FreePort's Big Move Into E&P Assets Is Bullish for Gold

Peter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Freeport's Move Into Oil & Gas Speaks Volumes

On Dec. 5, Freeport-McMoRan Copper & Gold, (NYSE: FCX) made a $20 billion move into Oil & Gas assets. Shareholders hate the move. In the two trading days since the announcement, FCX stock was down 19.5% from $38.3 to $30.8. Shareholder lawsuits have already begun to fly. Shareholders are livid that they were not given the chance to approve this transformational decision. Why would Freeport make such a drastic and controversial change and risk facing the violent reaction of Shareholders and analysts?

Analysts were quick to downgrade Freeport's price targets and move from Buys to Holds and, "Under Review." Almost without exception, analysts questioned management's judgment and in some cases management's motives. And of course management's experience and ability to run an E&P business is a an open question. Far less discussed is what I believe to be an important takeaway from this highly unusual action.

Why Invest in Indonesia and Africa When One Can Get Similar Margins in North America?

Freeport felt compelled to diversify away from mining into E&P not because E&P has better margins than copper or gold, but because mining for metals in places like the Democratic Republic of Congo and Indonesia, and to a lesser extent Chile and Peru, has become too risky. Freeport is simply balancing its high risk assets with lower risk assets. Why didn't Freeport simply sell some of its metals assets? They probably couldn't find a buyer willing to pay a decent price.

My thesis is far from ground breaking. It's already been mentioned in various commentaries about Freeport. In fairness to Freeport, they have a perfectly reasonable model to follow. BHP, (NYSE: BHP) is the poster boy for this exact strategy. Several years ago, BHP diversified away from the mining of coking coal and iron ore into E&P. Good move. Today that segment is the best performing and biggest in the company. Teck Resources, (NYSE: TCK) is also moving in this direction. The company is building a formidable Oil Sands business in Canada. Oil will effectively hedge Teck's copper and coking coal operations. Both BHP and Teck appear to recognize that mining is an increasingly uncertain endeavor.

Resource Nationalism A Growing Concern

By my rough calculation, up to 40% of last year's global gold production came from countries with an elevated level of mining risk. There are three main risks, collectively known as Resource Nationalism. The first is arbitrary and unexpected increases in taxes and royalties. The second is political demands for greater and greater ownership of foreign gold projects. And third, labor demands for higher and higher wages and benefits. These risks are hard to contain or plan for. Typically, companies are forced to pay the ransom and move forward with significantly higher operating costs. 

Green field gold projects in many African countries are coming under increased scrutiny. Planning projects that might not be in production for up to ten years requires the use of estimates to calculate a Net Present Value, "NPV." With added country and labor risk, how can a company even calculate a NPV or compare multiple prospective projects? As the hurdle rate of return increases to justify the heightened risks, fewer projects will be approved. This, combined with natural decline rates and lower ore grades, could lead to declining gold supply in coming years.

2013 Could Be A Good Year For Gold and Gold Companies

Next year could be a good one for gold companies. With gold prices at $1,700 per ounce and more discretion in capital expenditures for growth projects, free cash flow should improve. Increased cash flow could be used for share repurchases or increases in dividends. Shareholder friendly activities like these would be much appreciated by investors. Make no mistake, the same scenario is not playing out for all natural resource companies.

For example, many coal and iron ore producers are facing severe headwinds in 2013 as coal and iron ore prices have slumped. Coking coal, used in the process of making steel, is down exactly 50% from mid 2011. It's quarterly settlement price for 1Q 2013 came in at $165 per metric tonne. In the June, 2011 quarter the price was $330 per tonne. By contrast, gold is up 11% since June 30, 2011. The slowing of China, Europe and an anemic recovery in the U.S. has not stopped gold from advancing for the 11th year in a row.

Newmont Mining, a Simple and Prudent Way to Get Your Gold On.

Newmont Mining, (NYSE: NEM) is a good way to play the possibility of ongoing strength in gold prices. Newmont is yielding a solid 3.2%. However, last year it adopted an innovative dividend policy. The company's dividend is now directly linked to the price of gold. For example, if gold prices reach $2,000 per ounce, Newmont's annual dividend would increase to $2.20 per share, 57% higher than it's current dividend of $1.40 per share. Assuming today's stock price of $44 per share, a $2.2 dividend would equate to a yield of 5.0%.

To put that in perspective, if Newmont stock maintained its 3.2% yield at a gold price of $2,000 per ounce, that would imply a stock price of $68, 56% above the current price. However, if gold prices fall, Newmont's dividend would decline, so it works both ways. A lot has been written on Motley Fool about Newmont and its unique dividend policy. Newmont is a highly liquid, blue chip company that is a simple way to get direct exposure to gold.     

MockingJay2011 has a long position in Newmont Mining Corp. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus