What's Taking The Shine Off Barrick Gold?

| About: Barrick Gold (ABX)
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Barrick Gold Corporation‘s (NYSE:ABX) has seen its stock price plummet in the last month from about $21 to $14-15, a precipitous drop of nearly 25%. It’s not just Barrick Gold that’s reeling – almost all miners operating in the precious metals space are sinking in the same boat. However, as the world’s largest gold producer, Barrick gets intense scrutiny from investors as a barometer for the industry’s health.

Barrick’s problems are being caused by macroeconomic as well as company specific factors. The Federal Reserve Chairman Ben Bernanke has hinted at the possible withdrawal of the quantitative easing program later this year as long as the economy continues its recovery, and this is being held responsible for plummeting gold prices. Also, Barrick has been forced to delay the first production from its Pascua Lama mine in Chile and Argentina from late 2014 to mid-2016.

Declining gold prices and production delays has forced the company to announce a $5.5 billion impairment charge against the Pascua Lama project. Some investors fear that this is just the beginning and that there are more impairments in the offing (Barrick Provides Updates on Pascua-Lama Project, Barrick News Release).

Plunging Gold Prices

The price of gold suffered a nearly 15% drop in the second half of June alone. It touched a new low of $1,180 per ounce towards the end of June before rebounding slightly to cross the $1,200 mark. Things were set into motion after the Ben Bernanke announced that if the U.S. economy and job market continue to improve, the quantitative easing program could be reduced or withdrawn later this year. Right now, the Federal Reserve is pumping nearly $85 billion into the economy every month (Gold Price Charts, Kitco).

The withdrawal of monetary injection could lead to a drop in inflation and a rise in interest rates. Gold is preferred as an investment because it is seen as a hedge against inflation and as an instrument that generates high return in a low interest rate environment. If inflation peters out and interest rates rise, the attractiveness of gold as an investment avenue will be reduced. The U.S. economy appears to be strengthening and money is flowing out of emerging markets back into the U.S. as future expectations strengthen. Within the U.S., money is flowing out of the relative safety of gold and silver into equities, thus exerting downward pressure on gold and silver prices.

Since gold is not a productive asset, it has little fundamental value of its own. This leads to wild price swings at times due to speculation that triggers herd behavior in buying or selling. We think that the recent fall in price has an element of panic to it and the sell-off is a bit overdone.

High Production Costs Will Limit Decline In Prices

While gold may have no fundamental value of its own, its production cost can serve as a backstop to plunging prices. In 2012, Barrick reported an average all-in sustaining cash production cost of $919 per ounce of gold. Since Barrick is the cheapest producer of gold in the world, other companies’ costs are much higher. Players like Kinross, Newmont and Goldcorp have production costs in the range of $1,038-1,135 per ounce. The costs are not stagnant, and they are ballooning year-over-year due to rising costs of labor, energy, exploration and development in geographically challenging regions, and royalty payments to governments across the world. Barrick expects a cost figure of $950-1,050 per ounce in 2013 (What is the Cost of Mining Gold?, Visual Capitalist).

In addition, many companies need to service their significant debt burdens and meet dividend commitments to investors. Barrick alone had a debt of nearly $14.8 billion on its balance sheet at the end of Q1 this year, which is quite high as compared to its peers. Companies are also expected to invest in exploration and development for future growth. In short, significant free cash flow is needed. The present price levels make it all but impossible for small and medium scale gold miners to survive. If the present price levels persist, many of these companies will go out of business, major miners will shut down high-cost mines and supply will fall. Once the demand-supply equilibrium is re-established, prices are likely to go up. However, if the economy is doing well they won’t regain previous levels.

Woes At Pascua Lama

Barrick announced a few days back that based on preliminary assessments, it expects to take an after-tax asset impairment charge of $4.5-5.5 billion in the second quarter for the Pascua Lama project. The impairment was triggered by falling gold prices and the additional one and a half year delay announced by the company before production can commence. This delay, in turn, has resulted from a Chilean court order that bars Barrick from developing the project before it complies with regulatory demands. The company needs to carry out the construction of canals and drainage systems to divert run-off water away from the Pascua Lama mine. This is likely to take time (Chilean President gives Barrick Gold its Pascua-Lama fix-it orders, The Globe And Mail).

Barrick has already spent close to $5 billion in capital expenditure at the Pascua Lama project. The total budget currently stands at $8.5 billion after a nearly three-fold rise over the years from its original estimate. The company has decided to reduce its capital expenditure at Pascua Lama in 2013 by approximately $700-800 million (which includes the $300 million in previously announced deferrals) to $1.8-2.0 billion. Capital expenditure in 2014 is expected to be reduced by approximately $0.8-1.0 billion to approximately $1.0-1.2 billion. It will provide an updated capital cost schedule in the third quarter. In all likelihood, total capital expenditure will exceed currently budgeted levels by the time the project is complete. This has led some to question why Barrick isn’t simply walking away from the project. We think that this is due to the company’s expectations about the long term benefits from Pascua Lama. The mine is expected to have an all-in sustaining cash cost of just $50-200 per ounce and produce 0.80-0.85 million ounces of gold per year for the first five years, contributing to about 11% of Barrick’s revenues. The life of the mine has also been estimated at 25 years. The long-term benefit vis-a-vis cost is still up for debate, but Barrick’s revenues for the next two years are sure to take a big hit from previously projected levels (Barrick Gold Delays Production at Pascua Lama Mine, Sets Big Charge, WSJ).

More Bad News In The Offing?

In announcing the $5.5 billion impairment, Barrick stated that it is still in the process of impairment testing for other assets, including goodwill. The company is carrying $3.5 billion as goodwill on its balance sheet on account of its acquisition of Equinox Minerals in 2011. With copper prices plunging, the market expects a significant write down in this value. Also, its Buzwagi mine in Tanzania has a book value of $747 million, and is vulnerable to weaker gold prices and higher operating costs. Therefore, there may be a write down in value for this asset.

Based on a weak outlook for gold prices in foreseeable future and setbacks at the Pascua Lama project, we have revised our price estimate for Barrick Gold to $19.

Disclosure: No positions