What It Really Costs To Mine Silver: The First Quarter Pan American Silver Edition

May.20.13 | About: Pan American (PAAS)


In an earlier article, we 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 SLV and/or the silver miners. In that analysis, we used the FY2012 financials to calculate the combined results of publicly traded silver companies and come up with a true all-in industry average cost of production to mine each ounce of silver.

In this analysis we will calculate the real costs of production of Pan American Silver (NASDAQ:PAAS). Pan American Silver is one of the largest primary silver producers in the world and they have operations that span North and South America. Their countries of operation include Argentina, Mexico, Peru, Bolivia, Canada, and the United States.

Calculating the True Mining Cost of Silver - Our Methodology

In the previously mentioned article, we gave a thorough overview of the current way mining companies report their costs of production and why it is inaccurate and significantly underestimates total costs. Then we presented a more accurate methodology for investors to use to calculate the true costs of mining gold or silver. Please refer to that article for the details explaining this methodology, and I would encourage all precious metals investors to understand this concept.

Explanation of Our Metrics

Cost Per Silver-Equivalent Ounce - is the costs incurred for every payable silver-equivalent ounce. It is Revenues minus Net Income, which will give an investor total costs. We use payable silver and not produced silver, because payable silver is the silver that the miner actually keeps and is more reflective of their production. Miners also use payable silver and not produced silver when calculating their cash costs, so this is pretty standard.

We then add Derivative Gains (or minus Derivative Losses), which will give investors total costs without the effects of derivatives. Finally, we add Foreign Exchange Gains (or minus Foreign Exchange Losses) to remove the effects of foreign exchange on the company's costs.

Cost Per Silver-Equivalent Ounce Excluding Write-downs - is the above-mentioned "Cost per silver-equivalent ounce" minus Property/Investment Write-downs and Asset Sales. This provides investors with a metric that removes exceptional gains or losses due to write-downs and asset sales.

Cost Per Silver-Equivalent Ounce Excluding Write-downs and Adding Smelting and Refining Costs - is the above-mentioned "Cost per silver-equivalent ounce excluding write-downs" adding in smelting, refining and all other necessary pre-revenue costs. This is a new metric that we are now introducing to our true all-in cost series because it will more accurately measure all-in costs and allow comparisons between miners.

Most investors are unaware that many miners will remove smelting, refining, and other costs BEFORE reporting their total revenues figures and it will not be present in the income statement. The result of this is that it skews all-in costs higher for miners that refine themselves or include the costs in their income statement, while inaccurately showing lower costs for miners that remove it before reporting revenues.

A simple test can be done on any miner to see if there are any pre-revenue costs that are not reported in the income statement. Simply take payable production and multiply it by average realized sales price and this should come relatively close to the total revenues figure. If it gives you a number much higher than reported revenues then there are pre-revenue costs that are not being reported.

This line should alleviate these issues and allow comparisons on a fair basis.

Real Costs of Production for PAAS - 4Q 2012 and FY2012

Let us now use this methodology to take a look at PAAS's results and come up with their true all-in cost figures. When applying our methodology for the most recent quarter and FY2012, we standardized the equivalent ounce conversion to use the average LBMA price for Q4FY12 which results in a silver-to-gold ratio of 52.7:1, copper-to-silver ratio of 9:1, lead-to-silver ratio of 33:1, and a zinc-to-silver ratio of 37:1. 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 appropriately represent the by-product conversion.

Click to enlarge
(Click to enlarge)

Note about Adjustments to True Costs Values for PAAS

We had to make a minor adjustment to our true costs numbers for PAAS from previous releases for FY2012 and Q4FY12. This adjustment was because we began using PAAS's payable production rather than their top-line mined ounces (about 5% less than produced ounces). Additionally, we have estimated their other mined production to have the same payable ratios so we have used an estimate 5% reduction in the other metals to make them "payable". These changes will much more accurately reflect PAAS's all-in costs.

Additionally, PAAS seems to subtract their S&R costs (Smelting and Refining) before reporting their revenues, so the new S&R all-in cost line reflects the addition of these costs in the production price and is a much better way to calculate PAAS true all-in cost and compare them to other miners who may not take off these costs pre-revenue.

For example, PAAS reported the following sales figures on page 16 of their quarterly report:

Click to enlarge
(Click to enlarge)

When an investor calculates these figures out for the 2012 sales numbers, it comes to approximately $267 million, while PAAS reported revenues of only $243 million - a $24 million lower figure than their sales numbers would suggest. The difference is the smelter and refining costs were removed before total revenue figures - so to calculate PAAS's true costs these costs have to be included. This is the reason why we are adding S&R costs to our true all-in cost figures.

Observations for PAAS Investors

The first thing to note is that the Q1FY13 true all-in costs of production were approximately $24.97 per ounce which was an improvement on a year-over-year basis ($25.70 in Q1FY12) but was up on a sequential basis from $22.33. Compared to the average 2012 cost of $24.61, management did a fairly good job containing costs to a little over 1% in the first quarter compared to the 2012 average. Containing mining costs has been a problem for many mining companies, so even though costs rose 1% from the 2012 average that is not bad for a miner.

On the negative side, true all-in costs of $24.97 are well over the current spot price. This means that unless PAAS can lower production costs, they will be producing silver at a loss in this current low price silver environment. For companies in this situation it is important for investors to analyze the company's liquidity to make sure they will not be stressed. PAAS seems to have plenty of cash with almost $500 million in cash, cash equivalents, and short-term investments and so they can weather this silver price decline for quite some time before they experience a liquidity crunch. The one concern would be related to the jurisdiction of this cash, PAAS does not seem to specify a breakdown of where the money is held but if there is a large amount in Argentina there would be some asterisks next to this cash pile.

In terms of production, PAAS has been ramping up production and based on the Q1FY13 results they should exceed 2012 numbers in all their production categories. Though the numbers do fall a little short of management's outlook of 25-26 million ounces of silver, but we do expect the outlook of PAAS and other silver miners to change significantly due to the recent massive drop in the silver price. We believe many will cut output to slash costs and we are more interested in the second quarter production outlook than the earlier management production estimates.


PAAS management did a relatively good job containing costs and holding them to a little over 1% increase, while increasing production. But true all-in costs are still above the current silver price so without a major rise in the silver price (or cut in costs) there is a good chance PAAS may have negative earnings in the second quarter. We will have to see what management's cost-cutting strategy will be.

For investors in SLV, CEF, PSLV, and physical silver who are more interested in silver as a commodity, PAAS's report was a positive sign because it shows that mining costs are still rising and silver is costing more to produce than the spot price. Production was up, which is a negative because investors want to see reduced production, but we expect production to drop for the rest of the year from PAAS and the other silver companies as they aggressively cut costs. The second quarter reports will be very interesting to see how much production and costs are cut - if costs continue to rise then that will be a very bullish signal.

Disclosure: I am long PAAS, PSLV, SIVR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.