On May 05 I published 'The Investment Case For Junior Mining Companies' part I which had a strong focus on the technical set-up. Highlights of that article:

Highlights:

• Gold correction most probably over (bottomed out at $850)
• Junior sector just recovering from deepest over-sold condition since late 2002
• CDNX has started outperforming gold over the last few weeks
• Previous bottoms in CDNX/GOLD ratio were being characterized by sharp up-moves that lasted for many months
• CDNX/GOLD ratio charts leave plenty of room for a giant up-move that could last for more than a year
• Sentiment in junior sector has hit an all time low. This is a dream scenario from a contrarian perspective.

END.

I suggested a high probability for gold to have bottomed out at $850 and elaborated more on that in my piece 'GOLD/HUI - Bottom Must be Near!' last week. Well, lucky shot I guess but $850 gold turned out to be the bottom indeed.

Now that gold finds itself in a new up-leg again we can finally be looking forward to some excitement in the junior gold shares coming months. As pointed out in part I the technical set-up leaves plenty of room for a giant up-move for the juniors that could last for more than a year. Please think about it, juniors bouncing off their most severe oversold condition in 8 years on the back of rising gold prices. This is the best technical set-up one could ever dream of. On top of that we could expect a wave of take-overs during the next two years since the major producers are hungry for new gold reserves. In other words, juniors with large proven resources will be hot!

Reasons why juniors will be watched (by major gold producers and investors):

• The industry is not replacing the reserves it is mining every year
• High grade mines are running out of ore.
• Even with gold at $1000 / oz , it still takes four to seven years to open a mine.
• The industry isn't going to be able to respond immediately to higher gold prices.
• Reserves will be depleted in less than 10 years at current annual production rates
• The industry needs some major new finds desperately. Since 1999 only a very few world class gold deposits have been found.
• Majors are forced to acquire juniors because of the need for more reserves
• Juniors making discoveries are phenomenally profitable.

Now let's dig into each item listed above:

The industry is not replacing the reserves it is mining every year

The top 5 Gold producers are each pulling between 3.5 million and 7 million ounces out of the ground every year. In order to keep up with the current production rate the miners need to replace their mined-out reserves through exploration . But that's exactly the problem. In order to replace 3.5 - 7 million ounces of gold each year you'll have to find a major world class gold deposit ( > 5 million ounce) each year which is highly unlikely. Of the 800+ discoveries listed of greater than 100,000 ounces (US Geological Survey's database), only about 6 percent contains 5 million ounces of gold or more. And even if a big discovery is made, it can take anywhere between three and 10 years to permit a mine in Canada or the United States, prospective areas where the major miners prefer to look for gold.

High grade mines are running out of ore.

Production rates are going down because the high-grade mines are running out of ore, which is forcing the producers to mine the low grade stuff. Since mill capacity doesn't change (mines are designed for a specific rate of production in tonnes mined and milled, not in ounces of gold produced) the output has nowhere to go but down. This has led to a dramatic production decline in South Africa the past decade and the end is nowhere in sight! Furthermore, many large gold mines, and particularly in South Africa, tend to close down with large ore resources still on the books.

The industry isn't going to be able to respond immediately to higher gold prices.

Even with gold at $1000 / oz , it still takes four to seven years to open a typical mine. On top of that, rising gold prices lead to a falling gold production in short term. The reason for that is mentioned above since mine management will focus more on the low grade ore that was considered 'waste' at gold prices a few hundred dollars ago. With gold prices below $600 the producers where forced to mine the 'high-grade' stuff since mining the low grade stuff wasn't economical. Now that a lot of the high grade ore is mined out, all that's left is the 'low-grade' stuff.. Since mines are designed for a specific rate of production in tonnes mined and milled the production rate of gold and silver metal will drop since ore head grades are dropping.

The example below tells it all:

A mine's operating structure is generally set at initial design, in that it has a rated mill capacity of 100, 1,000, or 10,000 tonnes per day. Its cost structure is likewise set by design in that a tonne of ore costs $x to mine, $y to process with $z for G and A. Therefore, for example, a 1,000 tpd mine with the costs $x+y+z equal to $200 per tonne must process ore of that minimum value to break even. No operator will survive for long processing sub $200 ore. At US$660 per ounce and assuming a 90% recovery from the mill, the minimum profitable grade is close to 13 gpt (or near 1/3 of an ounce per tonne). As such, the operator will optimize by mining from various orebodies and stopes to mine as much as possible above the 13 gpt cut-off. Rock with grades of 8 gpt are waste. Daily production might be economic down to as low as 300 ounces per day (1,000 tpd at 1/3 per ounce x recovery).

As the gold price moves to say $900+ per ounce, few of the mine's costs change, but now the revenue is 30% greater. Consequently, the Mine Manager's first priority is to extract the extra ore that was a short time ago, waste. The cut-off or minimum grade mined goes from 13 gpt down to 9 or 10 gpt, so the mine's 1,000 tpd output now drops from 300 ounces per day to 280 ounces per day.

Most gold mines operate this way! So as the price of gold goes up, primary mine production drops. The higher the price of gold, the greater the drop in primary mine production.

END.

The industry needs some major new finds desperately. Since 1999 only a very few world class gold deposits have been found.

As mentioned above, the top 5 Gold producers are pulling each between 3.5 million and 7 million ounces out of the ground each year, which translates itself into the need for a world class gold discovery each year to replace the mined reserves. Well, that simple fact is that new world class gold discoveries are very rare and hard to find, by exploration or purchase. See chart below:

The chart is a bit dated but after 2003 only one huge world class gold discovery has been which was Aurelian's FDN project. Unfortunately it may take a while before those new discovered ounces (10+ million) will be accessible for production since the Ecuadorian government isn't exactly providing the support necessary to move things forward here. Two large gold deposits in nearby Venezuela also have just been denied production rights which isn't a big help either for future gold supply!

You get the picture? Wanted (desperately) several new world class gold discoveries each single year but (almost) no major world class gold discoveries announced over the last 10 years. Result? An inevitable, major decline in world gold production! The decline is already well underway since world gold production peaked in 2001 and has been in decline ever since.

Now some analysts argue that there isn't a problem at all since world gold reserves are estimated at about 30.000 tonnes so at current production rates we could easily produce a for another 10 years. What these analysts fail to recognize however is the simple fact that it becomes harder and harder to produce the remaining ounces left. Late in the life of mines, the typical case is that the mine shuts down early, with a large amount of "reserves" still showing on the "books". A good case in point was the Homestake Mine in South Dakota, which was shut down with a large base of ore "reserves" (millions of ounces) still on the books. Anyhow, the proof the decline simply can't be ignored since world gold production peaked in 2001 and has been in decline ever since. The decline and closure of any existing big gold mines, such as in Nevada’s mega-producer Carlin Trend, will exacerbate the supply problem dramatically.

Majors are forced to acquire juniors because of the need for more reserves

So, the major gold producers can't replace their produced ounces of gold simply by means of exploration, so what are they supposed to do then? Well, the answer is simple, they simply have to open up their check-books and buy the ounces. In other words, the majors are simply forced to look to juniors in order to acquire the exploration opportunities that they themselves can't find. When you realize that one of the most important factors to increasing the odds of making a discovery is to have experienced and qualified geologists with a proven track record plus the fact that juniors continue to steal the top geologists of the major companies then it's easy to understand why 75% of all discoveries are made by juniors.

So, the major gold producers have to make new acquisitions to meet their growth targets, well, it seems that that's exactly what'll happen during the next two years: