In this article, I will explain how important it is to watch the total marginal cash cost of gold mining in order to predict where the gold price (GLD) will be headed to. This marginal cost can be divided into two parts: cash cost of production and other costs (exploration, construction, maintenance, etc...). Today, that marginal cost of production is approximately $1,300/ounce. With the recent decline in the price of gold, I believe we have finally hit the bottom.
The gold price has always followed the marginal cost of suppliers throughout history (figure 1). The correlation between gold prices and gold mining cash costs between 1980 and 2010 stood at 0.85, which means that the correlation is quite high (source: CPM Gold Yearbook 2011).
With the price of gold at $1,400/ounce today I'm pretty sure we can't go much lower if this correlation proves to be correct (chart 1).
If we only look at the cash operating costs, we have the following situation (chart 2).
Chart 2: Production cash cost
While cash operating costs only went up from $200/ounce in 2001 to $700/ounce in 2013 (Chart 2), the total marginal cash costs went up from $300/ounce to $1,300/ounce in that same period (chart 1). So, the biggest move in total cash cost came from overhead, discovery, construction and sustaining capital. In the 1980s, we see that cash operating costs contributed the most to the total cost of mining. Today on the other hand, the biggest chunk of the costs go to overhead, discovery, construction and maintenance. Another way to look at it is that the exploration and development of a gold mine is taking an increasingly higher share in the overall cost of mining. A summary of the cost structure is given in chart 3.
For investors, the key point to keep in mind is that cash operating costs aren't a good indicator for the gold price. You need to look at the overall replacement costs and that includes all additional costs to mine gold. That total cost will drive the price of gold.
I hear many analysts say that gold will go to $10,000/ounce one day. I don't think this will happen soon, unless the total marginal cost goes up the same amount. This could happen when energy, labor, exploration, maintenance, construction costs go up or when ore grades go down. At the same time, some people say gold will go back below $1,000/ounce. This is not possible because marginal cash costs are rising and we know that there is a high correlation between marginal cash costs and the gold price.
The following chart is the most important chart every gold investor needs to be aware of. As I mentioned before, there is a high correlation between the all in cash costs of gold mining and the gold price (chart 4). So investors need to monitor the total cash cost of gold mining in order to predict the trend in the gold price itself.
The gold price will always follow the cost of mining, which proves another important point. The rising gold price is an indicator of inflation because the high cost of mining is a direct result of inflation.
Now consider the following. We see that many gold mining companies with development stage projects have had increases in their exploration spending and many of these companies have had upward revisions in their feasibility studies. To name a few examples: Kinross Gold (KGC) and NovaGold Resources (NG). So if capital spending on all of these projects go up, it isn't too difficult to see that the gold price will keep rising in the future.
|(click to enlarge)|
|Chart 5: Gold Exploration Spending|
As a matter of fact, the mining industry in general is even underreporting on production costs. The Australian (paywall) reports that the actual cost of mining gold is over 50% higher than the cash costs gold producers disclose in financial statements, which depicts even higher gold prices to come. Instead of a production cost of $773/ounce, the real cost should be around $1,170/ounce. Knowing that the total marginal cost of production is around twice the cash operating cost, the gold price should be somewhere around $2,340/ounce already (2x$1,170/ounce). I believe we will get to that price target in the coming years.