With each passing day, it seems like gold (GLD) drops lower and lower as it nears the mentally important $1,200 level that could bring out many more sellers. Gold prices are down 12% over the past quarter and about 7.5% in the past month. As you would expect, the selloff in the precious metal has crushed the miners with Barrick (ABX), Newmont (NEM), Agnico-Eagle (AEM), and Goldcorp (GG) all faring even worse.
Should you try to catch this falling knife by purchasing shares of the miners? These miners have tremendous operating leverage, which means that mild changes in gold prices can significantly impacting their profitability. The major miners report sustaining all-in cash costs of between $915/oz and $1,150 with Goldcorp ($992) and AEM ($1,025) in the middle. The industry average is believed to be somewhere in the range of $1,000-1,100. While a drop in prices from $1,250 to $1,200 is only 4%, profits would be impacted by 25% (though many miners have resumed hedging, which mitigates some of the volatility). Similarly when prices rise, mining profits explode, which is why these stocks tend to both rally and fall more aggressively than the underlying metal.
However, I do struggle to find a near term catalyst that will put a floor in gold or send it higher. Unlike stocks, gold pays no dividend, so it is not as if income investors will jump in when it falls to provide some support. Next, it is virtually impossible to find an intrinsic value for gold as it provides no income and has virtually no industrial purposes, which is a reason why "value investors" cannot be counted on to buy gold at any price point. At the same time as we near the end of the year, investors often look to sell some losers to generate some tax losses to minimize their tax bill. This tax-selling could pressure GLD and the miners through the end of the year. Moreover, a weak rupee has limited India's consumption of gold, which has hurt overall end demand.
At the end of the day, there are two primary catalysts for gold: inflation/Fed policy and momentum. Right now, the momentum is clearly on the side of the sellers, and (barring some unforeseen black swan event) there is no reason to expect a reversal. Headline inflation also remains extremely tame, consistently below the Fed's 2% benchmark, which limits gold's "storer of wealth" appeal. As mentioned above, gold provides no income; therefore, there is an opportunity cost to owning gold. I could buy treasuries and earn a return (their yield) or buy gold and earn nothing, hoping to get price appreciation. As treasury yields increase (like they have been), the opportunity cost of owning gold grows from 2% to 2.5% to 3% annually. As yields rise, some investors will find the opportunity cost too great, and rotate out of gold into income producing assets.
This is why tapering is a major headwind for gold. Less money creation should in the longer run mean lower inflation, which is negative for gold. Furthermore, a less dovish Fed means higher interest rates, which in turn increases the opportunity cost for owning gold, which is also a negative. With tax selling through December and tapering likely in March alongside tame inflation and rising bond yields, everything is set up badly for gold over the next 4 months.
However, there is some reason for optimism looking out several years. The Fed has created a lot of money over the past five years with a balance sheet that nears $4 trillion, which could spur inflation. The government's $17 trillion in debt and over $100 trillion in unfunded liabilities related to Medicare and Social Security could make the government more willing to accept inflation or even increase a now non-zero risk of a significant dollar devaluation. These themes are rooted in macroeconomic fundamentals that will take years, not weeks to play out.
Nonetheless with so many near term headwinds around gold, investors do need to be cautious and understand their risk tolerance. A gold bull can always own the metal, but I believe investors in the long run are better in high quality miners who have significant operating leverage and can return profits to shareholders through dividends and buybacks than the metal which only produces income when you sell it. I need to emphasize that investors should own high quality miners who can ride out a challenging 12-18 month period in prices without having debt issues or major dilution to shareholders.
In particular, I would avoid some miners like Newmont, which carries $6 billion in debt against an $11 billion market cap. While its debt to cap ratio of 35% is not egregious, NEM has a high cash cost of about $1,150 and has had to write down some properties. Even with cuts to its capex program of about 40%, low gold prices will likely leave the firm free cash flow negative in 2014 (I estimate it needs a selling price of $1,325-$1,350 to be FCF positive). As a consequence, I would look for further dividend cuts below $0.20 as the firm preserves cash. It has already slashed its dividend in half in 2013, but to retain its credit rating and manage cash, it probably needs to do more. If gold prices remain below $1,300 over the next six months, NEM could do a secondary to pay down debt.
Barrick Gold was especially expansive during the boom time, and even though it has a low cash cost of about $915, that debt has become a serious burden, forcing management to do a secondary and a $1.5 billion secondary to pay down its massive $14.5 billion in debt. Even after this deal, ABX has a debt to cap of 42%. With forced reductions at expansionary projects to preserve cash, I think ABX is hunkering down for a rough 2014. There will be significant pressure on management to do another offering to right-size its balance sheet after a $9 billion write-down. Until gold moves above $1,300, Barrick is being run for its bondholders as it deals with the aftermath of its expansion. I would avoid ABX.
On the other hand, Goldcorp and Agnico avoiding adding much debt during the good times with debt to cap ratios of roughly 17%. As a consequence, I would not expect dilution or liquidity issues at either firms, though their higher cash costs of about $1,000 will limit profitability. Over the next 6-9 months, it will be a bumpy ride in GG and AEM, but investors can rest easy. I much prefer these miners to ABX or NEM, which have far more serious balance sheet repairs to undertake.
Investors who want exposure to gold but cannot stomach the volatility will be happiest owning Freeport-McMoRan (FCX). Gold is a significant part of its business, but copper, which has industrial purpose, is far bigger while its expansion into oil will add cash flow stability. At current prices, FCX should earn $4.00 next year and have operating cash flows of about $6.5 billion giving it an 8.6x multiple to earnings and 5.5x cash flow multiple. FCX remains an exceedingly cheap miner that is focused on reducing debt, and I believe it will provide investors who expect inflation with great upside without the volatility of the gold miners or the metal. I would be a buyer of FCX, though I think GG and AEM are okay for investors who want exposure to only gold. On the other hand, I would avoid NEM and ABX as I expect further dilution as they repair their balance sheets.