First Quarter 2013 True All-In Cost Silver Industry Figures: Unsustainable Silver Prices

by: Hebba Investments

Over the last month we have been analyzing and posting the silver industry's true costs to mine each ounce of silver. We have analyzed all the major publicly traded primary silver producers, which includes close to 19 million ounces of mined production for Q1FY13 - a very large portion of the total worldwide production of silver (estimated at over 190 million for Q1FY13). 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 silver ETF investors (SLV, SIVR, CEF, and PSLV) this metric is very important because it allows an inside understanding of the true costs associated with producing each new ounce of silver. 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 lowered, cause scarcity, and then the price will increase.

Calculating the True Mining Cost of Silver - Our Methodology

In our previous analysis of 2012 true all-in silver costs for silver miners, 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

Cost Per Silver-Equivalent Ounce - is the costs incurred for every payable silver-equivalent ounce. It is Revenues minus Net Income, which will give an investor total costs. We use payable silver and not produced silver, because payable silver is the silver that the miner actually keeps and is more reflective of their production. Miners also use payable silver and not produced silver when calculating their cash costs, so this is pretty standard.

We then add Derivative Gains (or minus Derivative Losses), which will give investors total costs without the effects of derivatives. Finally, we add Foreign Exchange Gains (or minus Foreign Exchange Losses) to remove the effects of foreign exchange on the company's costs.

Cost Per Silver-Equivalent Ounce Excluding Write-downs - is the above-mentioned "Cost per silver-equivalent ounce" minus Property/Investment Write-downs and Asset Sales. This provides investors with a metric that removes exceptional gains or losses due to write-downs and asset sales.

Cost Per Silver-Equivalent Ounce Excluding Write-downs and Adding Smelting and Refining Costs - is the above-mentioned "Cost per silver-equivalent ounce excluding write-downs" adding in smelting, refining and all other necessary pre-revenue costs. This is a new metric that we are now introducing to our true all-in cost series because it will more accurately measure all-in costs and allow comparisons between miners.

Most investors are unaware that many miners will remove smelting, refining, and other costs before reporting their total revenues figures and these pre-revenue costs are not reported in the income statement. The result of this is that it skews all-in costs higher for miners that refine themselves or include the costs in their income statement, while inaccurately showing lower costs for miners that remove it before reporting revenues.

A simple test can be done on any miner to see if there are any pre-revenue costs that are not reported in the income statement. Simply take payable production and multiply it by average realized sales price and this should come relatively close to the total revenues figure. If it gives you a number much higher than reported revenues then there are pre-revenue costs that are not being reported.

This line should alleviate these issues and allow comparisons on a fair basis.

What are the Industry's Silver Costs?

We have compiled all the numbers for silver companies that we analyzed for 2011 and 2012 and provided them in the table below. The companies included (with links to their associated detailed calculation pages) are: Pan American Silver (NASDAQ:PAAS), First Majestic (NYSE:AG), Coeur d'Alene Mines (NYSE:CDE), Gold Resource Company (NYSEMKT:GORO), Alexco Resources (NYSEMKT:AXU), Great Panther Silver (NYSEMKT:GPL), Hecla Mining (NYSE:HL), Endeavour Silver (NYSE:EXK), and Silver Standard Resources (NASDAQ:SSRI).

Important Note: For our silver equivalent calculations, we have adjusted the numbers to reflect the Q1FY13 average LBMA price for all the metals. This results in a gold ratio of 1:30, copper ratio of 8.4:1 (pounds to silver ounces), lead ratio of 29:1 (pounds to silver ounces), and a zinc ratio of 32.6:1 (pounds to silver ounces).

This will also lead to minor differences in our previously published true all-in silver costs for the industry since in our 2012 analysis we used Q4FY12 LBMA average prices, while for this quarter we used Q1FY13 LBMA average prices.

(Click to enlarge)

Note about write-downs: A positive write-down value signifies a loss, while a negative write-down signifies a profit. The primary cause of the 2012 write-downs was related to a $100 million fourth quarter charge PAAS experienced which was partially offset by a $50 million asset sale gain by SSRI. The primary cause for the 2011 write-down was a $88 million asset sale gain by SSRI.

Observations for Silver Investors

True Cost Figures - Investors can see that true all-in costs continued to rise on a sequential and year-over-year basis, averaging $25.21 for Q1FY13.Though compared to the 2012 average price of $25.20, first quarter costs were relatively flat and may be showing silver costs starting to stabilize - though we will feel more comfortable with that assertion when we see second and third quarter costs.

Since the first quarter silver price averaged around $30 per ounce, the average miner had a slim profit on a true all-in cost basis. But after the recent drop in silver prices, most silver miners are now producing silver deep in the red. True all-in costs will have to drop significantly for miners simply to break-even at current silver prices.

These rising costs are not only something witnessed in the silver industry, but are being experienced by miners across the board. This was even addressed recently by Barrick Gold (NYSE:ABX) CEO Jamie Sokalsky when talking about the future shortage of gold. The reasons why costs are rising significantly are beyond the scope of this article, but they are a combination of lower ore grades, less discoveries, energy and materials inflation, and a lack of new technologies.

This should not be that surprising and investors can look at the oil industry as an example. After the break-through in shale development and the US increasing its oil supply by very large amounts, oil is still hovering in the $90 range - what would be the price of oil if shale reserves had not been viable? This is exactly what we are seeing in the mining industry - a lack of new techniques and technologies is causing costs to rise significantly as cheap ore bodies are exhausted. These are structural increases in price and not due to management and operational inefficiencies.

Production Numbers - Silver production increased on a year-over-year basis by around 600,000 silver ounces from 18.3 million ounces in Q1FY12 to 18.9 million ounces in Q1FY13, which is a little over 3% rise in total silver production. But on a sequential basis, silver production dropped about 1 million ounces from 19.9 million ounces in Q4FY12 to the current 18.9 million ounce level. Finally, extrapolating current first quarter numbers will lead to production numbers of around 75 million ounces for 2013 from the covered silver miners, but we think that this number will be much lower as silver miners cut production to conserve costs in the current low silver price environment.

Conclusion and Investor Takeaways

Using this information offers investors a number of valuable takeaways. For investors in the silver ETF's (SLV, SIVR, PSLV, and CEF), the true cost of silver production is arguably the most important metric to understand for their investment. Understanding the true cost of producing an ounce of silver allows investors to see the sustainability of silver prices on a long-term basis.

According to the recent quarterly numbers, it shows that many silver miners produce silver around $25 per ounce on a true all-in cost basis. In the first quarter, this allowed for a little profitability amongst miners (at $30 silver) but with prices around $22 per ounce, we expect the majority (if not all) miners to report negative net income for the second quarter.

First and foremost this means that silver miners will have to drastically cut costs to conserve capital. Management teams at almost all silver miners have already announced cost-cutting initiatives, and we expect as a result of these initiatives that silver production will be reduced in the second quarter as new mine development is delayed (Alexco announces mine commissioning will be delayed) and lower grades are avoided. Miners are also significantly cutting exploration budgets, which will reduce future silver production and may cause structural shortages of silver for industrial use associated with any economic recovery.

These developments are very bullish for silver investors because we expect both second quarter and FY2013 silver supply to be cut as miners try to adjust to significant losses on their silver production. Second and third quarter numbers should be very interesting as we see how much miners can cut their costs and production to try and stay afloat.

Maybe one of the best things that can happen to silver is if prices drop below $20 or stay at current levels for an extended period of time. This would not only cause significant losses for many miners, but it would call into question the viability of most primary silver miners. That is because as we mentioned earlier, we believe that the rise in true all-in costs are not due to management or operational inefficiencies, but are due to structural mining issues and will not be solved by cutting costs.

Long-term silver investors should be accumulating silver aggressively at these prices and hoping for further price drops. The further the price drops, the more it will suffocate miners and cause future silver supply to plummet. If investors can take a long-term view of silver, there is a huge opportunity here for patient investors to take advantage of the current silver price and buy silver that is produced at a loss by most miners.

We know it's difficult for investors to think long-term nowadays, but it is a necessity for wise investors. We think that when sentiment changes and traders and silver shorts realize that silver at $20 is not sustainable the price will jump significantly - at that point silver investors will have wished they had bought more silver at $22 per ounce.

Disclosure: I am long PAAS, SIVR, PSLV, EXK, AG. 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.

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