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Additional	Information
Market:	AIM
Sector:	Gold Mining
Epic:	MCR
News:	Latest news
Web Site:	Mercator Gold plc
Other Articles:	19-02-201012-01-201031-12-2009

Mercator Gold: the AIM market seems slow on the uptake

by Ian Mclelland

We find ourselves in an interesting situation at the moment, regarding smaller gold explorers and producers. The price of gold breached the US$1000/ounce level before falling back, and there will no doubt be a range of explanations for this, from conspiracies by central banks to the end of the commodities bull market. Whatever the many possible explanations, experience shows that no stock market can sustain parabolic price rises, or falls, for long. Gold and silver prices have been rising like rockets, and the US dollar has been sinking like a stone for a couple of months - so price corrections are due. Although in the medium to longer term, the US dollar will resume its downward trend and investors will seek safer havens, such as precious metals.

Also, equity markets have taken an absolute pounding in recent weeks. And with the market, many small companies that offer exposure to gold and silver, and other commodities, have been hit hard, too. Smaller gold producers are finding themselves in a Catch 22 situation. While higher gold prices have, in theory, lowered the bar dramatically for converting a gold resource into an economic gold mine, the credit crunch has put the squeeze on secondary equity placing and debt financing options. Meanwhile the rise in the price of oil, in particular, has pushed up operating costs because diesel fuel is the largest cost input for most mines. So to sum up, the price of gold has soared, which is a good thing for gold explorers and producers, but the availability of finance has dried up, and inflation in the industry is eroding the gains of the gold price.

Mercator Gold is not immune to these pressures and found out just how concerned the market is about these issues when it released its first guidance at its operations in Meekatharra, in Western Australia. By and large, the update that Mercator put out was positive, and on target. Gold production in the first quarter of its ‘ramp up’ phase came in 12% ahead of expectations at 9,470 ounces. Gold production in January 2008 hit 4,000 ounces.

Mercator’s gold production, in the near term, is being sourced from two open pit mines, Surprise and Bluebird. During the ramp up phase, it was widely expected that overall grades would be low because the strip ratio would be higher while the company worked down towards higher-grade material. They would also have to process some low-grade ore in the ramps and access ways in the Surprise pit; as the company reported later, that was exactly how it went.

Looking ahead, Mercator said that it now expected to produce 200,000 ounces over the next 20 months, bang on target with its original ambition of 120,000 ounces per annum. This production profile places Mercator firmly in the mid-tier range of gold producers listed on AIM. It also implies that the company should be trading at a much higher level. Edison Research noted that on current production forecasts, Mercator is trading on a forward profit to earnings ratio of 5 versus a sector average of 15. Edison additionally calculated a net present value (10% discount) of more than 130 pence, suggesting there is plenty of room on the upside in Mercator’s share price.

Edison’s conviction is backed up by Patrick Harford, Managing Director of Mercator Gold, who told Proactive that the company was very pleased with its progress to date. However, investors appeared to be annoyed with Mercator’s decision to sell call options to cover 35,000 ounces of its anticipated 200,000 ounces of production over the next 20 months, at A$906/ounce, and buy put options to cover a further 35,000 ounces. Investor displeasure aside, the business logic for doing this appears sound. Mercator will be guaranteed to receive A$906/ounce on one lot of 35,000 ounces, and be able to sell another 35,000 ounces at A$906/ounce, or at the prevailing spot price, whichever is higher. This allows the company to benefit from a good upside to its production costs whilst protecting the downside, should the price of gold suddenly fall – which ironically occurred last week.

In fact, the price of gold has risen so far and so fast that it could fall to around US$788/ounce (A$869/ounce) before checking in with its 200 day moving average, and down as far as US$706/ounce (A$779/ounce) before checking in with the long term up-trend line. Assuming a steady US dollar/Australian dollar exchange rate, at both these levels Mercator would still be producing gold profitably at A$530 to A$570 an ounce.

Some investors have also suggested that Mercator should be hedging its diesel costs to protect against further increases in fuel costs. “Not so,” says Patrick, who believes the conservative and responsible action would be to lock in some of the company’s gold production, and not get drawn into a long-term contract for diesel when fuel prices are at record highs. Interestingly, despite Mercator announcing a 20% increase in costs during this period (partly due to bedding down issues on the primary crusher) gold prices have risen even quicker, and the company’s inflation guidance is in-line with other Australian gold producers. Life of mine costs for the Surprise and Bluebird pits have been revised to US$524/ounce, but the company believes they could drop by another 7% if higher grades are found. This again, is in-line with recent guidance to produce gold at an operating cost of approximately 50% of the prevailing gold price.

So, to summarise Mercator Gold in its current form, you get exposure to a gold producer which expects to move into profitability in the next few months, with about as low a country risk as you can get. The major issue with Mercator, and in fact many Australian mining companies, is cost inflation. So there is a pay off to consider. You get gold production in politically low risk Australia, but the key risk to monitor is whether costs are getting out of control; something which Mercator has managed as well as one could possibly expect, to date. Cenkos Securities, broker to Mercator, notes that gold producers with similar production profiles to Mercator trade at a value of between £350-£1500 per production ounce. If you put Mercator on a value of £800 per production ounce - at 120,000 ounces you arrive at a value of £1.53 per share - more than double the current share price.

Beyond the Surprise and Bluebird pits, Mercator continues to develop its resources with drilling at a number of additional ore bodies including Fenian West, Paddy’s Flat, Vivian-Consol, Euro and Prohibition. Although gold production headline numbers have been driving the share price for a while, the addition of resources or conversion to additional reserves is likely to attract the attention of institutions, as this will be seen to be underpinning the company’s credibility as a mid-tier gold mining and adding mine life to the project.  Mercator is very aware of the need to add resources, and has a progressive exploration budget in place which will see up to A$14 million invested in drilling a number brownfield and greenfield targets in 2008 and 2009.  In particular, the company is keen to prove that it can add resources along strike as well as at depth, and with this in mind is dewatering the Vivian-Consoles underground mine so it can extend the decline, and add a cross-cut at the 200m or 250m level to allow extensive diamond drilling.  There is also additional infill drilling occurring at Paddy's Flat and Prohibition, plus continued drilling at Euro, the newest gold discovery.  

Recently, Mercator announced that it had divested 600 sq km of non-core exploration leases, in areas that are prospective for base metals, to ASX listed, Silver Swan Group. Dr Susan Vearncombe, former General Manager of Geology for Mercator Gold, is to become the Managing Director of Silver Swan and Michael Elias, a non-executive director of Mercator, is to become Non-Executive Chairman. Mercator took a 30% equity stake in Silver Swan for the acreage, and although early stage, this offers Mercator Investors additional exposure to other prospective areas, whilst ensuring Mercator keeps its eye on its gold operations.

So where does this leave investors? Mercator is considering a secondary listing on the ASX, which speaks volumes about the company’s concerns that AIM is not recognising its achievements to date. Perhaps the Sydney will be more willing to re-rate Mercator than the London.

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