By Ronald-Peter Stoferle, Incrementum AG Liechtenstein
November 21 (King World News) – Worried About Gold / Silver Action – Just Read This
Creative destruction: does an about-face for the sector lie ahead pt1
Gold stocks have failed to deliver the expected leverage to gold in recent years. It appears that mining stocks are being punished by investors for the mistakes made in previous years. Apart from cost inflation, the main reasons for this were sub-optimal capital allocation and the investment alternative offered by gold ETFs backed by bullion, but above all, the extrapolation of an ongoing upward trend in the gold price.1 In the course of the bull market, the industry used ever higher price assumptions in order to include previously unprofitable ounces into its mine plans. As a result, the life of mines was increased and production expanded.2 A large part of the expansion however consisted of high-priced ounces….
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Moreover, increasingly demanding and complex projects were tackled and highly dilutive takeovers were undertaken. In combination with steadily rising labor and input costs, as well as rising tax rates, the result was a decline in operating cash flows.
Costs increased by an average of 11% per year from 2000. In an environment of rising gold prices, this didn't pose a problem, production could be expanded “at any cost”. However, the expansion was driven mainly by the issuance of new shares. According to US Global, gold production of the 80 largest producers grew by 14% since 2008, while production per share actually fell by 9% per year.3 As a result, the industry produced barely any free cash flow in 2012 (with the gold price averaging USD 1,670), while indebtedness had risen markedly.4
The sharp correction in the gold price abruptly revealed that numerous projects, which had been profitable at USD 1,600, were suddenly unprofitable. Additional development projects are not only a waste of money at current price levels, but would even threaten the existence of a company should the gold price remain at current levels (or a lower) for an extended time period.
Numerous costs are direct derivatives of the gold price (such as royalties, input factors such as e.g. drilling costs, taxes, wages for skilled workers, etc.). Considering this, we think David Baker's proposal that gold producers should keep their accounts in gold terms and pay out a fixed percentage of their production to shareholders sounds very interesting. This would have numerous advantages, such as e.g. higher transparency and comparability within the sector, imposing the highest possible discipline on management in the context of M&A activities, etc.5
In our last “In Gold we Trust” report, we already pointed out that we were skeptical with respect to the mantra of “forever rising production costs” and are forecasting an end to rising costs, resp. even a deflation of mining costs. This was clearly proven correct in the course of the past year. Due to anaemic economic growth and a strong decline in commodity prices, numerous input costs stopped rising, resp. even fell. Thus prices for industrial tires, explosives, as well as wage costs have declined strongly in the course of the current brutal market adjustment. We are of the opinion that the sharp correction in the gold price was a wake-up call for the industry.
There were recently numerous positive changes in the sector:
* CEOs were replaced at nearly 30 companies, including the likes of Barrick Gold and Newmont Mining
* Cost discipline: radical improvements in productivity, personnel reductions, new agreements with suppliers, etc. have led to lower operating and capital costs. According to Black Rock, all- in costs fell from USD 1,200 at the end of 2012 to USD 1,190 in Q4 2013. This implies a reversal of a 10-year long upward trend in costs
* Cost transparency: among others, Yamana, Barrick Gold and Goldcorp will from now on publish their “all-in continuing cash costs”
* Numerous exploration and development projects were sold or put on hold
* Renewed focus on “higher return ounces”. The reserve grade at the largest producers rose by 12% to 1.11 g/t
* Balance sheets were strengthened through the issuance of shares or debt conversions
* Numerous commitments to dividend growth and shareholder value
The result is a clear improvement in operating performance and a higher beta for the sector.
Conclusion:
The industry is currently experiencing changing tides. Such an amount of creative destruction within a sector is quite normal and healthy. It appears as though the industry is currently in the process of setting new priorities. Profitability, capital discipline, and stable cash flows per ounce are winning over the maximization of gold production. We believe this renewed commitment to cost transparency, greater financial discipline and shareholder value to be an important – if somewhat belated – move by the industry. Whether this new focus is pure lip service or not will become evident in the coming quarters. Since the massive write-downs and charges were one-off measures, massive upside leverage could follow. We therefore believe that gold stocks exhibit a highly asymmetrical risk-reward ratio at the moment.
1 see „Gold: Beta’s back“, Catherine Raw, BlackRock, Mining Journal.com
2 Gold production rose by 24% between 2008 and 2013
3 see „Time to Mine for Gold Mining Opportunities?“, U.S. Global Investors
4 see “Gold: Beta’s back”, Catherine Raw, BlackRock, Mining Journal.com
5 see “Getting Closer to our Gold”, “Defining a New Identity and Restoring the Appeal of Gold Shares”, “Issues Facing Junior Gold Companies & Introducing the Production Linked Dividend Model”, David Baker, Baker Steel Capital Managers
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