Where has all the gold gone?

Since 2011, gold is down over 35% while US equities are up 44%.  That is a sizeable move in asset classes which you could argue currently both require QE money printing for support.

The media will tell you that there has been a “great rotation” into stocks and gold investors have sold all their holdings. They will tell you that this is because of the “economic recovery” in the US. One look at the ISM Manufacturing index will tell you that hugging the 50 line is hardly a stellar recovery.

But more importantly we have to challenge the above statement.  ”Knock knock , McFly, anyone in there?”  In the last 6 months there has been new production of gold of 0.7% of the above ground supply. In the last 5 years there has been no net issuance of US equities.  Basically the same gold and equities exist as they did 6 months ago, only the price of exchange has changed. For every buyer of a stock at new highs, there must have been a willing seller.

 

For every seller of an ounce of gold at 3 year lows, there must have been a willing buyer. There is no great rotation when the quantity of stock remains the same, it just changes hands at a different price and acquires a different value. The fundamentals change much slower than fashion. Greed and fear play havoc with ‘fair’ valuations and the media has to constantly justify market movement and investors desires.  Speculators usually drive asset prices too high or too low relative to the “new” fundamentals which often fail to materialise. At the highs of the equity markets, you will find signs that speculators have bought stock from the long-term holders like endowment funds and vice versa.  At the lows of the gold market you will find low degree of net speculator longs even shorts.

As you can see from the charts above, high NYSE margin debt shows that the speculators own the stocks at these levels (presumably bought from the long-term holders who now have high cash balances). Conversely, the lowest level of Comex net gold speculator longs in a decade with the lowest level of GLD ETF holdings since it became on most investors’ radar in 2009, shows you that it is the long-term holder who currently owns the gold. The stale investors in gold over the last several years have sold it to them. Who is that likely to be? As you would suspect it is likely to be the central banks and the emerging economic powerhouses of the proverbial BRIC countries.

 

History tells us that subsequent returns tend to favour the long-term holder rather than the speculator at the extremes, especially when the fundamentals are dodgy at best.

 

The speculators or shorter time frame investors have recently been influenced to exchange their equities at higher prices and gold at lower prices because of the belief in the economic recovery and with it less monetary support.  This has been the general view peddled out by the media and accepted by the public.  The weak recovery in the US seems to get far more positive coverage than the severe problems faced in China, Australia, Brazil or France to name a few. It is far from a global recovery you would have to concur.

You have to hat tip to this year’s bearish commentaries on gold from Goldman,  Soc Gen and Credit Suisse. Their predictions of a lower exchange rate of gold were correct, a good call. Whether it has happened because of their widespread writings or because of their economic analysis remains unclear.  What has always fascinated me with these gold commentaries is the discussion on gold’s demise is in isolation of any discussion on the production cost of gold.
 

We have written many times about the challenges facing the mining industry, principally the costs incurred.  Last week , the World Gold Council launched a new standard for reporting mining costs, “all-in sustaining costs” and “all-in costs metrics”.  This is seen to be a new standard to replace the “cash costs” standard that has been in place for over a decade.  While not compulsory, it is seen as a more comprehensive analysis of the full cost of mining.  At a broad stroke, it has seemingly increased the cost of mining from $800/oz to $1200/oz on average.  Unfortunately just as the cash costs understated the full costs, so does the new method, albeit less so.
 
According to our analysis, when you include ALL costs of mining for the last few years, and for the next few years, then estimate the break even price/cash neutrality price (call it what you want), it is over $1750/oz. In this world of production-cost accounting, everything is seemingly grey and up for discussion. We would argue that reported cash costs always miss out “one off” line items so it shows an accurate estimation of all-in costs if everything goes accordingly to plan. It doesn’t tend to include asset write downs from past highly priced acquisitions or outright confiscation.  Increased costs also come through delays due to heavy rains, terrorism, geological set-backs, cyanide-related cattle deaths, restating reserves due to imperial/metric errors, etc, etc.
 
Trust me after seeing 4 mining CEOs a week here for the last 6 years, I think we have heard just about everything.  Make no mistake this is a difficult and challenging, often dangerous business. Give me the inside job with no heavy lifting any day but the crucial element is that these problems are not one off, they are  regular, happen every year, and should be factored in to the full cost of mining. The number that inevitably shows the real cost of mining is the average long-term free cash flow. It is severely in negative territory with gold spot at $1250/oz.  Recently, experienced miners have told me that they had felt bad times before in the 1990s, when gold was selling for $300/oz, and survived by the skin of their teeth. I would argue that back then in those tough times, the negative margin was -10% to break even and that, while many folded, some struggled valiantly through.  Today if our costs are to be believed they are operating at -30% negative margin. That is totally unsustainable.
 
Make no mistake, there might be a few mines in the world who have a positive margin but at a rough guess 90% of them are completely unprofitable at this gold price, no matter what they say. As the old shout goes, “show me the money!”; in this case show me the free cash flow.  Ahhhh, it’s negative.

 

“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

Sir Winston Churchill, Speech in November 1942 after the battle of El Alamein.   British politician (1874 – 1965)

 

Of course when you need a quote, it is not quite right. This is not the end of the mining cycle, it is more likely the beginning of the end. Expect announcements like the one below to become widespread. If it costs you more to mine a finite asset than it will sell for, the best option is to close. As the old adage goes, the easiest way to dig yourself out of a hole is to first stop digging..

 
 
Golden Minerals Announces Suspension Of Production

“GOLDEN, Colo., June 21, 2013 /PRNewswire/ — Golden Minerals Company (NYSE MKT: AUMN); (TSX: AUM) (“Golden Minerals” or “the Company”) announced that it has suspended operations at its Velardena mine as of June 21, 2013, in order to conserve the asset until operating plans and prices for silver and gold indicate a sustainable cash margin for operations. The employees at the Velardena mine were informed of the Company’s decision in the afternoon of June 21, 2013.  In February 2013 the Company anticipated the Velardena operations would achieve operating cash neutrality during the third quarter 2013, assuming gold and silver prices of $1,600 per ounce and $30 per ounce, respectively. In May 2013 the Company projected a $5 million negative margin from the operations for the remaining three quarters of 2013 at prices of $1,500 gold and $25 silver.  Metals prices have continued to decline and remain below these levels.
 
 ”The Company is placing the mine and processing plants on a care and maintenance program to enable a re-start when operating plans and metals prices support a cash positive outlook for the property.  Approximately 470 positions at the Velardena operations are being eliminated as a result of the suspension. The Company is presently negotiating the specific terms of a severance package with its labor unions.  The Company plans to retain a core group of approximately 50 to 60 employees to facilitate a re-start of operations and to maintain and safeguard the longer term value of the asset.”
 
There are 2000-3000 gold/silver mining companies with some 500,000 employees on all continents who in the space of 6 months have found themselves in a completely unprofitable business. They might as well be making black and white TVs. It is no laughing matter, it is a complete tragedy.
 
What is the likely outcome? We have been mining for 4000 years, it can’t just stop. The most immediate scenario is a combination of closures, mass bankruptcies, M+A activity, and a dramatic cost cutting coupled with asset sales.
 
The trouble is that the input costs for mining are pretty basic:
1/3 Labour
1/3 Energy/Water
1/3 Equipment
 
And all the admin that goes with it. How do you get back just to break even if gold remains at current prices?
 

Labour, oil and equipment have to drop by 30%. Is this really possible in the short run? In South Africa today mining unions are demanding a 100% increase in wages. Despite the so-called shale revolution in the world, oil remains stubbornly near $100/ barrel. Will Germany really be able to offer their plant machinery and mining precision tools at 30% discount?

 

 
After digesting all these facts, my natural conclusion is that after a 35% drop in the price of gold and a 44% rise in the price of equities, coupled with the fact that there are huge speculator longs in equities and virtually none in gold, that expecting a continuation of this trend is unlikely. Gold as an asset class is far cheaper on valuations than equities at this juncture.  Speculative positioning favours gold over equities as well. Any belief in the miracle of a US recovery being able to withstand the global problems should be challenged by looking at NAPM and the situation in China. If gold prices stay here, hundreds of mining companies will close by and thousands of workers will lose their jobs. Production will fall quickly and with exploration dramatically reduced as well, so will future production.  Will sharp production declines stabilise the gold price?, despite the large stock/flow ratio.
 
We can never rule out a deflationary collapse and gold prices staying low or even lower, but it will not be in isolation. Oil, platinum, copper and all materials will fall. Despite their inputs into equity costs, equities might well suffer dramatically from the high level of speculative activity.

Comments are closed.