Dear Reader,
With gold back up within reach of its nominal record high last year, a lot of new investors are thinking about gold mining stocks.
With this in mind, today we take a peek at one of the issues that confuses some metals investors: cash mining costs. It's simple in a way, but also nuanced and subject to misinterpretation. I'll let Andrey Dashkov explain.
The point, for now, is no surprise; be careful, think things through, be thorough in your due diligence. But there are opportunities out there, and more coming.
Sincerely,
Louis James
Senior Metals Investment Strategist
Casey Research
| Rock & Stock Stats | Last | One Month Ago | One Year Ago |
| Gold | 1,784.00 | 1,690.00 | 1,617.00 |
| Silver | 34.85 | 32.10 | 28.69 |
| Copper | 3.79 | 3.53 | 3.10 |
| Oil | 91.71 | 95.36 | 79.68 |
| Gold Producers (GDX) | 53.65 | 47.93 | 54.88 |
| Gold Junior Stocks (GDXJ) | 24.82 | 22.03 | 28.22 |
| Silver Stocks (SIL) | 25.39 | 21.80 | 20.99 |
| TSX (Toronto Stock Exchange) | 12,418.99 | 11,990.14 | 11,457.22 |
| TSX Venture | 1,344.98 | 1,246.27 | 1,413.65 |
By Andrey Dashkov, Research Analyst
When you read about mining companies, you'll often see "cash cost" figures given for production. "XYZ Gold Corp. produced 25,000 ounces of gold from its mines this quarter at a cash cost of $676 per ounce." This is a non-GAAP figure similar to the general idea of "cost of sales" – what it takes to calculate a gross margin.
Why would anyone report something so near the top line when it's the bottom line that's, well, the bottom line? Because it's useful. The bottom line can be subject to major fluctuations from quarter to quarter, even in large companies if they get hit with one-time write-downs, changes in taxes, changes in accounting, etc. that are separate from the actual profitability of mining operations. By looking at cash costs, we can make our own estimations of how rich a company's mines are, and hence how much abuse a company can take on non-mining costs and still deliver to the bottom line over time.
For exploration and development companies, of course, there is no EBDITA, and the bottom line is almost always negative. Reasonable cash cost projections can give us a basis for evaluation when normal metrics don't apply.
With rising costs, we've been hearing industry talk about shifting away from reporting cash costs, which can make mining companies seem more profitable than they are to the financially illiterate – like politicians. Political leaders in some countries are pursuing windfall profit taxes, higher royalties, etc., because they see higher metals prices and relatively low cash cost figures, when in reality there may be little or no windfall profits to be taxed.
At a recent meeting at the Denver Gold Forum sponsored by the World Gold Council, the idea of moving away from the traditional cash cost reporting figures was proposed. A more standardized, "all-in" cost figure has been proposed, to include operating costs, sustaining capital expenditures, and general and administrative costs. If adopted, this figure would provide a more accurate and definitive picture of actual mining costs.
Here at Casey Research, we aggregate our own "all-in" costs when not reported by a company, so such a change would not impact the way we look at companies much. However, for others who are used to looking at cash costs, the "all-in" figures could come as a bit of a shock, and could result in negative investor reactions toward companies that make the change. That's probably just as well; the smart money will be back – it already knows there's much more to the picture than cash costs.
More on this shortly. First, let's have a quick look at cash costs for gold producers today.
The latest update to the Thomson Reuters GFMS Gold Survey reports that in the first half of 2012, average cash costs for gold producers increased to a new high of US$727 per ounce. However, higher year-on-year gold prices have seen producer margins increase by 11%. Still, GFMS also points out that "on a quarterly basis, margins have in fact declined for the last three quarters."
The chief reasons cited for cash costs increasing are declining ore grades, labor cost increases, higher energy prices, and other input factors. Our expectation is that on average, these costs will continue to rise throughout this year and beyond.
However, profit is not a one-variable calculation. With the underlying commodity – gold – rising faster than cash costs for over a decade now, many mines that were previously unprofitable have become profitable.
Sharp investors have noticed that many profitable mining companies aren't seeing fatter margins. Why? Because mines with higher-grade material start processing previously uneconomic lower-grade ore while they can do so at a profit, adding to the life of their mines and total cash flow while maintaining their bottom lines today. In other words, what was once waste becomes ore, leading to increases in overall production and profit. It's a good business strategy, but it also contributes to the rise in average mining costs.
Still, while costs have risen in nominal terms, gold has continued upward as well. As a result, average operating margins, based on the spot gold price, have gotten wider in recent years. The below quarterly comparison of the average cash cost vs. the average price of gold over the past seven years shows this quite clearly.
(Click on image to enlarge)
A real eye-opener, however, comes from another chart we built using the same data set. Here you'll see that wider margins mean that cash costs – stated as a percentage of the price of gold – were at multiyear lows earlier this year.
(Click on image to enlarge)
This year we have observed rising costs, so it will be interesting to see how this chart looks going forward. If gold continues trading sideways, the window of profitability will shut down for marginal operations. However, if gold heads much higher – as we expect it to – the trend in the chart above could keep margins fattening.
Capital expenditure – "capex" – is also a cost of doing business for mining companies, but as the name implies, it's capitalized. That means it's subject to depreciation and not treated as an expense, and doesn't show up in operating costs. You still need to pour this money into the ground to build and operate your mine, of course, so it does affect the bottom line, where depreciation, taxes, and other costs are all taken into account. For exploration and development companies, you look for the impact of capex in internal rate of return (IRR) and net present value (NPV) figures.
Capex has been ballooning of late, due to higher labor and material costs and much greater regulatory burdens. There's nothing new in this trend, but it seems to be accelerating substantially, especially for larger projects. We don't have updated industry-wide average figures for this, but one of most striking recent examples of skyrocketing capital costs is Barrick's Pascua-Lama project on the Chile-Argentina border.
Business News Americas reports: "A previous cost estimate for Pascua Lama was US$3.3bn-3.6bn, but this was revised up to US$4.7bn-5bn after a review in 2011." The current cost estimate is about US$8 billion.
Barrick's situation is a vivid example of why capex has become a significant detriment to building new mines – more so than rising operating costs. When it comes to calculating a project's IRR, the size of the initial investment has a huge impact. So, in spite of the rising gold price, we're not seeing as many new mines being built as we might expect.
Indeed, the relatively low pace of mergers and acquisitions among mining companies this year may be principally due to concerns about rising capital costs. Many of the larger companies that might have been snapping up successful exploration companies while they were on sale over the summer had their plates full with huge projects they were already committed to.
That will change at some point; the majors must replace depleting ounces or cease to be major mining companies. However, that tipping point does not seem to have been reached yet.
Operating costs are rising, but on a yearly basis over the last ten years, production margins have been rising faster. The industry, recognizing problems with cash cost reporting, is considering a new metric that would provide a more accurate picture. However, many in the industry hesitate: some executives want to keep using the cash cost figure since it reflects how much it costs to mine right now.
We don't know how that issue will turn out, but unless and until the industry does adopt a more comprehensive and accurate figure, we'll keep using our own "all-in" estimates. All investors in the sector need to remember that the real cost of any mining is going to be higher than what companies report as cash costs.
And – obviously – there's much more to evaluating a precious metals producer than just costs. Does its management team have a track record of success? Does it have enough money (or access to it) to move its projects forward? Is the company likely to be taken over by a major producer?
That last point is particularly important, because when juniors are bought out, their investors usually get big windfalls. Right now Louis has identified seven companies that are especially ripe for takeover.
Rupee Aids India's Gold Buying Ahead of Festivals (The Economic Times)
An appreciated Indian rupee pushed local gold prices to a five-week low, providing an opportunity for gold importers in that country to stock up on bullion for upcoming festivals. The world-famous Indian festival and wedding seasons start in late October, a time when people traditionally buy gold for gifts and dowries.
The rupee rose to its highest level against the dollar in more than five months, which kept prices of the precious metals in rupee terms subdued, even as dollar-priced gold hit an 11-month high above $1,795 last week.
"There is heavy demand, because the rates have come down on rupee appreciation," said Ganesh Agarwal, director of Shiv Sahai and Sons India Limited, a Chennai-based wholesaler, noting that investors were also among recent gold buyers.
It is unlikely that the autumn festivals and revived demand will offset the considerable decline in India's gold consumption that we've been seeing during the year. A weak rupee and higher import duties on gold imposed by the government in an attempt to cut the deficit were among the main reasons for demand decrease from Indian customers.
$2,200 Is a Realistic Target for Gold in 2013 (Mining.com)
In a recent interview, Kitco's head of precious metals, Peter Hug, said gold prices could hit the $2,200 level next year. However, he doesn't expect to see gold reaching such lofty highs prior to the year's end.
Hug observes the market as constructively bullish, given aggressive stimulus plans by the US Federal Reserve and the European Central Bank. But he says gold prices could dip short-term on profit-taking, providing a buying opportunity for investors.
These expectations are in line with our own. For more information, read an exclusive Kitco interview with BIG GOLD's Jeff Clark.
For Both Gold and Apple Fans: A 24-Karat Gold-Plated iPhone 5 (Mining.com)
London jeweler Gold & Co. has hit the market with a 24-karat gold-plated iPhone 5 that costs "only" $4,380 (£2,695).
"This stunning iPhone is uniquely crafted. Best quality crystal stones are added to its own mounted 24ct gold logo and home button. Like the diamond setting process, each stone is individually set into cut clasps adding seductive detail."
We like gold, but we also know it's a soft metal. Somehow, this plating doesn't seem very practical – but, we suppose that's the point.
Striking South Africa Miners Fired by Platinum Producer (Toronto Star)
Anglo American Platinum (Amplats) has embarked on a massive layoff of striking miners. The company reported that "approximately 12,000 striking employees chose not to make representations, nor attend the hearings, and have therefore been dismissed in their absence." The company representatives said that a more detailed statement would be issued soon.
80,000 miners – about 16% of the country's mine workforce – are on strike, causing mine stoppages and political complications. The country's president called for "constructive social dialogue," but the turmoil continues.
We're keeping a close eye on the situation in South Africa. The current crisis may present interesting investment opportunities – and our subscribers will know about them first.
International Speculator
BIG GOLD