We have analyzed and posted the costs of almost all the publicly traded gold miners, which includes close to 6 million ounces of mined production for Q2FY13. This represents 25% of total estimated world production for the second quarter, which is a very large portion of the total worldwide production of gold. We believe our numbers represent a large enough portion of mined production to extrapolate as a general figure across the industry.
Why These Costs Are Important
For gold ETF investors (GLD, SGOL, CEF, and PHYS) this metric is very important because it allows an inside understanding of the true costs associated with producing each new ounce of gold. This is arguably the most important metric in analyzing any commodity because it shows the price where production of that commodity becomes uneconomic. 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 cost more to produce than to buy, which is an environment that cannot last for very long because eventually supply will be cut, cause scarcity, and then the price will increase.
There are some people that erroneously believe that newly mined gold supply is irrelevant to the gold price. Unfortunately, this causes investors to completely ignore the fundamentals of global gold mine supply and leaves a large hole in their understanding of the gold market. This article isn't the place to go into why they are wrong, but I've addressed this issue thoroughly in a previous article.
But to make a long story short, the two main reasons why newly mined gold supply is very important to the gold price are the following:
- Newly mined gold supply makes up a large portion of annual gold supply (it provides two-thirds of annual physical demand, according to the World Gold Council's numbers).
- It is held in the weakest hands (the gold miners) who sell that gold at the prevailing market price.
Again, please refer to that article for a more detailed description of these reasons.
Calculating the True Mining Cost of Gold - Our Methodology
In our previous analysis of 2013 first quarter true all-in gold costs, 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, which is an important concept for all precious metals investors to understand.
Explanation of Our Metrics
All Costs per Gold-Equivalent Ounce - These are the costs incurred for every payable gold-equivalent ounce. It includes all company costs to produce gold including write-downs, smelting and refining costs, taxes, etc. We use payable gold and not produced gold, because payable gold is the gold that the miner actually keeps and is more reflective of their production.
This is the broadest measure of costs, and since it includes write-downs, it is essentially the "accounting cost" of producing gold-equivalent ounces. When there are large write-downs, it can have a significant portion of costs that are the decline in value of existing assets, which is not a cash cost.
Costs Per Gold-Equivalent Ounce Excluding Write-downs and S&R - This is the cost to produce each gold-equivalent ounce when subtracting write-downs and smelting and refining costs, but including everything else. Removing write-downs allows this cost to be a much more relevant cost to what it truly costs to produce each ounce of gold, but since it does not include smelting and refining costs (which is a requirement to be able to sell mined gold), it will underestimate true production costs.
Costs Per Gold-Equivalent Ounce Excluding Write-downs - This is similar to the above-mentioned "Costs per Gold-Equivalent Ounce Excluding Write-downs and S&R" but includes smelting and refining costs. That makes this measure one of the best ways to estimate the true costs to produce each ounce of gold, since it has everything (including taxes) except for write-downs.
The one flaw with this measure is that when removing write-downs it is necessary also to remove the tax benefits associated with those write-downs, which we have to estimate based on the size of the write-down. We use a 30% base tax rate for these calculations, but investors can use whatever tax rate they feel most comfortable with.
For example, if a company reports a $100 million dollar write-down, we will remove $100 million from its total costs (removing the effect of the write-down) and then add $30 million to costs (30% * $100 million) to represent the estimated tax benefit that the company gained from this write-down. You must do this if you want to remove any item from the income statement, otherwise you will be using taxes based on a removed income statement item.
Costs per Gold-Equivalent Ounce Excluding Write-downs & Taxes - This measure includes all costs related to gold-equivalent production excluding all write-downs and taxes. Essentially this is the bottom dollar costs of production with an artificial 0% tax rate (obviously unsustainable) which works well because it removes any estimates of taxation due to write-downs or seasonal fluctuations in tax rates which can be significant.
The negative to this particular measure is that since it does not include taxes, it will underestimate the true costs of production. All companies ultimately pay taxes, and by removing them you create a production cost figure that is a bit optimistic and may be misleading to investors.
As investors can see, all the cost approaches above have their pros and cons, but we believe the last two are the most effective in evaluating the true costs of gold production - so we will focus on these approaches even as we list the cost figures for the other two for comparison sake.
What are the Industry's Gold Costs?
We have compiled all the numbers for gold companies that we analyzed for 2011 and 2012 and provided them in the table below. The companies included (with links to their associated detailed calculation pages) are: Barrick Gold (ABX) (costs just under $1300), Goldcorp (GG) (costs over $1250), Yamana Gold (AUY) (costs over $1300), Newmont Gold (NEM) (costs over $1600), Eldorado Gold (EGO) (costs under $1100), Goldfields (GFI) (costs over $1500), Allied Nevada Gold (costs over $1300), Alamos Gold (AGI) (costs under $1250), Kinross Gold (KGC) (costs over $1500), Randgold (GOLD) (costs over $1000), IAMGOLD (IAG) (costs over $1300), and Richmont Gold (RIC) (costs over $1300), Silvercrest Mines (SVM) (costs over $1000), and Agnico-Eagle (AEM) (costs over $1400)
Important Note: For our gold equivalent calculations, we have adjusted the numbers to reflect the Q2FY13 average LBMA price for all the metals. This results in a silver ratio of 61.2:1, copper ratio of 436:1, lead-to-gold ratio of 1520:1, and a zinc ratio of 1704:1.
Investors should remember that our conversions change with metal prices and this will influence the total equivalent ounces produced for past quarters - which will make current-to-past quarter comparisons much more relevant. This will also lead to minor differences in our previously published true all-in gold costs for the industry since in our 2012 analysis we used previous LBMA average prices, while for this quarter we used Q2FY13 LBMA average prices.
Observations for Gold Investors
Since there were major write-downs in this quarter which may throw off costs associated with write-downs and write-down tax relief, we will focus primarily on the "all-in costs excluding write-downs and taxes". As investors can see, these costs continued to rise on a sequential and year-over-year basis, averaging $1221.75 for Q2FY13 per gold-equivalent ounce - which was the highest costs for gold miners that we have on record.
Investors need to remember that this $1221.75 costs is not the break-even point for miners, it is the break-even point assuming they never have to pay any taxes. Essentially, if a miner was allowed to extract a country's mineral resources without ever having to pay a dime to government, this would be the cost figure associated with Q2FY13 extraction. Obviously, this is not the case in the long-run, and countries such as Mexico are increasing mining taxes and also associating the taxes with top-line production revenues - which would mean miners would pay a portion of taxes regardless of the profitability of operations. Either way we want to emphasize that even though we will cite this number for the best measure of costs for the quarter, it will under-report costs in the long-run because taxes will be paid, and that is obviously a cost associated with mining.
These rising costs are not only something witnessed in the gold industry, but are being experienced by miners across the board. This was even addressed recently by Barrick Gold CEO Jamie Sokalsky when talking about what he predicts will be a future shortage of gold, which we will note he gave at the end of 2012 with the gold price close to $1700 per ounce. The reasons why costs are rising significantly are beyond the scope of this article, but they are a combination of lower ore grades, less discoveries, energy and materials inflation, and a lack of new technologies.
Production Numbers - Gold production increased on a year-over-year basis by around 450,000 gold ounces from 6.3 million ounces in Q2FY12 to 5.9 million ounces in Q2FY13, which is around a 7% drop in total gold production. Sequentially production was up slightly from 5.8 million ounces in Q1FY13 to the current 5.9 million ounces. Since Q2FY13 was the quarter with the large drop in precious metals prices, we expect it will take a few quarters for gold miners to adjust to the new prices, and we wouldn't be surprised to see gold production numbers drop as exploration is delayed and unprofitable ounce production is cut.
Conclusion and Investor Takeaways
What is surprising is that gold costs continue to rise by significant amounts, even though the industry is well aware of declining margins and has been in efforts to cut costs. We expect Q3FY13 costs to decline as miners adjust to the new gold price level and aggressively cut costs further - which is a bit of what we are seeing with the early Q3 reports from gold producers.
But mining is unlike many other industries because miners have to replace every ounce they produce - it is not a manufacturing business. Decisions that miners make today will affect production one, five, and ten years down the road, and since it can take more than a decade to bring a mine into production these decisions cannot be easily changed.
Exploration budgets are being cut to the bone, and many small and large projects are being mothballed and shuttered. For example, ABX recent stopped development on its Pascua Lama project which was expected to produce a large amount of total world gold and silver production. The result of this is that costs will fall, but in the long run production will be severely affected and gold production should drop - and it may be significant.
Additionally, miners are beginning to "high-grade" their mines - meaning that they are producing from the high-grade ore in their mines and changing original mine production plans. This can have major long-term consequences for the mine's future lifespan that will also add to the future production crunch, investors interested in learning more about this can read a piece by Michael Kosowan that goes into more details.
So what do investors take away from all of this? First, gold production at current prices is only breaking even (before taxes) and miners will be cutting costs further by high-grading and cutting exploration budgets. This means future production will be handicapped by cost-cutting today, and this was despite gold production being essentially flat (up just under 10%) over the last 10 years even as the gold price rose 400%.
That means buying physical gold and the gold ETFs (GLD, PHYS, and CEF) makes a very good long-term investment based only on the crunch in supply that is coming. Ignoring other gold-positive factors like low Western gold inventories, continued worldwide government monetary stimulus (i.e. money-printing), increasing Asian demand and average affluence, soaring government debts, and central bank dollar diversification - you could make a strong argument to buy gold simply on the expected decline in supply.
We know that for long-term gold investors the last two years have been a very rough time for gold investments. But if investors look at the larger picture, there are still a lot of fundamentals for gold that make it a very good investment, but it needs patience. Additionally, investors should remember that physical gold is different than ETF gold - which is also different than investments in the gold miners. Physical gold is the safest of these investments, while miners are a much riskier proposition since they entail a number of other risks outside of the gold price.
As investors can see, the future of gold supply is not bright and as costs continue to rise, miners are cutting back at the expense of future production. Third and fourth quarter production totals and costs will be very interesting because even though we see costs dropping due to budget cut-backs, we expect to see production also dropping along with costs. Throw in the numerous other reasons to own gold that we mentioned above, and we believe the picture for gold's future is rather bright.
The only thing lacking is sentiment - all the other fundamentals are there for a much higher gold price. When will sentiment change? Nobody knows. But what we do know is that when it does change - it can change quite fast. Gold bulls should be confident in their investment and be patient, because the fundamentals are all present for a much higher gold price.