What’s Your Edge?

Richard (Rick) Mills

Ahead of the Herd

Page 1 of 3

As a general rule, the most successful man in life is the man who has the best information

In early July 2014, Mark Bristow Randgold Resources CEO, said the gold mining industry was fundamentally broke at a gold price of US$1,300.00/oz.

“Gold has special properties that no other currency, with the possible exception of silver, can claim. For more than two millennia, gold has had virtually unquestioned acceptance as payment. It has never required the credit guarantee of a third party. No questions are raised when gold or direct claims to gold are offered in payment of an obligation; it was the only form of payment, for example, that exporters to Germany would accept as World War II was drawing to a close. Today, the acceptance of fiat money — currency not backed by an asset of intrinsic value — rests on the credit guarantee of sovereign nations endowed with effective taxing power, a guarantee that in crisis conditions has not always matched the universal acceptability of gold.

If the dollar or any other fiat currency were universally acceptable at all times, central banks would see no need to hold any gold. The fact that they do indicates that such currencies are not a universal substitute. Of the 30 advanced countries that report to the International Monetary Fund, only four hold no gold as part of their reserve balances.” Golden Rule, Alan Greenspan

The number one rule of investing is ‘always buy an asset that is priced below its replacement value.’ The cheaper you can pick up quality assets, knowing the price HAS to rise, the better.

Let’s see if gold is priced below replacement value.

In 2012, the World Gold Council (WGC), and senior gold producers, come up with a new production cost reporting measure. The new industry standard is now ‘all-in sustaining costs’ or AISC.

AISC was widely adapted by the sector in 2013. AISC includes sustaining capital (as grades decline and mines get older sustaining capital costs rise) as well as general and administrative (G&A) expenses.

AISC does not include costs such as project capital, dividends, working capital, taxes, financing and interest charges on debt, costs related to business combinations, asset acquisitions and asset disposals and items needed to normalize earnings (ie. stock options, charges for discontinued operations).

Let’s take a quick look at Newmont Mining Corp., a company that is primarily a gold producer.

Newmont Mining’s full year AISC guidance for 2014 is US$1,020 to $1080/oz. With today’s gold price of US$1223.00/oz and using a median price of $1,050/oz Newmont seemingly has a nice margin of US$173.00/oz.

But…

With US$350 billion in interest payments and US$200 billion in dividends each of the 5,000,000 ozs of gold Newmont is suppose to produce in 2014 gets $110.00 added to its $1,050.00 cost equaling $1,160.00/oz dropping Newmont’s margin to just $63.00.

Newmont is very close to being in the red even before many hundreds of millions of dollars have to be paid in taxes. And remember those other charges – project capital, working capital, costs related to business combinations, asset acquisitions, asset disposals and items needed to normalize earnings that are NOT included.

By taking a knowledgeable look at AISC reporting it’s easy to believe the gold mining industry, taken as a whole, is not generating free cash flow below US$1,300.00/oz.

Measures Taken

Attempting to get costs under control is having a hugely negative effect on the entire industry.

“As gold prices have decreased, miners have responded by cutting sustaining capex, research and development, and exploration costs. Let’s pay attention to how the industry is achieving these cost cuts, because it matters if they’re coming on the sustaining side.” Dave Milstead, How much does it really cost to mine an ounce of gold?, Globe & Mail

Gold miners have resorted to high grading – mining the higher grade ores while leaving behind the lower grade. Dundee reported miners under their coverage processed 8% higher grades in 1H14. This is unsustainable over the long term and means much higher gold prices in the future are needed to make a go of mining the lower grade.

As gold prices dropped miners have cut back on spending. Many mines are no longer profitable at today’s gold price and they are being put on care and maintenance. New projects are on hold or cancelled outright, exploration spending levels have fallen through the floor.

A junior resource companies place in the food chain is to acquire projects, make discoveries and hopefully advance them to the point where a miner takes it over. Discoveries won’t be made if juniors aren’t out in the bush looking at rocks.

According to the Engineering and Mining Journal (E&MJ) junior resource exploration budgets dropped 39% in 2013 and fell a further 29% in 2014.

“It seems inevitable that the mining industry’s response to 2013′s gold price crash will be detrimental to mine supply levels in future years.”Gold Survey 2014 Update, Thomson Reuters GFMS

According to Visual Capitalist the global average grade of producing mines is 1.18g/t. The world average grade of undeveloped deposits is 30% lower, coming in at .89g/t.