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September 05, 2008

Gold Mining Challenges 2
by Scott Wright

With seven consecutive years of rising gold prices, the gold mining industry has had ample reason to boost output. The demand for gold has grown and will continue to grow and legendary profits can be won for shareholders. But in provocative fashion not only have the gold miners been unsuccessful in growing supply, global mined gold production is down since the beginning of the bull.

In last week's essay I revisited gold's strategic fundamentals with particular focus on economics, drilling down on global gold production and reserves trends. And interestingly global gold production is down 4% since 2001. In a secular bull market this is not a logical supplier response to an economic imbalance.

With mine production trending down, it is apparent there is a structural problem with the gold mining industry. And the top-four primary gold miners in the world tell this story with their production declines in the last two years. In 2008 Barrick Gold (ABX-NYSE), Newmont Mining (NEM-NYSE), AngloGold Ashanti (AU-NYSE), and Gold Fields (GFI-NYSE) are on pace for an 18% (4.5m ounces) decrease in collective gold production.

And the numbers from just these four companies are material, as they are responsible for over 25% of the annual mined supply of gold. So what's going on with the gold mining industry? Mining for gold should be more popular now than ever before and there is a lot of money to be made in a bull that is expected to stay strong for many more years. Why the decline?

Well a recent interview with CEO Tye Burt of senior gold miner Kinross Gold best presents what is going on in his industry. "While the gold mining industry has seen successively higher gold prices over the last decade, permitting and construction challenges, operational difficulties, and cost pressures have caused global mine production to decline with no signs of this trend abating in the near future."

Instead of an environment of joy and jubilation, Mr. Burt tells us the gold mining industry is experiencing pain and strife in getting its product to the market. Well in order to understand the trends we are seeing today, we have to step back and view the gold cycle in strategic context. And it all boils down to flows of capital.

As any seasoned investor knows, the markets are slave to cyclicality. And commodities are not an exception. At Zeal we have extensively studied this cyclicality in our thread of Long Valuation Wave research. And these LVWs make the case for today's secular commodities bull based on the inverse relationship commodities have with the general stock markets.

In a nutshell when the stock markets thrive, like from 1982 to 2000, capital flows out of commodities and into stocks. The inverse works in the same fashion. When commodities thrive, capital tends to flow out of the stock markets and into natural resources. But 7+ years into this current commodities bull cycle, what we are seeing today is proof positive as to why LVWs are secular in nature. The simple fact is it takes a long time to restore the health of an industry that was ravaged by a fierce and unforgiving bear.

The pitiful state of the gold mining industry at the turn of the 21st century is a result of years of industry neglect on the capital investment front. Capital flowing out of commodities for an extended period of time radically altered this industry's health. And since the process of finding and mining gold is very capital intensive, when the money disappears this industry experiences what feels like a slow death.

When capital dries up, the small and mid-tier companies that explore for and discover the gold deposits of the future are the first to die. Since these explorationists rely mostly on stock offerings to fund their operations, when capital flows out of commodities there is nary a person to subscribe to their shares.

The larger gold miners are also quick to hemorrhage as the price of gold falls and profits erode. And when the books need to be overhauled in order to stay afloat, the exploration budget is the first to go. It is even tough for these senior miners to find financing in a bearish environment. Why would a bank want to fund gold exploration when it can fund the next great website or tech gadget?

When the little guys die and the big fish slash exploration expenditures, the gold mining industry begins to implode. Gold discoveries become less frequent and robust and the existing infrastructure quickly erodes. And with gold prices so low, there is simply no incentive to hit up the markets for exploration financing.

But just when the plug is about to be pulled on gold's life support, the markets change their tune and begin the resuscitation process. While the carnage that precedes this process can decimate an industry and send investors over a cliff like lemmings, it is all part of Mother Market's natural cycles.

Ultimately after years of underinvestment in exploration and infrastructure, the gold mining industry is faced with a massive rebuilding effort. So when the general stock markets ended their bullish cycle in 2000, the flow of capital slowly began to shift to the beaten and bloodied commodities sectors that were starving for capital.

Leading into the gold bull that began in 2001, many of the world's largest gold mines were quickly depleting reserves, there was a lack of sufficient development to bring online the next generation of gold mines, and there was a lack of exploration to discover the gold deposits of the future. And from what we saw last week, even this far into this bull the gold mining industry still has its work cut out for it to reverse the production trend and grow reserves.

This slow reaction speed of the miners is a good testament to why major market cycles are long-term, with a full LVW cycle historically averaging about 34 years. Gold miners simply can't turn on a spigot to increase production. It takes a lot of time and capital to expand existing operations and develop mines from scratch.

And rebuilding the gold mining industry is all the more difficult since decent-sized gold deposits are much harder to find these days. Most of the super-high-grade gold in the geopolitically-safe regions of the world has been found. In the last several decades of modern gold mining, it seems as though the miners have picked most of the low-hanging fruit.

Just look at South Africa for example. For a long time SA was by far the largest gold-mining country, producing up to 70% of the world's gold. The rich gold veins knifing through the earth in SA's massive gold fields were second to none. But over the years the near-surface high-grade veins were depleted and the larger elephant-sized discoveries became rarer.

Aside from everything else working against SA in the last decade such as labor, power, and currency issues, the geology has simply fallen out of favor. SA gold has become harder to find and it is not grading as high as it used to. And for many of the large mines in this country, following the veins deep into the earth grows more expensive with depth and presents mounting safety issues.

Last week when I looked at global reserves measured by the US Geological Survey, there was a large drop off in 2002 that was a direct result of South Africa lowering its country's gold reserves. And to this day production and reserves continue to fall in SA, as its production volume is less than a third of what it was 40 years ago.

But South Africa is not the only historically-rich gold region losing its luster. In many countries that have strong gold-producing histories, discovery is way down from the past. What are considered major gold discoveries (3m-ounce deposits) have become exceedingly rare. And a recent study by the Metals Economics Group offers some insight into this alarming trend.

So far in the 2000s even though exploration budgets are up from what they were in the 1990s, this decade is on pace for 75% less 3m-ounce gold discoveries than the 1990s. And in a recent interview with Gold Fields CEO Nick Holland he claimed there's only one 5m-ounce deposit found each year in the entire gold sector, and it takes about $4b to find this one ore body. It is definitely getting harder to find big gold.

So since gold is getting harder to find in South Africa, the US, and Australia among the world's leaders, gold miners are forced to search elsewhere for major discoveries. And this is where geopolitics come into play now more than ever. In Latin America, Asia, Eastern Europe, and West Africa there are indeed major gold discoveries being made. But the cost of doing business in some of the countries that host these deposits can be quite lofty, if not lethal from a fiscal perspective.

Ignorant bureaucrats and non-governmental organizations can wreak havoc on gold miners. On the environmental front the judicial systems in non-developed and/or non-first-world countries can be bullied and bribed by deep-pocketed NGOs that can quickly shut down exploration or mining operations.

And some governments are either too greedy or economically inept to understand the social and economic benefits of a gold mine. They either establish taxes and royalties that are too high or flat-out nationalize a portion or all of an operation run by a private international company. This drives out foreign investment and eventually leads to failure when state-controlled companies try to profitably operate a gold mine.

Just look at some of the goings on in countries such as Venezuela, Romania, Bolivia, Uzbekistan, Turkey, and Mongolia. In some of these countries there are 10m+ ounce high-grade gold deposits that may never be brought into production thanks to an array of bureaucratic shenanigans.

There will of course be the occasional monster discovery such as that to which Nick Holland is referring that is located in a place that can actually be mined. But with the slim pickings these days many miners have to take a different approach to their gold exploration. And thanks to a higher gold price this is possible.

Interestingly there is a lot of gold in the world. The world's oceans even host a low concentration of gold in their waters. And if the price is high enough it can be mined. But for the land-loving gold miners, geology is the ultimate constraining factor that dictates whether a deposit can be economically mined.

Since ultra-high-grade deposits are not as abundant, miners must go after the lower-grade deposits to get their gold and bank their resources. And with the gold price where it is today, the miners can take a closer look at deposits that several years ago might not have been economical to mine.

But with these higher gold prices opening up a broader range of gold mineralization to be mined, why are there still production declines and just flat reserve renewal? Well from a production standpoint Tye Burt tells us that existing operations are struggling with cost pressures and operational difficulties. And combine this with the fact that not enough new mines are being built, global gold production does not have favorable conditions to rise.

Barrick Gold Chairman and interim CEO Peter Munk puts these cost issues into perspective in a recent statement. "The main challenges that face Barrick, and I think I may as well speak for the industry at large, are the cost factors. They are relentlessly moving upwards...and the key to controlling costs in the future will be opening new mines with fundamentally different cost structures."

If you ask any gold mining CEO about industry challenges they are almost certain to mirror the sentiment of Peter Munk with costs being the main issue. But with the gold price rising so sharply, is it possible that costs are rising proportionately? Looking at the chart below it doesn't appear this way at first glance.

In what proved to be a tedious but fruitful exercise, I scoured the quarterly financial statements from 2001 to current for each of the gold miners that reside in the HUI and XAU gold stock indexes. The purpose of this was to translate the grumblings of the gold miners into cold-hard data. And with cash cost data for each quarter I can now paint an interesting picture.

Before digging too deep it is important to note that this cash cost data is compiled using simple averages. But even if I was to use weighted-average data based on the volume of gold each company produces, this trend would not substantially differ. For example the average H1 2008 cash costs for the big-four gold miners mentioned above is $435 versus a group average of $401. This would not make a material difference on the implied gross margins.

Another dataset I include in this chart is average cash costs without major byproduct credits. A handful of gold miners are fortunate enough to mine gold from ore that has strong byproduct mineralization of such metals as copper, zinc, lead, and silver. If these minerals can be extracted economically many miners will use their revenues to credit gold's operating costs.

So with the prices of base metals launching parabolic from 2005 to 2007, gold operating costs were artificially skewed to the downside thanks to these massive byproduct revenues. And with this playful accounting cash costs can appear exceptionally low, even negative sometimes. Because of this the simple averages were thrown off during the base metals parabolas.

As you can see cash costs (the red series) from 2005 to 2007 were relatively flat. But in throwing out the negative cash costs from three gold miners that had exceptionally high byproduct revenues, we get a better picture of true cash costs for gold mining. So considering global commodities inflation and industry sentiment, the yellow data series better reflects cash costs growth for gold miners. And this is the series I use to calculate the hypothetical gross margins.

On an interesting note you can see that with the price of oil up and base metals down in 2008, the gap between the two series of cash costs is not as wide as in the previous two years. Byproduct credits haven't been as plush this year and the multi-metal gold miners are now feeling the cash cost burn like everyone else.

Starting from the beginning of the bull we can see that cash costs are indeed on the rise. But so is the price of gold. In fact as you can see the average annual price of gold is rising at a much faster pace than cash costs. Nearly every year in this bull the spread between cash costs and the gold price has been rising. Visually this chart makes it look like unhedged gold miners should be greatly growing their booties each year.

But if you calculate simple gross margins off average gold prices and cash costs, the financial growth story is quite a bit different. This is why Nick Holland can make this statement. "What we have had over the last couple of years is a rising gold price...but we've also had rising commodity prices across the industry as a whole...And that's put a lot of pressure on costs. As a consequence of that, you've seen the revenue line increase, but you've seen the cost line following it. So the margins haven't really opened up."

Well in stepping back and looking at this industry's financials as a whole, I believe Mr. Holland has hit the nail on the head. While PEs have slowly been grinding down as the gold miners strive for profitability, margins are sliding sideways. My crudely calculated gross margins show no growth until just the first half of this year.

And cash costs are just window dressings for the markets to chew on. All they measure is general operating expenses such as the labor and utilities necessary to pull the gold from the ground. Other costs actually lie on top of cash costs that raise total production costs, including depreciation, depletion, and amortization (DD&A) costs. And the costs don't stop here.

Since gold miners are constantly pressured to renew reserves and grow production, they must explore for more gold and develop new mines. And these endeavors are not cheap. It takes significant capital expenditures (capex) to acquire property, perform preliminary exploration such as surveying, sampling, and trenching, initiate drilling campaigns, and then pay geologists and engineers to perform the necessary studies to determine whether the identified mineralization is even economical to mine.

Then if a miner is fortunate enough to have an economically feasible gold deposit, this is where the serious expenses come into play. Even a small mine can cost over $100m to develop and construct. And a large mine these days can cost over $1b. But while these lofty capex figures are not new news to the miners, input costs have been rising so fast that capex for mine development can be radically different from when a mining plan is originally written up to when construction hits full stride.

The costs of energy and other raw materials such as steel, machinery, and even labor have just skyrocketed. So even though the projected operating cash costs of mining the gold may be economically feasible, miners have to deal with the sharply-rising costs of developing the necessary infrastructure to mine the gold. And this greatly alters capex payback, which is a part of the mine-building equation that is terrifying the miners as well as the financiers of their projects.

Ultimately building a mine these days is such a daunting task for gold mining companies that it seems like many simply aren't doing it. And for those that are building mines or getting the process going to build a mine they are facing increasingly-powerful headwinds. Even before breaking ground miners must endure numerous regulatory hurdles which are tedious, expensive, time-consuming, and stricter than ever.

After developing a mining plan and attempting to build in an inflation allowance, obtaining the funding is yet another daunting task. Most gold miners, even the seniors, must tap bank loans in order to fund their massive projects. And with costs rising so fast, debt facilities approved just a short time ago are now not enough to cover growing capex. A Newmont executive was recently quoted saying that gold mine capex inflation is happening at a rate of 15% to 25% annually! I personally believe this to be conservative, but regardless these are staggering figures.

This massive inflation is perhaps why many gold miners instead of taking the path of organic growth, via internal exploration, discovery, and mine development, are obtaining their reserves via acquisitions. This would help explain the lack of reserve growth. If the larger miners are spending much of their money on acquisitions instead of exploration, this leaves the onus on the smaller miners to discover the gold. And since smaller miners don't have as big of exploration budgets and have trouble raising capital, sizeable discoveries are occurring fewer and farther between.

No matter how you look at it, the gold mining industry must confront the challenges of growing production and reserves. But with costs rising so fast, it has been increasingly difficult for the miners to evaluate capital outlay decisions.

In Peter Munk's statement above he mentioned fundamentally different cost structures. But the simple fact is gold miners have to be smarter about running their businesses. And when discussing the lackluster financials of the gold miners, Nick Holland's approach is likely where most industry executives, and eventually the markets, will focus.

Cash flows are more than ever proving to be the metric of utmost importance. Mr. Holland calls it notional cash expenditures, which takes into account an all-in cost of production. Controlling and managing operating costs and capex together will allow gold miners to make money. But in order for this to happen the price of gold must continue to remain high so the industry can work to improve its margins and funnel more capital into capex to grow its businesses.

Ultimately much like oil companies, gold miners require significant excess capital, via profits, in order to renew their reserves. Folks who don't understand economics and free markets grow incensed over the massive revenues, cash flows, and profits that oil companies, and now many well-managed gold miners, are turning.

But these improving financial conditions are what it is going to take to secure supplies in the future. If prices weren't high and margins were too thin commodities exploration would grind to a halt, and eventually so would supply. But since the free markets won't allow this to happen, growing capital flows into commodities is necessary. This all feeds into the circular cycles that the LVWs carve out over time.

So while the price of gold is indeed high relative to its nominal price history, gold miners are still faced with a challenging environment that has not been conducive to the growth that this industry eventually needs to exhibit. Geopolitics, geology, and cost inflation are just some of the many factors that contribute to the gold mining industry woes.

Until the miners can find a balance and figure out how to actually grow their production, this bull market in gold simply must carry on. In the coming years the demand for gold will continue to rise, and the miners have no choice but to respond. So while the typical summer doldrums have spooked some investors into believing the gold bull is over, don't believe what you hear.

At Zeal we believe gold is moving out of the summer doldrums and into a season that is likely to produce another powerful upleg. In our acclaimed Zeal Intelligence newsletter we have been layering in trades into gold stocks that are likely to capitalize on the increasing flow of capital into the gold mining industry. Subscribe today if you are interested in cutting-edge market analysis and to mirror our trades.

The bottom line is the gold mining industry is experiencing major challenges. Gold prices are on the rise, but since the construction and operation of mines requires a heavy load of ancillary commodities, rapidly inflating costs are taking their tolls on the mining companies.

In order for the gold miners to forge through these adverse conditions they need to continue to plow capital into the rebuilding and expanding of their industry. In order for this to happen gold prices need to remain high so the miners can believe in this secular bull and have the necessary cash flows to invest in their growth.

Scott Wright
Zeal LLC.com

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Thoughts, comments, or flames? Fire away at scottq@zealllc.com. Depending on the volume of feedback I may not have time to respond personally, but I will read all messages. Thanks!

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