2013 Third Quarter All-In Gold Mining Costs: Numbers Suggest Miners Are High Grading Their Mines

by: Hebba Investments

We have analyzed and posted the costs of almost all the publicly-traded gold miners, which includes over 6 million ounces of mined production for Q3FY13. 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 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:

  1. 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).
  2. 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.

As for future gold production, we will quote Mr. Jamie Sokalsky, the Barrick Gold (NYSE:ABX) CEO which we discussed in more depth in a previous article:

However, the outlook for growth in supply in a few years looks more and more under threat. Thus, the supply of gold is likely to be lower going forward. We are not going to see huge growth, even if the gold price goes up considerably. That should then be supportive for the gold price and ultimately result in a healthier industry.

This speech was given in late 2012 with the gold price at $1700 per ounce - how does the outlook for future production look with gold hovering around $1200 per ounce?

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 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 the gold companies that we analyzed in 2011 and 2012 and provided them in the table below. The companies included (with links to their associated detailed calculation pages) are: Newmont Mining (NYSE:NEM) (costs under $1200), Kinross Gold (NYSE:KGC) (costs around $1200), Goldcorp (NYSE:GG) (costs under $1200), Gold Fields (NYSE:GFI) (costs over $1300), Yamana Gold (NYSE:AUY) (costs over $1150), Alamos Gold (NYSE:AGI) (costs above $1250), Randgold (NASDAQ:GOLD) (costs above $1150), Barrick Gold (costs above $1350), Agnico-Eagle (NYSE:AEM) (costs under $1150), Iamgold IAG) (costs under $1150), and current quarterly cost leader Eldorado Gold (NYSE:EGO) (costs just over $1100).

Important Note: For our gold equivalent calculations, we have adjusted the numbers to reflect the Q3FY13 average LBMA price for all the metals. This results in the following approximate ratios: a silver ratio of 62:1, copper ratio of 413:1, lead-to-gold ratio of 1580:1, and a zinc ratio of 1397:1.

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 second quarter analysis used previous LBMA average prices, while for this quarter we used Q3FY13 LBMA average prices.

Observations for Gold Investors

Unlike the second quarter, which saw a flurry of write-downs by gold miners which significantly affected the true all-in costs, in the third quarter we saw much less write-downs which should result in much more accurate numbers in terms of true all-in costs.

In the third quarter, true all-in costs averaged $1244 per gold-equivalent ounce which were all the costs excluding write-downs. If we include write-downs to get all costs incurred by gold miners, the figure rises minutely to $1246 per gold-equivalent ounce.

We're not going to compare this number to Q2FY13 because the second quarter number was significantly impacted by write-downs and estimated taxes, but compared to first quarter numbers, investors can see that miner costs dropped significantly from the $1333 to $1244 per gold-equivalent ounce - a reduction of about 7% over the span of two quarters. Additionally, third-quarter costs were below the $1282 average for FY2012 which is the first time in quite a while that we've seen costs drop from the previous year.

The core costs of the industry (costs which exclude taxes and write-downs), dropped in Q3FY13 to $1084 per gold-equivalent ounce. This was a drop from Q1FY13's $1161 per gold-equivalent ounce, and a slight drop from FY2012's $1100 core costs.

We'll deal with this drop in costs in the conclusion because there is more than meets the eye to this drop, but we are seeing drops across the board in industry costs.

Production Numbers - Third quarter gold production increased on both a year-over-year basis and a sequential basis to 6.19 million ounces of gold and 7.16 million ounces of gold equivalent. Which was a significant 370,000 gold ounce increase from the second quarter and a 200,000 gold ounce increase on a year-over-year basis.

One thing we do have to point out is that FY2011 and FY2012 production totals are not going to be exactly comparable to FY2013 numbers since many miners changed the way that they do their accounting for joint operations. Though beyond the scope of this article, this results in less attributable ounces for the industry but also ends up reducing reported costs for the industry. The point is that year-over-year comparisons will be a bit off because of accounting changes at most of the major miners.

Drop In Costs - More Than Meets The Eye

As is obvious after looking at the numbers, it seems the gold mining industry is dropping costs while increasing production for the first time in many quarters. But we believe there is more than meets the eye in this newfound efficiency across the industry.

Whenever investors see increases in production and drops in cost across the industry for almost all companies, the question of "how" should come to their minds. After years of rising costs, reduced margins, and a big second quarter drop in gold, all of a sudden miners seem to have found the formula to reduce costs and increase their production. We don't think so.

What we think is going on is that miners are "high-grading" their mines to mine higher grade portions of the mine, which produces more gold at the same total costs - which ends up reducing the costs per ounce. This is exactly what we're seeing in the numbers as Q3FY13's total costs of $8.79 billion are very similar to Q1FY13's costs of $8.76 billion, even as the industry increases production.

But the negative side to high-grading is that it sacrifices future mine production for cheap present production. It ends up reducing the average grade of the rest of the mine because the high-grade zones are no longer mined with lower grade material as per efficient mine plans.

The reason why we believe that what we're seeing is high-grading is because of the suspicious rise across the industry in production, and a similar drop in costs. The cost drop is expected because miners are certainly cutting G&A, exploration, and other costs, but a uniform rise in production across many different miners in just a single quarter is not a normal occurrence.

If it were one, two, or a handful of miners that increased production in the quarter that wouldn't be abnormal, but everybody increasing production in a single quarter or two suggests that this is more about mining richer ore than anything else. Geology certainly does not change overnight.

Conclusion for Investors

As we stated earlier, the most important thing gleaned by this information is regarding the impact on the gold price that production costs should and will have. Even though this quarter's production costs dropped to $1244 per gold-equivalent ounce, they are still above the current gold price (as of December 2013) and that means that miners cannot sustain operations at the current scale without a higher gold price.

Additionally, if miners are truly high-grading their mines as some of the data suggests, that would mean that the $1244 cost that was achieved in Q3FY13 itself is unsustainable, and in future quarters as high-grade ore is depleted, we may see costs rise substantially even as production drops.

Now, predicting the gold price in the short term is no better than educated guesswork, but over the medium to long term the industry needs higher gold prices to sustain itself. That means that we still believe strongly that in the next few years we will see a higher gold price, as basic economic laws assert themselves even without any bullish financial catalysts for gold.

That's why investors looking for investments (note we did not say "trades") that will perform well in the future should look no further than an investment in physical gold and the gold ETFs (GLD , PHYS, and CEF).

The miners on the other hand are much more risky than investments in physical gold and the ETFs. Costs are still high and make gold mining an unprofitable or very marginable business at current gold prices. Though we do note that cost-cutting is occurring, and that should set the industry up to be much more efficient and profitable when the gold price does rise - the problem is the question of when that will happen.

If we get a rise in the gold price in the short term, then current miner valuations would suggest a very large increase in share prices. But if gold prices linger at current levels or even drop further then miners are not good values at current share prices, and many of those with weak balance sheets could be desperate for cash to maintain operations - which is not very good for current shareholders. Thus investors should tread carefully in the mining sector unless they have a strong belief in a short-term rise in the price of gold.

Investors should feel confident buying gold in the medium to long term, as the industry simply isn't sustainable at the current gold price. Additionally, if we are correct in reading the data that the industry is high-grading their mines to produce lower costs for the short term, then the reduction in third-quarter costs is a short-term temporary occurrence and future costs will be proportionally higher.

As they say, what can't go on forever won't, and the industry simply can't produce gold at the current price forever. We're either going to see a higher gold price, or we'll see much lower gold production totals in the future, and both of these outcomes are bullish for gold investors - it's only a question of when.

Disclosure: I am long SGOL, GG, AGI, SVLC, RIC. 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.