Gold Mining Profits 2

Scott Wright
Zeal LLC
Dec 1, 2006

In this great commodities bull market of nearly six years, gold has been an unrelenting leader. It was gold that was first to pick itself up off the mat after the ugly secular bear had it pinned for so many years. And nobody was more excited to see this swing in fortunes than the gold miners that bring new supply to market.

The vicious supercycle that took gold from its 1980 high down to its lows at the turn of the century was catalyst to some major carnage among the gold miners. Gold companies were shredded to pieces as this ravenous bear devoured the weak. Only the strong survived, and many barely limped into this bull market.

But with gold now on the rise and shaping nicely into a secular running with the bulls, gold producers are finally able to hold their heads high and run their organizations with the confidence that their product is the king of commodities once again. A far cry from the ill-fated mantra the great bear created.

So as the price of gold powers higher, so should the revenues and profits of its producers. And it is these increasingly appetizing financial benefits that attract the investment public to the gold miners. Gold stocks have indeed been a great beneficiary of the price action of the Ancient Metal of Kings which has led to them being a part of one of the best performing stock sectors of the new millennium.

One of the reasons gold producers are so attractive in a bull market revolves around the positive financial leverage these companies have in their product. Theoretically, the price at which these producers can sell an ounce of gold on the open market rises faster than the costs of extracting this ounce from the earth. This should create more profits per ounce of gold sold, hence positive leverage to rising gold.

If this concept holds true for most producers, they should be wildly profitable as gold continues to rise. The anticipation of such profits is the reason why the producers that comprise the venerable HUI gold-stock index have supported a nearly 1,000% gain over just five years. And with gold up 183% from trough to peak so far, these gold stocks currently hold a 5.4-to-1 leverage to the price of gold. This leverage is very impressive and has led to excellent profits for gold-stock investors thus far.

As this secular gold bull takes shape and gains maturity, it is appropriate for gold-stock investors and speculators to examine the financial health of the industry. Last autumn I penned an essay that looked into the vitals of this leverage concept. So now with the largest bull-to-date gold upleg under our belts, let's take a look at how things stack up after another year of exciting gold action.

One of the most important vital signs that analysts look at in relation to the bottom-line earnings and growth potential of a gold producer is cost management. Gold mining costs center on the expenses of pulling an ounce of gold from the earth and delivering it to market. Known as cash costs per ounce, these costs are the bread-and-butter of a miner's success. If a miner cannot efficiently and effectively manage cash costs, then it is toast.

In order to assemble a broad market survey of gold mining industry cash costs, I dug into the quarterly SEC filings of each of the gold producers that comprise the HUI and XAU gold-stock indices, the best-of-the-best and biggest gold miners, and captured the appropriate cost data from their operating results.

Reported cash costs are typically displayed on a per-ounce basis and include general mine operating expenses such as labor and utilities. But as we will go into in more detail later, cash costs do not directly translate into profits as there are other expenses that add to the overall cost of goods sold.

Examples of these other costs not factored into cash costs are depreciation, depletion and amortization (DD&A). These costs are included in what is normally labeled as total production cost per ounce. But since cash costs give us a good metric to measure operating expenses from one miner to another and since most analysts favor this figure in their analysis, cash costs are king.

Five quarters of data ago I penned my previous essay on this topic. And as measured by cash costs, it was apparent that there was a trend of increasing positive leverage among the major gold miners. With this newest data that captures the quarterly results reflecting the powerful gold upleg earlier this year, this trend appears to continue its pace.

This first chart shows leverage as measured by the average quarterly spot price of gold compared to the average quarterly cash costs of the major gold producers. The spread between these two figures provides a hypothetical gross margin for each ounce of gold sold with the assumption that these companies can realize their gold sales at the going market price.

It is also important to note that the quarterly cash cost data is reflected using simple averages. Even if I was to use weighted-average data based on the volume of gold each company produces, this general trend would not substantially differ.

As you can see, the spread between cash costs and the gold price continues to widen showing increasing positive leverage to the price of gold. So theoretically profits should be rising for these gold producers, right? Well not necessarily as we will see below. But before we delve into this, first I need to address another concern apparent in this chart.

The price of gold has indeed been rising at a faster pace than cash costs, but cash costs are continuing to rise at a much faster rate than one would expect. It is logical that over time costs in a capital- and labor-intensive operation would gradually rise. Justification through inflation.

Equipment and labor costs do rise over time, gradually. But in just five years, cash costs on average have risen about $100 per ounce, which amounts to a nearly 70% increase. This is hardly a gradual increase and cannot be explained through simple inflationary justification. There are several reasons for this precipitous rise in cash costs.

For many years now Wall Street has been hammering on the gold miners, questioning why their financials have not considerably improved in lockstep with the rise in price of their main product. In response to this criticism, mining executives and industry analysts have consistently cited drastically rising expenses to mine their gold.

Well as seen in this chart, they are correct. And the greater commodities bull can partially explain this phenomenon. Mining is a very energy-intensive operation. It requires energy to drill, dig, haul, crush, grind, smelt and refine the ore that eventually yields gold as the end product. So with energy prices significantly rising in the last few years, energy's related costs would obviously pass through on the expense side of gold production.

And with gold mines not always located in the most favorable geographical and geopolitical areas, this adds extra challenges. It isn't always easy or cheap to connect to a major power grid and obtain or transport fuel. And labor costs are so variable from one country to another that any problem in this area can negatively impact costs.

But another big reason for increased cash costs is one you won't likely hear from the mouths of mining executives or see in their financials or publications without reading in between the lines. This silent factor falls in the category of longevity, and is controlled by the gold miners themselves. Because the industry does not have a common phrase for this practice, at Zeal we call it low-grading.

As a shareholder who wants profits now, this practice is not always viewed with favor. But viewed from the eyes of a mine operator, it makes sense from a business perspective. Not all miners practice this, but for those that do, here is how it typically works.

In the mining industry product supply is finite. A gold miner is only viable as long as its mines are producing gold and it has a pipeline of other development projects that will produce gold in the future.

Each mine sucks in such large capital expenditures to construct that it is of utmost prudence to maximize its life and extract every ounce of gold possible. Mine operators must consider longevity just from a survival perspective. And in a high gold price environment, maximizing profits today does not always work hand-in-hand with the longevity angle as pursuing mine life can indeed lead to slower profit growth.

The way these miners perform such deeds is by targeting differing ore grades depending upon the price action of gold. Miners can control which rocks go to the mill first. And mills have limited processing capacity as measured by tons of rock/ore per day. So if mine operators have a good understanding of the location, accessibility and grade of the ore in their mines, then they can ultimately control gold output.

When the price of gold is low, mine operators target the high-grade ore for processing. Since there is more gold per ton in the ore being processed, more gold will be produced daily. Eating through the high-grade ore though is not the optimal plan for mines as it drastically reduces mine life. But at low gold prices it is necessary to maximize cash flows in order to cover operating expenses and keep the mine/company afloat during the tough times.

But gold miners are smart and understand that the gold market runs in cycles. So when gold prices are high, mine operators sometimes shift to mining the lower-grade ore in order to save the high-grade stuff for future lean times. So though less gold is produced per day, thus contributing to higher cash costs per ounce, the market price is high enough to support operations and perhaps still even turn a small profit. And the more lower-grade ore a mine can process, the longer the mine will thrive and the more ounces it will yield in the long run.

So as alluded to, many mine operators have indeed shifted to low-grading operations where they can in order to take advantage of the higher gold prices. Because of this, soaring cash costs have pinched leverage capability and profits have been lower than they could be.

But even though cash costs seem to be trending higher over the years, you'll notice an interesting reversal that has occurred in the last four or so quarters. Average cash costs actually appear to be flattening and even easing a bit in the last couple quarters. Surely there has to be an explanation for this, as if you are at all attuned to the gold stock scene most of these producers are continuing to report increasing mining costs.

Behind the smoke and mirrors of this anomaly lies the wonder of the almighty byproduct credit. And gold miners are grateful for this as now more than ever they are benefiting from what I call the byproduct bull market. Gold is mined all over the world, and in various geographic locations geologic anomalies present themselves that are very favorable for gold miners. Within various ores that house gold, other minerals are present. And in some occurrences these minerals are abundant enough to economically extract on top of gold.

A handful of the gold miners in this study are fortunate enough to have strong byproducts of copper, zinc and silver in their gold mines. And all of these metals went parabolic starting roughly in Q4 2005 through the first half of 2006, which happens to be the same period in which average cash costs seemed to settle.

And it is because of a nifty little accounting practice that enables these mineral byproducts to greatly reduce gold cash costs. The revenue obtained from selling these byproducts can be credited to the operating expenses required to produce an ounce of gold thus driving down overall gold cash costs. And with various base metals becoming significant revenue generators for some of these gold miners, cash costs have in some cases actually gone negative.

In the chart above I added a dataset that shows average quarterly cash costs excluding the numbers from three gold miners that were ultimately responsible for throwing off this trend. These three miners have enormous byproduct credits that have actually reduced their recent cash operating costs to the negative hundreds-of-dollars-per-ounce level thus skewing the data.

As you can see illustrated in brown fill, average cash costs for 14 of the 17 major miners in this study that do not have significant byproduct credits are actually well above the $300 per ounce level, nearly a $100 per ounce differential. With copper and zinc greatly exceeding all-time highs this year, it is no wonder these base metals can be so impacting.

And I imagine cash costs would be even higher on balance as nearly all of these miners have byproduct credits on some level that have positively impacted their cash costs. So while the byproduct bull has positively impacted cash costs for some gold producers, in reality the actual cash operating expenses not including the byproduct credits have continued to rise at a swift pace.

But with or without the byproduct help, average realized prices the unhedged gold is being sold for still appears to be garnering a larger margin spread as measured by cash costs. So once again, theoretically, profits should be rising for these gold miners and the fundamentals of the stocks should be growing more attractive.

So if profits should scale proportionately to the action of the price of gold, this should be reflected in the financials of these gold producers right? Again, not necessarily. Even though I had a hunch as to why we will not yet see the wild profits many expect at this stage in the gold bull, for reasons that are on top of the low-grading many miners are doing, I pulled the revenue and earnings data for each of the companies in the HUI and XAU and summed them up through the course of our current gold bull to provide us with a visual depiction.

As you can see in this chart, revenues represented by the red columns are on the rise. Also plotted in this chart is the average annual gold price. So as the gold price is trending higher, so are the revenues the gold miners are reporting as they receive more money for their gold. This trend is absolutely logical and is to be expected.

But when you look at the sum of the profits being reported by the gold majors as represented by the blue columns, a peculiar path is taken that is not quite in line with revenues and the price of gold. From a pure fundamental viewpoint, this oddity is illustrated by looking at the wacky valuations many of these gold companies exhibit. Price-to-earnings ratios, for those producers that actually turn a profit, rank abnormally high.

My partner Adam Hamilton has written a series of essays that analyze the gold-stock valuation phenomenon and provide background with some excellent top-down reasoning surrounding this issue. In his most recent essay in this series of less than two months ago, Adam pieces together an excellent table with all the P/E ratios for these producers.

Though the earnings are getting better of recent as gold continues to rise, amazingly nearly half of these gold producers are still not profitable and many of those that are have skimpy profits that have them trading at high multiples.

A reason for the seemingly illogical lethargy these gold producers display runs along the line of timing and gold mine life cycles. Through the skinny bear-market years the gold producers had to learn to appropriately manage their costs just to stay afloat. The highest-grade ore had to be mined and any non-core business expense was slashed.

Even with this, the gold lows in the $250s just shredded the gold miners. In many cases cash costs to mine an ounce of gold were higher than the realized gold price. And non-core assets had to be written off and charged to the books because of their inactivity and crashing carrying value. This just decimated profits as seen by the negative reported earnings in 2000.

But as the price of gold started to trend higher in 2001 and 2002, profits began to rise with revenues, a logical path to take. But a peculiar thing started to happen to earnings from 2003 to 2005. Profits slumped and did not follow the revenue and gold price trend. Now comes to play the longevity and life-cycle factors for the gold miners.

In the 1980s and 1990s the budgets for exploration and acquisitions trended down in unison with gold. As revenues and profits turn downward, so does the discretionary capital that would support spending on this front. Exploration is key for any natural-resources producer. And it is key for the ultimate longevity of not only an individual company but the industry. Over- and under-exploration are among the most important strategic fundamental drivers of commodities supercycles.

In a bear market when commodities prices are low and companies are only generating enough income to fund ongoing operations, exploration is neglected which leads to the lack of discoveries and development. This greatly affects supply to the downside for many years into the future.

Well on the gold front a supply crunch has reared its ugly head as demand has left it in the dust. There are simply not enough new gold mines opening to meet this growing demand. This is capped off by the fact that maturing gold mines are quickly depleting their resources.

There was just not enough discovery and development in the 1980s and 1990s to secure a modest future gold supply. Not only has this triggered higher gold prices, but it has lit a fire under the butts of the gold companies to ramp up their exploration efforts. These efforts directly translate to dollars and cents.

Exploration is expensive, and in the last few years companies have been spending a lot more money on this front. And for those companies that do not have the desire or skill to grow from within, they are buying up the projects or companies that do, and this costs money as well. So since companies are seeing higher cash flows they are able to spend more to boost exploration. This is much needed in order to make up for past shortfalls.

Another reason profits aren't high revolve around the effects of the hedging that was so rampant at the end of this last bear. As the price of gold trended lower, many companies felt compelled to lock in the price of the gold they sold in the future fearing a continuingly tumbling gold price.

This occurred not only to secure operating needs but to finance the few development projects that were around back then. Well this hedging, known as forward selling, is now coming back to bite many of these gold producers that couldn't see a light at the end of the tunnel.

With gold rising so rapidly, virtually all of the hedges that were contracted before 2001 and many after have become losers. Many of these gold producers are locked into commitments to sell their gold for much lower than what the open market is paying and are then forced to recognize significant losses, both realized and unrealized.

Because of this many producers are aggressively trying to reduce their hedgebooks by structuring buybacks or delivering early to avoid potentially wider losses in the future. Dehedging is a lesser-known word in most vocabularies, but it's sure been flying around the gold community in recent years.

It has been estimated that over 12 million ounces of gold have been dehedged so far this year, a part of a greater trend that has seen total global hedging decline in recent years. But as referenced, dehedging comes at a hefty price and has been costing gold producers billions of dollars each quarter.

Yet another factor that has been eating into gold miners' profits lies on the geopolitical front. With the discovery of rich gold deposits becoming scarcer in the first-world geopolitically-safe countries, gold companies have been forced to scour the planet for the next big discovery. Fortunately they are finding these deposits, but unfortunately many are laden with geopolitical risks that are costing these gold miners big money.

In the less-developed countries that do not have the resources to build and operate a mine, they have to rely on, or allow, foreign investment to exploit their resources. And unfortunately the governments of many of these countries are run by bureaucrats that bask in the faulty glory of socialism, Marxism and authoritarianism.

And these countries are not blind to the fact that a global commodities bull market is making these "greedy capitalist miners" (this means you and me) a lot of money. So because of the lack of accountability, many of these governments have the freedom to essentially do as they wish. And in the case of the mining industry, they feel it is appropriate to forcibly obtain a greater share of the pie from these evil foreign miners that are pilfering their resources.

So even though these miners already contribute a sizeable portion to some of these countries' GDPs through employment, taxes and royalties that are currently in place, these governments feel it is their right to either add windfall-profits taxes among other extraneous taxes, jack up royalties or even nationalize a mine by taking complete or majority ownership away from the foreign corporation. So even though cash costs may be low at some of these foreign mines, after taxes and royalties add up, it is near impossible to turn a profit for the shareholders.

But with all these factors among many that have been eating away at gold mining profits, recent profits are finally starting to strengthen, and quite significantly compared to the last few years. The average gold price so far in 2006 is now just over $600 an ounce which is 35% higher than last year, by far the most significant year-over-year jump in this entire bull. Also the effects of hedging are finally starting to wane even for the most notorious hedgers in the industry.

And incredibly the 2006 data in this chart is only through Q3 and not annualized. So this year's revenues and profits are in line to shatter those annual numbers the gold producers have provided bull to date.

But due to the nature of this industry, the lack of exploration and discovery in the previous decades has and will continue to hurt it. Because it takes so much time and capital to explore, discover and construct a gold mine, global gold production has and will continue to lag demand. It will take many more years of large exploration and development expenditures to ramp up supply enough to stabilize the price of gold.

Today's high gold price is finally starting to show signs of support for the massive expenditures gold companies will need to continue to spend in growing global supply. On top of a variety of other fundamental reasons why gold should continue in a secular bull market, the financial performance of the gold miners serves as an excellent proxy for the health of the industry.

And it is the stocks of these gold miners that will provide investors the leverage to really capitalize on this gold bull. At Zeal we have been layering back into gold stocks since the beginning of what appears to be the next upleg for gold. So far the unrealized gains for our newsletter subscribers average 25%+ in just a few months and we will continue to layer in as the best is likely yet to come. Please subscribe today to our Zeal Intelligence newsletter to see our latest gold stock picks just recommended today.

The bottom line is even though the average gold price has risen high enough to provide record revenues for the gold producers, profits still continue to lag. This abnormality can be attributed to a number of factors, but ultimately the miners are still playing catch-up from the bear years.

Despite this, the positive leverage we still see in gold stocks to the performance of their underlying metal allows investors and speculators to greatly profit from a continuing gold bull. As profits continue to get better, this small market sector should draw attention and enthusiasm from a greater pool of capital that should continue to bode well for the gold stocks.

Dec 1, 2006
Scott Wright
ZEAL

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