Second Quarter All-In Cost To Mine Silver: Core Costs Of Production Continue To Rise

by: Hebba Investments

We have analyzed and posted the costs of almost all the publicly traded silver miners, which includes over 21 million ounces of second quarter production - a significant portion of the total worldwide production of silver (estimated at over 190 million for Q2FY13). Though not as large a portion of total production as for our gold miner analysis, we believe our numbers represent a large enough portion of mined silver production to extrapolate as a general figure across the industry.

Why These Costs Are Important

For silver ETF investors (SLV, SIVR, 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 cut, 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

All Costs Per Silver-Equivalent Ounce - These are the costs incurred for every payable silver-equivalent ounce. It includes all company costs to produce silver including write-downs, smelting and refining costs, taxes, etc. We use payable silver and not produced silver, because payable silver is the silver that the miner actually keeps and is more reflective of production.

This is the broadest measure of costs, and since it includes write-downs, it is essentially the "accounting cost" of producing silver-equivalent ounces. When there are large write-downs, it can have a significant portion of costs that are the decline in value of existing assets, which is not a cash cost.

Costs Per Silver-Equivalent Ounce Excluding Write-Downs and S&R - This is the cost to produce each silver-equivalent ounce when subtracting write-downs and smelting and refining costs, but including everything else. Removing write-downs allows this cost to be a much more relevant cost to what it truly costs to produce each ounce of silver, but since it does not include smelting and refining costs (which is a requirement to be able to sell mined silver), it will underestimate true production costs.

Costs Per Silver-Equivalent Ounce Excluding Write-Downs - This is similar to the above-mentioned "Costs per Silver-Equivalent Ounce Excluding Write-downs and S&R" but includes smelting and refining costs. That makes this measure one of the best ways to estimate the true costs to produce each ounce of silver, since it has everything (including taxes) except for write-downs.

The one flaw with this measure is that when removing write-downs it is necessary also to remove the tax benefits associated with those write-downs, which we have to estimate based on the size of the write-down. We use a 30% base tax rate for these calculations, but investors can use whatever tax rate they feel most comfortable with.

For example, if a company reports a $100 million write-down, we will remove $100 million from its total costs (removing the effect of the write-down) and then add $30 million to costs (30% * $100 million) to represent the estimated tax benefit that the company gained from this write-down. You must do this if you want to remove any item from the income statement, otherwise you will be using taxes based on a removed income statement item.

Costs Per Silver-Equivalent Ounce Excluding Write-downs And Taxes - This measure includes all costs related to silver-equivalent production excluding all write-downs and taxes. Essentially this is the bottom dollar costs of production with an artificial 0% tax rate (obviously unsustainable) which works well because it removes any estimates of taxation due to write-downs or seasonal fluctuations in tax rates which can be significant.

The negative to this particular measure is that since it does not include taxes, it will underestimate the true costs of production. All companies ultimately pay taxes, and by removing them you create a production cost figure that is a bit optimistic and may be misleading to investors.

As investors can see all the cost approaches above have their pros and cons, but we believe the last two are the most effective in evaluating the true costs of silver production - so we will focus on these approaches even as we list the cost figures for the other two.

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) (costs over $25), Endeavour Silver (NYSE:EXK) (costs over $25), Hecla Mining (NYSE:HL) (costs over $22), Great Panther Silver (NYSEMKT:GPL) (costs over $25), Alexco Silver (NYSEMKT:AXU) (costs over $30), Coeur D'Alene Mines (NYSE:CDE) (costs just over $30), Silver Standard Resources (NASDAQ:SSRI) (costs over $25), Gold Resource Corporation (costs over $21), Fortuna Silver Mines (NYSE:FSM) (costs around $20), and cost leader First Majestic (NYSE:AG) (costs under $20).

Important Note: For our silver equivalent calculations, we have adjusted the numbers to reflect the Q2FY13 average LBMA price for all the metals. This results in a silver-to-gold ratio of 61.2:1, a lead-to-silver ratio of 24.8:1, and a zinc-to-silver ratio of 27.8:1, and a copper-to-silver ratio of 7.1:1.

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. 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 Q2FY13 LBMA average prices.

Observations for Silver Investors

Since there were major write-downs in this quarter, we will focus primarily on the "all-in costs excluding write-downs and taxes." As investors can see, these costs continued to rise on a sequential and year-over-year basis, averaging $22.80 for Q2FY13 - which was higher than every recent quarter except Q3FY12.

With the average silver price a little over $23 for Q2FY13, silver miners are really making no profit on their silver production at current prices. Additionally, since we are excluding taxes, their true all-in costs are even higher than the $22.80 figure, and net income is actually a net loss at these 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 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.

Production Numbers - Silver production increased on a year-over-year basis by around 2,000,000 silver ounces from 19.6 million ounces in Q2FY12 to 21.6 million ounces in Q2FY13, which is a little over 10% rise in total silver production. Sequentially production was also up from 19.9 million ounces in Q1FY13 to the current 21.6 million ounces - which shows that the year-over-year increase in silver production was primarily due to a recent quarter increase. Since Q2FY13 was the quarter with the large drop in precious metals prices, we expect it will take a few quarters for silver miners to adjust to the new prices - which may result in a cut in production as unprofitable mines or projects are shut down or delayed.

Conclusion and Investor Takeaways

This information offers investors a number of valuable takeaways. For investors in the silver ETF's (SLV, SIVR, PSLV) 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.

To be fair we also have to note that the majority of silver is the byproduct of other metals (gold, copper, zinc, etc) and thus some producers' all-in costs will be linked to their primary metal's price and not the silver price. But since silver is their byproduct, and since the sale of that silver affects the profitability of their mining production - drops in the silver price do matter to them as well. Lower silver prices will cut the margin of their base production or even make operations unprofitable.

According to the recent quarterly numbers, many silver miners' all-in costs when removing taxes and write-downs are $22.80 per silver-equivalent ounce. Since this price is currently around the silver price, that means most operations are producing silver with no profitability. Additionally, since these costs do not take into account taxes, many producers are producing silver at a negative cost to their shareholders - not a sustainable environment.

Silver production increased on a year-over-year basis by approximately 10%, but since many of these production plans were initiated before the big drop in silver, we expect that silver production may drop as producers cut back on expenses and unprofitable ounces.

Miners need profitability to survive - which means we expect management teams to cut costs in whatever ways they can to conserve cash and try to make silver profitably. This is what we are seeing in the recent statements by management and we expect silver miners to aggressively cut exploration expenses, thus we expect production costs to drop in the near future (it would be very problematic if they didn't).

But the fact of the matter is that there are consequences to cutting exploration budgets in terms of lowering future silver production. Investors should remember that mining is a business where companies constantly have to replenish reserves and exploration is the way to do that. Cuts to exploration may lower costs in the short term, but they will lead to lower future production (and higher costs) in the long-term.

All of these things are bullish for silver investors with a long-term investment horizon. The first thing they should keep an eye on is the costs of production in Q3FY13, with rising or flat production costs being bullish for silver investors, while lower costs would be negative. This should be paired with monitoring production silver numbers - if silver production is dropping while costs are lowering then that suggests miners are high-grading or cash-cow mines are depleting, which will have future consequences for silver production and costs.

We are of the opinion that the production cost rises are not temporary and are structural, and thus even if they drop it will not be by significant amounts (we believe the days of $10 silver all-in costs are long gone). That means that investors who purchase silver at these levels are buying silver at or below the all-in costs of production, which is a good long-term strategy, especially since silver carries a number of other bullish fundamentals in terms of its function as a monetary metal.

Investors should keep an eye on the costs and production numbers of the silver miners over the next few quarters. Look for production to drop and the miners to struggle to produce silver profitably, which is bullish for silver investors. We do not know how long silver will languish at $20 per ounce, but we do not think this price is sustainable long term (and neither does CPM group) and investors who gradually accumulate silver and do not get frustrated by the day-to-day and month-to-month price moves should do quite well in the long-term.

Disclosure: I am long SIVR. 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.