 Gold
Production and Reserves
Scott Wright
Zeal LLC
Feb 2, 2007
Nearly seven years into this
mighty gold bull, it is important for investors to occasionally
step back and revisit the fundamental nature of this secular
uptrend. And though there are a myriad of fundamental drivers
that build the case for gold, economics still reign superior.
The delicate balance of supply
and demand is ultimately the driving force of all financial markets
and serves critical to any market cycle for any tradable asset.
This holds ever-so-true for the Ancient Metal of Kings.
Because gold not only serves
a utilitarian purpose but crosses the boundaries of fiat influence,
it is globally desired as a store of wealth and security. And
global investment demand through such mediums as physical accumulation
and ETFs is on the rise.
With demand on the rise supply
has struggled to keep pace. And when demand chronically exceeds
supply, an imbalance occurs which leads to the rising prices
that are commonplace in a bull market. As the price of gold
rises, there are natural forces that kick into gear to straighten
out this imbalance.
The forces designed to correct
an imbalance are quite simple. Rising prices encourage suppliers
to increase their output, and rising prices also serve to quell
demand. But for commodities, precious metals in particular,
supply and even demand-side tendencies cannot change overnight.
Today I will focus on the supply
side of gold. And since gold-mining output is the number-one
supplier of gold to the market each year, the key factors that
need to be considered are production and reserves.
Since gold mining is so pivotal
to gold supply, this industry has captured increasing exposure
among investors and speculators trying to capitalize on this
strategic trend. And because of this, gold stocks have become
the best vehicle for investors to catch this trend.
So in order for us investors
to maintain a strategic investment perspective on gold-stock
investing, it is healthy to exercise an occasional assessment
of how this industry is faring not only through the eyes of some
of the elite individual companies, the industry leaders, but
the global aggregate.
Production: Since the process
of mining gold is extremely capital- and time-intensive, supplying
the markets and meeting demand has been a challenge all throughout
history. And since mankinds lust and desire for this rare and
precious metal is unwavering, people in all ranks of society
have and will demand more and more of this beautiful metal.
And history can do a fine job
illustrating gold's supply crunch. For example, in 1900 when
there were only about 1.6 billion people roaming the earth, a
whopping 13 million ounces of gold was mined to meet demand.
This equates to about 0.008 ounce per person on the planet mined
that year.
It took about 65 years for
the world's population to double from there. During that time
the global mined production of gold nearly quadrupled to a 1965
volume of 47 million ounces. This equates to a 75% increase
in the per-person quantity of annual gold ounces mined.
And more gold per person makes
sense as a number of studies have revealed that since 1800 per
capita income has grown at a 50% faster rate than the population
growth rate. So since wealth grows faster than the population,
it makes sense that more people with more money want more gold.
Well in just the last six months
or so the world population has achieved another double from 1965
to a global population of about 6.6 billion. And in 2006 mined
gold supply is expected to come in at around 77 million ounces
(using true production data provided by the World Gold Council
and GFMS for the first three quarters of 2006 and projecting
full year using simple average), which is an 18% decrease in
annual gold ounces per person.
Is this decrease a supply dilemma,
a demand dilemma or just a healthy balance? Confused yet? Now
I know this is hardly a standard metric, comparing the world
population with annual mined gold supply. But stick with me
here because this does help paint a partial picture of what we
may be faced with in the years to come.
It is indeed a fact that the
world today is a lot wealthier than it was one hundred years
ago. Vastly more money per person is floating around today than
ever before. It is also a fact that over 60% of today's global
population resides in the fastest growing economic region of
the world, Asia.
One hundred years ago the fractional
gold demand that came from poverty-stricken and economically-weak
Asia was from a handful of aristocrats that squandered the wealth
of their nations. But today the 4 billion people in these growing
economies, those taught by their parents to save big and store
their wealth in gold, will command a sizeable share of today's
and tomorrow's gold demand.
This long-repressed Asian populace
will participate in a greater share of global wealth. And the
Asians are not the only ones who will be plowing more money into
gold. The Middle East petrodollars pouring in from this 21st
century oil bull will also need to continue to find refuge.
Middle Easterners are culturally attuned to gold investment and
simply adore the shiny-yellow metal.
So as the world grows not only
in population but industrially, technologically and economically,
this wealth is and will be distributed among a portion of the
world that has historically had little opportunity to buy gold.
In fact, the per-capita growth rate mentioned above had very
heavy weightings from the US and Europe with insignificant growth
from Asia.
So as per-capita growth rates
now rise faster driven by the Asian people, there could be a
huge market impact on gold demand. To put this in perspective,
people that earned say $500 per year in the expanding Asian economies
can sustain a large year-over-year income growth rate for an
extended period of time. Even if only a small fraction of this
income growth transfers into gold investment, it will surely
be felt. More gold per person will be demanded.
Now in order to meet growing
global demand, mined supply must continue to rise. When the
world reaches a population of 8 billion people, projected for
2025, just to sustain the 2006 per-person consumption of mined
gold, over 93 million ounces will need to be mined. And if per-person
demand rises as expected, even more ounces will need to be produced.
These are lofty figures for the gold miners to achieve, and
I suspect gold will need to be priced much higher in order for
them to have a shot at this.
But as you can see in this
trending decrease in gold mined per person in addition to a more
recent trend as revealed in the chart below, there continues
to be a structural problem with the mined supply of gold. A
supply dilemma indeed seems to be driving the rising gold prices.
As indicated in blue, the global
mined supply of gold has been falling in recent years. It is
apparent that the producers tasked to bring gold to market have
been greatly challenged. So with global gold production continuing
its struggles from a macro perspective, economics dictate that
investment opportunities still abound in the micro-scene among
the gold miners.
If the supply side of a product
is pinched, overweight demand drives up the unit price of the
product. And who better to benefit from this situation than
the suppliers, the gold producers/miners, that bring the metal
to market. As the price of gold rises, positively leveraged
gold producers should be well-positioned to earn great fortunes
for their shareholders as they earn more money for their gold.
And there is no better measure
to gauge the gold-mining industry than the elite miners that
comprise the venerable HUI gold-stock index. Some of the biggest
and best unhedged gold producers populate this index, and its
996% trough-to-peak gain gives it an incredible 5.4x leverage
to gold's 183% gain in this bull.
At Zeal we have traded in and
out of various HUI components a number of times in this gold
bull and these stocks have scored our newsletter subscribers
outstanding gains. And as the price of gold continues to rise,
the shares of these gold producers ought to continue to perform
quite well.
And with the likelihood that
we are still in the first half of a secular bull market in gold,
the best gains may yet to be won. Even with the amazing gains
we've seen thus far in the gold stocks, it is still a relatively
unknown sector and has not yet begun to tap mainstream capital.
Case-in-point, the 15 elite miners that comprise the HUI are
responsible for 26% of global gold production yet have a combined
market capitalization of only $91 billion.
The entire HUI market cap is
about $60 billion lower than that of Google alone. At $604 gold
(the daily average gold price for 2006), the $12 billion plus
of revenues these miners brought to market last year will exceed
even a double of Google's 2005 revenues. If you think Google
is growing fast, wait and see the growth of these gold producers
when gold continues to catch its bids. With revenues and profits
for the unhedged miners positively leveraged to gold, any rise
in its price will greatly benefit their financials.
But even though the HUI components
continue to slide up the scale and capture a greater portion
of global gold production, the structural problem of overall
global production declines cannot be ignored. Global gold production
is down 7% since 2003! This is a bigger problem than most people
realize.
Since gold demand isn't likely
to ever go away, the weight of this problem lies on the shoulders
of the gold miners. So in order to once again achieve a market
balance, gold producers will have to extract more gold from the
ground until their supply can meet demand at a stable price.
This chart paints a picture
of the slow-moving nature of this industry which provides ample
reason for being in the midst of a bull market. But seven years
into this bull, the supply and demand spread doesn't appear to
be closing. So with the price of gold more than doubling in
recent years, why hasn't gold production increased? Wouldn't
it behoove a gold producer to step up its production in order
to take advantage of these higher prices?
Well in short, gold's rare
existence in nature plays a large contributing factor. This
natural resource only has so many identifiable reserves housed
within the earth's crust. And the lead time in turning raw gold
minerals within an ore body into a fine shiny ounce is significant.
You can't just speed up an assembly line or open a spigot to
increase gold production.
And to further contribute to
the problem, significant underinvestment in gold exploration
in the 1990s places producers behind the curve for ramping up
their output. During this time gold prices were low and the
miners were forced to cut expenses, slash exploration budgets
and cease production at unprofitable mines.
>From discovery to production,
it can take up to ten years to develop a producing gold mine!
So today as existing and long-producing gold mines continue
to deplete their resources with many shutting- or ramping-down
production, a strong pipeline of replacement mines is just not
there. New mines are not coming online quick enough to pick
up the slack as is apparent in the chart above.
Thankfully producers are facing
these handicaps head on, it's just going to take time. With
gold prices high, mining companies can now afford to explore
for the next generation of gold mines. In fact, it is estimated
that a record $7 billion was spent on gold exploration in 2006.
So as it is expected to take
years for the gold miners to ramp up production and for the supply/demand
imbalance to equalize, gold-stock investors would benefit greatly
by using the HUI components as a guide for the entire industry.
The charts in this essay should serve well to showcase the HUI's
growing global influence in the gold-mining sector.
Reserves: In order for gold
miners to sustain, grow and secure their future production, they
need to have a bank of reserves to pull from. The lifeblood
of gold miners is their reserves. Because active mining works
as a constant drawdown on the reserve base, these companies often
feel like they are swimming against the current.
Since each ounce of gold extracted
from the earth depletes an ounce from the reserve base, renewing
and growing reserves stands as the most important business objective
for any mining company. And since the market weighs mining life
and reserve growth so heavily, there is constant pressure on
these companies to skillfully manage their reserves.
In simple terms, gold reserves
are defined as economically recoverable gold ounces. Most gold
producers update their reserve figures at least annually. They
are calculated through extensive technical studies conducted
by highly-trained geologists. But even though a lot of "rock-jock
speak" goes into the formula for proving reserves, existing
market conditions probably play the most important role.
The most influential yet most
variable component in the economic viability of in-ground gold
is the price at which the metal is trading. The cost of extracting
an ounce of gold and preparing it for market readiness is immense.
So once gold is identified, it is typically accompanied by a
feasibility study that has these costs forecasted at a semi-fixed
rate. If mined gold can be sold for more than it costs to produce,
then it is economically viable.
When researching gold producers
you will find that reserves are measured by the ounce and by
years of mining life remaining at current production rates.
For example, if a gold miner is producing 250,000 ounces of gold
per year and has 2 million ounces of gold reserves, then it has
a mining life of approximately eight years.
But here is the challenge for
the gold producers. If the miner in this example continues to
draw off its reserves without replenishing them, not only will
it quickly lose favor in the eyes of investors, but it will run
out of gold in eight years and be dead. As mentioned earlier,
it is of utmost importance for gold miners to maintain and grow
the longevity of their companies. Investors must consider mining
life in strategic context before they risk their hard-earned
capital in these markets.
And a good gold company is
adept at growing its reserves. Since the producers that comprise
the HUI rank among the best in the business, I thought it prudent
to update their reserve figures from the last time I penned an
essay on this topic to see how they were doing.
By scouring the annual reports
and websites of each HUI component, I was able to compile historical
production and reserve data dating back to the beginning of this
gold bull. This next chart displays this combined data for the
HUI components along with the index's effective average mining
life.
The 2006 production data, also
displayed in the first chart, is projected based on the latest
guidance numbers that each of the HUI producers reported. And
the 2006 reserve data is projected with a calculated growth rate
based on historical data. I eagerly anticipate the full-year
data from each of these companies that should be reported in
the next couple months, but these projections should be relatively
close to reality and should serve just fine for our purposes.
As you can see, the HUI has
done an excellent job of not only renewing, but growing its reserves.
Since 2000 the HUI has increased its production by just over
30%, but it has increased its reserves by an incredible 57%.
This is a very healthy increase and should definitely catch
the attention of investors.
Generally mature and top-tier
gold producers maintain enough reserves to provide a mining life
of about ten years or greater based on their current rate of
production. As you can see, the HUI gold miners have averaged
well over 15 years of mining life in this gold bull and have
been steadily increasing this as reserve growth has outpaced
production growth.
Now there are several different
ways for gold miners to renew and grow their reserves. One common
way to accomplish this is through organic growth, in which reserves
are harvested from within a company's existing portfolio of land
holdings and projects.
Upgrading resource classes
is a large part of organic growth and usually comes as the result
of further technical studies within development-stage projects
or through the expansion of an existing mine. Preliminary technical
studies may identify mineral resources within an ore body, but
resources are not proven to be economically feasible, or reserves,
until more advanced and thorough studies are completed.
Higher gold prices play a large
role in upgrading resources, because reserves are only reserves
if they are economically recoverable. For example, three years
ago it wasn't economically feasible to recover gold if its costs
were greater than about $400 per ounce. Now with $600+ gold,
these resources that were not economical three years ago may
in fact be economical today.
Organic growth occurs within
gold companies that employ or contract top-notch geologists and
explorationists. This is more important now than ever before
as discovering gold has become increasingly difficult. The world
is a lot smaller than it was one hundred years ago and those
parts of the world that remain underexplored present increasingly-high
barriers of entry.
Another popular path gold companies
are taking to grow reserves, especially of recent, involves acquisitions.
The M&A realm has been quite active in this industry with
even the elite HUI gold miners entrenched in its dealings. Merrill
Lynch recently reported that 2006 M&As in the gold-mining
industry had a transaction value of greater than $19 billion,
an all-time record, and triple that of 2003. So since reserves
and hence mining life are so important for the viability of these
companies, many miners deem it necessary to partake in the occasional
acquisition in order to bolster their portfolios.
Some gold producers may not
be high-caliber explorers, some may not have the land holdings
and some reason that it is financially prudent to buy reserves
rather than find them. Any way you look at it, reserve growth
is instrumental and gold companies will do whatever they must
in order to stay ahead of the competition.
But even though the HUI is
experiencing remarkable reserve growth as its components try
to position themselves to capitalize on this secular bull, an
alarming trend has emerged when reserves are measured globally.
This next chart reveals that global gold reserves are actually
declining.
Interestingly, according the
USGS, global reserves in 1980 were estimated at 1.13 billion
ounces. As of the end of 2005, global reserves were estimated
at 1.35 billion ounces. So in 25 years global reserves have
grown by about 19%. Though not as impressive as the reserve
growth rate of the HUI, it still equates to a global mining life
of about 17 years.
This trend is not appealing
though for the longevity of the industry. Throughout history
reserve renewal has kept ahead of production. But with reserve
growth down, supply pinched and demand rising, the future of
the gold industry could get really interesting.
I am not usually an alarmist,
but a lot of gold is going to need to be found in the years ahead
in order to maintain this mining-life cushion. 17 years is not
a long time and this whole situation really shows the importance
of high gold prices in order to continue to support aggressive
exploration and development across the industry.
The good news is the HUI miners
are among a group of elite gold companies that are positioning
themselves to take advantage of this continuing bull market.
As a result of the aggressive reserve growth of these miners,
the HUI portion of global reserves has jumped 75% since 2000
and is now host to nearly a third of the total global reserves.
Conclusion: With global production
and reserve growth down and demand poised to perpetually rise
in this growing global economy, the suppliers are going to have
to kick it into gear in order to support the markets. And gold
miners are not foolish. They understand the long-wave cyclical
nature of the commodities markets and realize that this is not
just a temporary problem.
This is why we are seeing an
environment of aggressive exploration, mergers and acquisitions
and ultimately rising gold prices. It is going to take many
years for the gold mining industry to noticeably increase supply
as it continues to explore, discover, develop and construct gold
mines. The gold producers should greatly capitalize on this
trend.
And it is not too late to take
advantage of this gold bull. The elite miners of the HUI are
poised to lead the way as they ramp up their production and reserves,
but they are not the only gold companies positioning themselves
for success. Hundreds of gold companies are jockeying for investor
attention and capital.
There are gold companies of
all sizes, from junior to mid-tier to major producers in addition
to the highly speculative junior explorers that play such an
important role in the gold cycle. I recently published a research
report profiling Zeal's favorite junior gold stocks that are
poised to make an impact on the near future of the gold-mining
industry. This report is available now for purchase on our website.
At Zeal we have been bullish
on gold since its bull market began at the turn of the century
and we are just as bullish today as we were back then. In the
February issue of our monthly Zeal Intelligence newsletter just
published, we provide our subscribers several new gold-stock
trade recommendations as we ready ourselves for the next gold
upleg. Please subscribe today if you are interested in cutting-edge
commodities-market analysis and stock picks.
The bottom line is gold supply
is not going in the right direction to support demand as seen
by the recent global production and reserve trends. The mining
production is struggling to bring enough gold to market and the
companies that are tasked with this responsibility have incredible
upside exposure to rising gold.
As the price of gold rises,
gold miners are in line to greatly profit on the sale of their
goods. As a result, the gold-stock sector should remain one
of the strongest market sectors in the next decade or so. Once
mainstream interest and capital starts to flow into the gold
stocks, prudent investors that were already deployed should be
in for a wild ride.
Feb 2, 2007
Scott Wright
ZEAL
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