Graham Stack in Moscow -

With worried financial investors fleeing to gold as a safe haven and the price expected to hit $1,000 this year, it's an ideal time for Russia to auction the world's second-largest gold deposit. Not such good timing is Russia's biggest gold producer and favourite to win that auction being stricken by a corporate dispute that saw $1bn worth of its stock go to an unknown buyer in January.

On January 25, the price of gold set another record high, reaching $923 a troy ounce (k oz). "We believe the price will reach $1,000 by the end of the year," predicts Trust investment bank's Dmitry Sergeev. "Under conditions of financial instability, gold will be used as a hedging instrument and this will increase demand."

Alfa's Maxim Semenovykh agrees: "We expect the price of gold to rise in these financial conditions because it's a safe haven for investors."

The latest price surge is just the icing on the cake for gold. In 2006, gold prices grew by 23% and reached a record $730 per ounce. Gold prices increased by 25% in in the first 11 months of 2007 and climbed to a 27-year high of $830.

"Structural price drivers are the falling production in the main producer country of South Africa. South African deposits are increasingly exhausted and metal content in ore is falling. South African production will continue to decrease," explains Troika Dialog's Mikhail Stiskin.

Demand has been boosted by growing demand for jewelry products on emerging markets like Russia, China, India, Brasil and Turkey. The fall in the dollar and political tension in the Middle East are also contributing to the rise in price.

Russia will benefit hugely from the price development, as it's one of the four richest countries in the world by total gold reserves with 3,000 tonnes, compared with South Africa's 6,000 tonnes, Australia's 5,000 and Peru's 3,500. What's more, the giant Sukhoi Log gold field in Irkutsk region, the world's second-largest deposit, is up for sale in 2008.

A golden log

A reassessment concluded last autumn sensationally doubled the reserves to 1,920 tonnes of gold. Russian state agency Rosnedra calculated that gold sales over the field's life would total $30bn and that state revenues from mining of this Eurasia's biggest gold deposit would run to more than $2.5bn. The future mine should be capable of producing 30-50 tonnes of gold from 12m tonnes of ore per year. And in 2008, all this will be - apparently - up for sale.

"The tender for Sukhoi Log will take place, we think, in the second half of 2008, after the presidential elections - this is more or less the unstated official position," says Trust's Sergeev.

Other gold analysts agree that the tender will be in the second half of 2008, and about who the favourite is. "The most likely candidate is Polyus Gold, around which the consolidation of the gold sector could take place," says Sergeev. "Polyus Gold has a deposit adjacent to the location, and thus all the infrastructure at hand, and also Polyus Gold participated in the revaluation of Sukhoi Log reserves."

Polyus Gold, by far Russia's largest producer, with 1,215 k oz output in 2006 compared with the next-best miner Peter Hambro with 261 k oz, ranks among the world's top-10 gold producers.

"Polyus Gold is the most probable candidate," reckons Semenovykh. "But there are other possibilities like Severstal or Alrosa, maybe someone else. Highland Gold issued 40% of shares in favour of [Russian tycoon Roman] Abramovich, so they now have the financial resources for such a project. It will be a very competitive tender, so the price is completely unpredictable."

Nevertheless, foreign investors are more or less excluded from the bidding, because the scale of the Sukhoi Log deposit means it has been put on the government's restricted strategic list. Moreover, in September 2007, the Russian Natural Resources Ministry announced it was going to hold a tender for the licence instead of an auction."There is a fine difference between an auction and tender. Sukhoi Log is a strategic deposit, and in my opinion, it was a political decision to hold a tender, perhaps to additionally restrict access of foreign investors," says Sergeev. "Investors can only participate through minority holdings in Russian companies mining the deposit. There is a possibility that Baring Gold as minority and [Abramovich's] Millhouse will jointly submit a bid for the licence."

Another reason for holding a tender with investment commitments is the scale of investment that'll be required. "Mining of Sukhoi Log will cost $1.6bn investment and it will take two-three years before gold can start to land on the market," says Sergeev.

Polyus Gold - the plot thickens

Polyus Gold might be the favourite to acquire the Sukhoi Log tender, but it's far from clear who will be in charge of the company itself.

A splurge of over-the-counter deals in Polyus Gold shares took place between January 18 and January 22, at the same time as the Russian stock market plummeted. "We've just seen about $1bn of Polyus gold stock changing hands", says Renaissance Capital's Yury Vlasov. "That's about 10% of Polyus' market capitalisation."

Vlasov says there could be a number of explanations, such as investors needing cash to meet margin calls as the markets plummeted. "But the size of the transactions indicated it has to do with the EGM meeting called for mid-February, where there will be another clash between Mikhail Prokhorov's Onexim Group and Vladimir Potanin's Interros. So in all probability it was Potanin beefing up his stock in preparation for the EGM," Vlasov reckons.

The context is a bitter divorce between Polyus Gold's owners - the metal tycoons Mikhail Prokhorov and Vladimir Potanin - that began when the French police caught Prokhorov indulging in après-ski activities with young girls in Courchevel in December 2006. Their ensuing custody tug-of-war over joint metals assets, such as copper giant Norilsk, spilled over to Polyus Gold in 2007. Prokhorov appointed his own man Evgenyi Ivanov as CEO in October. In December, the new board decided to carve out greenfield Polyus projects into a subsidiary, Polyus Exploration, to be subsequently floated.

Potanin protested this decision on January 17, forcing an EGM to be called for mid-February. The next day the buying started. Potanin needs around an extra 3% to achieve a blocking stake in Polyus Gold. "If the dispute between Potanin and Prokhorov continues, it will have a negative effect on implementation of large projects such as Natalka," believes Alfa's Semenovykh. "It will not effect the operation of current activities, but the future plans." The Natalka deposit, for which Polyus already holds the licence, is Russia's second largest.

More worryingly, because the dispute has now crystallised around the proposed spin-off of greenfield sites into a separate entity, it could directly call into question ownership of the Sukhoi Log licence. "A potential asset split between Interros and Oneksim, including a possible transfer of part of Polyus Gold's licenses to a subsidiary, Polyus Exploration, (asset spin-off) would create additional risks," reads a Trust bank research note.

Evidently stricken by gold fever on seeing prices move towards the $1,000 mark, two Russian oligarchs bought themselves gold companies for Christmas. In December, Alexei Mordashov of steelmaker Severstal completed the acquisition of 81% of Celtic Resources, while Abramovich - owner of another large steelmaker Evraz - announced the acquisition of a 25% stake in Highland Gold, with a view to acquiring 40%.

There is, however, still plenty of room for consolidation in the sector. "The top three - Polyus Gold, Peter Hambro and Polymetal - produce only 36% of total gold production in Russia," explains Sergeev. "By way of contrast, the three largest gold producers in the Republic of South Africa produce 85% of total gold production."

"We expect Severstal to continue activity in buying licences. Alliance Group is bidding for a stake in Polyus Gold being sold by KM Invest. Millhouse has already bought 40% of Highland Gold. Peter Hambro will probably continue to be independent. But the point is that the sector is very under-consolidated and Severstal is planning an IPO of its gold assets within five years," says Sergeev.

A research note from Unicredit bank agrees: "Severstal and Abramovich are far from done with consolidating their new gold businesses." Unicredit mentions as acquisition targets further Russian/CIS gold juniors such as European Minerals and Uzbekistan's Oxus Gold.

"I think some smaller players will definitely be acquired by majors," says Alfa's Semyonovykh. "It's hard to predict huge deals, though. There's probably enough oligarchs in the sector already."

This overdue consolidation could prompt an upturn in stagnating production, believes Sergeev. Russian gold production fell in 2006 by 2.9% on year to 147.6 tonnes, and Sergeev expects that in 2007 total gold production in Russia might have decrease by another 2% to 161 tonnes. But he is bullish about 2008: "Thanks to the arrival of large companies, increased investment, the high gold prices, and ongoing consolidation, I expect 2008 to be a turnaround year for the gold-mining sector in Russia."

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