It only took eleven years, but in 2011 global gold-mine production has finally returned to pre-bull levels. In fact, with 2011's volume expected to come in at around 88m ounces, we'll see a new all-time production high. The latest exploration-and-development cycle is finally starting to bear fruit.
This fruit has been hard-earned though, as the miners have had to reverse the course of a brutal production decline that bottomed out in 2008. Incredibly global gold production had fallen nearly 13% in five years from 2003's high, to a level not seen since the mid-1990s. Needless to say, that painted quite an alarming fundamental picture considering demand was on the rise.
Thankfully, in the last three years the miners have diligently worked to grow production, adding about 15m ounces per year to supply at 2011's rate. We've seen this production growth on a variety of different fronts. The miners have brought back to life past-producing mines that now have positive economics at the current gold price, they've expanded existing mines to push through more material, and they've built brand-new mines to tap the latest generation of discoveries.
This growth is the product of billions of dollars of capital investment, along with a healthy dose of blood, sweat, and tears. Gold mining is a tough business, especially in a world where gold is getting harder and harder to find. And the miners in the trenches getting their hands dirty to bring us the shiny-yellow metal we so crave must be rewarded for their endeavors.
This reward comes in two main forms, profits and stock appreciation. If a miner can sell its gold for more than what it costs to produce it, it should make a profit. Operating profitably obviously goes a long way towards its stock price heading higher. As investors, both profits and stock appreciation capture our attention. And with now hundreds of gold-producer stocks to choose from, we have a myriad of options.
One way to break down these options, at a high level, is to figure out where the miners fall in the global supply chain. By categorizing the miners into like peer groups, investors have a mechanism for identifying outperformers and underperformers, while also gauging risk.
First and foremost are the majors, which naturally own the largest piece of the production pie by far. And thankfully many of these miners have NYSE listings, giving investors easy access to their liquid stocks. As a group most of the world's biggest and best gold-mining stocks reside within the venerable NYSE Arca Gold BUGS Index (HUI).
The HUI is comprised of 16 stocks (most of which are dual-listed on the Toronto Stock Exchange), including the world's six largest gold miners [Barrick Gold (NYSE:ABX), Newmont Mining (NYSE:NEM), AngloGold Ashanti (NYSE:AU), Gold Fields (NYSE:GFI), Goldcorp (NYSE:GG), and Kinross Gold (NYSE:KGC)]. This index is rounded out by several other top major and intermediate producers. And with combined production of around 33m ounces, it is the bellwether vehicle that investors look to for strategic movements in the gold-stock sector.
But though the HUI components combine to account for about 38% of gold's total mined supply, 50m+ ounces per year of production coming from outside this camp naturally allows for many more investment options. Interestingly though, most investors aren't familiar with where the rest of these ounces come from.
Even though the US and Canada tend to be the hubs for natural-resources stocks, particularly gold stocks, not all companies list on their big-board exchanges. Companies like Newcrest Mining (OTCPK:NCMGF) (world #7, ~2.5m ounces) and Polyus Gold (OTCPK:OPYGY) (world #10, ~1.5m ounces) have their respective primary listings in Australia and London for example. U.S. investors can buy these stocks via the Pink Sheets, but that realm is only for experienced traders.
Another big chunk of this 50m+ ounces are from mining companies that produce gold as a byproduct, with Freeport-McMoRan (NYSE:FCX) being the best example. Even though FCX produces about 1.6m ounces of gold per year (ranking it in the top 10), it is better known as the world's largest publicly-traded copper miner. FCX's gold only accounts for about a fifth of its total revenue. There are many other mining companies like FCX that do produce gold, but as a subservient mineral to say copper, zinc, or silver. These companies' stocks are not what investors should own if they are looking for gold exposure.
Also part of non-HUI gold production is the 11m or so ounces produced in China, and the nearly 3m ounces produced in Uzbekistan. And unfortunately most of these ounces are inaccessible to US investors. As for China, while there are some exchange-listed companies (Zijin Mining Group listed on the Hong Kong Stock Exchange is the largest), the majority of its gold is produced by smaller miners that are either government-owned, don't have a stock listing, or are illegal. And since most of the gold production in this country is consumed domestically, there isn't much motivation to formalize China's gold-mining industry.
In Uzbekistan most of its gold comes from the massive Muruntau mine, the largest open-pit primary gold mine in the world (~1.8m ounces). Interestingly Newmont was in this country for a while, producing gold from Muruntau's tailings, but its assets were illegally expropriated. Muruntau, another massive gold mine under development, and the rest of the Uzbek gold mines are operated by state-owned companies. And this precludes any type of foreign investment.
Moving down the rungs are the world's intermediate, or mid-tier, gold miners. And thankfully investors have dozens of options with their stocks. In the U.S. and Canadian markets investors have access to such companies as AuRico Gold (NYSE:AUQ) (~470k ounces), Alacer Gold (OTCPK:ALIAF) (~440k ounces), and Osisko Mining (OSKFF.PK) (~640k ounces). And in the foreign markets Petropavlovsk (OTC:PPLKF) (~680k ounces) and St Barbara (OTC:STBMF) (~350k ounces) are among the better known.
I categorize this mid-tier group as those miners that produce between 200k and 800k ounces of gold per year. From a risk perspective these mid-tiers are naturally going to be a bit more risky than the majors. They usually don't have the operational diversification and financial strength of the majors. And because of their smaller size, they tend to hold more downside risk when gold stocks fall out of favor. But their smaller size does have its benefits. The mid-tiers are always acquisition targets, and they can move to the upside a lot faster when capital chases gold stocks.
Rounding out the mined supply of gold are those ounces attributable to the juniors. Junior producers are gold companies that produce less than 200k ounces per year. It is in this realm where investors will find the most abundant population of stocks. In my recent survey of junior producers, I tallied nearly 100 that list in the U.S. and Canada alone. And it is these stocks that offer investors the biggest risk/reward trade-off.
Even though the output of any individual junior is miniscule in the grand scheme of things, in aggregate this group is very important in the global supply chain. In 2011 these miners produced a combined 5.5m+ ounces, which is very material. But even more important than this volume is their role in the gold-mining ecosystem.
Provocatively most juniors either didn't exist or weren't producing gold a decade ago when this bull was just getting started. Capital from retail investors, their primary source of funding, was essentially non-existent. Gold mining was not sexy, and there wasn't much money to be made with where gold's price was at.
But as gold gained popularity, and appreciated in price, the market for these juniors quickly opened up. Investors craved the rapid gains that could be won with these stocks, and the larger producers were desperate to replace their reserves and bolster their portfolios (most of which were quite neglected amidst gold's secular bear).
The entrepreneurial geologists that formed these juniors were among the first to take the risk of exploring for gold in this new bull. They risked their capital and their livelihoods scouring the world for the next generation of gold deposits. And over the last decade they've been invaluable contributors to the supply chain.
Juniors' contributions have been both seen and unseen over the course of this bull. Seen are the juniors operating their own mines today. And unseen are those countless many that have been acquired. It's no secret that many of the new mines that the mid-tiers and majors are bringing online were originally discovered and/or developed by the juniors.
So as investors, how are we to look at juniors? Most important is we need to accept the juniors for what they are in the world of gold stocks, risky. When you look at the profiles of these companies, you'll first notice that most operate only a single mine. This obviously gives them a higher level of risk due to the lack of diversification.
Junior producers also have financial risk, with their balance sheets and cash flows nowhere near as strong as the mid-tiers and majors. As for their balance sheets, the good news is most juniors don't have much debt since they raised most of their capital via equity financings. But you'll also find that most are cash-strapped, with very little working capital. They are either recovering from the big draws of a recent mine build, or are in the process of aggressive exploration and/or development programs in their quests to find/build their next gold mines.
Their balance sheets also tend to be weak due to a lack of cash-building income. Even though these juniors are now generating revenue, cash flow is not yet material enough to quickly build back up the treasury. With average annual production of only 79k ounces, the juniors aren't exactly drowning in cash. Margins also tend not to be as good in this realm, as juniors' costs are on average higher than those of their larger counterparts. As part of my research I carefully examined cash operating costs. And as you see in the chart below, this difference is quite substantial.
In 2011 the average cash operating costs for juniors was $723 per ounce, compared to $574 per ounce for the larger miners that comprise the HUI. On average it costs 26% more for the juniors to produce their gold than the majors. This difference is indeed considerable, and I've found there to be a number of reasons for such a spread.
First and foremost it is imperative to understand that mining costs in general, for all miners, have been sharply rising in recent years. Amazingly back in 2006 average cash costs for the world's major gold miners was only $250. A double in only five years seems excessive, but in reality things aren't as mismanaged as perceived. Some of this rise is naturally attributable to rising materials, labor, and energy costs, but much of it has to do with the quality of the ore sent through the mills.
With the price of gold on the rise, miners have had the luxury of intentionally "low-grading" existing operations (saving the higher-grade material for lower gold prices). They've also been building new mines on deposits that are either low-enough grade or have complex-enough geology where the economics are only feasible at higher prices, and juniors in particular fall into this camp. Ultimately squeezing an ounce of gold out of the earth from lower-quality/higher-complexity ore is going to be more costly.
Expanding on the ore-quality issue, junior producers often have a tougher time planning and controlling their grades. Prior to development many either don't go through the effort (advanced drilling and metallurgical testing) necessary to understand their deposits, or don't have the money to pay for feasibility studies that would prove up their resources. When the planning/engineering/design isn't thorough, operations are likely to struggle. And when the grade control isn't optimized, costs are going to be higher.
Overall juniors' operational and financial risk definitely makes their stocks more speculative than the larger gold stocks. But don't let their challenges dissuade you from dabbling in this realm. The rewards for owning the right junior producers, at the right time, can be legendary.
Remember that these juniors are producing gold in a gold bull. And even if this gold is being produced at a higher average cost, there is still plenty of margin to be had. Even at these higher costs, 2011's margins were some of the best ever seen. With 2011's average gold price of $1573, the majors and juniors scored respective gross per-ounce cash margins of $999 and $850. This is vastly better than 2006, where an average gold price of $604 yielded margins of only $350.
And if the margin differential between the majors and juniors makes you think twice about investing in these smaller producers, keep in mind that it takes a lot more capital to push a high-market-cap stock higher than it does a smaller-market-cap stock. When gold stocks gain popularity, it doesn't take much capital chasing the juniors for their stocks to soar higher.
It is also important to consider the attractiveness of juniors as growth stories and acquisition targets. Quality juniors won't remain juniors for long. They'll either grow organically or via mergers and acquisitions, or they'll be snatched up by the larger mining companies. And the majors are now really starting to swing around their capital considering gold stocks' general undervaluation after being out of favor for so long.
Most important for investors considering juniors is effective due diligence. The cash-cost average in the chart above is just that, an average. Several juniors are producing their gold at costs over $1000, and several are producing at costs under $500. Some juniors are losing money, are poorly managed, and have low-quality assets. Meanwhile others are making money hand over fist, have top-shelf management teams, and own spectacular portfolios of assets.
The bottom line is when the dust settles on 2011, the gold market will likely have seen all-time record supply from mine production. The miners have finally taken heed to the call of this gold bull, and as a result stock investors have seen their options greatly expand over the years.
The reliable major producers continue marching along, pumping out a large chunk of the global supply. The mid-tier group remains strong, its population flowing and ebbing as graduating juniors replace those leaving due to M&A. But the most dynamic group of all is the juniors. Juniors have been paramount to the growth of this industry, and they continue to pioneer the exploration and development of the next generation of gold mines. Fortunately for investors junior-producer stocks are plentiful, and the quality ones have the potential to deliver huge gains.Disclosure: