Gold-Mining Profits Healthy?
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.
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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.