High gold prices drive Russian consolidation: Norilsk Nickel leads the way

by Simon Pirani

The Russian gold industry has gained from booming prices faster than its competitors and made itself the world’s key player for the next decade.

Russia, the world’s eighth-largest producer in 1999, overtook Canada, Indonesia and Peru to take fifth place in 2002. Russian gold production rose by 11% in those three years, while China’s rose 4% and the big three – South Africa, the USA and Australia – had growth rates of between zero and minus 2%.

Norilsk Nickel, Russia’s largest producer by far, is leading a consolidation drive in the gold sector. Valery Rudakov, head of its gold division, Polius, told MB in an interview that Russia could soon overtake the US, Australia and Canada to take second place after South Africa. “The Soviet Union was for many years in second place after South Africa, and Russia has every opportunity to get back to that position in five or six years' time,” he said.

The boom is attracting western gold companies: Barrick Gold, the world’s number three producer, this month upped its interest in the UK-Russian miner, Highland Gold. Alexander Pukhaev, metals analyst at United Financial Group in Moscow, says gold is “exceptional in the Russian economy: it is enjoying tremendous interest among western strategic investors.”

Kinross Gold of Canada was a pioneer: it acquired 54.7% of Omolon Gold Mining Company, in the far eastern region of Magadan, in 1998-99, and early last year paid $44 million to buy out shareholders linked to the Polymetal group and up its stake to 98.1%. Kinross is also developing the Birkachan open pit adjacent to Omolon's main mine, Kubaka.

Others will follow, possibly taking a similar route to Barrick’s and buying into one of the smaller miners who are scouring Russia's far-flung gold-producing regions for hard-rock mines and raising cash from UK and Canadian stock exchange listings to pay for their development. Russia’s big base metals companies are picking up gold assets to hedge their other production: the copper group UMMC is already producing 2.5-3 tonnes of gold annually.

Two thirds of Russia’s gold is produced from hard-rock mines by the top 20 gold companies. But the 14-year high in gold prices has also injected life into the smaller seasonal alluvial producers, and enabled some of them to start up heap-leaching operations. Alia Samokvalova, spokesperson at Peter Hambro, one of the longest-standing western players in Russia, says: “Once prices started rising, alluvial gold production was easy money and that’s where the consolidation started. Now some medium-sized players are looking at hard-rock deposits too.”

Mikhail Leskov, director of the NBL Gold consultancy, explains that it was the fall-out from the 1998 financial crisis – which resulted in a ruble devaluation and liberalisation of the export regime – that revived many ailing small producers. "Literally overnight small producers’ export proceeds soared in value, and they were catapulted into financial stability.”

The small producers usually sell their output to Russian banks licenced to export gold, and for the last two seasons western banks, led by Standard Bank (London), have provided one-year syndicated deals to banks for on-lending to producers. This year’s round of loans included a $64 million deal syndicated by Standard, Commerzbank and UFJ to Nomos Bank and a $14 million deal syndicated by Standard to Avangard Bank.

The Russian industry must use the next five years to build on the gains of the last five, say participants and analysts. Prices are expected to stay strong this year and then move down; production will continue to increase, although not as rapidly as before – and the longer-term future will depend on companies’ ability to invest the proceeds of the current boom wisely.

Gold prices, which increased by 17% in 2003 to a 14-year high, are expected to stay at $385/oz this year, and then ease, Standard & Poors gold analyst Tom Watters said at a recent briefing. Pukhaev at UFG sees prices holding this year and then easing to $370 by 2009 and $350 by 2012.

In terms of production, analysts believe that Russia will continue to expand faster than the other largest producing nations, but not as fast as in the last five years. The gains made possible by the increase in export earnings after 1998 and the liberalisation of the export regime have now largely been achieved, says Leskov at NBL Gold; from here, modernising the mines and improving cost-effectiveness is the key.

"I expect the rate of growth to remain healthy, at 3-4%, but it will be less than the 8-10% we have seen up to now," he said. “Hard-rock mining, in particular, is a capital intensive business. The benefits of investment in new technology started since 1998 are only starting to come through now, and it is crucial that proceeds from current high prices are invested in order to contine that trend. That will allow for further substantial increases in production in future.”

He adds: “At current high prices, the most difficult and most worn-out deposits are credit-worthy and attractive: this is driving consolidation, to the extent that Russian metals groups are buying gold producers without any thought about what sort of investment is needed. But at the next stage, everything will depend on Russian producers' ability to source finance and manage investment effectively."

Note: a tonne, the usual measure in the Russian gold industry, is 32,150 ounces.
 

NORILSK LEADS CONSOLIDATION DRIVE

Norilsk Nickel is riding the crest of a wave of Russian gold consolidations: it has swept into the world’s gold-producing top ten and positioned itself to win the privatisation auction of Sukhoi Log, the world’s second-largest undeveloped gold deposit, later this year.

The sustained price boom is starting to bring the gold majors to Russia: Barrick Gold, the world number three, has bought in to a new UK-Russian miner, Highland Gold. Other players in the consolidation game are an aggressive Russian gold and silver producer, Polymetall; Kinross of Canada; and a string of smaller miners who are funding development from UK and Canadian stock exchange listings.

Norilsk Nickel set the pace in the race for prime gold assets last year with its acquisition of Lenzoloto, the Irkutsk group of mines, which has about 200 tonnes of reserves and increased production from about 6 tonnes in 2002 to 9.4 tonnes in 2003. In August, Norilsk paid $2.7 million for a 5.6% stake auctioned by the Irkutsk region, and the next month a further $152m for a 44.9% federal government stake.

The acquisition spree didn’t end there. In August Norilsk also paid $34 million for a controlling stake (38%, comprising 50.7% of voting shares) in Matrosova Rudnik, a gold company in the far eastern region of Magadan that holds the licence to the 245-tonne Natalkinskoye deposit – and plans to raise annual production there from 1 tonne to 10 tonnes in the medium term. Then in December the base and precious metals giant forked out $10.4 million for the Titimukhta deposit in Krasnoyarsk, which has 34.3 tonnes of reserves.

The acquisitions have been made through Polius, which, when Norilsk bought it in October 2002 from Khazret Sovmen, the entrepreneur and governor of the Adigei region in the Caucausus, was Russia’s largest gold producer. This year, as Norilsk’s gold division, Polius will easily surpass 40 tonnes’ output, more than three times that of the second-largest Russian producer, Omolon of Magadan, controlled by Kinross Gold Corporation of Canada.

Mikhail Prokhorov, chairman of Norilsk Nickel and no.2 to Vladimir Potanin in the Interros empire, reportedly talks about little else but gold these days. But for Norilsk’s owners, the creation in a year of a monster dominating the Russian gold industry is merely the means to an end: the real prize is Sukhoi Log, the 1029-tonne deposit in Irkutsk, separated out from Lenzoloto in the mid 1990s and subject to several failed privatisation attempts then.

So while the multiple over the auction starting price paid by Norilsk was higher for Titimukhta and Matrosova Rudnik than for Lenzoloto – 41 and 13 times compared to five – in plain $/ounce of reserves, it was Lenzoloto they were prepared to pay most for: analysts’estimates range between $35 and $53, compared to $9-$11 for the other deposits. The reason: Sukhoi Log is next door.

Sukhoi Log has been re-slated for privatisation – and with Russian politics transformed and the gold price high, no-one thinks it will be postponed much further. On 20 January, deputy economy minister Mukhamed Tsikhanov said that auction terms would be published in the second quarter. Irkutsk’s regulations require a six-month wait after that.

Valerii Rudakov, the former Soviet precious metals and stones boss enticed out of retirement by Norilsk last year to head up Polius, told MB in an interview: “We hope to increase production at Lenzoloto to 16-17 tonnes in the next few years. But what is really on our minds is the Sukhoi Log auction.

“Let’s not beat around the bush: without Lenzoloto, no-one else can do a good job at Sukhoi Log – and we bought Lenzoloto for that reason. We have all the necessary infrastructure – power; road, rail and water transport – without which Sukhoi Log can’t be developed.”

Rudakov said that Polius would spend about $70 million on pre-production work at its new deposits over the next two years, probably funded from Norilsk’s cash flow. Project investment will cost around $500 million, and if Norilsk wins the Sukhoi Log auction, expected in the first half of 2004, “more than $1 billion of investment will be needed there. Some of that will need to be debt-financed from the international bank market”.

Rudakov added that “given the fairly serious competition” from Buryatzoloto and the Moscow-based company Tafigura, the price paid for Titimukhta was “reasonable”. Titmukhta ore will feed the processing plant at Olimpiada, Polius’s main producing deposit, he said. “We expect that further exploration work in deep horizons at Titimukhta may increase the reserve base to 55 tonnes or so.”
 

WHO’S WHO IN THE GOLD RACE

 Highland Gold, which is opening the door to Russia for Canadian major Barrick Gold. Barrick bought a 10% stake in Highland from Harmony Gold of South Africa last year, and as we went to press was completing due diligence on a deal that will take its stake to 29%. Highland chairman Peter Daresbury told MB: “The global operators are not yet in Russia, but the window is now open. We are very pleased to have Barrick’s firepower.” Barrick intends to fund future acquisitions 50-50, he said. Vince Borg, director of corporate communications at Barrick, told MB that Russia is a “potential new frontier” with “prolific” resources.

Highland, whose main producing asset is the Mnogovershinnoe mine in Khabarovsk region in southern Russia, which produced 5.5 tonnes in 2002, has done much of the hard part for western companies – including learning to deal with political and other peculiarities of Russia’s far-flung regions. Those politics probably worked to its advantage in September last year when it acquired the 280-tonne Maiskoe deposit in Chukhotka: Highland board member Ivan Kulakov used to be a director of Sibneft oil company, which is controlled by Chukhotka governor (and Chelsea football club owner) Roman Abramovich.

A less comfortable experience was the dilemma that surrounded the equipment and buildings at Mnogovershinnoe, which were on lease from local government when Highland started producing there. Last year it cost the company $26.7 million to end the uncertainty by buying the infrastructure at auction, in fierce bidding against Alrosa Invest of Yakutia.

 Peter Hambro, which, like Highland, is listed on AIM, owns 98% of Pokrovsky Rudnik, which produces from three mines in the Amur region – and now aims to expand there, and in Magadan, Russia’s largest gold-producing region, via two joint ventures. The Amur JV, Rudnoe, will develop the Solovievskii deposit and acquire other properties. The larger Magadan JV, Omchak, is with Susumanzoloto headed by Viktor Khristov, which produced 5.8 tonnes in 2002, and Shkolnoe, a smaller gold company.

Omchak was formed last year to bid, unsuccesfully, against Norilsk Nickel for Matrosova Rudnik, and then the partners decided to stay together as a magnet to Magadan’s mass of smaller mines. Alia Samokvalova of Peter Hambro told MB: “We have worked out a big M&A programme. We plan to expand both via acquisitions and via JVs.”

 Celtic Resources, Irish-registered and AIM-listed, has producing assets in Kazakhstan, but will leap to prominence in Russia this year when it completes negotiations with local authorities in Yakutia and the state-controlled investment company IG Alrosa over the South Verkhoyansk Mining Company (SVMC) and its gigantic Nezhdandinskoye deposit (902 tonnes of gold and 3110 tonnes of silver).

Celtic spent most of last year working with IG Alrosa, which is jointly controlled by the federal and Yakutia regional governments, on a swap deal under which it will increase Celtic’s stake in SVMC from 50% to 100% in return for IG Alrosa taking a 23% stake in Celtic and becoming its largest shareholder. In November the two sides issued a joint statement saying the transaction would be “completed as soon as possible” and industry observers say it remains likely to go ahead.

 Trans-Siberian Gold, which followed Celtic and Highland on to AIM in December and raised £16 million there, has three properties: an open pit at Veduga, Krasnoyarsk, where it expects to start production in 2005 and the Asasha and Rodnikova deposits in Kamchatka (in which it has 90% stakes), expected to start producing in 2005 and 2006 respectively.

Company chairman Jocelyn Waller told MB that total project cap-ex is estimated at $142 million, and would be raised about two-thirds debt and one third equity. “We have been in discussion with Russian banks about the finance. We favour doing traditional project finance in which they would be partnered by a western bank,” he said.

Waller, who worked for Avocet in Malaysia before entering Russia with Trans-Siberian in 2000, said: “Russia stood out as a place where the rocks are right, where the geological work had largely been done, but the technology was not yet in place. Coming in under the Putin adminstration was obviously easier than arriving in the 1990s.”

 Buryatzoloto, listed on the Moscow and Berlin stock exchanges but barely traded, is controlled by High River Gold of Canada, which holds 51% of voting shares. It operates three deposits in the republic of Buryatia and one in Amur.

 Bema Gold, listed on the Toronto and Amex exchanges, has been producing from the Julietta mine in Magadan since 2001. It is now drilling at the Kupol gold and silver deposit in Chukhotka.

 A significant Russian player, Polymetal, is gathering hard-rock mines – and has achieved a wider geographical spread than any of its western competitors. The company, 100% owned by the privately-owned IST group of St Petersburg, has seven mining and six service subsidiaries in Buryatia, Khabarovsk, Sakhalin, Chita and Magadan. Its main business is silver, and in 2000 it won control of its flagship silver facility, the Dukat mine in Magadan, the world’s third largest, after a bruising battle for control with Pan American Silver of Canada.

Polymetal produced 4 tonnes of gold and 54 tonnes of silver in 2002 and in October 2003 brought its new Khakandzhinskoe deposit in Khabarovsk into production. Its strategy is to keep everything from prospecting to sales in-house, and last year it became the first Russian producer to be licenced to export gold under liberalised rules. In December its first shipment – from the Vorontsovskoe deposit, processed into bullion at the Novosibirsk refining plant – went to the United Arab Emirates. Polymetal is in talks with Standard Bank of London about a $100 million-plus trend-setting project finance deal, with a tenor of up to five years.