A worrying alchemy
John Gray
From the April 24-May 7, 2006 issue of Canadian Business magazine 
If you want to get investors' attention these days, just tell them you run a gold company or your business is moving into China. After all, gold has been trading above US$600 an ounce — its highest price in more than 25 years — and China's economy has an insatiable appetite for everything from raw materials to luxury goods. But tell investors you're looking for gold in China, and what happens? Suddenly, they lose interest.

Maybe that's not so surprising. Doing business in China is complicated, and mining is risky. A company has to spend millions of dollars to find and develop a gold deposit, and that could well be lost to a simple dispute with a local partner or any one of the many layers of the bureaucracy. The Chinese government has made great strides in recent years to mitigate those risks, but when it comes to mining, many Canadian investors still see China as a closed Communist country — like Russia during the bad days, when contracts or business arrangements could be set aside by government fiat. "Investors are still nervous, so they give our stock a bit of a discount," says Ken Cai, president and CEO of Minco Mining & Metals Corp. (TSX: MMM). "They look at China and think it's the same as Russia."

The reality is that it's never been easier for companies doing business in China, says Cai, who was born and raised in Hubei province and worked as a geologist with China's ministry of mining until immigrating to Canada in 1990. Minco has been exploring for gold, silver and base metals in China for 11 years, and expects to spend nearly $6 million this year drilling on its four major Chinese joint ventures.

The Chinese mining sector really began opening up just over three years ago, with the establishment of the Shanghai Gold Exchange. Since then, the government has eased restrictions on foreign participation and has streamlined the requirements for business and exploration licences. That said, in many ways the culture of the sector still has more in common with Russia than with Canada. The bureaucracy — as well as mine projects themselves — has historically been quite inefficient, says Cai. "In Canada, we build large mines to maximize profit," he adds. "In China, they build small mines to maximize employment."

That inefficiency could be seen as an opportunity, but it also illustrates the complexity of working in China, says Garry Stein, vice-president and chief investment officer at Toronto-based Golden China Resources Corp. (TSXV: AUC). "Canada is the seventh-largest gold producer in the world, and we do that with about 25 major mines," he says. "China is the fourth largest gold producer, and they do that with about 1,300 mines." Last year, Golden China tried — but failed — to convince the owners of four small Chinese mines working the same ore body to modernize and consolidate into a more efficient company. Despite the setback, the company is not giving up on China. This June, it expects to have completed a complex merger with Australian-based Michelago Ltd. that will give it a seat on the Shanghai Gold Exchange — making it the only foreign company on the exchange. The deal will also give it ownership of an operating BioGold refinery in the Shandong town of Laizhou. The facility uses bacteria to separate gold from ore, and it produces about 150,000 ounces annually, with cash flow of about US$6 million. An upgrade is underway that will increase production to more than 230,000 ounces, and profits will help fund exploration and acquisitions within China, says Stein. But despite the positive impact on the company's bottom line, China Gold is still a tough sell with Canadian investors. "We have a much easier time," Stein says, "attracting investment from European institutions that are a little more comfortable looking abroad."

Make no mistake: there are real risks in China. Last September, Vancouver-based Mundoro Mining Inc. (TSX: MUN) announced that the provincial government of Liaoning failed to renew the licence for its Maoling gold project. (The company continues to lobby the government to renew the licence.)

Problems like that have frightened away not only retail and institutional investors, but also major gold producers, who are more interested in projects in Nevada, Australia or other more stable mining centres. That is one of the main factors holding back the shares of Chinese gold companies, says Jim Mustard, an analyst with Vancouver-based Haywood Securities Inc. "Without the promise of a big, established company coming along to buy you out once you have found a decent gold deposit, it's that much harder for a junior in China to get investor attention," he says. The juniors face another layer of scrutiny that keeps their share price low: not only do investors have to evaluate the company's Canadian management, expertise and the potential of its properties, but they must also judge the capabilities of the company's local Chinese partner — something most investors are either unwilling or unable to do, says Mustard.

Still, the reward for investing in Chinese gold may soon outweigh the risk. That doesn't mean mining executives — and their investors — won't have a few sleepless nights as the Chinese mining sector opens up. But with shares of Chinese gold companies trading at such hefty discounts, that might just be the price an investor has to pay to get in on what could be the next great gold rush.