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Gold mining is a
tough business. In the quest to meet growing global demand these miners are
constantly barraged with challenge after challenge. They are attacked by
environmentalists, targets of governmental meddling, purveyors of a science
that is not exact, and must always fight to renew their finite resources.
Gold miners are also
at the mercy of fluctuating gold prices. Prices can be radically different
from when a mine initially commences development to when it pours its first
gold years later. Even on a month-to-month or week-to-week basis, miners can
see material differences in their revenues based on what prices are doing.
But thankfully, this blitz of opposing forces proves worthwhile in a secular
bull market.
With the price of
gold going from an average of $272 in 2001 to $1165 in 2010, pulling gold
from the ground has become a lot more alluring. And the miners able to
deliver gold to market at these record-high prices have seen huge
increases in revenues. So long as this revenue growth outpaces costs, these
miners have had the potential for fast-growing margins and stellar profits.
And this
potential for profits leverage is what makes the stocks of these miners so
appealing to investors. The venerable HUI gold-stock index is up a whopping 1155%
from its 2001 low to its latest interim high for a reason. Gold miners should
be cashing in on a secular bull in their underlying metal. But as always,
there is much more than meets the eye in this wild and wacky industry.
Even though the
miners are generating higher revenues, the challenges don't go away. In fact,
there are even more challenges today than there were 10 years ago. And
prudent gold-stock traders must be aware of and understand these challenges
in order to profit in this arena.
Over the years
I've written a series of essays on gold-mining challenges, and one of
the most transparent challenges is on the cost front. As we've learned over
the course of this bull, miners have really struggled to control
costs. And the hopes of only moderately-rising expenses are pure fantasy for
most.
To really
understand these costs across the industry and at an individual-company
level, analysts and investors alike have a couple different options. They can
either meticulously dig in the financial statements and craft their own cost
measures, or use a common metric that most miners offer as part of their
headline performance data. I prefer the easy option, and this "cash
cost" metric indeed provides a high-level summary of the expense side of
producing an ounce of gold.
Fortunately most
miners submit to a canned format of calculating cash costs according to a
standard (non-GAAP) implemented by the Gold Institute (GI) back in 1996.
Prior to this standard gold miners were very creative and non-uniform in how
their expenses were presented to investors. And while not all miners submit
to today's standard, or comply to a tee, the GI-coined "Production Cost
Standard" has since become a relatively uniform metric across the
industry.
According to this
standard, total cash costs are calculated by adding cash operating costs
(direct mining expenses, stripping and mine-development adjustments,
third-party smelting/refining/transportation costs, and then adding back
byproduct credits if applicable) to royalties and production taxes. This
number is then divided by total ounces produced to get a per-ounce figure.
Now bear in mind
that cash costs are not the complete tell-all of a miner's strategic health,
future direction, or ability to generate cash flow. But this standard
performance measure does offer investors a pretty good idea of its interim
financial standing.
Cash costs
tallied across the greater complex also offer a read on how the industry is
trending. And thanks to a unique dataset that we painstakingly compile
in-house here at Zeal, we can get this industry read. With quarterly
cash-cost figures cataloged for all the major gold stocks trading in North
America since 2001, we are able to calculate average annual cash costs. And
with the average annual gold price thrown into the mix we are able to
calculate gross margins.
For purposes of
this analysis I used the simple average cash costs of the nearly two-dozen
companies in our pool. And since these companies collectively produce about
half of the global mined supply of gold each year, I would say this is a
fair representation of the industry as a whole.
Focusing on cash
costs first, you can't miss the upward trend over the course of gold's bull.
It's also hard to miss the change in slope just over halfway through this
timeline. Early on the miners were able to control costs for the most part.
In each of the first six years cash costs increased by an average of 8% per
year, which is equivalent to about $15 per ounce per year.
Conditioning was
among the main reasons for this early moderate rise in cash costs. Over the
entire decade of the 1990s the gold price averaged a ghastly-low $350, and
the gold miners were forced to adapt. And those miners that survived the
ravenous secular bear preceding this bull were producing gold from mines with
very favorable mineralization. They learned to operate under lean cost
structures.
But these
somewhat-restrained rises in costs were smashed coming into 2007. In the last
four years cash costs have progressively blasted higher, increasing by an
average of 22% per year, or about $75 per ounce per year. At $554, 2010's
average cash costs are 214% higher than they were in 2001. Even more
astonishing is today's cash costs are double 2001's average gold price!
There are a
number of reasons for this meteoric rise in cash costs. And provocatively one
of the biggest reasons is the rising gold price. These historic highs are allowing
miners to develop deposits that would not have been economical several years
earlier. And the newer mining operations that pull from lower grades and more
complex ores are naturally going to have higher operating costs. More and
more of these higher-cost mines have come online in recent years, thus
driving up industry cash costs.
And speaking of
lower grades, this higher gold price affords the option of a sneaky system of
selectivity that you won't hear many executives openly discuss in their conference
calls. What is commonly referred to as "low-grading" is an
opportune way to extend a mine's life without compromising too much on the
revenue front. This of course only works in a rising-gold-price environment.
In simple terms,
low-grading involves mixing and/or shifting the ore that is being mined.
Mixing is nothing more than intentional dilution. Occasionally you'll see
miners mix higher-grade reserves with waste rock, tailings, or lower-grade
ore in order to preserve the higher-grade stuff for later if gold prices are
lower. You'll also see operators shift mining to lower-grade portions of a
deposit, again to preserve the higher-grade material for future use.
These methods
will obviously drive per-ounce costs higher since it costs the same to process
a ton of ore regardless of the grade. While investors aren't usually keen on
this strategy, it helps secure longevity in a business that is constantly
fighting time.
Another major
factor influencing these sharply-rising costs is energy-related expenditures.
From fueling a mining fleet to generating power in processing facilities,
mining is an energy-intensive business. Gold miners are therefore very
sensitive to energy costs. And with the price of oil going from $50 in early
2007 to nearly $150 in mid-2008, miners were indeed seeing their energy costs
skyrocket.
Last but
certainly not least of the major factors negatively impacting costs are the
effects of byproduct credits. Gold mineralization is often accompanied by
other minerals, predominantly economic grades of copper, silver, lead, and
zinc depending on the specific geological makeup of a given deposit.
As noted in the
formula above, it is customary for gold miners to use the revenues from the
sales of these byproduct metals to credit cash costs. And with silver and the
base metals enjoying huge bull markets of their own, these byproduct credits
have had material impacts on gold's net cash costs. The higher the prices of
these metals, the lower gold's cash costs will be. But if the prices of these
metals decline, the resulting lower revenues make for less of a byproduct
credit. And this naturally leads to rising cash costs.
Interestingly all
these major byproduct metals peaked and turned south around the same time
cash costs started to balloon. Zinc saw its high in Q4 2006, and even after a
strong 2009 recovery it is still trading well less than half its high. Lead
saw its high in Q4 2007, with its subsequent price activity very similar to
zinc's. Copper saw its first major high in Q2 2006, ground sideways for a
couple years, and then got a huge panic haircut. Even after a major recovery
its price is still well below its 2006 high. Silver saw its high in Q1 2008,
and so far has been unable to challenge those levels again. Overall this
byproduct weakness over the last several years has indeed had an adverse
affect on gold cash costs.
Ultimately with
the cost of doing business rising at such an astronomical pace, you'd think
this industry was broken and failure was imminent. Not many businesses can
withstand a more than double in unit costs over a short period of time and
survive. But thankfully gold mining is not your typical business. Incredibly,
thanks to the rising gold price these miners are seeing their margins as
robust as they've ever been.
As you can see in
this chart, increases in the average gold price have easily outpaced
cash-cost increases. With gold's average price rising by 328% since 2001,
well ahead of cash costs' 214% rise, gross margins have actually improved.
Assuming the miners are selling their gold at spot, the price/cost spread has
grown by over $500 per ounce since 2001. And even with these sharply
rising cash costs, a simple gross-margin calculation shows that business is
doing just fine.
Gross margin is
defined as the proportion of each dollar of revenue that the company retains
as gross profit. And with GMs over 50% each of the last 5 years, these miners
should be in pretty good shape. But of course there is more to what these raw
GM numbers tell us.
Gross margins
over 50% are certainly nothing to complain about, but with such sharply
rising revenues shouldn't we see consistent growth on the margin front? We
should, but we don't. Interestingly over gold's entire bull market the vast
majority of GM growth occurred over only two years, 2002 and 2006. If you
look closely you'll notice two major stretches of flat GMs. These stretches
highlight the toll of rising cash costs.
Even though the
average gold price was up 43% from 2002 to 2005, gross margins were flat. And
then from 2007 to current even though gold is up 67%, we again see no growth
on the GM front. Thanks to these rising cash costs, margins have just not
opened up as one would expect with gold achieving record highs.
It is also
important to keep in mind that "gross" margins are indeed gross.
Not included in Gold Institute cash costs are depreciation, depletion, and
amortization costs (DDA), along with reclamation and mine-closure costs.
These non-cash expenses, charges/credits for the capital investment that was
made in the past, are tacked on to cash costs to create what the GI
classifies as "Total Production Costs" (still non-GAAP).
These margins
thin even more when we consider miners' expenses outside of operating a mine.
Such endeavors as procuring mineral rights and exploration require
significant capital. And if economic grades of gold are actually found,
developing a mining operation comes with an enormous price tag. It can cost
northwards of $1.0b just to build a decent-sized mine!
Since mining is
inherently a risky and capital-intensive business, gold miners need
higher margins in order to maintain and grow their pipelines. Don't let these
robust gross margins have you believing that gold miners are swimming in
cash. This just isn't the case considering non-cash opex and capital outflows
on the exploration and development fronts.
As long as gold
demand continues to rise, which it will, this industry will be faced with a
lot of supply pressure. And in order to handle this pressure the miners will
need to continue to spend a lot of money to build out the necessary
infrastructure to replace depleted mines and build additional mines at a
fast-enough pace to meet demand.
Overall the gold
price should continue to trend higher over the course of this bull based on
its solid fundamentals. But with more higher-cost mines coming online, cash
costs are likely to continue to trend higher as well. Thankfully this current
cost-and-margin picture tells us that even though miners have yet to control
costs, rising gold prices allow them to maintain margins that should
allow for healthy financials.
So as investors
we need to ask ourselves how these miners are managing their margins. And we
need to ask this question because many don't do a good job of it. You'd be
amazed to find that a lot of gold miners with strong gross margins have
unhealthy financials and future direction. But the miners that do
successfully manage their margins have and will continue to leverage gold's
gains, and thus greatly reward their shareholders.
Fortunately it is
not too late to capitalize on the potential fortunes of owning gold-mining
stocks. As a group they still have a lot of room to run higher, in the near
term and over the course of this bull. In fact, most gold stocks are bargains
at today's prices. The stock-panic overhang still has this sector well
undervalued relative to its historical
relationship with gold. And even better, now is one of the seasonally
strongest times to buy.
If you are
wondering which ones to buy, you can leverage our expertise with a
subscription to one of our acclaimed newsletters. In the brand-new September
issue of our monthly newsletter, we recommend three new
gold-stock trades and a silver-stock trade as part of a campaign to position
ourselves for what we believe to be a coming strong upleg for gold and gold
stocks. Subscribe
today to get all our recommendations along with cutting-edge market
analysis.
The bottom line
is even though cash costs are on the rise, the sharply rising gold price
allows gold miners to maintain strong margins. But though these margins show
the potential for legendary profits, they don't tell the entire story
considering the challenging business these miners are in.
These robust
margins have and will make the stocks of these companies very attractive to
investors. And it is critical for these margins to remain high if the miners
are going to have any chance of meeting gold's growing demand.
Scott Wright
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Thoughts,
comments, or flames? Fire away at scottq@zealllc.com .
Depending on the volume of feedback I may not have time to respond
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Copyright 2000 -
2005 Zeal Research (www.ZealLLC.com)
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