Gold Mining Challenges

Scott Wright
Zeal LLC
Sep 29, 2007

With gold once again above $700/oz, there is a renewed interest in gold stocks. Throughout the course of this gold bull it is indeed the gold stocks that have provided investors with excellent leverage to the rising price of gold. These companies that are responsible for bringing the metal to market should be well positioned to greatly profit in a secular gold bull.

But now more than ever gold mining companies are finding it increasingly difficult to do what they do best. The geopolitical, regulatory, inflationary and environmental hurdles are higher than ever. And the discovery shortfalls from the previous bear-market cycle have really hindered this industry's growth prospects.

Since I get to research and closely follow mining companies on a regular basis, I've been able to watch the gold mining industry trends unfold. And it is simply amazing to watch the dynamics of this industry change on almost a daily basis.

Early in this gold bull it was the concept of leverage that really got folks excited about gold stocks. And this leverage concept is very logical. Simply put, assuming relatively stable operating costs, with of course moderate inflationary adjustments, a rising gold price would significantly grow gold mining profits.

So theoretically for every dollar gold rises, most of this dollar would translate directly into profits for those mining companies selling their gold at market prices. Ultimately the allure of gold stocks surrounds the ability of the mining companies to increase their profits at a much faster percentage rate than that of the underlying metal. Thus gold stocks positively leverage gold.

So with gold more than double what it was back in 2003, how are the profits looking for the mining companies? Are profits leveraging gold's gains in the fashion people thought they would? Well looking at the HUI you would sure think they are.

The gold stocks that comprise the venerable HUI unhedged gold-stock index are up over 1,000% to date. This demonstrates incredible leverage to gold's gains, by a magnitude of over 5 to 1! But are profits or even profit margins up 5x? Hardly! In fact many gold miners have been struggling to get their profits to even match gold's double since 2003.

The gold mining industry as a whole, which provides about two-thirds of the annual gold supply, is indeed experiencing major structural problems. Costs are precipitously rising and global production issues have really been weighing on the gold miners.

Well what the heck is going on with these gold miners? Many investors are indeed scratching their heads asking this exact question. When their favorite miner releases earnings and profits haven't doubled, is there reason to worry? Not really, and in order to remain sane it would behoove gold stock investors to be cognizant of the goings on in this industry.

Most important to understand is the great difficulty and many complexities of mining gold. And to even begin to explain how difficult it is to mine gold, we need to understand the creeping nature of this industry. In plain and simple terms, the gold mining industry reacts to market noise at about the same pace as an oil supertanker changing course to avoid an iceberg. Slow and methodical.

Gold miners cannot simply turn a spigot to increase supply if prices are favorable. Increasing volume at existing mines or bringing fresh new mines into production is a tedious and capital-intensive process. The chart below does a fine job painting a picture of this reality and displays the true slow-moving nature of gold mining.

You would think that with the price of gold rising at such a swift pace the gold miners would do everything in their power to increase production. More gold sold at higher prices leads to greater profits, a no-brainer right? A no-brainer yes, but gold miners are in fact striving to increase production.

All this effort doesn't appear to be having an impact on global gold production though. As you can see since the beginning of this gold bull mined production is actually down! From its all-time high in 2003, production is down by about 5%, or the equivalent of approximately 4m ounces.

There are several strategic factors that lead to this trend. But before we go into these it is critical to understand the evolution of a gold mine, as producing gold is not quite as simple as building a widget on a factory assembly line.

Unlike widgets that can be created from scratch and are subject to real-time production-volume adjustments, all gold in the earth has already been created and we have to find it. This complicated hide-and-seek involves the quite tedious process of identifying a target gold deposit, exploring it, developing it and building the infrastructure to mine it. And this all runs in parallel with the constant pressure of procuring permitting, funding and then producing the gold profitably.

This entire process for a gold mine large enough for the markets to notice can take ten years or more and cost hundreds of millions if not billions of dollars. And even if an existing mine has the resources to expand operations, it still takes several years and millions of dollars to obtain the appropriate permitting, construct the facilities and procure the equipment necessary to increase capacity.

I recently toured a large-scale gold mining operation that resides in a situation that can help put this in perspective. The mine operator has spent tens of millions of dollars on a successful exploration program that has identified additional gold resources adjacent to its current pit.

Because of this it believes it can not only extend its mining life past 2012 as originally projected, but it may even be able to increase production volume. This company is now scrambling in order to make this happen. It won't see the fruits of this endeavor until years down the road, if at all. But it now must dedicate significant time and capital to obtain permitting and begin preliminary development before it can even start construction and possible production four years from now.

The simple fact is that it will take many years for the gold mining industry to respond to increased demand and higher prices. So the evolution of a gold mine explains why there is not a noticeable increase in global gold production. But after six or so years of a gold bull why the downtrend? Why isn't there at least a small production increase?

Well one big reason for this surrounds the nature of commodities super-cycles. In the late 1980s and 1990s gold was entrenched in a ravenous bear market. During this time the price of gold sunk from about $500/oz to the mid-$200s and it became increasingly difficult to profit from gold mining. As cost-cutting measures became priority, managing and reducing operating expenses naturally took front seat to any other secondary expense. This was necessary just so gold miners could stay afloat.

Exploration budgets were the first to go. With the price of gold in a downward spiral, there was little incentive to spend massive amounts of capital on exploration. Because of this not only were there very few significant gold discoveries, but capital wasn't being spent to develop those already-identified gold deposits. This greatly shrunk the pipeline of projects available to the miners that grabbed the bootstraps of our current bull.

This cyclical action now results in a replacement conundrum. The big low-cost mines that were able to survive during the bear didn't get any younger. As these mines mature, fresh new replacement mines have not been able to balance production. Many of these older mines have reached the latter years of their lives and are either shutting down or low-grading.

This low-grading leads to another factor that has slowed production growth. Low-grading is simply the processing of ore that contains a lower mineralization of gold. Gold mining operations perform such deeds as low-grade ore is either all they have left or they are trying to preserve the higher-grade ore for when gold prices are lower.

And intentionally low-grading when higher-grade ore is available is something shareholders do not smile upon. It's not that mine operators don't care about profits, they do, but they must prioritize extending the lives of their mines. It is hard to blame them considering the costs that go into a mining operation. Once a mine shuts down, most of the infrastructure is rendered useless and worthless, so they might as well maximize its utility.

Here is how it works. Lower-grade ore obviously contains less gold than higher-grade ore. And because most mines process their ore at a fixed capacity, usually measured by tons-per-day, lower-grade ore will yield fewer ounces per day than higher-grade ore. This increases per-unit costs, or cash operating costs per ounce, lowers production volume and ultimately reduces profits.

But with higher gold prices, a gold miner can send through its lower-grade ore and still turn a profit. Profit margins aren't as wide as they could be, but this preserves the high-grade ore for leaner times down the road when this low-grade ore would not be economical. And of course this increases the life of the mine. Shareholders obviously do not see eye to eye with this logic. They expect miners to maximize profits, achieving the stellar leverage I discussed earlier.

Now not all mines intentionally low-grade, many mines cannot, and the miners that do low-grade typically don't advertise this to the public. All the public sees is lower production and higher costs. You can now see how this can factor into the global production trend we see today.

And since we are considering the nuts, the bolts and the grease that spin the wheels of gold mining, we must consider the inflationary forces that have presented themselves to the gold companies in recent years. And moderate is not the word we can use anymore when we look at rising costs for gold mining companies.

Of the costs that go into producing an ounce of gold, labor is the biggest chunk, about half of the total costs. Energy is the next biggest expense at about a quarter, and the balance is a combination of consumables, royalties and various maintenance expenses among others.

As you can imagine, the energy costs to operate a gold mine have skyrocketed. The price of oil has quadrupled since the beginning of this gold bull. So while the miners have enjoyed a price surge in the commodities they produce and sell, they also sure have felt the surge in prices of the other commodities that are consumed to produce theirs.

And speaking of commodities, labor has become a hot commodity in the mining industry. Not only are the blue-collar laborers that get their hands dirty harder to find and commanding greater compensation, but the skilled white-collar positions have been extremely hard to fill.

The reality is mine engineering and geology have not been sexy areas to study in the last several decades. When you combine a commodities bear with the technology revolution, there has been little incentive for those entering the global workforce to attain higher education and training on rocks.

When I was in college the low-level geology courses only attracted the football players, "rocks for jocks". And those few that actually pursued degrees in this field were destined to flip burgers for a living. Well today things are quite different. Trained geologists, mining engineers, geoscientists or any type of mineralogists are truly hot commodities.

These folks, especially the experienced ones, hold all the cards when it comes to employment negotiation. They can literally write their own compensation packages. There is such an incredible shortage of these skilled workers that mining companies must shell out big bucks to attract and retain such talent. Unfortunately many projects around the world are delayed due to labor shortages, both blue-collar and white-collar. These problems are indeed a factor in the global gold production shortfalls.

And labor issues bring us to some of the geopolitical travails the gold mining industry must deal with. Labor upheaval, especially in third-world countries, is happening with more frequency as this commodities bull picks up steam and workers demand a bigger chunk of mining-company profits.

Labor strikes are very costly to miners. When each hour of downtime at a decent-sized mine can cost $1m or more in potential revenue, you can imagine the problems any kind of a strike would have on a typical mining operation that runs 24/7/365.

On top of this, the cost of labor along with operating costs in general are rising in many countries due to another observable fact, currency exchange problems. Many of the big global mining companies are slave to the US dollar. And mine workers and contractors are typically paid in the local currency of where the mine is located. So when the dollar continues to fall it costs more dollars on the currency exchange to cover labor and other costs paid in the local currency.

Many mining companies are now seeing their cash operating costs rise precipitously for their operations where the local currency is strong versus the dollar. One of the largest gold producers in the world, Newmont Mining, is painfully seeing this happen at its massive Australian operations. Newmont has seen a greater than 10% year-over-year rise in operating costs due to the adverse effect of the Australian dollar exchange rate. Australia's strengthening dollar to the US dollar is directly attributable to a $43/oz increase in operating costs.

Now rising costs do ultimately affect production, but there are broader geopolitical problems that really plague gold miners today. And this is because the gold miners have had to spread their reach in order to meet today's demand.

Throughout most of the modern era the majority of global gold production came from only four countries. South Africa, Australia, the US and Canada combined to produce well over two-thirds of the world's gold up through the 1980s. But with major gold discoveries within these borders dropping in frequency and the rich gold fields that were mined for centuries becoming depleted and more costly to mine, the miners were forced to look elsewhere.

Combined gold production from these four countries has declined each year over the last decade. And today these countries produce less than half of the global mined gold supply. In fact last year South Africa, long the world's largest gold producer, posted its lowest production output in 84 years.

But the gold mining companies have taken this to task and subsequently increased gold production throughout the rest of the world to cover for the shortfalls of the "Big Four". And though gold producers have found some success mining elsewhere, this success has come at a higher price. Transitioning away from the geopolitically-safe countries has exposed global gold mining companies to much more risk than they had ever seen in the past.

Many newly discovered gold districts around the world unfortunately reside in locations that are none too friendly to not only miners but foreign business in general. And with the price of gold at its highest levels in over 25 years, greedy and corrupt bureaucrats in non-capitalist countries are making it extremely difficult for mining companies to profitably mine within their borders.

When various countries aren't raising taxes and royalties on foreign mining operations, they are nationalizing their resources and closing their doors. Unfortunately this is a lose-lose situation for these countries. Not only are they losing out on the benefits to their national economies and the local communities, but when expropriation occurs an entire operation is likely doomed to failure.

The countries that are performing such deeds are typically incapable of successfully and profitably managing a business. Smaller and third-world countries simply do not have the skills, experience and technology to operate a gold mine on their own.

But we have still seen a trend of resource nationalization and over-taxation that has caused noticeable hiccups in global mined gold production. Some recent examples include Mongolia's incredibly steep windfall profits taxes on gold and copper mining. These new taxes are so ridiculous that this resource-rich country is now starting to feel the negative economic impact of vastly less foreign capital investment since it implemented these policies.

In Uzbekistan Newmont was recently victim to an illegal expropriation of an operating gold mine. The Uzbek government decided that Newmont's subsidiary owed more taxes. In order to get these funds Newmont supposedly owed, the Uzbek authorities seized physical gold and various assets from Newmont, sold them off, and filed bankruptcy on behalf of Newmont since the cash couldn't cover its claims. And to add insult to injury, Uzbekistan appointed one of its officials to step in and run the local subsidiary!

In South America Marxist-style governments are sweeping across the continent with fury. Of course Marxist governments loathe free markets and capitalism. So in various locations we are seeing further resource nationalization and hefty increases in taxes and royalties. This is obviously very discouraging for foreign mining companies.

And to add more fuel to the fire, when governments aren't erecting impossible barriers for mining companies to climb, environmental non-governmental organizations (NGOs) are doing their best to make life even more miserable for mining companies.

Now because of the nature of mining, environmental safety must be enforced with the utmost scrutiny. And because careless mining in the past has caused environmental disasters, mining companies today must acquiesce to stringent rules and regulations in the design, operation and reclamation of their mines.

This is one reason why mining is so capital-intensive these days. And I am all for this, as I truly believe mining companies should be held to high environmental safety standards. But because of isolated failures in the past, many NGOs believe all mining is bad and that any mining operation poses imminent environmental safety hazards.

This is ludicrous of course, but there are NGOs out there with very deep pockets. And these NGOs do all they can to disrupt, delay and shut down mining operations across the globe. One of my favorite gold companies, Eldorado Gold, has recently been victim to an NGO sting.

An NGO has been successful in temporarily shutting down Eldorado's flagship gold mine in Turkey. Turkey's highest court says there are claims that Eldorado's already-approved-by-Turkey environmental permits are invalid and not being executed appropriately. Eldorado's hands are now tied, especially since the courts ordered this shutdown right before their summer recess. It is currently losing millions of dollars awaiting just a hearing on this issue.

As evidenced by Eldorado's frustrations, a popular tactic of the NGOs is to go after mining operations in countries with weak legal systems and varying degrees of geopolitical instability. In Romania for example there are several sizeable gold mining projects that have been waiting years for environmental permitting.

NGO tactics in some of these cases involve bribing local communities that have very high unemployment rates to protest a mine that would actually improve their environment and boost employment. And these NGOs spend good money on lawyers with the specific goal of keeping things tied up in the legal system until mining companies can't afford to fight anymore.

One last example again involves Newmont Mining. It was recently exonerated in a multi-year case that saw its name undeservedly dragged through the mud on the international stage. A pollution scandal at a former Indonesian operation proved to be a vengeful and costly NGO hoax. Though Newmont was cleared, the damage had been done.

So with production shortfalls in many geopolitically-safe countries, gold miners are forced to look for gold elsewhere. And elsewhere sometimes happens to be in geopolitically-unstable countries where governments or NGOs can wreak havoc. Production disruptions and permitting issues have indeed been some of the many catalysts to the global production woes in recent years.

Ultimately there are countless examples of the intricacies that hamper the gold mining industry. This shows that gold mining is not for the faint of heart and that it is very difficult to find success. Now I know these gold mining woes all seem dreadfully depressing, but this is just the nature of the beast for commodities investors.

And from a strategic perspective this reality buttresses gold's bullish fundamentals over the long term. If suppliers are struggling to meet demand and grow profits at $600+ gold, then there should still be a long way to go in gold's price before an economic balance can be attained and sustained. And we want gold mining to be challenging and risky. This is why we get the big rewards as stock investors. If gold mining was easy we wouldn't even be playing this game.

So with gold mining stocks having 5 to 1 leverage to gold up to now, imagine where this leverage will be years down the road when the miners can actually show true positive profits leverage. And with $700+ gold today, I suspect the miners will grow their profits at a faster pace than not only rising gold but rising costs.

Gold mining is indeed difficult, but there are definitely mining companies out there that are better than others. At Zeal we pride ourselves on our research and strive to identify those gold stocks that are best leveraged to gold's bull market. And we have been backing up the trucks and aggressively buying gold stocks in preparation for what we believe is now the beginning of a glorious new upleg.

Many of the stock recommendations within our newsletters have seen excellent unrealized gains so far, but we believe there is a lot more room to run. Subscribe today to receive cutting-edge commodities market analysis and high-probability-for-success stock recommendations.

The bottom line is gold miners are finding it more challenging than ever to bring new gold mines into production and obtain the stellar profits leverage that many thought possible at the beginning of this gold bull. Controlling costs and dealing with an increasingly hostile environment on the geopolitical front has certainly given the miners a hefty challenge in keeping up with increasing global demand.

As gold stock investors it is very important to have at least a loose grasp on the intricacies of the gold mining industry. This will allow us to better understand how these companies operate and handicap their performance relative to gold. As gold continues to rise, we should see earnings grow in line with expectations and these companies should eventually be wildly profitable.

Scott Wright

Sep 28, 2007

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