What It Really Costs To Mine Silver: The Second Quarter Pan American Silver Edition

| About: Pan American (PAAS)


In an earlier article, we discussed one of the most important metrics to analyze the silver industry, the actual cost of mining an ounce of silver, which can help an investor figure out whether it is time to buy SLV and/or the silver miners. In that analysis, we used the FY2012 financials to calculate the combined results of publicly traded silver companies and come up with a true all-in industry average cost of production to mine each ounce of silver.

In this analysis we will calculate the real costs of production of Pan American Silver (NASDAQ:PAAS). Pan American Silver is one of the largest primary silver producers in the world and they have operations that span North and South America. Their countries of operation include Argentina, Mexico, Peru, Bolivia, Canada, and the United States.

Calculating the True Mining Cost of Silver - Our Methodology

In the previously mentioned article, 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, and I would encourage all precious metals investors to understand this concept.

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. When we remove a write-down we also remove the estimated tax benefit (we estimate at a flat 30% rate) since removing the write-down without the tax benefit will skew the results in favor of the company. For example, if a company reports a $100 million write-down, we will remove $100 million from costs and then add $30 million to costs to represent the taxable benefit this write-down had on the company's earnings. Thus the total removal will only be $70 million not $100 million.

This line is intended to provide 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 it will not be present 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.

Real Costs of Production for PAAS - Q2FY13

Let us now use this methodology to take a look at PAAS's results and come up with their true all-in cost figures. When applying the methodology for the most recent quarter and FY2012, we standardized the equivalent ounce conversion to use the average LBMA price for Q2FY13 which results in a silver-to-gold ratio of 61:1, copper-to-silver ratio of 7.1:1, lead-to-silver ratio of 24.8:1, and a zinc-to-silver ratio of 27.8:1. Investors should remember that our conversions change with metal prices and this will influence the total equivalent ounces produced for past quarters - which will make current-to-past quarter comparisons much more relevant.

Notes about True All-in Costs Table: Since we've updated our gold-to-silver ratio to 61:1 it has lead to a drop in true all-in costs for silver miners with large gold output (such as PAAS) since that gold output will convert into a larger amount of silver-equivalent production. The ratio has been applied to ALL previous quarters so that comparisons can be done on an apples-to-apples basis.

As we have stated before, large write-downs force us to estimate the taxable benefit of the write-down in the process of write-down removal. We estimate this taxable benefit at 30% of the write-down's value. The problem with large write-downs is that any small change in the taxable benefit can significantly change the all-in costs. For example, with PAAS if taxable benefits were assumed to be 25% instead of 30% then costs would be lower by 5% of $181 million (around $9 million) which would lower true all-in costs by close to $1.00 per silver-equivalent ounce. Unfortunately, this is a necessary evil with large write-downs and investors can use the above table to estimate the write-down tax benefit at whatever their desired tax level.

Observations for PAAS Investors

The first thing that investors should note about PAAS's Q2FY13 true all-in costs is that they rose to approximately $26.95 per silver-equivalent ounce. This was a significant rise on a sequential and year-over-year basis, and even was much higher than the $23.84 cost realized for FY2012.

As we have emphasized with other silver miners that saw a large increase in Q2FY13 costs, one quarter does not make or break a company of the size of PAAS, but investors should note the rise in costs. In the company's defense, large write-downs do add some assumptions to the true all-in costs figures, but regardless costs were much higher for PAAS in Q2FY13.

The only other primary silver miner we have done in Q2FY13 is Coeur d'Alene Mines (NYSE:CDE) (costs over $30). But the Q1FY13 costs comparisons may be useful of Silver Standard Resources (NASDAQ:SSRI) (costs just under $30), Great Panther Silver (NYSEMKT:GPL) (costs around $29), Endeavour Silver (NYSE:EXK) (costs around $25), Hecla Mining (NYSE:HL) (costs around $25), Gold Resource Company (NYSEMKT:GORO) (costs around $28), and cost-leader First Majestic Silver (NYSE:AG) (costs just under $22). Again, these are Q1FY13 numbers so the comparisons are not apples-to-apples but are just to establish a general range.

Corporate Liquidity - Liquidity is very important for investors to monitor in this current low-price silver environment especially since PAAS's costs are currently much higher than the spot price of silver. Based on the Q2FY13 balance sheet, PAAS had $238 million in cash and cash equivalents, $200 million in short-term investments, and around $35 million in debt. Though cash and cash equivalents are down around $50 million from the previous quarter, PAAS still seems to have plenty of cash to avoid any sort of near or intermediate cash crunch.

Production Numbers - Production numbers for silver and gold have been dropping slightly on both a sequential and year-over-year basis, which has led to drops in silver-equivalent production. Increased production of lead, zinc, and copper production has negated a little of this drop in precious metals.

Other Notes - Though beyond the scope of this article, it seems that management has precisely timed the bottom of the precious metals market to hedge a significant amount of production. As investors, we absolutely hate companies that hedge because it limits the upside of our investments because higher precious metals prices will not result in higher earnings, while not limiting the production and exploration risks of the miners. The fact that PAAS management decided to hedge after a two-year decline in the price of silver, punctuated by a greater than 30% six month decline in the silver, seems to us like a horrible decision.

Additionally, PAAS seemed to have plenty of liquidity to survive in a low silver price environment for quite some time, so there was no cash crunch requiring the company to hedge. We believe that this was a very poor decision done at a bad time and would hold this decision as a very large negative against the company.


True all-in costs rose in Q2FY13 for PAAS from previous quarters and FY2012, but were still at levels that are not extremely high compared to other miners. Liquidity is at sufficient levels for PAAS, and production increased in base metals while dropping slightly for precious metals.

We believe the big news for the quarter was the poor decision by management to hedge production at close to the lows of the market. As investors we thing this was a bad call by management and significantly limits our upside on a significant quantity of the company's silver and gold output. We think other unhedged miners offer a much better opportunity for investors to take advantage of precious metals prices rising from their lows.

Disclosure: I am long SIVR, EXK. 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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