A geopolitical-risk case study

The fact that Centerra Gold’s (TSE, CG) projects are potentially very lucrative assets is both a strength and weakness for the miner. Of their two key projects, Kumtor is located in the Kyrgyz republic, while Boroo is in Mongolia. This has proved to be the company’s Achilles heel, with both of these nations introducing a considerable element of geo-political risk.

The uncertainty surrounding negotiations with the Kyrgyz republic, in relation to ownership and taxation of Kumtor, led us to reduce our exposure by half in March last year. Our concern subsequently proved justified when talks between the parties broke down and Centerra reinitiated international arbitration in June 2008.

This led to considerable volatility in Centerra’s stock price, exacerbated by the wider market weakness of October and November. The Kyrgyz government did however resume talks with Centerra in July, after the company agreed to suspend the arbitration process.

Centerra CEO Stephen Lang recently commented that he expects to resolve the negotiations this year. Expectations are for the final agreement to include a revenue-based tax for the mine, as per the original 2007 agreement that the Kyrgyz government failed to sanction last year.

A revenue based tax system would be positive for Centerra, reducing the costs of the Kumtor operation by about $86 per ounce of gold. The agreement also includes the Kyrgyz government taking a 29.3% of Centerra. Uranium giant Cameco, who currently own 53% of the miner, would reduce their holding to 40.5% and public shareholders would account for the balance.

Over in Mongolia, last year’s formation of a new coalition government also resulted in a new mining ministry. Centerra is continuing negotiations in relation to an investment agreement for their Gatsuurt project in the country with the new body. In a marginally positive sign though, parliament increased the threshold price of gold sales that incur a windfall profits tax, from $500 to $850 per ounce.

Turning to Centerra’s operational performance, production for the full year to 31 December 2008 was boosted by a record fourth quarter performance at Kumtor. Total group production came in at 748,888 ounces of gold. The production was within management’s previously revised guidance and represents growth of 35% over 2007.

Despite the production growth, average cash costs rose from $442 to $483 per ounce, due to higher labour, diesel and electricity expenses. These cost pressures have however eased following the significant pull back in energy prices. Indeed, fourth quarter cash costs fell to $379 per ounce.

In terms of the year ahead, management expect to deliver another solid result, with 2009 production guidance at 720,000 to 770,000 ounces of gold. Centerra’s production will once again be characterised by a fourth quarter uplift from Kumtor, as a result of the mine’s sequencing schedule.

However, management announced just this week the suspension of production at Kumtor for unscheduled maintenance. The work could affect Centerra’s full year production guidance if it extends beyond the scheduled 8 to 10 days.

Centerra’s improving operational performance is an attribute we look for when evaluating exposures to our view of continued gold price strength. However, the threat of onerous taxes or even nationalisation mitigates the likely upside. Even if Centerra achieve a positive resolution in Kyrgyz, there is no guarantee that the government will ultimately honour the agreement.

From a charting perspective, recent gains have greatly improved the outlook for Centerra Gold. As evident on the daily chart, following a dramatic collapse in investor support during 2008, prices have rallied strongly since November, returning near-term momentum to the upside.

Since listing in 2004 though, Centerra Gold has been particularly volatile, trading between a high of C$16.08 and a low of 93 cents. Until a sustained upward trend emerges, we cannot rule out further wild swings in price during the months ahead.

And this is the crux of the matter. The threat of adverse government intervention is constantly likely to over-shadow Centerra’s operational performance. The potential for which simply increases as the outlook for gold improves. We are therefore taking advantage of the stock’s recent price strength to sell the remaining half of our exposure.

We recommend Members sell Centerra Gold around C$5.20.

For those Members looking to retain their gold exposure, we re-iterate our recent buy recommendation on Gold Corp (GG, see FAT152 for details).