In my earlier article, I discussed one of the most important metrics to analyze the silver industry, the actual cost of mining an ounce of silver, which can help an investor figure out whether it is time to buy the iShares Silver Trust (SLV) and/or the silver miners. In that analysis, I used the 3Q 2012 financials to calculate the combined results of a number of publicly traded silver companies and come up with the average cost it takes to mine each ounce of silver.
In this analysis, we will calculate the real costs of production of Goldcorp (GG), one of the largest gold companies in the world.
The Industry's Current Calculations and Why it Underestimates Costs
Publicly traded gold companies offer investors a quick non-GAAP formula to give investors a glimpse at their costs per ounce called the "cash costs." This measure may vary slightly from company to company (it is non-GAAP after all) but it is generally their 'mining costs' (cost to operate their mines, process the ore, pay miners, etc) divided by the amount of gold equivalent ounces produced.
Unfortunately, this measure is completely misleading, and selectively reports costs without really giving investors a true picture into the cost it takes to produce an ounce of gold. This inaccurate measure of the production costs of an ounce of gold has been criticized by many investors and funds, so the industry has begun to offer a new measure of costs called the "all-in sustaining cash costs."
This measure is an improvement on "cash costs" and tends to be significantly higher, but it still does not accurately reflect the cost it takes to mine an ounce of gold. The reason why is that it does not include any costs associated with discovery, the expansion of reserves, or expenditures related to operations which are deemed expansionary in nature. Simply put, it is all costs related to running existing operations with the goal of never expanding reserves, or making any discoveries on new or existing properties. We do not feel like this is an accurate measure because any mining company NEEDS to expand or maintain its reserves to survive, which is a very real cost of doing business in the mining industry. Companies should not report the costs it takes to sustain a mine, but rather the costs it takes to sustain a mining company. The costs related to the expansion of reserves and exploration of properties are a necessity in the industry and SHOULD be included in the estimated cost of producing an ounce of gold.
Finally, the measure does not include financing charges (interest paid on existing debt) or taxes. These are also costs indirectly associated with the production of gold but are very important (after all tax rates are used to determine if a mining jurisdiction is viable) and should be included in the calculated production costs.
Calculating the True Mining Cost of Gold - Our Methodology
To calculate the true costs to mine an ounce of gold, we use the total costs reported for the quarter (revenues minus net income before taxes) and then we add taxes to come up with total costs. Finally, we remove gains/losses on derivatives and gains/losses on investments, since these really have nothing to do with running and sustaining the company.
Then we calculate the number of gold-equivalent ounces produced by converting all by-product metals (such as silver, copper, zinc, etc) into gold by dividing the gold price by the price of the by-product. For example, if gold is trading at $1650 and silver $30, then every 55 ounces of silver would convert into one gold-equivalent ounce. We like using the average LBMA cost for the reporting quarter or year to determine the proper ratios. Finally, when doing year-over-year comparisons, we use the same conversion ratio even if the price of the byproduct was different in the different quarter. This is because this allows an even comparison when determining the cost of production - we do not want one quarter's jump in copper prices to affect a year-over-year comparison in gold prices.
The final thing that we have to deal with is write-downs. I have changed my opinion on write-downs, which I used to use as a cost when determining the costs of production, but now I think it is preferable to remove write-downs from my calculations of the true cost of production - though I still include it below for investors to evaluate.
One thing to note is that if we remove derivatives and write-downs, we also have to remove the associated taxes from our calculations (usually write-downs involve tax benefits so they artificially lower taxes). There is no exact way to do this, so we just use a flat 30% tax rate and deduct the appropriate amount from the tax benefit (or charge) that the company received from the write-down or derivative. Not perfect, but it does the job.
Real Costs of Production for GG - 4Q 2012 and FY2012
Now that we have gone through the methodology, let us take a look at GG's results and come up with their average cost figures. When applying our methodology to GG for the most recent quarter and FY2012, we standardized the equivalent ounce conversion to use the average LBMA price for Q4FY12. This results in a silver ratio of 52.7:1, copper ratio of 480:1, lead ratio of 1722:1, and a zinc ratio of 1957:1. We like to be precise, but minor changes in these ratios have little impact on the total average price - investors can use whatever ratios they feel most appropriate to represent the by-product conversion.
Observations for GG Investors
The first thing that investors should take note of is that the "all-in sustaining cash costs" (reported by GG in their annual report as $874 per ounce) is significantly lower than the $1082 true cost of production that we have derived from our analysis.
In terms of costs, GG kept costs relatively controlled on a year-over-year basis and limited them to only 2%. This is actually very good for a gold miner since many other miners costs have been increasing at a much higher rate, such as Barrick Gold (ABX), whose costs I analyzed in a previous article. This cost control may be a result of streamlining operations, or it may be a result of streamlining the actual amount of mining, because investors should notice production is down slightly on a quarterly and yearly basis, including gold production being down 5% year-over-year. Regardless, if management's goals are to control costs, they are doing a pretty good job of it.
Investors should also notice that gold mining costs are still rising while gold production is declining, though production cost rises have been minimized by GG. A greater industry analysis will need to be done to see if total industry costs have been rising at 2% (like GG) or are rising at a different rate - once we analyze more miners, I will compile that and post it and that will help us develop a better comparison picture for GG.
GG management is doing a great job managing cost increases (even at the expense of production) as evidenced by the 2% growth in costs - which is lower than the rest of the industry. If GG management can keep a good control on costs, then it may be one of the best miners for investors to keep their money because management seems to be maintaining their margins in a low margin gold environment while the gold price meanders.
For GLD investors who are more interested in the general costs it takes to produce an ounce of gold, GG's report is an indicator that gold mining costs for even the low-cost producers are in excess of $1000 and rising further. Though it is a little tricky with gold since it is more like a currency than a commodity, we do believe that these costs of production will provide a very solid floor for the price of gold. Assets can overshoot on both the upside and downside, but investors should be confident that gold will have a floor around the $1100 - $1300 range, while their upside is much greater - so gold investors should accumulate if the metal continues to drop in price.