What If Gold Cost Of Production Is The Next Price Support Level

Includes: ABX, GDX, GG, GLD
by: Richard Shaw

Now that gold is in a bear market condition (down 20% or more from its 1-year trailing high), the question becomes where is likely support. There isn't much on the technical front to help, but what about fundamentals?

Unfortunately, because gold does not have metrics like P/E, P/B and dividend yield, we have to look elsewhere. Two areas that we think could make some sense are (1) the exchange of all currency in the world for gold (effectively an instant gold standard), and (2) the cost of production of new gold.

Exchange of All Currencies Globally for Gold

On October 31, 2012 (gold price $1,710) we wrote:

"Our logic would say that if we add up all the world's currencies in circulation and convert them all to their US Dollar value, and then divide that sum by the total number of ounces of gold that are estimated to be above ground at this time, then that is the paper money value of gold.

That number is about $1,100.

If that is true, then gold is either in a major overshoot at the moment, or currency in circulation is about to explode up by about 50%.

Both of those ideas seem plausible, but it should give some pause to see how far ahead of present currency in circulation the price of gold is. Price and value are not the same thing.

We are not saying gold is going to $1,100, but we are saying that one logical method of estimating "value" (not price) says $1,100."

We were, of course, brutally savaged by many commenters. That's what always happens when any negative views are presented about popular assets that are in strong up trends.

Cost of Production of New Gold

Similar to the cost of finding and raising new oil being a kind of price support for oil, the cost of producing new gold might be one area to consider price support for gold.

Interestingly, and most likely coincidentally, that number is quite similar to the exchange of all currency for all gold we just discussed.

Figure 1: 20-Year Gold Bullion Price
(shows plausible price support at gold "all-in" production cost)

The idea is that, except for short periods of time, producers of any commodity, including gold, either will not or cannot sell the commodity for less than it costs to produce it.

There are two key metrics for the cost of production: the "cash cost" and the "all-in" cost. The "all-in" cost represents not only the direct costs of extracting gold, but also all of the costs of exploration, administration, financing, royalties, regulatory compliance, environmental remediation, and whatever else must ultimately be spent per ounce as a result of mining.

Two of the very largest gold miners are Goldcorp (NYSE:GG) and Barrick Gold (NYSE:ABX). According to a Forbes article published on March 4, 2013, both Goldcorp and Barrick project "all-in" gold production costs between $1,000 and $1,100 per ounce for 2013.

Goldcorp reported a 2012 Q4 "all-in" cost of $910, and Barrick reported a 2012 Q4 "all-in" cost of $972.

The cost of production is rising rapidly due to a combination of lower grade ores and increased finding costs and compliance and remediation costs. That means price support based on this logic should be expected to rise rapidly too.

The same Forbes article said that a survey of 60 gold mining companies resulted in an average production cost of $1,391. Since the gold price is in that range already, a large number of gold miners will be unprofitable now.

The junior minors (NYSEARCA:GDXJ) as a group are in really tough shape with the current gold price and that $1,391 average cost. The major miners (NYSEARCA:GDX) have more old reserves and lower production costs, and are in less difficulty, but still have collapsing margins at today's gold prices.

If the "all-in" gold production costs of some major gold producers is a fundamental economic parameter, then it could well be the basis of a price support level for gold.

Figure 2 for the leading gold ETF (NYSEARCA:GLD) shows the approximate equivalent support price for that ETF should the "all-in" production cost serve as a price support level.

It also shows where GLD fell below a trend line in mid-2012, then failed to go above that trend line later that year, and now has broken below prior bottoms found at the beginning of and in the middle of 2012.

Figure 2: 5-Year Gold ETF Price

Of course, prices can and do swing well above and below logical or fundamental value levels. Gold is no different. The price could go lower than the production cost, but probably not for long. There is also no certainty that gold will decline to its production cost, but that is a reasonable possibility.

Given that "all-in" costs are rising rapidly (falling ore quality, rising costs and rising environmental remediation costs), gold will have those costs providing lift to the price over time, once it finds its bottom in this current move.

We suspect production costs are likely to rise at a faster rate than general inflation, which means that gold should rise at a faster rate than inflation, if production costs are a logical fundamental price support for the metal.

Disclosure: QVM has no positions in any mentioned security as of the creation date of this article (April 15, 2013). We certify that except as cited herein, this is our work product. We received no compensation or other inducement from any party to produce this article, but are compensated retroactively by Seeking Alpha based on readership of this specific article.

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