Argonautica

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‘$1200/oz and falling: the gold industry in crisis’

A few weeks ago with the gold price trading at $1,400/oz we wrote that fair value for gold on a purchasing power basis was just $240/oz and that in view of the debate on quantitative easing in the US shifting to the timing of exit we believe there was no reason for gold to trade at such a significant premium to its fundamental value.  We also pointed out that optically cheap P/E ratios of gold mining companies were based on assumptions of $1500/oz gold and that profit margins were likely to be quickly eroded by further falls in the gold price. The $240/oz question: who needs gold now?

Today the gold price breached $1,200/oz. In our view this means that the gold mining industry as a whole is now unprofitable and haemorrhaging cash. This may be surprising to some as reported cash costs are well below the current gold price ($780/oz).  However “cash costs” do not include all the costs involved in mining. The key costs added to the reported numbers are those for sustaining capex (cash costs related to keeping mines running and maintaining production levels), on-going exploration (to replenish ore mined) and general corporate and admin costs. Most of the world’s leading gold miners (many of whom are on the lower end of the curve) have begun to report these for their own company and the industry. As we can see from the chart published by Barrick Gold below, the industry has seen significant cost escalation over the last decade which has resulted in the break-even gold price for the industry including “all-in costs” rising from $300/oz to $1,200/oz over the last decade.

 Chart 1: Gold industry all-in costs

Source: Barrick Gold, 5th June 2013

We feel the gold industry will respond to this crisis by cutting higher cost production (only mining higher grade ore) and mothballing capacity. However we believe this is a short-term fix and will also generally go hand-in-hand with a freeze on exploration and capital project spending plans. As mines are closed, orders for mining equipment will dry-up and second hand equipment (excavators, trucks, grinders, drills etc) dumped on the market. This will have calamitous ramifications for those companies reliant on gold miner’s capex spending plans. Remember too, that the all-in costs do not include financing charges. This means that those miners with significant debt commitments and financing charges will be either close to bankruptcy, or at the very least need to raise equity to recapitalise their balance sheets for tougher times.

Normally the marginal cost of production of a commodity acts as a floor to the commodity price. However, there are a number of reasons why this is not relevant to gold. Gold is unique. It is not used or consumed by industry or individuals like copper or corn, and indeed all the gold ever mined remains in existence today. This above-ground stock in essence represents its supply.  The World Gold Council estimates this stock at 175,000 tonnes. This year annual mined production is expected to be 2,900t or just 1.5% of total supply, and thus is not material in influencing the price. The fact is, gold is only mined when financially feasible and at current gold price levels, this feasibility is no longer clear. Moreover, if no gold was mined, unlike the production of other commodities, it would not prevent the global economy from functioning perfectly well.

With Gold having fallen $200/oz in just a few weeks there will be those who believe that this is a buying opportunity. We disagree. We are similarly sceptical of gold mining equity where we see significant bankruptcies and mothballing of capacity ahead. This curtailing of capacity in contrast to other commodities will not prevent further falls in the gold price, where we see another $1,000/oz downside before gold starts to offer fundamental value.

Greg Bennett
28th June 2013

Sources:
Bloomberg, 28th June 2013
World Gold Council, April 2013
Citi, 18th April 2013

Readers should assume Argonaut have short positions in gold miners and stocks geared towards gold mining capex reflecting our views/research.

P/E – Price/ Earnings
CAPEX – Capital Expenditure

This document has been provided for informational purposes only solely for Professional Clients as defined by the FCA and does not constitute investment advice. Information and opinions expressed in this material are subject to change without notice and are accurate at the date of producing the document. They have been obtained or derived from sources believed by Argonaut Capital Partners LLP to be reliable but Argonaut Capital Partners LLP make no representation as to their accuracy or completeness. The writer of this piece may have conflicts of interest as may have personal holdings in the companies mentioned.