 Gold-Mining
Profits Healthy?
Scott Wright, Zeal
LLC
Oct 28, 2005
It's no news that energy
prices are on the rise. Business and commerce have become
so energy dependent today expenses are multiplying in order to
keep the wheels greased. Today's world economy is growing at
such a breakneck pace the natural resources consumed to produce
this energy are being relentlessly devoured.
Because of this increased demand
for natural resources, global supplies are struggling to keep
pace causing the consumer to feel the cost crunch in everything
from filling their gas tanks to paying their utility bills. And
businesses are feeling it even more as the costs of manufacturing,
trade, etc. continue to rise.
The producing companies that
supply the economy with these commodities are certainly not exempt
from the rise in costs of doing business either. It requires
energy to drill, mine, refine, smelt and in general produce any
commodity. Since our attention at Zeal has centered on precious
metals throughout this commodities
bull, we'll focus on mining with particular emphasis on gold
miners in examining their environment of increasing expenses.
Since mining is not as simple
as picks, shovels and donkeys anymore, pulling minerals from
the ground has universally become a very capital- and energy-intensive
process, with each step requiring some form of energy. Many miners
need to be creative with their power needs as their mines do
not have the luxury of being located near big-city power grids.
It also requires significant
amounts of liquid fuel to power mining equipment and machinery.
Once the ore is extracted from the ground it is processed on
site, and then in most cases is transported to an external refinery
to perform the finishing touches. Each of these steps requires
energy. With energy prices playing a large role in increasing
the expense of doing business around the world, how much of an
impact does this have on the health of a leveraged commodity
producer?
Historically, the financial
health of many commodities producers hinges on the success of
their specific financial markets within their accompanying economic
market cycles, not necessarily the management of expenses. Market
cycles have built and broken many commodities producers, and
those that are resilient are able to persevere through the thick
and thin of them. On the thick, or flow, side of these cycles,
commodities producers watch their revenues and profits skyrocket.
Where on the thin, or ebb, side of these cycles commodities producers
can get slaughtered, in which only the strong survive.
Investors are able to play
both slopes of these cycles and, if they time them correctly,
legendary gains can be won. Since we are currently in the flow
side of this cycle, smart investors are going long in the commodities markets.
Commodities prices are ultimately
determined by the economic reality of supply and demand, and
monetarily by the commodities futures markets. Commodities producers
cannot take their product to market at any price they see fit.
In reality the daily activity of the futures markets dictate
what price they can sell at or what kind of a hedge or contract
they can set up with their buyer. Until, for example, gold producers
withhold a significant portion of their product from the market,
they are slave to them.
For years now our focus at
Zeal has been on today's spectacular secular gold bull market.
The price of gold has risen 87% since this bull market began
and gold miners have been enjoying an enormous increase in their
leveraged profits resulting in stock appreciation far exceeding
the gains of the underlying metal they produce.
Even with this, there are grumblings
among gold mining executives and investors alike about how increasing
expenses are making it continually hard on the bottom line and
are dampening investor enthusiasm. Today we'll take a closer
look at the financial health of these gold miners, their leveraged
profits and how increasing expenses are truly affecting them.
In order to get health readings
on these gold miners we first need to look at their vitals. Most
important to these vitals are their financial statements. To
assemble a broad market survey of the gold mining industry, I
gathered data from all the top publicly traded gold miners that
comprise the popular HUI and XAU indexes. In doing so I pulled
each company's quarterly SEC filings since 2001 and built a massive
spreadsheet indexing all of their pertinent data relating to
mining expenses.
Gold miners report their operating
expenses on a per-ounce basis. This makes it easier to gauge
where they are in comparison with the average realized selling
price per ounce they receive per quarter. This information can
provide a high-level look at where profits may be, as the lower
the operating expenses theoretically the higher the profits should
be.
When scouring these financial
statements you will find that expenses are reported on a cash
basis, or cash cost, which includes general operating expenses
such labor and utilities. Expenses are also provided on a total
production cost per ounce basis that includes such items as depreciation,
depletion and amortization. For our discussion we are going to
use the cash-cost basis, as this gives us a good reflection of
the variables that go into operating expenses in addition to
the fact it is usually what analysts cite.
Because of this recent chatter
around increasing expenses, I decided to take a closer look at
those the gold miners are reporting to see if I could identify
a tangible trend. Each quarter publicly traded gold miners are
required to publish cash costs per ounce of gold mined in their
SEC filings. This data is presented on the first chart showing
average cash costs each year since 2001 for the gold miners that
comprise the HUI and XAU.
Charted on this dual-axis chart
against the cash costs of producing an ounce of gold is the price
of oil over this same period of time. In reading the Management
Discussion and Analysis (MDA) reports that accompany most financial
statements, management has storied a trend in recent years attributing
a good portion of rising cash costs to increased expenditures
on energy costs. Crude oil seems to be the best chartable measure
of rising energy prices as other energy sources such as diesel
fuel and gasoline typically follow its trend.
As you can see on this chart,
there is a distinct upward trend and apparent correlation of
the rise in price of oil to the rise in cash costs of producing
an ounce of gold. Since 2001 oil has gone from just under $20
a barrel to nearly $70 a barrel. This amounts to a 300% increase
from its low of just over $17 in late 2001 to nipping $70 at
the end of August of this year. As mentioned earlier this dramatic
rise in price has been felt by consumers and businesses globally,
and this does not exclude gold miners.
The rise in energy prices is
one of many factors, albeit a major one, contributing to an increase
in the cost of producing an ounce of gold. As this gold bull
has picked up steam, the average reported cash cost per ounce
has increased by over 50% in the last five years. In 2001 and
2002 miners averaged $170 cash costs per ounce whereas so far
this year they are averaging over $250 to produce each ounce
of gold.
This $80 per ounce increase
in expenses is not your standard economically acceptable price
inflation. This enormous increase in operating expenses would
have most non-commodity-producing companies flat on their backs.
We'll discuss factors other than energy that contribute to this,
but since mining is so energy intensive, the trends apparent
in this chart cannot be ignored. Energy expenditures are directly
affecting gold miners in a big way.
Now I need to throw in the
caveat that this is an average cash cost per ounce for the major
miners. When investors do their homework and perform their due
diligence in choosing companies in which to invest, they will
find one miner can be vastly different from another. Some companies
are able to produce an ounce of gold for cash costs of under
$100 an ounce, and some are spending an average of over $400
an ounce to produce an ounce of gold. There are several reasons
why there may be such a difference from one miner to another,
but when it comes down to it the company that produces gold for
cheaper has greater profit potential which in most cases reflects
positively on its stock price.
As mentioned, many other factors
go into and can increase the cash costs of producing an ounce
of gold for these miners. Factors such as changes in production
rate, changes in ore grade which can lead to changes in milling/processing
costs, maintenance costs, labor costs, development costs, currency
fluctuations, royalties and production taxes are sometimes included,
refining costs, selling costs, transportation costs, inventory
adjustments as well as many other costs form this equation. The
management of each of these costs has the capability of increasing
or decreasing overall costs.
In addition to all the various
expenses that influence total cash costs, there are also mechanisms
capable of directly decreasing overall cash costs. Most gold
mines produce byproducts, for example silver. Instead of selling
and booking the byproduct exclusive of gold, it can be lumped
in with gold so its profits can act as a credit to the operating
cash cost of gold. Changes in byproduct production can also influence
overall cash costs.
In the grand scheme of things,
there are generally accepted standards for determining cash costs,
but there is also wiggle room that allows each miner to do things
a little differently. No matter how you look at it, the cash
costs of producing an ounce of gold have been on the rise, with
energy costs leading the way.
So we know expenses are on
the rise, but how is it really affecting the profits of gold
miners? Now we must revert back to the premise that the product
these companies are producing is a commodity. A commodity, mind
you, that has been on a tear in the last five years.
Now in order to understand
how increasing cash costs are affecting the overall profits of
gold miners, there are a few things we need to understand about
leverage. The basic premise of leverage assumes each company's
operating expenses, or cost per ounce, is uninfluenced by the
underlying metals activity in the futures markets. It is also
assumed that cash costs stay relatively the same over the short
term, of course allowing for gradual economic increases.
As the cost of energy rises
significantly, so do the expenses on any company's financial
statements, regardless of their business. Whatever the product,
when expenses rise on a per unit basis, especially for non-commodities
producing companies, it reduces margins and usually results in
a direct decrease of realized profits.
Increases in expenses of course
affect commodities producers, and obviously will reduce margins.
But depending on what's happening in the commodities markets,
revenues and profits can still rise significantly without an
increase in production. This phenomenon is attributed to the
power of leverage.
As an example, lets say miner
XYZ is able to produce its gold at a cash cost of $250 per ounce.
What XYZ can sell it for on the open market varies depending
on the daily price fluctuation of gold, assuming XYZ is unhedged
(if a miner is hedged its selling price is already set independent
of where the market is).
If gold was trading at $350
per ounce, XYZ would theoretically be looking at a $100 profit
per ounce sold. But if gold were in an up market and shot up
to $500 per ounce, it would have a $250 profit per ounce sold.
XYZ's margins are leveraged to the price of gold and this hypothetical
$150 difference in profits can be directly added to the bottom
line because its costs of producing that ounce of gold remain
the same at either price. In a gold bull market, gold miners
are leveraged to make some serious profits as the price of gold
continues to rise, as in this case XYZ's profits nearly tripled
on a modest 40% increase in gold.
Though gold miners have had
high positive leverage to the price of gold in this bull market,
these increases in expenses have apparently been enough to warrant
some worrisome chatter in the gold community. One of gold's most
respected proponents Robert McEwen, Chairman and former CEO of
market-darling Goldcorp, was featured on CNBC a couple weeks
ago with his take on the recent strength of gold and this expenses
topic.
When asked why gold was on
the rise, in addition to a myriad of fundamental
reasons, Mr. McEwen started by explaining that expenses were
on the rise and that there was a cost push for labor and materials
in the gold mining industry. I was surprised at the airtime anti-gold
CNBC gave Mr. McEwen, but wasn't surprised seeing Sue Herrera
wince when Mr. McEwen gave his prediction of $850 gold in the
next five years in order to stabilize gold demand.
Though Mr. McEwen gives further
testament to rising expenses, we cannot ignore the blistering
pace at which gold is rising as well. If these companies were
producing a product in which prices were fixed or only rose modestly
with inflation then these rising cash costs would absolutely
be gouging away at their net profits. But what these miners have
been able to sell their gold for has been on the rise, a significant
rise. And we'll find that even with these rising expenses, gold
miners' leverage and exposure to this rising gold price has left
them in an increasingly better position than five years ago and
has more than compensated them for their increased operating
costs.
Our next chart shows quarterly
data for the average cash operating costs of the major gold miners
along with the average quarterly spot price of gold. As you can
see there is an obvious increasing trend for both data series.
Cash costs are rising and so is gold.
Interestingly, the trend wedge
drawn into this chart is widening. In order to understand the
theme of this chart, I calculated some rough and hypothetical
figures. Now let's assume these gold miners are for the most
part unhedged, which is the case for all the miners in the HUI
and XAU sans four. All I did was take the simple spread between
cash operating costs per ounce and the average spot gold price
per ounce to come up with a rough profits estimate.
Please understand this is not
a true representation of these companies' profits as each has
different operating costs and additional production costs commonly
called DD&A (depreciation, depletion and amortization) that
are not included here. On top of this each company derives different
profits depending on its accounting measures and other extraneous
entries. This simply shows an increasing gross-margin spread
that theoretically should reflect increasing profits.
In 2001 there was an average
$100 spread between cash costs and gold spot price for these
miners. And as you can see on the chart there are incremental
increases each year up to 2004. In 2002 there was a $142 spread
between average cash costs and spot gold, which turned out to
be a massive 43% increase in theoretical gross-profit margins.
Even though there was a 31%
increase in cash costs from 2001 to 2004, there was an 84% increase
in theoretical profits during that same period of time. 2005
profits are slightly down from 2004 for the first half of this
year, but a big breakout in gold so far in the second half of
this year will push these numbers up significantly most likely
even eclipsing the 2004 numbers.
This chart makes it blatantly
obvious that even though cash costs are rising, profits should
be rising even faster. With this gold bull market and the operating
leverage these miners have to the price of gold, this chart should
continue to paint a pretty picture for investors.
Now with these theoretical
increases in profits due to the outstanding leverage these miners
have, you can't tell me gold-mining stocks have lost the air
in their sails. Even if cash costs continue to rise, which they
most likely will, if gold continues to rise like we
think it will, even to Robert McEwen's conservative $850
in the next five years, profits are still going to be enormous
for these gold miners and their margins should continue to rise.
Gold miners' profits appear
to be healthy, do not be swayed to believe otherwise. Cash costs
have been on the rise but gold has been outpacing it and should
continue to do so as this bull runs its course.
In light of this, there are
discretionary but necessary expenses outside of production costs
that have contributed to this chatter. As gold mining increases
its output to meet today's demand, gold miners need to position
themselves to meet future demand as well. As gold is extracted
from existing mines, the ore grade and reserves from these mines
decrease. So miners are faced with the challenge of developing
their other reserves, which depending on ore grade may lead to
more costly production, as well as explore for more in order
to renew their reserves. Both of these endeavors are costly and
add to overall expenses as time goes on.
I have seen various estimates
as to how much exploration is adding to expenses on a per-ounce
basis, but none of it is alarming and is natural in an environment
where miners can now afford to explore. Whereas in the 1990s
when gold was down there was not a budget for this, today profits
can fund such ventures.
Good management at gold companies
should be able to balance the cash flows generated between benefiting
the fundamentals and shareholder value of the stock and exploration
for the future. But even if margins are squeezed as many lean
towards, this will only add to the strength of this gold bull
as Mr. McEwen and astute gold bulls have been speculating. Only
higher gold prices are going to encourage miners to spend money,
otherwise the gold supplies will shrink.
At Zeal we continually monitor
the financial trends of the world's gold miners. In picking individual
stocks in which to invest, it is important to identify those
that are well positioned to leverage outstanding profits in today's
and tomorrow's markets and those that prudently manage their
expenses.
As we identify these companies
and our trading indicators are signaled, we recommend them to
our newsletter
subscribers. Please subscribe
today if you would like to tap our cutting-edge research
and analysis and ride this commodities bull with us.
The bottom line is even with
rising costs in gold production, gold-mining profits are still
healthy. As this gold bull market picks up steam costs may continue
to rise, but profits should be even healthier. Investors that
are positioned in the stocks of those gold producers best leveraged
to their underlying metal and able to efficiently manage their
expenses should reap legendary rewards.
Scott Wright
ZEAL
October 28, 2005
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