South African Mining in Crisis
We take a look at the mining situation in South Africa, an industry in crisis, because of that government policies in that country. Unless steps are taken to correct the situation tragedy will be compounded with failure.
But South African mines are different from South African Mining Companies, the first currently facing a bleak future, the latter a bright future. This is that story.
The unfolding tragedy of the South African has just detailed the latest level of decay. Coming from two of the most significant of the South African Mining companies, Anglo American and Goldfields, they gave a "bloodied though not bowed" presentation of this picture. This has served to confirm the present South Africa's mining industry scene, which saw a sharp decline in the contribution it made to the South African economy last year, according to the Minerals Bureau. Last year mining contributed R78,5bn to gross domestic product, or 7,1%, compared to 7,7% or R85.13 billion, in 2002. This represented the sharpest since 1996, due to the in large part to declining gold production and lower rand prices received from primary mineral revenue, such as gold and platinum group metals. But the seemingly small drop in this contribution belies an even more serious picture, below the surface of these figures. The South African Chamber of Mines recorded that around 88% of South African mines are operating at a loss, a figure set to rise, if the present picture is maintained, without relief. The very real prospect of the Rand strengthening further, by up to another 10%, could give the 'coup de grace' to perhaps the world's greatest mining story, going back to the beginning of last century. Why?
Originally, South Africa, in Colonial days, was established as a supplies replenishment area for shipping on its way to the Far East. After the Afrikaner trekked North to get away from the English, the English followed up to the more northerly areas of South Africa, to mine diamonds in the Kimberley area, initially. Then gold was found in the Johannesburg area. The mining industry spawned the growth of the country and established it as the richest sources of precious metals and mining in the world for nigh on the entire last century. Whilst there has been a steep decline in the production of precious metals and diamonds in South Africa, it still remains the richest mining area in the world. The question being asked today is how long will that continue?
In a sentence, South Africa appears to be ignoring that it is part of a global economy dominated by world prices for the bulk of its products, including exports from other sectors. It should have been keenly aware of its dependence on the global economy for longer than any economy in the world, but it is now suffering from a political and financial myopia that may well strangle it, in the long run. It could well repeat the tragedies suffered by so many wealthy African nations, who took and took from their wealth, incapable of realising that wealth needs to be nurtured to keep it and encouraged, if it is to grow.
The major problems:
1. The Gold Boom without a $ Gold Boom & the $gold Boom, without a Rand Gold boom. The Rand, in the last few years has gone from R6.00 : $1 down to R12.50 : $1, then recovered from that level back to R.6.00 : $1. In the first part of this period the gold price remained around or below $300. However, as the Rand weakened, the income to the mines increased in Rand terms. In addition, because many of the larger South African Mining companies had an international share register, the Rand price of the shares soared. To South Africans this was the gold boom, they enjoyed, a gold boom without a gold price boom.
Then the Rand bottomed and the stance of the South African Reserve Bank changed towards the currency. As the Rand began to recover, the gold price began to rise, but at a far slower pace than the Rand recovered. So what the rest of the world saw as a 'Bull' market in gold, became a 'Bear' market in the gold price in Rands, and in the Rand price received by the mines. Hence, ask a South African how his gold shares fared in the last two years, you will see a very long face.
By way of example, the income from a steady gold price rose from [for convenience we use the gold price of $300] R1800 per ounce to R3,750. As the gold price then began its rise to $400 per ounce, the income to South African mines began to fall as the Rand strengthened back to R6.00 taking the income back down from R3,750 to [at $400 for simplicity's sake] to R2,400 an ounce. And so South Africa missed out on the real gold 'Bull' market.
This whole story has been a Rand story, not a gold story, illustrating that the first priority of any Analyst, when investing abroad, is to examine the entire picture in detail the shape of the company's income now and in prospect, during the expected life of the investment. It is from a deep understanding of this type of analysis and an experienced international investment philosophy, that this article has been written.
2. South Africa's Rand Policy: The South African Exchange rate policy is determined by the country's Central Bank and its management, or lack thereof, of the currency. As is common with most nations, South Africa aims at "Price Stability" internally, adjusting interest rates to the factors that might affect price stability, using interest rates as a prime, but clumsy tool, and its currency is "left to find its own level".
Currently, South Africa's inflation rate is in the low 3 - 6% area, but its prime rate stands at 11.50%. Extraordinary, isn't it? Even South Africans have not discussed this fully, with some observers adopting a sycophantic attitude of saying, business must adjust, become competitive at a higher rand values, thereby condoning what is a destructive policy of high interest rates. Yes, inflation has dropped to lower levels as a result, but far lower than present interest rate levels.
As you are no doubt aware, one of the main driving forces between the Euro and the $ are the differentials on interest rates, particularly 10 year Treasuries [German versus U.S.], which is favouring the $, at present. In South Africa the raw differentials of Prime rates, between S.A. and the U.S.A. translates into a real rate of 8.5% to 5.5%, not allowing for the margins the Banks keep by way of profits. The danger to South Africa lies not in excessively high borrowing costs but in the attraction these rates have for overseas Investors. By way of example, if you borrow in New York at around 5% [?] and still take home another 5% and more, the interest arbitrage is irresistible to the "carry" trade globally. 'Hot' [extremely liquid, mobile money] flowed into the country, sending the Rand up to levels we see now and possibly further to perhaps the R5.50: $1 level from the present R6.30:$1 now, if the differential persists. Bobby Godsell of Anglo American made this comment, "The last time the exchange rate was at this level was in 1996. Since then inflation has taken South African costs up by at least 40%. So, in relative terms, we are 40% worse off, at the same exchange rate. And that I don't think the nation can afford for very much longer."
This may be great for the money markets in South Africa and elsewhere, but the eventual death of industries that keep the economy producing, through exports. These industries are the backbone of the economy, the main national employers, the industries that feed the wealth of the country and without which the current unemployment rate of 30%+ would rise far more. As all you exporters know, you need to have a stable exchange rate on which to do your business planning, be it buying of resources or gauging future cash flow, so imagine if such stability were not open to you, that every transaction had to be hedged in the currency market, to fix your income. Not healthy, and with so few businesses capable of hedging their currency risks, both Importers and exporters are continually at risk on the profit front. This risk is heightened by the very fact that your own currency has squeezed your profit margins to an almost none existent level. Now factor in that your prices are set in U.S.$ not your home currency! Now factor in that your nation is dependent on global markets and their prices, not local ones and that the interest rate policy of your country ignores the global relationship of the economy. Not much chance of controlling let alone rectifying the situation?
The disaster facing the mining industry is a little less in other industries in South Africa, who focus mainly on Europe for their exports, and hopefully price them in Euros, [which has risen somewhat itself, so softening the strength of the Rand]. And in a country possessing the "fairest Cape of all" according to the great explorer Captain Cook, tourism is being undermined by prices rapidly moving to and above international prices.
And what is the reason why nothing is being done to assist the lifeblood of the South African economy? Worries of containing consumer demand at stable levels is the reason put forward. The focus is internal leaving the "Rand left to find its own level", according to the Reserve Bank Governor, Tito Mboweni. Is this strong Rand allowing the Reserve Bank to increase gold and foreign exchange reserves, yes, but this is not being done.
The situation reminds one of the a man who sells his business to simply to repay his overdraft. What then? The solution? Senior economists in South Africa have confirmed that the dropping of the prime rate by 2% at least and a real attempt to increase gold and foreign exchange reserves in the process of taking the Rand down to R7.5 to R8.50 to the $1, would rectify matters. Then all export industries including the South African Mining industry will become competitive and profitable again. To put a figure on it, if the Rand went to R7.50 to the $, at the current gold price, we would be back at R95,000 a kilogram from the present late R70,000 a kilogram!
3. South African Taxation Attitudes: With the passing of the Apartheid policies the new government came in with the aim of putting matters right, a commendable attitude in principal. What this entails is now seen as a spreading of the wealth across the Black as well as white peoples of the country. Again reasonable you may say. Free water and lights affordable housing and many other laudable policies have been established. But they have to be paid for, from, primarily, taxes. Understandable, of course! The wealth lies, as in all countries, in the hands of the few, so the few are where the money must come from, including the successful export industries. This is where the delicacy of a surgeon is required. There stands the "golden Goose" of the mining industry, laying wonderfully golden eggs, seemingly perpetually. Her continued existence depends on the sale of her eggs. Now along comes the government feeling justified in taking more of her eggs.
The Unions want more eggs, but because of the stronger Rand the goose is getting less for her eggs.
Now to further the cause of enriching "previously disadvantaged" people [a few of them at least] government has put forward the idea that Black Empowerment bodies should own more of the egges in the form of 51% of the equity of all new ventures, on both private and publicly owned land. This denies fundamental investment criteria.
Suddenly the government, overcome with the desire for even more of her eggs, puts forward the prospect of a "Royalty" tax, levied, not on profits, but on turnover, so overriding the entire profit motive of the miners. This is equivalent to cutting the throat of the gorgeous bird, such a "Royalty" presently hangs in the air, awaiting government imposition.
So with her throat horribly exposed to the short blade that may cut her throat, the prospect of such a mindless tax lurks in the background, deterring both present and future Investors. The myopic view of those responsible for imposing taxes focuses on the present and actual levels of taxation, not on the perceived display of their attitudes by those investing in the industry, hurriedly putting their hands back in their pockets. The mere fact that the progress of South Africa's tax policy is undeniably rapacious, with scant regard for the consequences on the mines and on the profit motive that drives the mines, seems to escape the South African government. It may take the demise of important mines to convince them of that, but too late, too late. Not one move has been made to assist or lessen these wounds. Despite persistent and dramatic reports of the worsening plight of this industry, the Finance Minister has merely acknowledged the damage being inflicted by the Rand [with no comment on the dropping health of the industry] due to excessive wage increases and over taxation] saying "the Rand's strength should be discussed", but promising no short term solution.
The solution? An understanding of global investment and profit requirements and how they produce bodies capable of being taxed and a reining in of "politically justified" tax excesses. More importantly, the public abandonment of a perceived attitude that foreign direct investment and its income are fair game for the South African Government.
The impact on South African mines: Initially this seems a disaster for the mines in South Africa. Not so! The story has tragic elements, but for South Africa mainly, not the Gold Mines or Mining Houses!
The tragic side.
Already recovering mining operations such as East Rand Propriety Mine, an old mine sold to Black Empowerment companies in the hope of widening the wealth spectrum, have had to close their doors, consumed by the losses achieved, primarily because of the strong Rand. 800 workers have just been released with 1500 more to follow. Other older marginal mines will follow, for certain, unless the Rand weakens soon.
The closure of shafts of the larger mines is next, being the areas of a mine where the grades are too low to be profitable at the current Rand prices for gold.
Eventually mines will have to close, unless sense prevails, by the transmission of the realities of the job loss situation from the mines Unions, across to Government.
In this time of high $ gold prices we have reports from Harmony gold mine that it lost Harmony lost 191 cents per share this quarter, after a loss of 31 cents per share, last quarter.
Last year, the year to June, the average gold price was R97,000 a kilogram. The Rand appreciated over the corresponding fiscal year, 2003 to 2004, by 24%. That is really what has hit South African mines hard.
Loss containment: Losses are being minimised on the mines through cost savings such as, 24hour 7day working weeks and shortening the lives of the mines by moving to the higher grade portions of the mines from the lower quality areas. This will become permanent if the Rand does not weaken. The mine's life will shorten as a result. The 40 to 50 year life high quality mines will be the last to fall, for sure, but even they cannot withstand more rises in the Rand. So how long can they last?
Long Wall stoping: But South African mining is different to most of the rest of the world's gold mining in that it is extremely deep level in parts. These mines can go as deep as 5 miles, such as Western Deep, ERPM, Durban Deep [the mine, not the group of mines] Kloof, etc. This means that the mine face [called a 'stope' has to extend in a straight line, with o part going ahead of the next, giving rise to a corner. At these corners, the underground pressures build up terrifically, sometimes resulting in a "pressure burst", wherein a four yard and more high working area can drop, in an instant, to be less than the size of a shoe box reducing any people in that space to the same size. Therefore they have to keep the grade at levels demanded by deep mining techniques. These mines remain most vulnerable to loss of profitability beyond a certain level
Anglo American: In the Anglo American mines, the overall costs in South Africa in local currency terms declined by 4% to R59,000 a kilogram, as a result of these cost savings and efficiencies this year and left them a margin, given that the gold price is sitting at R77,000 or R78,000 at the moment. This was the comment from Bobby Godsell, Anglo's Chief Executive, when asked if he had moved to a higher grade as a defensive move, "Unfortunately, in our case, particularly in South Africa, both because the ore bodies we are mining here are mature, and because in many cases we are using longwalling mining methods, we really have very limited opportunity to flex the grade. We've got to mine, generally speaking, what we get and what we can take. We can obviously improve grade through the plant processes and getting recoveries better. But we've simply got to use workers better, we've been through a major reskilling programme, we've taken really 80 or 90% of our workforce to functional literacy. That's enabled us to work in teams and to get great efficiencies in that direction." Having said that these margins set to erode further with a rising Rand, will certainly deter new investment, as has been the case with Anglo Platinum who have pulled back on expansion plans, until the situation improves.
Goldfields: Despite the rich long life ore bodies that back South Africa's Gold Fields Ltd, it reported a 17% year-on-year drop in fourth quarter operating profit. The drop in operating profit was exclusively due to a 6% reduction in the Rand gold price, a picture reflected almost throughout the industry. The burden of a royalty tax brought this response from Ian Cockerill, the Chief executive of the company, "From a national perspective, it is a bit worrying, though, to see 60% of your production comes from South Africa, but only 30% of your profits...... I think at current levels if we added a 3% royalty there will be very little left.....government have said that the decision on the level of the royalty is being deferred until further notice." So long as the Royalty tax remains a prospect, new foreign capital for mining will be diverted to more mining friendly countries, to the long term detriment of South Africa itself.
The future of South African Gold mining companies is bright, not their South African Mines. This is not as obvious as it may seem on the surface. A mine in the old days was simply a piece of land containing a mine. When we talk of South African Mines, that is what we refer to. But a South African Mining Company is a group of mines, usually of mines both inside and outside South Africa, [like Harmony and Durban Deep]. In some cases its shareholders are mainly outside South Africa [like Durban Deep]. Anglo American and Goldfields are still 'Mining Houses', of holding companies for the individual mines, with executive oversight, being held in the house.
As a result they are constantly searching for new mining ventures and, not surprisingly, overseas, in currency and tax friendly nations. So many of the concerns of Investors are being addressed by the companies themselves.
For example, Goldfields, the largest gold mining company in South Africa, is a year into a five year strategic plan to achieve a balance between South African and offshore gold output by boosting offshore gold production by around 1.5 million ounces per annum. In particular, the company is targeting U.S. dollar linked countries, such as China, for expansion. With the bruising from South Africa in mind, Goldfields says, " A lot of our offshore mines are operating in currencies that are also appreciating against the dollar, like the Aussie dollar, the Brazilian real, the Argentinean peso and the Central African franc, which is the currency used in West Africa. So we do benefit from the diversity, but we don't escape the kind of weak revenue currency, strong cost currency, that's a feature of all gold miners, except those producing in the United States. With mines from Platinum mines in Patagonia, to Cripple Creek in the States, Goldfields is growing. Indeed, their offshore mines are blossoming with four offshore mines, two in Ghana, two in Australia, contributing 70% of Gold Fields' earnings while they produce only 35% of the gold. That shows just how important their international diversification strategy has been.
The policy of Gold Fields is also the policy of Harmony [despite their acknowledged capability in making difficult South African mining situations profitable] and Durban Deep, being forced away from the country to other more profitable ventures, to ensure their survival. This will make these shares good investments in the future, whilst leaving South Africa's golden goose in a terminal condition. Anglo American is following the same route too, as are all these highly skilled and superbly qualified Miners. We have no doubt that in this global world, these men and their companies will remain important global players, with profitable global companies, whose shares are well worth the values placed upon them.
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