Continued from the
last article…
Something missing here?
There is another
important factor left out of this research train of thought however; and that
is ‘cost of production’. We have to be careful to get this right
or we could end up comparing apples to oranges.
Therefore to complete this line of reasoning we have to consider the
profitability factor. Cash costs are confusing across the industry because
they are not standardized. Royalties and other factors vary from company to
company and lease to lease.
From the World Gold
Council site:
“Environmental
considerations require that mined gold must be ‘replaced’ as part
of the mining process. The average cost of replacing and producing an ounce
of gold rose to $928/oz in 2010, from $282/oz in 2001, and it continues to
climb, according to Metals Economics Group.”
Editor – so total cost climbed $646
in 9 years which averages out at $71.77 per annum. I will take this on face
value and therefore “assume” $999.77 for 2011 and $1,071.54 for
2012 additions to this linear progression. (Assumption: I know this is a
dangerous practice however I am generalizing on this theory at the macro
level for the sector, therefore this provides the best estimation possible.)
By linear
progression I mean to say the averaged cost increase for the industry applied
equally each year as follows in the table below. I know this is not a perfect
system and that costs moved slower in the early years of the rally however
this is for illustrative purposes. I believe the averaged figure still serves
a purpose for this exercise because it adds
understanding of the principles.
Here is a table
that accounts for total costs and adjusts for the AUD and our market. As you
see we are only just beginning to get into a profitable area. If the world
wants companies to mine gold then they have to get used to higher prices.
Year
|
2002
|
2003
|
2004
|
2005
|
2006
|
2007
|
2008
|
2009
|
2010
|
2011
|
US$ Gold av.
|
310
|
363
|
410
|
445
|
603
|
695
|
872
|
972
|
1225
|
1572
|
A$: USD ratio
|
0.545
|
0.660
|
0.740
|
0.761
|
0.758
|
0.844
|
0.851
|
0.798
|
0.920
|
1.044
|
AUD$ Gold av.
|
569
|
550
|
554
|
585
|
796
|
823
|
1025
|
1218
|
1332
|
1506
|
Total cost A$
|
649.5
|
644
|
671.6
|
747.7
|
845.6
|
844.8
|
921.3
|
1072
|
1008
|
957.8
|
Implied Margin
|
neg
|
neg
|
neg
|
neg
|
neg
|
neg
|
103.7
|
146
|
324
|
548.2
|
NOTES:
·
US$Gold is an annual average like the A$: USD ratio and Total
cost.
·
Total cost has been adjusted using the average A$: USD ratio and
so has AUD$Gold av for the year.
·
The Total cost figure includes the cost of replacing ounces and
all costs however it is obvious that capital raisings and lower exploration
budgets were used by the majors to minimize their costs, and hence stay in
business. In fact merger and acquisition were used to replace ounces in the
ground against mining depletion due to the lack of large gold discoveries.
This is a phenomenon that continues to this day.
These figures do
not necessarily reflect accurate numbers for the each year or the extremes
during any of these years or for individual stocks – yet they do
indicate longer term (annualized) profitability industry averages over time
much like a long term indicator on any index. The effect is a smoothed long
term average.
It is also
noteworthy that I have used industry average total costs on a global basis
yet costs in Australia tend to be higher due to wage inputs. Accounting
practices and reinvestment also affect total costs on an individual company
basis. The numbers are important as a guide when we look at the sector
macro view. Once I explain the coming investment focus as a return to an old
model you will see how important this is.
Date
|
Apr 01
|
Oct 08
|
Now
|
May 05
|
Aug 09
|
Oct 06
|
May 06
|
Mar 08
|
Sep 11
|
Gold
|
255.45
|
682.8
|
1639.8
|
413.75
|
930.3
|
559.4
|
730
|
1030.8
|
1,920.8
|
XGD
|
993.25
|
2,674.4
|
5,776
|
2,186.4
|
4,614.7
|
4,052.2
|
4,928.2
|
6,921.5
|
7,995.3
|
Ratio
|
3.8882
|
3.9168
|
3.522
|
5.2844
|
4.9604
|
7.2438
|
6.7510
|
6.7147
|
4.1625
|
$A:US$
|
0.4778
|
0.6012
|
1.0244
|
0.7522
|
0.8445
|
0.7736
|
0.7793
|
0.9471
|
1.0764
|
Agold
|
534.63
|
1,135.7
|
1600.7
|
550.05
|
1,101.6
|
723.24
|
936.74
|
1,088.4
|
1,784
|
Aratio ©
|
1.858
|
2.355
|
3.608
|
3.975
|
4.189
|
5.603
|
5.261
|
6.359
|
4.482
|
Note table above is
slightly out of date – XGD now at 4972.7 as of 3rd July 2012
Conclusions:
Now I come to my
point and that is that high in Aratio for September 2011 was either an
anomaly or gold has to crash. A reading of only 4.482 as a high at that gold
peak compares to averages of around 6 in earlier periods of the gold rally to
date. Non-performance of the gold sector compared to gold at a market high
can mean the temporary end of a trend. I saw this in
April to May 2006. In May 2006 the Aratio topped at a lacklustre 5.261 which
was hardly inspiring at the time. The gold stocks topped in early April.
I believe the poor
sentiment on the Australian equities sector has been the main cause of the
lacklustre gold stock action into the 2011 gold high. This is a time of
extreme global markets running on spin and a lack of fundamentals. I also
consider the high Australian dollar up around those 1.10 levels and to a lesser extent at parity or just above would have held
back some offshore capital from entering. Our sovereign risk rating has
suffered to some degree thanks to the MRRT and a minority government with the
Green Party being anti-mining; these factors may not have helped. The MRRT
however does not include gold.
The current reading
of just 3.608 (table above) is a massive distortion of biblical proportions
when you factor in that these stocks are only now in a profitable situation.
It is always about the money when it comes to share price and the gold stocks
are the generators of growing cash flows in a low growth world struggling to
find yield. When we compare the current profitability to the lousy share
price performance the contrarian in us should start to get very excited.
From my table you
can see that real gold stock margins only began to gain traction over total
costs in 2008 when the average price was applied with the average AUD: USD
ratio. These figures were distorted at the lows and by those lows due to the
exceptional volatility. When you average 2008 down to months you would find a
shaky picture and great risk. The 2009 figures were more representative of an
initial real margin for the industry as a whole throughout the course of the
year, however the margin provided little buffer. In 2010 and finally 2011 we
have witnessed a watershed era for gold stocks in
terms of profitability and it was not accompanied by strong share price rises
for most companies, however there will be a catch up if this gold strength
continues. I believe it will more than continue.
The profitability
has been overlooked by investors that think they see a spike in gold and fear
that this is a major top for gold. I want to draw
your attention to the fact that gold stocks have become cash generators in
real terms for the first time of the gold bull in 2010 and 2011. This
happened to coincide with very poor sentiment for the industry and equities
as an asset class. This has trashed the sector setting us up for a massive
rally once sentiment changes. The lows are very significant at this time
especially when you consider this added layer of research on margins.
Now I would like to
take this research a step further and factor in the profitability of the
sector. The average industry total cost includes all administration,
corporate costs, development, maintenance, rehabilitation and replacement of
reserves. It is now estimated to be circa US$1,071.54 based on an average
US$71.77 increase per annum. Now this needs to be adjusted to establish an
average margin for 2012. To achieve this I factored an average AUD:USD and
average A$POG for this year - which I based on a 200 day moving average for
each.
The 200 day moving
average (DMA) for the AUD: USD is currently sitting at 1.0256 and we have had
around 180 days this year so far so near enough to use the 200 DMA. The
average USD gold price, by this measure is sitting at $1662 Adjusting the
gold price to an average A$POG is $1662 / 1.0279 = A$1616.90per ounce of
gold. Using the average exchange rate we can also calculate the average total
cost for the industry in AUD terms. US$1071.54 / 1.0279 = A$1,042.45
The most
appropriate way to measure apples to apples here is to calculate the margin
as a percentage of the total cost x 10. I call this a Pratio© which
stands for Profitability ratio. Here is the calculation: Implied Margin
÷ Total cost A$ (as a decimal) x 10 = Pratio©
An example is:
2008: 103.7 ÷ 921.3 = 11.25% = 0.1125 (expressed as a decimal)
0.1125 x 10 = 1.125 = Pratio©
In order to relate
this back to the Aratio© and value it according to the profitability
of the sector I have decided to take the Aratio© (which measures the
gold price compared to the XGD) and divide it by the Pratio©. Thus we
get: Aratio© ÷ Pratio© = GOzV©
This final figure
provides a relative value for the sector that takes into account the A$POG,
the level of the XGD (index of gold stocks) and the profitability of the
sector. This creates a true valuation that combines all of the variables we
grapple with. This GOzV© figure can be measured retrospectively to check
prior peaks - and at the same time it shows us exactly how cheap or dear the
stocks are based on profitability compared to gold and the share price right
now.
Year
|
2008
|
2009
|
2010
|
2011
|
2012
|
US$ Gold av.
|
872
|
972
|
1225
|
1572
|
1670
|
AUD$ Gold av.
|
1025
|
1218
|
1332
|
1506
|
1628
|
Total cost A$
|
921.3
|
1072
|
1008
|
957.8
|
1045
|
Implied Margin
|
103.7
|
146
|
324
|
548.2
|
583
|
XGD tops (*now)
|
6921
|
4615
|
8448
|
7995
|
(*5258)
|
Aratio©
|
6.359
|
4.189
|
6.04
|
4.482
|
3.254
|
Pratio©
|
1.125
|
1.362
|
3.214
|
5.724
|
5.579
|
GOzV©
|
5.652
|
3.076
|
1.933
|
0.783
|
0.583
|
For gold stocks to
reach the levels last seen in the peak in early 2008 they would have to rise
approximately tenfold – i.e. current GOzV is 0.583 x 10 = 5.83 compared to the
2008 high of 5.652.
Business Model to
Re-emerge
During the early
80’s when things turned sour in the business climate the Australian
stock market made lows of 450 on the XAO. At that time we saw rising defaults
and a recession along with opportunistic business operators who bought
companies and split them up. They kept the cash flow segments of these
businesses and sold off the rest. Cash flow was king and cash was king; just
where we are right now.
Bankers and finance
workers are looking for ways to maintain their lifestyles and gain traction
themselves in a slowing global economic climate. Old
growth models that predate the secular bull in paper assets are once again
becoming relevant today. This is because the growth model that post dated
this time in history was turbo charged by debt.
People borrowed and spent, so did companies and corporations and governments.
It was the beginning of the ‘greed is good’ eighties however it
all started with the cash is king / cash flow is king condition. For the next
few years the smart investors will be chasing yield – it is no longer
there in the bond markets and they are already starting to turn to stocks.
The only problem to
date is that some of the Funds have not woken up to the fact that things are
not going back to normal. So many bad choices are being made on stock
selection. You do not have to invest in gold stocks, if you can find a stable yield through the coming times and the balance
sheet of that company is sound then you are highly likely to do well.
Fortunes were made
in the early 80’s and they will be again today. Deleveraging will
remain in force for at least a decade given the size
of the task at hand, probably two. The longer the authorities balk at natural
market forces by trying to print their way out the worse it will become. The
longer it will take to turn this around. The severity of the pain just
increases because they don’t want to take the medicine on their watch.
Yet the time has long passed where a dollar of stimulus created any decent
return in terms of growth.
As gold picks up
and resumes its uptrend towards my next target circa US$2100, perhaps this
year investors will realize once again that they were wrong footed. It will
not come with good news, quite the opposite. The chase for a yield as opposed
to capital gains will become the focus for more investors and the risk in the
currencies will create volatility in foreign exchange.
The gold stocks
will launch on their next run up to at least an Aratio of 6 from here and
that equates to an XGD reading of 12,000 with gold $2100 x 6 (Aratio). We are
currently sitting at approximately 5,000 so I expect it to more than double.
Some stocks will outperform as usual. Maximum leverage will be gained by
those investors willing to buy when there is blood in the streets and the
sector is hated and we are about there now in my opinion.
Get prepared now,
why not subscribe to our Members area to get our Newsletters, see our
Educational Portfolio and Ratings Tables.
Neil Charnock
Editor, Goldoz.com.au
REGISTERED ADVISOR – WHO THE ADVICE COMES FROM
IN THE GOLDOZ NEWSLETTER:
Colin Emery is currently a Branch Manger and Senior
Client Adviser of a Stock Broking Company in Queensland Australia. Prior to
his work in Share broking he spent nearly 20 years in Senior Management and
Trading positions in Treasuries for major International Banks such as Bank Of
America, Banque Indosuez, Barclays Bank, Bank Of Tokyo and Deutsche Bank AG.
He spent a number of years as a Senior trader in New York, London, Singapore,
Tokyo and Hong Kong with these institutions. He also was Global Head of
emerging energy, emission and commodity products for the leading Energy and
Commodities brokerage firm of Prebon Yamane Ltd – Prebon Energy for
four years before moving to Cairns in 2003 to focus on the Stock market and
Private consulting work. The private consulting and advisory work currently
undertaken is with companies involved in Resources, Energy and Renewable
Energy and Forestry.
Neil Charnock is not a registered investment
advisor. He is a private investor who, in addition to his essay publication
offerings, has now assembled a highly experienced panel to assist in the
presentation of various research information services. The opinions and
statements made in the above publication are the result of extensive research
and are believed to be accurate and from reliable sources. The contents are
my current opinion only, further more conditions may cause my opinions to
change without notice. The insights herein published are made solely for
international and educational purposes. The contents in this publication are
not to be construed as solicitation or recommendation to be used for
formulation of investment decisions in any type of market whatsoever. WARNING
share market investment or speculation is a high risk activity. Investors
enter such activity at their own risk and must conduct their own due
diligence to research and verify all aspects of any investment decision, if
necessary seeking competent professional assistance.
|