The three successive annual increases in power costs of 24% to 26%pa, are ostensibly to pay for two new coal-fired power stations in South Africa that are already under construction, and expected to come on-stream in 2012/2013. The cost increases are being applied to the whole nation, not just industry which has to impact on inflation. With mining wages already expected to increase by ~10%pa, and historically comprising 50% to 60% of operating costs, GFI’s total costs appear to be heading for US$1000/oz to US$1100/oz within 3 years.

And as if that was not enough a 2% to 5% royalty is expected to apply to gold mines’ EBIT from 1 March 2010 being (based on 0.5% + an EBIT/gross sales ratio formula). At least it is on EBIT and not on revenue. There are also some speculated possible BEE increases coming too that have an as yet indeterminate impact on production.

It should be borne in mind that GFI has efficient, relatively low cost, deep mining operations in South Africa, and hence it is easy to see that South Africa’s gold production appears destined to continue falling, which reducing supply should help the gold price remain above US$1000/oz.

What South Africa needs is near surface mines with declines and trucks, like GoldOne showed in their presentation that they expect their cash costs to gradually reduce to less than US$300/oz as their ore resources are at depths of 300m to 500m below surface. Whereas for most South African gold mines, the sub-outcrop is at least 2km below surface, and the shallower parts have already been mined, placing most of them mining at depths of >3km.

GFI commented that at least they would have reliability of power supply afterwards, based on the two new power stations coming on stream in 2012/13. However, until that time, power disruptions are still possible, and also possibly afterwards as the reliability assumes no increase in electricity demand in the interim period.

While South Africa benefits from its royalties being based on profits, and the achievement of a minimum profit, Australia’s royalties are unfortunately based on revenue – which received wide comment at the conference especially the consideration that they could be doubled to 5% for WA’s gold mines.

Seen as filling a Budgetary hole in a quick grab for cash while gold prices are relatively high, no consideration has been made of the underlying fundamentals.

The gold industry is again facing rising costsdue to a mining industry skills shortage due to the oil industry and the iron ore growth again in northern WA. It was commented that TA’s (trade assistants) are being paid $140,000 to $150,000pa and yet again geos are in short supply.

What has been overlooked is that royalties based on revenue take no consideration for cash costs, so if the gold price falls, the royalties remain in place and mines could be forced to close. There are a number of small companies that have restarted previously dormant mines at high cash costs only because the gold price is relatively high and a reasonable margin established.

As Newmont commented, although royalties are under discussion in other parts of the world, the discussions are most advanced in Australia, and could make other countries more attractive to start and operate mines in than Australia.

There is also a risk that when governments “move the goalposts” on tax or royalties that investment is scared away. In this case, if royalties are increased, how long may it be before taxes are increased too ? We remember when PNG moved “their goalposts” many years ago, investment faith was destroyed and the country spent many years “in the wilderness”, with some investors still regarding PNG as too risky to invest in.

As Les Davis of Silver Lake pointed out, an additional 2.5% increase in the royalty to 5%, could mean a loss of revenue of $2.5mpa, which for Silver Lake amounts to a significant amount of drilling, or even a level of annual development at Daisy Milano.

It was also stated in the conference that any royalty changes would only apply to non-state agreements or agreements that specify that their royalties are according to what is in the Mining Act (WA has State Agreements that contain concessions in perpetuity for the major producers).

An example was given of BHP and RIO (who apparently paid about 80% of 2008/09’s WA royalties of $3.2bn) only have a 5.8% concessioned royalty in their State Agreement (and that royalty can only increase if both parties agree that it should increase – which obviously never happens),  whereas FMG being in the Mining Act pays 7.5%.

There was also discussion that consideration is being given at the Federal level for a resource rent tax but it was unclear whether this was replacing individual state royalties or becoming an additional tax by the Government trying to cash in to the commodity cycle too.

The WA gold industry has started reviving, it would be a great pity if it was nipped in the bud by Governments making a quick money grab for cash to fill their budgets, without considering the long-term impacts of their actions. The Gold industry has formed the Gold Royalties Response Group (GRRG), which for the sake of the gold industry we can only hope is successful in reducing the planned WA royalty increases in the coming WA Budget, or keeping them at their current 2.5% level.

Disclosure and Disclaimer : This article has been written by Keith Goode, the Managing Director of Eagle Research Advisory Pty Ltd, (an independent research company) who is a  Financial Services Representative with Taylor Collison Ltd, and with his associates, may hold interests in some of the stocks mentioned in this article. The opinions expressed in this article should not be taken as investment advice, but are based on observations by the author. The author does not warrant the accuracy or completeness of any information and is not liable for any loss or damage suffered through any reliance on its contents.