Gold Cash Costs Set To Decline

| About: VanEck Vectors (GDX)

Now would be the time to invest in gold mining equities (NYSEARCA:GDX). Gold mining equities have largely come under fire for poor cost management over the past several years. The increase in the price of gold since 2002 was accompanied by an increase in gold mining production costs as miners focused on quantity over the quality of ore mined. Poorly controlled costs are the biggest issue that investors have with gold mining companies and the recent decline in gold prices has drawn greater attention to the poor cost management at gold mining companies.

The increase in gold prices over the past several years has been accompanied by an increase in operating costs. The increase in operating costs result from an increase in input costs and a decline in the grade of ore being mined.

The increase in metals prices since 2002 has resulted in an increase in demand for various inputs across the mining sector and has also resulted in miners focusing on expanding quantity of ore mined versus the quality of ore that they mine. This has resulted in a sharp escalation of costs. Miners did little to control these costs, as the price of gold continued to rise providing them with healthy margins. The flat to declining gold prices since 2012 have been squeezing producer margins.

The relative weakness in gold prices in 2013 already is starting to begin bringing down production costs. Two to three consecutive quarters of declining gold prices is pushing mining companies to take cost reduction seriously. Mining companies already have reduced corporate staff in recent quarters in response to the decline in gold prices this year. They also have scaled back considerably on capital expenditures both for new projects and for expansion projects. This is already having a positive impact on the sustaining costs of these mining companies.

The next step will be to reduce the cash operating costs at these mining companies. The increase in cash operating costs is largely related to an increase in input costs and the mining of lower grade ores.

Going forward cash costs are likely to correct from the elevated levels at which they were at during the first half of 2013. This decline is likely because as metal prices decline or remain relatively weak there will be less of a rush to start new mines or expand existing mines. This therefore would reduce the demand for inputs, which in turn should reduce the level of cost inflation on these inputs. The increase in input costs is associated with a shortfall of supply compared with demand for various inputs such as skilled labor, parts and supplies, etc. This mismatch typically increases when there is an increase in mining activity resulting from an increase in the price of the metal being mined.

The one cost that is unlikely to decline is unit labor cost, but reduced demand could result in wage inflation stagnating. There is also a greater push toward mechanization and automation in the mining industry, which could help to alleviate some of the costs associated with labor over the longer term. Also over the past several years mining companies have focused on increasing production without consideration for the quality of ore that they have been mining, primarily because the high and rising gold price offset the inefficiencies generated from mining lower grade ore. The decline in gold prices is now leading mining companies to mine higher-grade material, which is reducing the per ounce cost of production.

Gold prices are expected to move sideways to lower over the next couple of years before heading higher beyond 2015. Ongoing investor interest in the market and curtailed mine supply are expected to push gold prices higher. The future increase in gold prices is not expected to be as strong as that which was seen between 2002 and 2011, however.

The downside potential for gold prices is limited from current levels - the downside potential for mining costs is fairly high from present levels. This scenario creates healthy margins for gold mining companies, going forward, which makes investing in them today a good proposition.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.