I had penned an article earlier this week titled "Are Gold Miners A Permashort?" The premise of the article was simple. Gold demand has been stagnating as India clamps down on imports, and China demand, while growing, is barely enough to make up for loss in Indian demand. This puts pressure on gold prices. At the same time, the cost of extraction keeps going up for the miners, thus squeezing their operating margin. As a result, the miners have been languishing for several years now. At the current rate of cost increases, at some point some will have no alternative but to go bankrupt.
Yesterday (Feb 14, 2013) gold (GLD) prices were down by 0.44%, but the miners (GDX) were up by 0.39%. This was surprising. Usually, when gold is down the miners also go down in synch. What could be the reason for the negative correlation between gold prices and miners today?
Today was not a good news day for the miners either. Two miners announced major write-offs.
First, reports Wall Street Journal:
Barrick Gold Corp. ABX.T +2.27% took a US$4.2 billion charge for the fourth quarter amid flagging commodities prices and rising costs. Toronto-based Barrick posted a fourth-quarter net loss of US$3.06 billion, or US$3.06 a share, on Thursday. The latest results compared with a profit of US$959 million, or 96 U.S. cents a share, a year earlier. Revenue increased 11% to US$4.19 billion.
Then, reports Mining Weekly:
Canadian gold miner Kinross Gold on Wednesday reported a multibillion-dollar net loss for the fourth quarter after taking a $3.2-billion impairment charge mostly related to its Tasiast mine, in Mauritania, which outweighed an increase in revenue. Kinross reported a net loss of $2.98-billion or $2.62 a share for the fourth-quarter ended December 31, compared with a net loss of $2.79-billion or $2.45 a share in the same quarter a year earlier.
What is going on here? Both these miners are up today, Barrick (ABX) by 2.6%, and Kinross (KGC) by 5.6%. This is usually reserved for the likes of Amazon (AMZN). The more money it loses, the higher goes its price. What did investors see in these two miners that just lost a lot of money? Well, adjusted for the write-offs, both these beat forecasts for earnings and revenue. So the street was happy to bid both up.
The respective CEOs also said all the right things. Reports CBC:
First, there is Barrick CEO Jamie Sokalsky:
"Barrick highlighted the need for change last year, and we are increasingly taking strong action and re-focusing our business based on the principle that returns will drive production, production will not drive returns."
Next, there is Kinross CEO Paul Rollinson:
"Although our 2013 operating costs are expected to increase due to higher consumable costs and anticipated lower grades, we are pursuing every opportunity for cost reduction."
In other words, both the CEOs realize that cost control is something that will be key to the continued success of their respective companies. Gold miners have for a while tried to grow out their troubles. This has led to ill-fated acquisitions which are now leading to write-offs. The changed focus would, it seems, be on profitable growth rather than just any growth. The market obviously believes the message, hence the positive price movements.
Should the market believe that gold miners will be able to control costs successfully? I am personally not hopeful. It may be possible for isolated companies to tease out more productivity out of aging mines or stumble upon mines that still offer attractive extraction costs, but as a group gold miners are faced with a bigger challenge. Reports the Economist magazine:
Metals Economics Group, a mining consultancy, estimates that in 2002 gold miners spent $500m on exploration. By 2008 they were spending $3 billion but finding much less. The world's miners dug up 2,689 tonnes of gold last year. Despite the huge surge in investment, it was only a few flakes more than the total output a decade ago.
This is an immutable law of geology. The earth is not making new gold that is easy to extract, and certainly not at the pace at which the miners keep digging out existing veins. So, there will be winners and losers in this cost cutting pursuit. There will be reductions for sure. It may come from overhead, but that is a finite pot from where to get a few extra pennies and can't continue forever. The key cost is energy, and that is not going to go down anytime soon. Labor costs are modestly up, but if inflation returns that will be another major drag. The new mines are in politically unstable regions, which also adds tremendous risk.
Unless there is new, breakthrough technology as in shale gas extraction, there is no realistic path for the miners to sustainably reduce costs. If there was indeed a silver technology lining in the horizon (pun intended) I am sure the CEOs would have made the investment community well aware of it. They didn't, which is telling. As a result, I remain confident that the miners as a group are still perma shorts.
So, what does that mean for your investment thesis, dear reader? I continue to believe that the obvious choice would be to hold the Direxion Daily Gold Miners Bear 3x Shares ETF (DUST). This ETF is up some 60% in the past three months, and some 30% in the New Year. I believe there is another 25% left in this ETF this year, as I expect gold prices to continue to flatline, as gold extraction costs keep going up. Of course, nothing is a guarantee, but the immutable laws of geology give me comfort that DUST is on the way up.
Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choices.
Disclosure: I am long DUST.