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The history
of gold mining has been well-documented for thousands of years. And with the
demand for this most precious of metals going nearly as far back as human
history, miners have ventured to just about every corner of the planet in
their quest to find it. Yet unlike the miners of yore that were commanded by
kings, today's miners are commanded by profits.
Like in any
business, gold miners do what they do in order to make money. If they can
sell their product for more than what it costs to produce, then they ought to
see profits. But unlike any business, gold mining is a complex endeavor with
a myriad of variables that can radically affect operations on virtually a
daily basis. This makes miners' financial affairs far from cut-and-dry.
Gold miners
can't just set up a factory anywhere they want to produce their product. They
must go to the gold, which doesn't always exist in optimal settings. Often
these settings have big risk on a jurisdictional basis, within the borders of
countries that may not have reliable or stable governing bodies and/or
regulatory systems. And gold certainly doesn't care if the rocks that hold it
are located in harsh environments or rough terrains.
Operational
settings present a whole different set of variables. Believe it or not, gold
mining is not an exact science. Though geologists have come a long way in
modeling deposits, engineers have come a long way in mine design, and
metallurgists have come a long way in processing techniques, when you are
dealing with the unseen there is just no way to completely avoid pitfalls.
No matter how
many drill holes pierce a deposit, it is impossible to know the exact
characteristics of every portion of an ore body. Though most operations are
pretty well dialed in, if the rock types and/or grades don't exactly line up
with the mine plan, the economics can waver significantly.
But the
biggest variable of all for the gold miners is price volatility. Unlike most
other businesses that have some degree of control over how they price their
products, sans hedging gold miners are slave to the daily futures activity of
their underlying metal. If gold's price is $100 lower from one week to the
next, they get $100 less for their gold.
Nevertheless,
the allure and beauty of this business is upside price potential. And in a
secular bull market, the miners are more than willing to deal with all the
variables involved in producing gold. From its low of $256 in 2001, gold is
up an incredible 640% to its recent high. And as you can see in the
chart below, gold's ascent has been consistent and reliable now for a decade.
Commodities
price volatility can drive miners batty. And in a bear market hedging, or
selling production forward, only provides so much protection. If the miners
don't have quality assets and capital reserves, then not even the most
intricate hedgebook can protect from insolvency
over a long period of declining prices. In a bull market though, the miners
tend to ditch their hedges and ride the wave to legendary profits. And this
bull's wave has been fantastic.
Since 2001
the annual average gold price has been up every year for 10 years
running. And we're not just talking a typical "cost-of-living"
inflationary increase like you might see at your favorite retailer or
restaurant. Over the last decade gold has been averaging a 19%+
year-over-year increase. If you've been investing in the physical metal
like we recommended our newsletter subscribers do back in 2001, you've
outperformed the markets tremendously.
As for the
gold miners, they've had a pretty good run themselves. In fact, their stocks
comprise one of the best-performing sectors of the last decade. The notion of
profits leverage has made them incredibly attractive to investors and
speculators, and thus many gold stocks have seen 1000%+ gains over
this time, well outpacing gold.
Costs are of
course a key component of profits leverage. And as it is in every industry,
cost is a four-letter-word for the gold miners. But for these miners, costs
are a seemingly-uncontrollable phenomenon. As you can see in the red data
series above, average cash costs are way up over the last decade.
These figures
are compiled by averaging the cash costs of nearly two dozen of the world's
largest gold miners that have stock listings in the US. And with in-house
historical data that catalogs these costs all the way back to the beginning
of this bull, we can get an easy read on the prevailing trend. Also of note
is since the producers responsible for this data cumulatively account for nearly
half of global mined production, I believe these cash costs fairly
represent the industry as a whole.
In looking at
this chart, the first thing that catches most people's eye is the
incredibly-low cash costs at the beginning of this bull. Amazingly back in
2001 and 2002 the miners were producing their gold at sub-$180 cash
costs. While low, these costs shouldn't be that surprising considering where
the price of gold was and what these miners had been through in the previous
decade.
With where
the price of gold is today, sometimes it's easy to forget that from its
near-$500 high in the beginning of 1988 to its 2001 low, gold's price had
been lopped in half. Over this stretch gold averaged $353,
and in the four years leading up to and including 2001 it averaged a paltry
$281. In gold's brutal secular bear only those miners capable of running lean
operations survived.
As the price
of gold finally trended higher year-over-year, so did miners' cost of
production. And by 2005 cash costs had risen a staggering 45% to $250. But
with 2005 marking a big inflection point for gold's bull (its price had
decisively pierced $500 for the first time in over 20 years), these rising costs were hardly a concern. Gold's
structural fundamentals remained rock solid, and the miners finally had faith
in its new bull's secular nature.
Going into
2007 cash costs really started to accelerate. And incredibly in the five
years to 2011 costs have risen an average of 21% per year, or $81 per ounce.
There are several reasons for these soaring costs, the most notable being
rising input costs and diminishing ore quality.
On the
input-cost front it is easy to overlook the energy-intensive nature of the
mining business. Miners burn a lot of fuel powering their equipment and
plants. And those lucky ones able to connect to a local power grid are not
immune to rising costs either. Fuel/energy prices have skyrocketed in recent
years!
Labor costs
have also seen huge increases. Even in third-world countries the unions are
successfully negotiating (often via menacing and intimidation tactics) pay
raises many multiples higher. Rising costs are also prevalent in such inputs
as water and cyanide.
But more
impactful on cash costs than rising input costs is the type of ore that is
being mined these days. With higher gold prices, the miners have been able to
revive old mines and develop new mines that would not have been economical 3,
5, or 10 years ago. These deposits consist of lower-grade mineralization and
higher-complexity ore, which obviously translates to higher per-ounce
production costs.
Adding to
this, many miners are intentionally low-grading their existing operations. As
a rough example, let's say an open-pit mine has a high-grade core of reserves
that grade 0.14 ounces per ton. And surrounding this core is a lower-grade
halo of reserves that grade 0.07 ounces per ton. Logically speaking the
high-grade core would produce an ounce of gold at half the cash costs than
the lower-grade material (assuming the same rock types and recoveries).
Well in order
to preserve the higher-grade material for future times when gold prices may
be lower, many miners will intentionally produce from the lower-grade
reserves so long as the economics allow. Some miners believe it to be prudent
to mine lower-grade ore at a cash cost of $650
rather than available higher-grade ore which may have cash costs of only
$325. In both scenarios a miner will still make good money at $1700 gold.
As an
"in-between", some miners may blend the differing reserves to
dilute the head grade. And some will even go as far as diluting their payable
ore with waste rock to further preserve the good stuff! You won't see many
miners admit to these types of tactics, but it is an unwritten rule that has
allowed some of the veterans to survive the unforgiving market cycles.
So with
2011's average cash costs at $657, there has been a staggering 273%
rise in costs over 10 years. In any other industry this type of cost increase
would be totally unsustainable and unacceptable. But in the gold-mining
industry, the miners have carried on like business as usual.
And as is
apparent in this chart, gold miners can get away with sharply-rising costs
thanks to sharply-rising gold prices. Even though in isolation these cost
increases are painfully steep, from a margin perspective things appear
to be going great for the gold miners.
By definition
gross margin is the percent of revenue a miner retains after incurring the
direct costs of producing an ounce of gold. In my crude example here, I
simply used the average gold price and average cash costs in the formula. And
as you can see, gold mining is a business that can generate some very healthy
margins.
Also included
in this chart is the raw dollar spread between the average gold price and
average cash costs. And it is quite visually apparent that this spread has
been widening over the course of gold's bull. But provocatively in looking at
the margins, we don't see this same consistent widening.
Over the
first five years of this gold bull gross margins were consistently flat,
averaging 42%. Even though the spread grew by $100, rising cash costs curbed
any potential widening of the margins. In 2006 margins then opened wide up,
with a huge increase in the average gold price and a rare year-over-year
stretch where cash costs were flat. This was the first real big taste of
profits leverage for investors.
Since 2006
the gold miners have enjoyed gross margins in excess of 50%. But again rising
cash costs have throttled margin growth. Even though the miners have seen
their gross profit per ounce increase by an incredible $550+ since 2006,
margins have remained flat.
Lack of
margin growth aside, gold miners' 2011 average gross margins of 58% are still
spectacular. With numbers like this, these companies should be landing
on a lot of investors' radars. But 2011 was actually quite a rough year for
gold stocks. Even though gold was up 10% on the year, the big gold-stock
indices were down 10%+.
Unfortunately
as mentioned things just aren't that simple for the gold miners. While gross
margins do tell a captivating story, they don't tell the whole story. A
brilliant tactic taken out of the pages of the oil companies, gross margins
and cash costs are nothing but window dressing, eye candy that invites
investors in for a closer look.
Interestingly
cash costs are not the all-in production costs of mining an ounce of
gold. And what is rolled into cash costs can vary from company to company.
Thankfully there is some sense of uniformity that investors can cling to,
with most miners submitting to a non-GAAP standard that was implemented by
the Gold Institute back in 1996.
Under 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 credits from
byproduct sales if applicable) to royalties and production taxes. And the
per-ounce figure we see is calculated via dividing total cash costs by the
total ounces of gold produced.
What these
costs don't include are non-cash expenses such as depreciation, depletion,
and amortization, along with reclamation and mine-closure costs. They also
don't include the "effective cost" of replacing the reserves that
are being mined. The miners are constantly in search of their next deposit,
and it takes a big capital effort to do so.
So in
reality, gross margins are truly gross. They don't tell the complete story of
a miner's ability to generate cash, nor do they paint an accurate picture of
the future. What they do tell us is the gold miners need high margins in
order to survive, sustain, and grow their businesses.
But gross
margin is still an important metric for investors to understand. Not only
does it offer a read on how the industry is trending, it allows investors to
recognize the higher-quality companies, the ones with lower cash costs and
thus higher margins compared to their peers.
Overall while
the miners have enjoyed a prolonged period of prosperity where higher gold
prices are masking rising cash costs, investors might be starting to catch on
to the fact that margins are not increasing as perhaps they should. This
could be one of many reasons why gold stocks have been lagging recently.
Fortunately
with gold's fundamentals
still rock solid a decade now into this bull, demand and thus prices should
continue to trend higher in the years to come. And so long as the gold miners
can control their costs, there is ample opportunity for margins to increase
from here. Gold stocks ought to continue to positively leverage gold to the
upside. And when they eventually catch a long-overdue
bid, those quality ones that are on the low side of the cash-cost average and
high side of the gross-margin average will perform the best.
At Zeal we
favor the smaller companies to outperform in any upleg,
which is why our newsletters are heavily positioned in low-cost high-margin
junior producers that were profiled in our recent research report. Subscribe today to our weekly or monthly newsletters to
find out which gold stocks we are trading. And by becoming a subscriber not
only will you get trade recommendations, you'll gain unique contrarian commentary
and analysis that will be sure to grow your market knowledge.
The bottom
line is gold mining is like any other business in the sense that the miners
are driven to make money. And considering what the price of gold has done in
the last decade, this effort shouldn't have been too difficult. But in gold
mining, nothing is easy.
While many
miners have capitalized on gold's bull, as a group they've struggled
controlling costs. And in balancing external forces they can't control with
internal forces they can, these cost challenges have limited their ability to
grow margins. Thankfully we are still in a gold environment where its miners
can thrive.
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