Why Gold Miners Are Poorly Leveraged To The Price Of Gold

 |  Includes: ABX, AU, GG, NEM, NG
by: Goombarh

Gold miners are economically known as price-takers, as they normally sell into the market and their sales would not be influential enough to move the market pricing for this golden commodity that they produce. Even as price-takers, the gold miners are presently selling their commodity in a rising price environment and should therefore be making good profits that attract investors to their stock. It would be reasonable to assume that a gold miner's stock price should leverage the gain in the price of gold. However, that is not the case presently, as written about here. This article will attempt to examine gold miners from various viewpoints, to ascertain what may be the issue in their poor leverage to the price of gold.

Operational Leverage - Not

In accounting theory, companies that have high fixed costs and low variable costs are classified as having high operational leverage. This means that the profitability of these types of high operational leverage companies are significantly impacted by the market prices of the product that they produce.

Contribution margin is the term given to the marginal sales of a product and is a measure of operating leverage. Marginal in this sense means that the large fixed costs are already captured and accounted for in the regular production and the marginal production would only carry the variable costs specific to that product. The simplistic formula for this contribution is "Contribution = Sales - Variable Cost". Contribution in this sense means the margin between cost of the product and the sales price of the product that might flow right through to the bottom line of net income for the company. Thus, the contribution from the marginal sales revenue has a great impact on the financials for a company.

An example of a high leverage company would be Microsoft (NASDAQ:MSFT). It has large fixed costs in product development but very little variable costs in sales of each piece of software. Furthermore, Microsoft determines the pricing of its product.

After researching and a great deal of rumination, the author comes to a conclusion that gold miners do not have operational leverage in their operations. The reasoning is this: There are no marginal sales, as each ounce of gold produced has to be excavated, transported and processed, incurring much cost for power, materials and labor. Each ounce of gold carries its own baggage of variable costs, which are relatively high compared to the selling price. Mining seems to be a unique activity with high fixed costs and also high variable costs. Furthermore, the market prices of the produced commodity gold is out of the control of the miner and is set by world market conditions.

Lower Gold Mining Grades

In business, there are many paths to take towards an end result of turning a profit, and in gold mining this is no exception. For miners in general, the acquisition of resources and reserves to mine is a never ending task. Geology in forming the gold deposits may not be even in the distribution of the gold grade within the deposit. In the start-up of a mine, the mine plan would usually attack the high-grade portion of the deposit first as that would make good economic sense. Therefore over time, as the mining progresses, the grades for processing become lower and lower. This is the case for Newmont Mining (NYSE:NEM) in its Yanachocha open pit gold mine in Peru and its Boddington mine in Australia.

In thinking along these lines, it would make sense for any miner to mine their higher grades first and save the tailings and low grades for the future and the end of the mine. If that is the case, then all miners should be experiencing a trailing off of the grades as they continue to mine out their deposits. Therefore, unless the mine is new, the gold grades being mined should be expected to become lower with time and reduce production levels and revenue and increase costs in the future for the miner.

Spiraling Costs

In order to be competitive and attract investors, gold miners need to manage their costs and earn a profit, eventually - a fundamental concept. These miners, participants in the gold mining industry shoulder an enormous amount of fixed costs in order to build and operate a gold mine. It is a very capital intensive industry, requiring huge outlays of money to build the infrastructure for a mine and also for the continued operation of the mine. An example of the capital required for a project was detailed in a recent November 2011 feasibility study for a JV between NovaGold (NYSEMKT:NG) and Barrick Gold (NYSE:ABX). The sum of $6.7 billion is what the study concludes is needed for the huge Donlin Creek project in Alaska, with 39 million ounces of gold resources. The plans for Donlin Creek include $1 billion for a 300 mile natural gas pipeline. With a small NPV of $547 million (5% discount rate) for Donlin, and IRR of 6% ($1200 gold price) for the project and the huge capital costs involved, it is doubtful that this project will ever be constructed. It's a small miracle that any mine gets built and operated successfully, considering all the obstacles that are stacked against it.

The source of power for mining is a key cost variable as fuel typically forms about 25% of the costs for a miner. For 2011, the world price of petroleum mostly stayed above $100 a barrel, adding excessively to the gold miners costs of operations. Along with the price of gold moving higher, the inflation pricing of all the components needs for gold mining has risen as well. Prices for transport, materials such as steel and cement and skilled labor, have all risen.

Steve Letwin, CEO of IAmGold (NYSE:IAG) made a statement on February 6, 2012 referring to gold mining costs:

Most of it being lower grade and in more remote locations... it's going to be difficult for anybody to produce gold at less than $1200/oz.

Mark Cutifani, CEO of AngloGold Ashanti (NYSE:AU) gave his own confirmation of the costs of mining gold on February 16, 2012:

if you want to go on a total cost basis, we're running at about $1200. The industry average is probably around $1250

This is an all-in cost for gold production, coming from two knowledgeable mining CEOs, where the miner would not make money should the gold price decline to lower than that. This number may be surprising for some readers when we see the oft-quoted cash costs per ounce of around $500 per gold ounce produced.

With the price of gold at $1720, as of February 19, 2012 and the all-in cost of $1250, that would be a 27% margin for gold miners presently, not an overly large number. Therefore shareholders are less than ecstatic and are shying away from gold equities, preferring the metal instead and not having to endure the manifold mining risks.

Share Dilution

Pollitt & Company have this interesting view from June 2011 about stock dilution for the gold miners:

While the price of the average share in the Canadian-11 has underperformed gold, the increase in their combined market cap has almost doubled that of the metal. While the average international miner's market capitalization is still underperforming gold, this market cap is still increasing twice as fast as the average international miner's share price.

His thesis about the growing market capitalization versus less stock price growth is intriguing, indicating the miners were diluting the value for shareholders, I performed my own testing using historical data for Barrick and Goldcorp (NYSE:GG) over the last five years. I found that the resulting data plots showed a little more growth for market capitalization, but not nearly enough to explain the underperformance in the expected share price appreciation due to the rising gold prices. Therefore, I am skeptical of the explanation that the gold miners are over-diluting the existing shareholders of the value that should be created by the rising gold price.

No Gold Mining Leverage Outlook

In summary, I harken back to a chart showing the HUI Gold Bugs Index relative to the price of gold displayed following: (Click to enlarge)

Click to enlarge

One main observation can be made from this chart above; the large gains of the gold equities were made during the rise from the mining lows of 2000 and the crash of 2008. The easy gains are already accomplished and the equities are now gyrating violently, possibly in a topping formation. In fact, one may make a case that there is a head and shoulders formation showing for 2011, similar to the one in 2008 just prior to the crash. The author is not foretelling a crash, only a leveling off of the gold price for the intermediate term, similar to 2006.

The other conclusion is that gold mining is not an easy endeavor and due to the spiraling costs of gold miners, the market is not embracing the value of their growth stories. This hiatus in gold miners stock price leverage will stay until either of these two things happen: One - gold prices need to break higher still to give the miners more enduring profits and two - time has to pass to let the market realize that higher gold prices are a reality that stays with us for the longer term.

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

Additional disclosure: Equities mentioned – HUI index, gold, NG, ABX, IMG, AU, GG, NEM

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