Late last week, Rio Tinto (ASX: RIO) announced it was selling its 40% stake in the Cortez gold project in the U.S. state of Nevada to major gold producer Barrick Gold (NYSE: ABX) for US$1.7 billion. Barrick gets 4.6 million ounces of additional proved and probable reserves at Cortez, where it's cash-cost of production is below $US300 per ounce.
Cortez produced 538,000 ounces of gold last year. Barrick said it expects some planned investment in the property will ramp that up to about 1 million ounces per year in two years. So why would Rio Tinto sell its stake in a gold mine when gold prices are rising?
Rio Tinto carried the Cortez property on its balance sheet at a value of just $155 million, according to Andrew Trounson in the Australian. Let's see... a 40% stake in 538,000 ounces of annual production is about 215,200 ounces. Take a gold price of $940, subtract a production cost of $300/oz and you get $640 per ounce multiplied by 215k oz... and you get about $138 million... the market value of Rio Tinto's share of Cortez's current annual production.
Of course, if you factor in a rising gold price and increased production at Cortez, well than the market value of Rio Tinto's stake is ever larger. Any way you look at it, though, at $1.7 billion, Barrick Gold paid a premium for Rio Tinto's stake. Rio Tinto got a price much higher than the book value of the asset. So was it a good deal for Rio Tinto and its shareholders?
Well, gold isn't Rio's main business. Iron ore and aluminium are. And Rio Tinto has all that debt to pay down that financed the Alcan merger. Plus, it must fend off BHP Billiton's $147 billion bid. Rio Tinto's stake in Cortez wasn't generating a lot of earnings, either.
It's the potential change in the market value of the underlying assets that Barrick Gold paid for. Barrick-a notorious gold hedger in years past-is also one of the world's largest gold producers. If you believe gold prices are going higher and you're a producer, you want to find more gold to produce.
This is what makes gold exploration and prospect generating companies so appealing in a gold bull market. They don't have to incur the actual cost of production. They just have to find the stuff (which is hard enough). If they CAN find it, the rising market value of the underlying asset is like a rocket booster to the share price.
Gold and Black Gold Exploration Booms in 2007
When a commodity goes up in price, more people start looking for more of it. ABARE reports that minerals and oil exploration was up 53% last year to $3.9 billion. More money was spent looking for gold than any single other mineral. Most Aussie oil exploration is taking place off short, either in the Bass Strait or up in the Northwest Shelf. Finding oil is expensive, but with oil around $100, plenty of people seem to think it's worth it.
Gold showed the smallest increase in exploration year-over-year. But if you were looking at in terms of the market value of the underlying assets, it's hard to argue against gold. The iron contract price is headed up. So is the oil price. Both are functions of strong economic growth in the developing world, and, in the case of oil, resource scarcity.
But gold? Yes, it's hard to find and expensive to produce. But the important thing about gold is its role as money. As central banks move to a new stage in the credit crisis, we reckon gold will resume its ancient role as a store of value.
Dan Denning
The Daily Reckoning Australia
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About the Author
Dan Denning is the author of 2005's best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 and has covered financial markets form Baltimore, Paris, London and, beginning in 2005 Melbourne. He’s the editor of The Daily Reckoning Australia and the Publisher of Port Phillip Publishing.
Comment by matt on 27 February 2008:
"Barrick Gold paid a premium for Rio Tinto’s stake."
Huh? According to you ("Take a gold price of $940, subtract a production cost of $300/oz and you get $640 per ounce"), Barrick bought 4.6 million ounces of proven + probable. If we say that Barrick can actually mine 75 percent of those reserves, that means Barrick bought $2.2 billion of gold for $1.7 billion. That doesn't sound bad to me at all.
Barrick is betting that prices will remain here (or go higher) for the next 5 years and Rio is betting that they will go down.
Comment by Werner Jungling on 27 February 2008:
I think it is rather shameless and deceptive for company president and chief executive, Greg Wilkins, to speak as if higher gold prices are good for Barrick Gold, while having 9.5 million ounces of gold on the hedge book which exposes Barrick to nearly unlimited losses as gold prices continue to rise.
Silver Stock Report
by Jason Hommel, February 25, 2008