalty payment system on gross earnings guarantees extra income for the state at high metals prices and has the advantage of being applicable at all price levels as well as being generally accepted nowadays in the mining industry.

President Correa has stated that, “Foreign investment that generates wealth and jobs and pays taxes will always be welcome.”(1), but if President Correa wants new foreign investors to play fair with Ecuador, he should remember that Ecuador must play fair with the foreign investors, else risk losing their revenue or even never seeing them arrive.