With
seven consecutive years of rising gold prices, the gold mining industry has
had ample reason to boost output.
The demand for gold has grown and will continue to grow and legendary
profits can be won for shareholders.
But in provocative fashion not only have the gold miners been
unsuccessful in growing supply, global mined gold production is down since the beginning of the bull.
In last week’s essay I revisited gold’s strategic fundamentals with particular focus
on economics, drilling down on global gold production and reserves
trends. And interestingly global
gold production is down 4% since
2001. In a secular bull market
this is not a logical supplier response to an economic imbalance.
With
mine production trending down, it is apparent there is a structural problem
with the gold mining industry. And
the top-four primary gold miners in the world tell this story with their
production declines in the last two years. In 2008 Barrick Gold (ABX-NYSE),
Newmont Mining (NEM-NYSE), AngloGold Ashanti
(AU-NYSE), and Gold Fields (GFI-NYSE) are on pace for an 18% (4.5m ounces) decrease in collective gold production.
And the
numbers from just these four companies are material, as they are responsible
for over 25% of the annual mined supply of gold. So what’s going on with the gold
mining industry? Mining for gold
should be more popular now than ever before and there is a lot of money to be
made in a bull that is expected to stay strong for many more years. Why the decline?
Well a
recent interview with CEO Tye Burt of senior gold miner Kinross Gold best
presents what is going on in his industry. “While the gold mining industry
has seen successively higher gold prices over the last decade, permitting and
construction challenges, operational difficulties, and cost pressures have
caused global mine production to decline with no signs of this trend abating
in the near future.”
Instead
of an environment of joy and jubilation, Mr. Burt tells us the gold mining
industry is experiencing pain and strife in getting its product to the
market. Well in order to
understand the trends we are seeing today, we have to step back and view the
gold cycle in strategic context. And
it all boils down to flows of capital.
As any
seasoned investor knows, the markets are slave to cyclicality. And commodities are not an
exception. At Zeal we have
extensively studied this cyclicality in our thread of Long Valuation Wave research. And these LVWs
make the case for today’s secular commodities bull based on the inverse
relationship commodities have with the general stock markets.
In a nutshell
when the stock markets thrive, like from 1982 to 2000, capital flows out of
commodities and into stocks. The
inverse works in the same fashion.
When commodities thrive, capital tends to flow out of the stock
markets and into natural resources.
But 7+ years into this current commodities bull cycle, what we are
seeing today is proof positive as to why LVWs are secular in nature. The simple fact is it takes a long
time to restore the health of an industry that was ravaged by a fierce and
unforgiving bear.
The
pitiful state of the gold mining industry at the turn of the 21st century is
a result of years of industry neglect on the capital investment front. Capital flowing out of commodities for
an extended period of time radically altered this industry’s
health. And since the process of
finding and mining gold is very capital intensive, when the money disappears
this industry experiences what feels like a slow death.
When
capital dries up, the small and mid-tier companies that explore for and discover
the gold deposits of the future are the first to die. Since these explorationists rely
mostly on stock offerings to fund their operations, when capital flows out of
commodities there is nary a person to subscribe to their shares.
The
larger gold miners are also quick to hemorrhage as the price of gold falls
and profits erode. And when the
books need to be overhauled in order to stay afloat, the exploration budget
is the first to go. It is even
tough for these senior miners to find financing in a bearish
environment. Why would a bank
want to fund gold exploration when it can fund the next great website or tech
gadget?
When the
little guys die and the big fish slash exploration expenditures, the gold
mining industry begins to implode.
Gold discoveries become less frequent and robust and the existing
infrastructure quickly erodes. And
with gold prices so low, there is simply no incentive to hit up the markets
for exploration financing.
But just
when the plug is about to be pulled on gold’s life support, the markets
change their tune and begin the resuscitation process. While the carnage that precedes this
process can decimate an industry and send investors over a cliff like
lemmings, it is all part of Mother Market’s natural cycles.
Ultimately
after years of underinvestment in exploration and infrastructure, the gold
mining industry is faced with a massive rebuilding effort. So when the general stock markets
ended their bullish cycle in 2000, the flow of capital slowly began to shift
to the beaten and bloodied commodities sectors that were starving for capital.
Leading
into the gold bull that began in 2001, many of the world’s largest gold
mines were quickly depleting reserves, there was a lack of sufficient
development to bring online the next generation of gold mines, and there was
a lack of exploration to discover the gold deposits of the future. And from what we saw last week, even
this far into this bull the gold mining industry still has its work cut out
for it to reverse the production trend and grow reserves.
This
slow reaction speed of the miners is a good testament to why major market
cycles are long-term, with a full LVW cycle historically averaging about 34
years. Gold miners simply
can’t turn on a spigot to increase production. It takes a lot of time and capital to
expand existing operations and develop mines from scratch.
And
rebuilding the gold mining industry is all the more difficult since
decent-sized gold deposits are much harder to find these days. Most of the super-high-grade gold in
the geopolitically-safe regions of the world has been found. In the last several decades of modern
gold mining, it seems as though the miners have picked most of the
low-hanging fruit.
Just
look at South Africa
for example. For a long time SA
was by far the largest gold-mining country, producing up to 70% of the
world’s gold. The rich gold
veins knifing through the earth in SA’s massive gold fields were second
to none. But over the years the
near-surface high-grade veins were depleted and the larger elephant-sized
discoveries became rarer.
Aside
from everything else working against SA in the last decade such as labor,
power, and currency issues, the geology has simply fallen out of favor. SA gold has become harder to find and
it is not grading as high as it used to.
And for many of the large mines in this country, following the veins
deep into the earth grows more expensive with depth and presents mounting
safety issues.
Last
week when I looked at global reserves measured by the US Geological Survey,
there was a large drop off in 2002 that was a direct result of South Africa
lowering its country’s gold reserves. And to this day production and
reserves continue to fall in SA, as its production volume is less than a third of what it was 40
years ago.
But South Africa
is not the only historically-rich gold region losing its luster. In many countries that have strong
gold-producing histories, discovery is way down from the past. What are considered major gold discoveries (3m-ounce
deposits) have become exceedingly rare.
And a recent study by the Metals Economics Group offers some insight
into this alarming trend.
So far
in the 2000s even though exploration budgets are up from what they were in
the 1990s, this decade is on pace for 75%
less 3m-ounce gold discoveries than the 1990s. And in a recent interview with Gold
Fields CEO Nick Holland he claimed there’s only one 5m-ounce deposit
found each year in the entire gold sector, and it takes about $4b to find
this one ore body. It is
definitely getting harder to find big gold.
So since
gold is getting harder to find in South Africa,
the US, and Australia
among the world’s leaders, gold miners are forced to search elsewhere
for major discoveries. And this
is where geopolitics come into play now more than ever. In Latin America, Asia, Eastern
Europe, and West Africa there are indeed
major gold discoveries being made.
But the cost of doing business in some of the countries that host
these deposits can be quite lofty, if not lethal from a fiscal perspective.
Ignorant
bureaucrats and non-governmental organizations can wreak havoc on gold
miners. On the environmental
front the judicial systems in non-developed and/or non-first-world countries
can be bullied and bribed by deep-pocketed NGOs that can quickly shut down
exploration or mining operations.
And some
governments are either too greedy or economically inept to understand the
social and economic benefits of a gold mine. They either establish taxes and
royalties that are too high or flat-out nationalize a portion or all of an
operation run by a private international company. This drives out foreign investment and
eventually leads to failure when state-controlled companies try to profitably
operate a gold mine.
Just
look at some of the goings on in countries such as Venezuela,
Romania, Bolivia, Uzbekistan,
Turkey, and Mongolia. In some of these countries there are
10m+ ounce high-grade gold deposits that may never be brought into production
thanks to an array of bureaucratic shenanigans.
There
will of course be the occasional monster discovery such as that to which Nick
Holland is referring that is located in a place that can actually be
mined. But with the slim pickings
these days many miners have to take a different approach to their gold
exploration. And thanks to a
higher gold price this is possible.
Interestingly
there is a lot of gold in the world.
The world’s oceans even host a low concentration of gold in
their waters. And if the price is
high enough it can be mined. But
for the land-loving gold miners, geology is the ultimate constraining factor
that dictates whether a deposit can be economically mined.
Since
ultra-high-grade deposits are not as abundant, miners must go after the
lower-grade deposits to get their gold and bank their resources. And with the gold price where it is
today, the miners can take a closer look at deposits that several years ago
might not have been economical to mine.
But with
these higher gold prices opening up a broader range of gold mineralization to
be mined, why are there still production declines and just flat reserve
renewal? Well from a production
standpoint Tye Burt tells us that existing operations are struggling with
cost pressures and operational difficulties. And combine this with the fact that
not enough new mines are being built, global gold production does not have
favorable conditions to rise.
Barrick
Gold Chairman and interim CEO Peter Munk puts these cost issues into
perspective in a recent statement.
"The main challenges that face Barrick, and I think I may as well
speak for the industry at large, are the cost factors. They are relentlessly moving
upwards…and the key to controlling costs in the future will be opening
new mines with fundamentally different cost structures."
If you
ask any gold mining CEO about industry challenges they are almost certain to
mirror the sentiment of Peter Munk with costs being the main issue. But with the gold price rising so
sharply, is it possible that costs are rising proportionately? Looking at the chart below it
doesn’t appear this way at first glance.
In what
proved to be a tedious but fruitful exercise, I scoured the quarterly
financial statements from 2001 to current for each of the gold miners that
reside in the HUI and XAU gold stock indexes. The purpose of this was to translate
the grumblings of the gold miners into cold-hard data. And with cash cost data for each
quarter I can now paint an interesting picture.
Before
digging too deep it is important to note that this cash cost data is compiled
using simple averages. But even
if I was to use weighted-average data based on the volume of gold each
company produces, this trend would not substantially differ. For example the average H1 2008 cash
costs for the big-four gold miners mentioned above is $435 versus a group average of $401. This would not make a material
difference on the implied gross margins.
Another
dataset I include in this chart is average cash costs without major byproduct
credits. A handful of gold miners
are fortunate enough to mine gold from ore that has strong byproduct
mineralization of such metals as copper, zinc, lead, and silver. If these minerals can be extracted
economically many miners will use their revenues to credit gold’s
operating costs.
So with
the prices of base metals launching parabolic from 2005 to 2007, gold
operating costs were artificially skewed to the downside thanks to these
massive byproduct revenues. And
with this playful accounting cash costs can appear exceptionally low, even
negative sometimes. Because of
this the simple averages were thrown off during the base metals parabolas.
As you
can see cash costs (the red series) from 2005 to 2007 were relatively
flat. But in throwing out the
negative cash costs from three gold miners that had exceptionally high
byproduct revenues, we get a better picture of true cash costs for gold
mining. So considering global
commodities inflation and industry sentiment, the yellow data series better
reflects cash costs growth for gold miners. And this is the series I use to
calculate the hypothetical gross margins.
On an
interesting note you can see that with the price of oil up and base metals
down in 2008, the gap between the two series of cash costs is not as wide as
in the previous two years. Byproduct
credits haven’t been as plush this year and the multi-metal gold miners
are now feeling the cash cost burn like everyone else.
Starting
from the beginning of the bull we can see that cash costs are indeed on the
rise. But so is the price of
gold. In fact as you can see the
average annual price of gold is rising at a much faster pace than cash
costs. Nearly every year in this
bull the spread between cash costs and the gold price has been rising. Visually this chart makes it look like
unhedged gold miners should be greatly growing their booties each year.
But if
you calculate simple gross margins off average gold prices and cash costs,
the financial growth story is quite a bit different. This is why Nick Holland can make this
statement. “What we have
had over the last couple of years is a rising gold price…but
we’ve also had rising commodity prices across the industry as a
whole…And that’s put a lot of pressure on costs. As a consequence of that, you’ve
seen the revenue line increase, but you’ve seen the cost line following
it. So the margins haven’t
really opened up.”
Well in
stepping back and looking at this industry’s financials as a whole, I
believe Mr. Holland has hit the nail on the head. While PEs have slowly been grinding down as the gold miners strive for profitability, margins are sliding
sideways. My crudely calculated
gross margins show no growth until just the first half of this year.
And cash
costs are just window dressings for the markets to chew on. All they measure is general operating
expenses such as the labor and utilities necessary to pull the gold from the
ground. Other costs actually lie
on top of cash costs that raise total production costs, including
depreciation, depletion, and amortization (DD&A) costs. And the costs don’t stop here.
Since
gold miners are constantly pressured to renew reserves and grow production,
they must explore for more gold and develop new mines. And these endeavors are not
cheap. It takes significant
capital expenditures (capex) to acquire property, perform preliminary
exploration such as surveying, sampling, and trenching, initiate drilling
campaigns, and then pay geologists and engineers to perform the necessary
studies to determine whether the identified mineralization is even economical
to mine.
Then if
a miner is fortunate enough to have an economically feasible gold deposit,
this is where the serious expenses come into play. Even a small mine can cost over $100m
to develop and construct. And a
large mine these days can cost over $1b.
But while these lofty capex figures are not new news to the miners,
input costs have been rising so fast that capex for mine development can be
radically different from when a mining plan is originally written up to when
construction hits full stride.
The
costs of energy and other raw materials such as steel, machinery, and even
labor have just skyrocketed. So
even though the projected operating cash costs of mining the gold may be
economically feasible, miners have to deal with the sharply-rising costs of
developing the necessary infrastructure to mine the gold. And this greatly alters capex payback,
which is a part of the mine-building equation that is terrifying the miners
as well as the financiers of their projects.
Ultimately
building a mine these days is such a daunting task for gold mining companies
that it seems like many simply aren’t doing it. And for those that are building mines
or getting the process going to build a mine they are facing increasingly-powerful
headwinds. Even before breaking
ground miners must endure numerous regulatory hurdles which are tedious,
expensive, time-consuming, and stricter than ever.
After
developing a mining plan and attempting to build in an inflation allowance,
obtaining the funding is yet another daunting task. Most gold miners, even the seniors,
must tap bank loans in order to fund their massive projects. And with costs rising so fast, debt
facilities approved just a short time ago are now not enough to cover growing
capex. A Newmont executive was
recently quoted saying that gold mine capex inflation is happening at a rate
of 15% to 25% annually! I
personally believe this to be conservative, but regardless these are
staggering figures.
This
massive inflation is perhaps why many gold miners instead of taking the path
of organic growth, via internal exploration, discovery, and mine development,
are obtaining their reserves via acquisitions. This would help explain the lack of
reserve growth. If the larger
miners are spending much of their money on acquisitions instead of
exploration, this leaves the onus on the smaller miners to discover the
gold. And since smaller miners
don’t have as big of exploration budgets and have trouble raising
capital, sizeable discoveries are occurring fewer and farther between.
No
matter how you look at it, the gold mining industry must confront the
challenges of growing production and reserves. But with costs rising so fast, it has
been increasingly difficult for the miners to evaluate capital outlay
decisions.
In Peter
Munk’s statement above he mentioned fundamentally different cost
structures. But the simple fact
is gold miners have to be smarter about running their businesses. And when discussing the lackluster
financials of the gold miners, Nick Holland’s approach is likely where
most industry executives, and eventually the markets, will focus.
Cash
flows are more than ever proving to be the metric of utmost importance. Mr. Holland calls it notional cash
expenditures, which takes into account an all-in cost of production. Controlling and managing operating
costs and capex together will allow gold miners to make money. But in order for this to happen the
price of gold must continue to remain high so the industry can work to
improve its margins and funnel more capital into capex to grow its businesses.
Ultimately
much like oil companies, gold miners require significant excess capital, via
profits, in order to renew their reserves. Folks who don’t understand economics
and free markets grow incensed over the massive revenues, cash flows, and
profits that oil companies, and now many well-managed gold miners, are
turning.
But
these improving financial conditions are what it is going to take to secure
supplies in the future. If prices
weren’t high and margins were too thin commodities exploration would
grind to a halt, and eventually so would supply. But since the free markets won’t
allow this to happen, growing capital flows into commodities is
necessary. This all feeds into
the circular cycles that the LVWs carve out over time.
So while
the price of gold is indeed high relative to its nominal price history, gold
miners are still faced with a challenging environment that has not been
conducive to the growth that this industry eventually needs to exhibit. Geopolitics, geology, and cost
inflation are just some of the many factors that contribute to the gold
mining industry woes.
Until
the miners can find a balance and figure out how to actually grow their
production, this bull market in gold simply must carry on. In the coming years the demand for
gold will continue to rise, and the miners have no choice but to
respond. So while the typical summer doldrums have spooked some investors into believing the gold bull is over,
don’t believe what you hear.
At Zeal
we believe gold is moving out of the summer doldrums and into a season that is
likely to produce another powerful upleg. In our acclaimed Zeal Intelligence newsletter we have been layering in trades into gold stocks that are likely to
capitalize on the increasing flow of capital into the gold mining
industry. Subscribe today if you are interested in cutting-edge market analysis and to mirror
our trades.
The
bottom line is the gold mining industry is experiencing major
challenges. Gold prices are on
the rise, but since the construction and operation of mines requires a heavy
load of ancillary commodities, rapidly inflating costs are taking their tolls
on the mining companies.
In order
for the gold miners to forge through these adverse conditions they need to
continue to plow capital into the rebuilding and expanding of their
industry. In order for this to
happen gold prices need to remain high so the miners can believe in this
secular bull and have the necessary cash flows to invest in their growth.
Scott Wright
Zealllc.com
September 5, 2008
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