Over the last month we have been analyzing and posting the silver industry's true costs to mine silver. We have analyzed all the major publicly traded primary silver producers, which produced a total of over 70 million ounces of mined silver in 2012 - a very large portion of the total worldwide production of silver (estimated at over 750 million for 2011). We believe our numbers represent a large enough portion of mined production to extrapolate as a general figure across the industry and silver investors should pay attention.
Why These Costs Are Important
For equity investors, these costs are important, because it gives insight into how much it costs a company to mine each ounce of silver. This allows investors to see how profitable a company can be in different silver price environments. Additionally, it allows a fair comparison between miners to see how cost structures compare across the industry.
For silver ETF investors (SLV, SIVR, CEF, and PSLV), this metric may be even more important, because it allows an inside understanding of the true costs associated with producing each new ounce of silver. This is arguably the most important metric in analyzing any commodity, because it shows the price where production of that commodity becomes uneconomic - which provides a very strong long-term floor for the price of the commodity. If it costs more to mine a commodity than the market is willing to pay for it, eventually producers will stop producing the commodity and close up shop. These are the type of environments that savvy commodity investors dream of, because it allows them to purchase assets that costs more to produce than to buy, which is a situation that cannot last for very long; eventually supply will be lowered and cause scarcity and the eventual price increase.
The Industry's Current Calculations Underestimate True Costs Of Production
Before we go into the methodology we use to calculate silver costs, it is important to give an understanding to investors why the current "cash cost" calculations are incorrect and give only a skewed picture of silver costs.
Publicly traded silver companies offer investors a quick non-GAAP formula to give investors a glimpse at their costs per ounce called "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 silver equivalent ounces produced.
But unfortunately this measure is completely misleading, and selectively reports some costs while ignoring others, and thus, offers investors an incomplete picture into the cost it takes to produce an ounce of silver. We are not the only ones to criticize the industry over this, and many investors and funds are also calling for improvements to these measures. Some miners have begun to offer a new measure of costs called the "all-in sustaining cash costs," which includes additional costs used to mine the commodity.
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 silver. The reason is, because it does not include any costs associated with discovery, the expansion of reserves, or expenditures related to operating sites 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 appropriate measure, because any mining company needs to expand its reserves to survive, which is a very real cost of doing business in the mining industry; investors should not be primarily interested in the costs it takes to sustain a mine, but rather, the costs it takes to sustain a mining company. That is why costs related to the expansion of reserves should be included in the estimated cost of producing an ounce of silver.
Finally, the measure does not include financing charges (interest paid on existing debt) or taxes. These also are costs associated with the production of silver and should be included in the calculated production costs.
Calculating the True Mining Cost of Silver - Our Methodology
To calculate the true costs to mine each ounce of silver, 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 extraordinary 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 1 ounce of gold would convert into 55 silver-equivalent ounces. We like using the average LBMA cost for the reporting quarter or year because it offers fair standardization of the price of the metal. Finally, when doing year-over-year comparisons, we use the same conversion ratio even if the price of the byproduct was different in the comparison quarter or year. The reason we do 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 silver prices.
The final thing that we have to deal with is write-downs. Most silver and gold companies report write-downs from time to time, which can add significant costs to a particular quarter or year. An argument can be made that write-downs can be very real costs associated to the loss of investment on a property or mine and should be included in the cost calculations. For our calculations, we do not include write-downs, though we do provide the cost of production with write-downs included so investors can compare.
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 do the job.
What are the Industry's Silver Costs?
We have compiled all the numbers for silver companies we analyzed for 2011 and 2012 and have provided them in the table below. The companies included (with links to their associated detailed calculation pages) are: Pan American Silver (NASDAQ:PAAS), First Majestic (NYSE:AG), Coeur d'Alene Mines (NYSE:CDE), Gold Resource Corporation (NYSEMKT:GORO), Great Panther Silver (NYSEMKT:GPL), Hecla Mining (NYSE:HL), Endeavour Silver (NYSE:EXK), and Silver Standard Resources (NASDAQ:SSRI).
For our silver equivalent calculations, we standardized the equivalent ounce conversion to use the average LBMA price for Q4FY12. This results in a gold ratio of 1:52.7, copper ratio of 9:1 (pounds to silver ounces), lead ratio of 33:1 (pounds to silver ounces), and a zinc ratio of 37:1 (pounds to silver ounces). We like to be precise, but realistically minor changes in these ratios have little impact on the total average price; investors can use whatever ratios they feel most appropriately represents the correct by-product conversion.
Note about write-downs: A positive write-down value signifies a loss, while a negative write-down signifies a profit. The primary cause of the 2012 write-downs was related to a $100 million fourth quarter charge PAAS experienced which was partially offset by a $50 million asset sale gain by SSRI. The primary cause for the 2011 write-down was a $88 million asset sale gain by SSRI.
Let us first discuss the annual figures and then we will go over the fourth quarter figures. The first thing silver investors should note is that the true cost to produce an ounce of silver (excluding write-downs) was $23.68 for 2012, which is around a 7% increase in costs over 2011. The true silver cost of $23.68 is much higher than the reported "cash costs" (under $10 for most miners) and gives silver miners very limited profit at current silver prices ($28-29 per ounce). This gives investors a much better picture that aligns with silver miner share prices and earnings, which have both been dropping. When considering these margin pressures this drop in share prices makes sense.
Not only are silver costs giving silver miners very slim margins, but they are also still rising (7% year-over-year) which makes it an exceptionally tough environment for silver miners. In our opinion, this cost pressure is related to the true inflation rate (much higher than government manufactured CPI) and that is also why we expect cost pressures to continue into 2013. Slim margins should continue into 2013 without a significant rise in the silver price.
Fourth quarter numbers give investors a much better picture of the direction silver costs are headed, because they represent the most recent costs for the industry. At first glance, fourth quarter costs of $23.04 look like the industry is lowering the cost of producing silver from the annual average of $23.68. But after this cursory glance, investors will notice that taxes paid in 4QFY12 was significantly lower than both 4QFY11 and the average amount of taxes paid for 2012, which totaled $210 million (the low fourth quarter taxes was primarily due to a large tax adjustment assessed to SSRI). When taxes are normalized to $50 million (the quarterly average for the year), production costs rise to $24.70 per ounce which would support our estimates that 2013 will see more rising costs for the silver industry.
There is much more for investors to gain from the analysis of these numbers which we will offer in the second part of this series.
Conclusion and Investor Takeaways
Using this information offers investors a number of valuable takeaways. For investors in the silver ETFs [SLV, SIVR, PSLV, and CEF], the true cost of silver production is arguably the most important metric to understand for their investment. Understanding the true cost of producing an ounce of silver allows investors to see where floors in the silver price may exist - where silver production becomes uneconomical. According to the 2012 numbers, the $24 range would provide the average silver producer no margin of profit, and if cost pressures continue to grow, this may be even higher (remember fourth quarter costs were close to $25 per ounce after normalizing taxes). Of course not all silver miners would be unprofitable and some miners may continue to churn out silver even with zero profit margins, but it would be a situation that would be unsustainable.
For investors in silver miners (PAAS, CDE, SSRI, HL, etc.), these low profit margins should not come as a surprise, since the stock prices of all these companies have been facing pressure. It is a negative in terms of profitability for these miners, and in our opinion, is the primary reason why their stock prices have been punished over the last year. Investors should keep a close eye on the miners that have the lowest margins to make sure that if the silver price stays in the mid-twenties, these miners have enough cash to cope, because there will only be limited cash flow for these companies.
But there is a light at the end of the tunnel for silver mining investors. The stocks have scared off a number of the weak hand investors and prices at current levels remind us of the prices during the 2008 crisis. If silver prices start to rise, mining companies should see significant upside and price appreciation for the few investors who have the courage to stay the course.
In terms of the direction of the silver price, the costs of production in the $24-25 level is bullish and provides a significant floor to the silver price; if the price reaches these levels, investors should be buying as much silver as they can. We do not believe that the silver price will reach these levels, though, because the factors that led to the rise in the price of silver have not changed (accommodative monetary policy, European financial risk, and a change in reserve currency status of the dollar) and much of this is evidenced in physical sales still being very strong.
We would advise investors to accumulate silver at current levels because the downside risk (10-15%) is much lower than the potential upside reward, while riskier investors should consider adding silver mining shares. For the most conservative investors, we would advise buying silver on any drops below the $26 range - though we do not think we will see those levels. Silver investors should hold tight and continue to accumulate silver at these levels; downside risk is very limited with costs of production so close to the silver price.