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In
2011 gold-mine production came in at an all-time record high. And in 2012
experts anticipate production to be even higher, edging above the previous
year's 87m-ounce tally. From the looks of it, the major source of gold's
supply is in fine fettle. But is the gold-mining industry truly healthy?
In
attempting to answer this question it is important to understand how we got
to the production levels we're at today, and then take a look at some of the
structural fundamentals that may impact this industry going forward. And in
terms of how we got here, it was nothing short of remarkable.
Interestingly
mine production had actually been on a pretty alarming decline for a large
portion of our current secular bull. Many folks forget that it was just in
2008 that production volume had fallen to a 12-year low, and that the miners
were producing a full 10m ounces less than what they were at this
bull's 2001 beginning.
Finally
after many years of increased capex towards
exploration, development, and overall upgrades to this industry's
infrastructure, 2009 delivered the first production increase in years. And a
now-three-year-running increase is something to behold.
Since
2008 gold-mine
production has experienced an average annual growth rate of a staggering 6%.
And this is especially impressive considering the relatively static nature of
mine production. Increasing output is not as simple as turning a dial on a
factory floor, as it takes many years of development to build a new mine
and/or increase capacity at an existing mine. And when you take the natural
depletion cycle into account, this 6% growth rate is all the more impressive.
A lot of big new mines and expansion projects have come online in the last
few years!
But
though impressive, it doesn't take a rocket scientist to realize that this
recent production growth rate is unsustainable. In fact, some recent
fundamental unveilings raise questions as to whether even the existing rate
of production is sustainable over time.
One
major tell on the inner workings of the gold-mining industry is exploration
spending. Exploration spending is essential in feeding the pipeline of
next-generation mines, those that will be built to replace the ones that are
depleting. And depletion is of course accelerated on higher production volume
like we are seeing today. Faster-depleting reserves lead to more pressure on
the replenishment front, which naturally leads to the need for more
exploration spending. It's a simple formula!
As
one can imagine, gold's secular bull has spawned a huge increase in
exploration spending. According to prominent research house Metals Economics
Group (MEG), gold exploration spending had seen a whopping 400%+
increase from its 2002 low to 2008 (~$3.2b). And though there was a huge dip
in 2009 as a ripple effect of the global economic crisis, spending has been
strong and on the rise ever since. But has it been enough?
Provocatively
there's an alarming trend unfolding on the exploration-spending front that is
likely to have a major fundamental effect on the gold market. MEG points out
that while exploration spending hasn't declined, there's an interesting shift
in the types of projects attracting the capex.
It
notes that over the last few years only about a third of exploration spending
has been directed towards greenfield (early-stage/generative) exploration,
with the majority going towards brownfield (near-mine) exploration. Even more
troubling than this historically-low ratio is the fact that this
industry-wide shift hasn't resulted in a proportionate increase in assets
advancing through the development pipeline. Typically in brownfield work the
availability of infrastructure allows for fast-track development, yet we
aren't seeing this.
On
one hand I can see why the miners have become more risk-averse considering
the state of the global economy. It's definitely less risky to prove up
reserves where positive mining economics are known to exist. But this trend
will have consequences on the reserve-renewal front.
While
miners will occasionally make big discoveries via brownfield efforts, for the
most part the biggest discovery in a brownfield zone has already been made.
In general the major multi-million-ounce discoveries that this industry needs
in order to effectively renew reserves are a product of greenfield
exploration. And this brownfield bias has led to a lack of major discoveries.
Interestingly
there are a couple different ways we can put this lack of major discoveries
into context. First is some fascinating intelligence from MEG's latest study
on gold-reserves replacement. According to this study, there have been 99
gold discoveries of significance (deposits containing 2m+ ounces) since 1997.
MEG added up all the reserves, resources, and production from these
discoveries as of the end of 2011. And assuming a 75% resource conversion
rate and 90% production recovery rate, the total sum only had the potential
to replace 56% of the gold mined during this timeframe.
As
MEG's data clearly implies, gold discoveries are not even close to keeping
pace with mine production. There are of course numerous factors contributing
to this revelation. But the one that likely trumps them all is the simple
fact that large gold deposits are getting harder and harder to find.
As
gold's scarcity rears its face, miners must expand their exploration efforts.
They must drill deeper, venture to places with rougher terrains, and enter
borders that may be hostile to their endeavors. These conditions are
characteristic of greenfield exploration, and are obviously much more costly
than brownfield work. And this cost differential perhaps explains why
spending is not where it needs to be on the greenfield front.
Drilling
down on MEG's study even more, this 56% replacement rate is likely well on
the high side considering some very liberal assumptions. Even MEG
acknowledges that the viability of this discovered gold is subject to a lot
of variables that could hamper its mineability.
Economics
is of course the biggest variable. Many of these deposits are of low-enough
grade or high-enough geological complexity that their higher extraction
and/or processing costs require a much higher gold price to be economical. If
the price of gold retreats much, these reserves/resources would quickly lose
their economic viability.
Geopolitical
risk is also a major variable. There are numerous amazing deposits that have
been discovered over the last decade that will likely never be mined due to
their location. Miners are constantly thwarted by deep-pocketed
environmentalists, unruly locals, over-regulation, and greedy governments.
So
you see even though 99 major discoveries seems like a lot over a period of 15
years, in actuality it is nowhere near what is needed to replace the gold
that is being mined. And if the major deposits at best are only able
to replace just over half of production, I can only imagine how many smaller
deposits need to be discovered to fill the gap.
Speaking
of gap fillers, this MEG research got me wondering more about the world's
gold deposits. Wouldn't it be nice to have a better understanding of the
asset base that supports current and future production? And wouldn't it be
nice to have some intelligence on the biggest tier of gap fillers, those in
the 1m- to 2m-ounce range?
Thankfully
our friends at Natural Resource
Holdings were in this same wonderment. So CEO Roy Sebag
and his team actually took to the task of compiling this information! After
painstaking research that likely took thousands of hours, NRH now has the
most comprehensive database of the world's large gold mines and deposits that
I have ever seen. And its 2012 ranking offers an invaluable fundamental read
on the world's asset base of gold deposits.
As
part of its research NRH identified 439 deposits throughout the world that
currently contain over 1m ounces of resources (all categories). And in
looking at this data, I was smacked by the reality of how scarce this
precious metal really is. Of the tens of billions of dollars being spent just
to find gold, there are only 439 deposits of meaningful size on
the planet to show for it!
Interestingly
in scrubbing up with MEG's data NRH identifies 312 deposits that hold 2m
ounces or more, which tells us that over two-thirds of the world's largest
deposits had been discovered more than 15 years ago. And of these 312
deposits, provocatively only 150 are currently being mined.
On
one hand it can be seen as encouraging that there is a large pipeline of
undeveloped major deposits for future use. But on the other hand it can be
seen as disturbing that there are so many deposits, especially numerous over
15 years old, that haven't found their way to production in the current
market environment. The fact is many of these deposits will never see the
bottom side of a shovel, for reasons discussed above and more.
Of
the world's 127 gold deposits in the 1m- to 2m-ounce range, 39 are currently
being mined. Again it is encouraging to see so much potential for the next
generation of mines. But I'm afraid the same variables of uncertainty will
again prevent many of these deposits from ever coming online.
This
NRH data also allows me to put into perspective the relevance of deposits in
this 1m- to 2m-ounce range. Interestingly these 127 deposits hold a combined
181m ounces of resources. If all of these resources were converted to
mineable reserves with a 100% recovery rate, this would only be enough to
cover just over two years' worth of mine production.
And
to put deposits of this size into even more perspective, consider their
average annual run rates. To be very conservative, let's assume that these
deposits are able to produce an average of 150k ounces per year. In such a
case the 39 operating mines would combine to contribute only 5.9m ounces,
which is less that 7% of total mined volume each year. While this next tier
of deposit size seems large, in the grand scheme of things they collectively
only make a small dent in the total supply. And this realization clearly
shows the need for major deposits.
Per
NRH, of the major deposits 33 hold greater than 20m ounces (19 in
production), 41 hold between 10m to 20m ounces (24 in production), 74 hold
between 5m to 10m ounces (40 in production), and 164 hold between 2m to 5m
ounces (68 in production). Though this provides the gold-mining industry with
an inventory of 162 major undeveloped deposits that have the potential to
replace production and reserves, it's just not enough.
And
to make matters worse, there's another prevailing trend that doesn't bode
well for the structural integrity of the mined gold supply. With much higher
input costs and uncertainty with the global economy, many miners have been
holding off on the development of their major deposits. Even if these
deposits are economically viable with high rates of return, lenders and
investors are hesitant to fund the $1b+ it would take to build a decent-sized
mine.
So
circling back around, is the gold-mining industry healthy? Unfortunately if
you peel away the excitement of record production in recent years, I'd say
no. Gold discoveries are not keeping pace with mine production, exploration
spending trends are not conducive to finding major deposits, the inventory of
large-sized deposits is thin, and development capex
is harder to come by. The future looks bleak for reserve renewal and
ultimately sustaining current production levels.
So
as investors, how can we apply this information to our investment strategies?
First is these major structural issues offer huge support for gold's
long-term fundamentals.
So long as the demand for gold stays strong, which it ought to, supply will
be strained as the lack-of-major-discovery-spawned lower-reserve-renewal rate
catches up with the gold miners. And this will keep gold prices high!
Gold
stocks should also continue to be great tools to leverage gold's strength.
Most of the world's largest producers are publicly traded. And according to
MEG it is the big ones that are doing the best job replacing their reserves,
with the top 26 producers (600k+ ounces in annual production each)
collectively replacing 208% of their production over the last decade. But
though this replacement rate is impressive, the larger gold stocks aren't
necessarily the best investments.
Interestingly
only about half of these top-26 producers had actually made a major discovery
over this timeframe. With a collective two-bagger replacement rate for the
group, there are obviously some miners that made elephant-sized discoveries
to cover more than their share. But to no surprise, a large chunk of this
replacement was via acquisitions. With robust treasuries and easy access to
credit, these major producers aren't afraid to swing around their financial
weight to get what they need.
From
an investment perspective it isn't actually the large slow-moving majors that
offer the greatest returns, but rather the smaller mining companies that act
as feedstock for the big boys. And the juniors especially offer huge
potential considering their bias towards greenfield-style exploration. Some
of the biggest and best major discoveries have come at the hands of the
junior explorers.
Now
if you've been at all attuned to the gold-stock sector, you know that juniors
are in a tough place right now. Their stocks have been getting crushed with
the rest of the commodities sector. And with a business model that relies on
equity investment, their losses are way outsized. But as a critical component
of the global gold supply chain, the majors simply couldn't survive without
them.
Juniors'
fortunes are bound to change soon as the gold-mining industry starts to
realize its shortcomings. And because they are so beaten down, investors now
have one of the best opportunities in gold's bull to buy them for cheap.
The
bottom line is the gold-mining industry has done a fine job rising to the
challenge of increasing production in order to meet higher demand. But behind
the curtains are some health issues that ultimately lead to a lack of
fundamental support for the future of this industry.
The
fact is major gold deposits are getting harder and harder to come by. And
this is reflected by a global development pipeline that is woefully short of
where it needs to be. Until exploration spending rises and the miners hit the
hills for more greenfield discoveries, reserve renewal will continue to be a
major challenge.
At Zeal our last several research reports profile our
favorite high-potential gold juniors. So if you're wondering which junior
gold stocks are likely to thrive in the years ahead, buy your report today! And to
find out which ones we are specifically recommending in our acclaimed weekly and monthly newsletters, subscribe today.
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