It is the beginning of 2016 and now is the time when gold mining companies issue their year-end gold reserves, which give investors a glimpse into future production. As we have mentioned before, we think this is very important because we believe that gold production will fall drastically over the next decade without significantly higher prices - without declining production the thesis doesn't hold.
Majors have started to lower production forecasts and we think we are starting to see some evidence of "Peak Gold" which is shown quite vividly in a chart by Goldcorp (NYSE:GG):
Source: Goldcorp Corporate Presentation
We are bullish long-term on gold because as investors can see, companies that analyze the industry (CPM Group, GFMS, Metals Focus, etc) are predicting a huge drop-off starting in 2016. This drop almost exactly mirrors the fall in discoveries over a 20 year lag period (the time to develop and permit mining) - all very logical.
While we may be bearish in the short-term as speculators are significantly overweighted in their gold positions, for the long-term gold makes an excellent investment. In fact, if the "Peak Gold" scenario plays out, then we can expect a much higher gold price as production drops while the world's money supply increases (and this is ignoring any increase in demand from developing nations as their populations get more affluent). But how do we verify that this is what we are seeing?
2015 Year-End Reserves
This is where the mineral reserves statements come in, as they reflect how much gold that mining companies confidently expect to be left in the ground. Growing reserves mean that companies are replacing the gold that they are mining, while falling reserves mean that current production is not being replaced. Thus if reserves are rising we can expect future production to increase and vice versa.
We only used proven and probable reserves as these are the only economically viable reserves, and as is very obvious, in 2014 reserves dropped dramatically by more than 27 million ounces. In fact, the only miner that increased reserves was Agnico Eagle , and that was due to its acquisition of Osisko which added 4.3 million reserve ounces - without that acquisition it too would have seen a decline in gold reserves. In 2015, we saw more of the same as reserves dropped by close to 20 million ounces, less than the drop in 2014, but certainly sizable. Additionally, every single major miner shown above saw reserve declines.
We want to stress that this is NOT healthy and normal as the mining industry needs to replace gold reserves every year to stay viable and continue to produce. What we SHOULD see is reserves either growing or at least flat reserves, without that it means that future production will almost certainly drop - which plays very well with our thesis on future gold production.
The only way we can expect reserves to increase is if we start to see a technological revolution like we have seen in the shale oil industry or if explorers are finding a lot of new discoveries. As for the technological revolution, we have seen nothing in the mining industry that seems new or innovative enough to drastically change the industry - no surprise as mining metals is much more difficult and complicated than drilling for oil.
Finally, as evidenced by the chart from Goldcorp, major discoveries have dropped decade lows as we are simply not discovering any new large deposits that are viable at $1200 or $1300 gold. Additionally, miners have been slashing exploration expenses over the last few years and less money will most likely not help speed discoveries. The industry is between a rock and a hard place (pun intended).
The Opportunity for Investors
Any investor taking even a cursory look at the industry will realize that the future is not very bright for gold production, and the recently issued reserve reports by the major gold producers are validating this view. Rising costs, falling exploration budgets, stressed financials, and a lack of economic discoveries are what we are seeing in the industry - but with that comes opportunity.
The way we see it is that investors can play this in three ways:
1. Invest in gold directly
2. Invest in producers with clean balance sheets and good future production
3. Invest in high-quality explorers
Investing in gold by buying and holding gold (and their paper equivalent the gold ETFs (GLD, CEF, PHYS), is the most conservative approach as we will probably see a much higher gold price or much less gold production - both positives for an investment in gold. This is not a complicated trade and everything which we've said so far has nothing to do with the many other catalysts that we write about on a regular basis (such as the US fiscal position, the battle between bondholders and the Fed, increase in central bank purchases of gold, or the deteriorating world order). In fact, even the supposed improvement in the US economic picture (the main reason investment banks forecast a falling gold price) would still have no effect on this much more important fundamental issue.
As for the producers, the implications are a bit different because some miners will suffer as reserves drop without being replaced and thus future cash flows also fall. The major miners with the cleanest balance sheets are the safest, but all miners need to be scrutinized carefully as none of them are "invest and forget" type investments. But of course, investors able to select the best companies that are able to grow reserves through exploration or acquisition despite the environment (we have covered a few previously), should do quite well as peers suffer. Quality miners should provide good leverage over any increases in the gold price as their profit margins can double with only moderate moves in the gold price.
Finally we come to the developers and explorers, where we think the real opportunity for massive gains is to be realized. Investors have to be careful here too because many of them have projects that may never be economic, but those companies that do have quality deposits will make excellent takeover targets for the majors as production and reserves fall.
In conclusion, despite all the negativity over the last few years, gold star is set to burn very bright regardless of what happens in the global economy as reserves are simply not being replaced at the current gold price. Investors do not need to see any financial chaos to have a higher gold price - all investors need is to have the same lack of discoveries trend that we've seen over the last 15 years continue into the future. Thus investors should buy gold, ignore the noise, and wait until economic fundamentals take gold to much higher prices.
Of course, if somehow the stunning growth in worldwide debt catches up with the global economy - all bets are off and we could see a gold price many multiples of what we have today. There are very few no-brainer investments out there, but gold seems to be one of them and for patient investors this is a great time to buy.
Disclosure: I am/we are long SGOL. 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.