Gold and Silver mining: A Post-Mortem

Since its peak in December 2010 the Market Vectors Junior Mining Index is down nearly 50%. The GDXJ ETF which replicates this index is comprised of an average of 85 small capitalised mining explorers, mine developers and producers. The smaller capitalised mining stocks have fared worse with many having collapsed 80% in the last year. In this time gold has risen by 20%. Even the major mining companies (GDX) are down over 30% since Sept 2011.

In anyone’s opinion this has been a disastrous time in the industry. While the Forbes billionaires list will show many fortunes have been made in the mining business, wealth is being destroyed in spectacular fashion today. Despite the near term despair from mining executives to investors, there is still a belief that if they have underperformed the metal by this degree they must be cheap and will recover in a cyclical fashion. But as with many economic issues currently, is it cyclical or structural?

What on earth has happened?

 

In a word – COSTS - but they come in many forms:

 

Labour - Wages have risen in all aspects of mining, not least because of the specific tightness in the mining workforce but all nominal wages have increased since 2000.

 

Quality of labour - The ‘gap’ in the quantity of high quality mining professionals, a throwback from the death of the last mining cycle in the late 1990s has left them spread very thinly and poor labour produce less ounces and hence adding to costs.

 

Taxes and royalties - The perception by governments or landholders that the miners are “raking it” has increased the demand for higher taxes and royalties raising costs.

 

Energy - Oil has increased ten-fold since 2000 and up to 50% of any mining extraction costs can be attributed to power usage.

 

Regulation and bureaucracy - Increased regulation, mostly worthless, is adding costs to all businesses and mining is no different.

 

Machinery and materials - From rubber tyres to processing plants, capital and operating costs are rising by up to 12 – 15% a year.

 

Financing - Mining has a long lead time to cash flow, and is a capital intensive business. Mining companies need constant financing to explore, drill, do surveys and eventually construct the mine. This is usually a mixture of equity, debt and forward stream sales. Invariably these companies have to accept worse and worse financing deals which again add to current and future costs even when cash flow is achieved.

 

Since 2000, gold extraction costs might well have risen from $200/tr.oz to $1300/tr.oz and are still rising. When the individual miners state their costs as a mere $656/tr.oz, this is often the pure Opex (operating expenditure) when the mine is up and running. Incidentally this number is also subject to a lot of deluded hope and optimism.

 

The total all-in cost must be the one that the industry as a whole bears and that includes;
1) All money raised for drilling by junior mining companies.
2) All preliminary Capex and all sustaining Capex including depreciation.
3) All clean up expenses.
4) All ‘goodwill’ costs paid by acquiring companies for reserve repletion.

 

Indeed, it would include every single expense borne by the mining industry divided by the number of actual ounces produced. Unfortunately it is this fully loaded cost that is potentially $1200-$1400/tr.oz and rising by double digits yearly that is producing the challenging situation for the mining companies today.

The following table should scare everyone:

 

If this is correct and that 2015 costs are $1750, while gold is currently trading at $1650 then what is a gold deposit or a gold company worth?

 

Arguably, if it costs more to produce than you can sell it for, whether it is widgets or gold it is worth nothing. However as the price of gold can rise over time then there is an implicit option (call) value that can be attributed to any mineral deposit, so that should the value of gold rise by X%, the company’s valuation who owns that gold deposit will rise accordingly.

 

Clearly the cost issue has potentially bullish implications for the price of gold. If the cost push inflation feeding through to the production of gold is rapidly approaching the market price of gold then uneconomic mines will be closed and supply at this price level will be sharply reduced. If demand remains the same, our textbooks will tell us that prices will rise.

 

A lesson from history


Cycles in anything often come in stages which can be described in many ways.

 

Despair-hope-faith-euphoria-disgust and back to despair might well describe the stages of the mining cycle, each with its own characteristics and wealth changing opportunities. The most profits are clearly made in the upswing from hope through to euphoria as ‘high’ potential margins encourage more and more companies and investors to participate in the bull market and high returns are made. Reality sets in, over competition prevails, costs rises for many of the reasons above and the biggest losses are made from euphoria back to despair which leads to consolidations and closures.

 

The last cycle ended in the late 1990s with the usual mine and company closures, inappropriate gold hedging and a wave of merger and acquisitions with a 20 year low in gold price.
The most difficult part of the current equation is to understand that we might well be coming to the end of another mining cycle despite the current ‘high’ price in gold. Despite the appalling returns in the sector over the last 18 months the cycle has more to play out. Now is not the end but perhaps the beginning of the end.

 

Hope for the future and what to expect

 

There are potentially over 3000 gold and silver mining companies in existence today. Expect that number to halve over the next 2-3 years through an increasing wave of M&A activity and closures.
Very few companies are safe, large or small but no doubt there will be winners and losers.

 

We would focus on companies that have current cash flow or imminent cash flow from operations and don’t need to death-spiral finance and we would focus on the highest grade deposits (the difference between 4 grams/tonne resource and 0.25 grams/ tonne, in basic terms means you have to shift 16 times less rock for the same gold which is one of the best ways of controlling costs) and those with largest exploration upside.

 

Remember that all the cost-push inflation that is reducing the forward margins will ultimately reduce the gold supply which may kick start the next leg up in the gold market and the mining cycle will begin once again. Timing is everything.

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