Gold Stocks Versus Gold Bullion

JOHANNESBURG  – In a truly useful piece of research, “Capital Punishment – Part III ‘Inflation Returns’ “, focused mainly on North American Tier I gold miners, RBC Capital Markets analysts have gone a considerable way to providing insights to why the prices of listed gold stocks seem nervous and hesitant, even as dollar gold bullion continues to extend a decade-old bull market.

The stock price of Barrick, the world’s biggest gold miner, breached $50 a share early in 2008, when gold bullion breached $1,000 an ounce. Today, with gold above $1,500 an ounce, Barrick is trading at just under $50 a share. What gives? And why did Barrick recently bid for Equinox, a copper miner?

One take-away from this latest RBCCM report is that since November 2009, gold miner capital and operating costs have risen by 21% and 17% respectively; RBCCM forecasts a 15% increase for both capital and operating costs in 2011 over 2010, “with additional upside pressure if oil prices remain elevated”. The good news is that at current gold prices, “the gold industry remains healthy; however, cost inflation has clearly returned pressuring operating margins and capital allocation decisions”.

The shorter-term picture is not very encouraging. So far in 2011, the average price of diesel is up 22%; steel is up 21% over 2010; a basket of construction materials is up 6% since the start of 2010, and concerns over labour shortages and wage inflation are becoming significant headwinds for the broad mining industry. RBBCM finds that if oil, energy, and steel prices remain at the current elevated levels and wage inflation continues, the current +15% estimated increase for 2011 in capital and operating costs could quickly become +20-25%.

Within RBCCM’s North American Tier I and II gold stock universe, during 2010, Newmont, Yamana, and Agnico-Eagle had the highest all-in costs due to high sustaining capital, while IAMGOLD and Kinross had the highest cash costs. The 2010 average all-in cost was $652/oz (in line with the fortieth percentile) comprising cash operating costs of $459/oz, G&A (general & administration) of $54/oz, exploration of $40/oz, and $99/oz of sustaining capital.

The specific all-in costs range on the high side from Newmont’s $782/oz to the likes of Eldorado at $554/oz. RBCCM anticipates that all-in costs are set to rise 6% in 2011 for its coverage universe.

Goldcorp, New Gold, Kinross, and Centerra are expected to record the largest increases in all-in costs in 2011 compared to 2010, due to aging mines, lower grades, and/or more open-pit operations, which are more exposed to rising fuel costs, while Yamana, Eldorado, and IAMGOLD are expected to benefit from new, lower-cost mines

RBCCM’s analysis shows that the all-in marginal cost at the ninetieth percentile to produce gold will rise to around $1,100/oz in 2011 from $1,000/oz in 2010. At the ninetieth percentile, cash costs were $747/oz ($932/oz all-in) in 2010; this is expected to increase to $860/oz ($1072/oz all-in) in 2011. The fiftieth percentile cash costs were $516/oz ($701/oz all-in) in 2010, and is expected to increase to $593/oz ($806/oz all-in) in 2011.

The all-in cash costs, as referred to, exclude the cost of new capital expenditure, which in itself is rising at an impressive rate, subject as it is to many of the general cost pressures. Seen from yet another perspective, RBCCM estimates of the components of the cost increase from 2005 to 2010, led by declining grades and rising labour, fuel and energy costs in addition to stronger currencies in producing countries, took average costs from $337/oz in 2005 to $557/oz in 2010.

For RBCCM, cost trends “suggests to us support for long-term gold prices at $1,000-1,100. If gold demand were to fall, we believe that prices would remain at or above marginal cost, which we estimate using the ninetieth percentile under the assumption that the highest-cost mines would be shut down”.

While operating cost escalation is seen as becoming a more pressing issue in 2011, gold price gains have been outpacing costs “thereby leaving producers with healthy margins to fund projects and return capital to shareholders; however, we may see contraction in 2011 if the gold price stalls. We forecast EBITDA margins of 51% in 2011 vs. 53% in 2010 for our coverage universe, reflecting our gold price assumption of $1,400 minus all-in cash costs”.

Meanwhile, capital costs at new mines are rising across-the-board. RBCCM analysts looked at 34 proposed mine developments during the past three years: the average cost per ounce to develop a mine rose 15% in 2010 compared to 2009. RBCCM anticipates that capital costs are set to rise by an additional 10-15% in 2011, based on increased demand for equipment and mining talent and RBCCM’s Brent oil price forecast for 2011 of $106/bbl and $112/bbl in 2012.

While noting that recently completed projects benefitted from more favourable capital conditions in 2009, being completed for less that $150/oz, including Goldcorp’s Penasquito, Alacer’s Copler, Agnico-Eagle’s Meadowbank, Eldorado’s Efemçukuru, and IAMGOLD’s Essakane mine, RCCM reminds that the longer term picture shows that project costs were relatively flat from 1995-2003, but have increased on average by 25% a year since 2003, as the current commodities construction boom began. Compounding at 25% a year can eventually develop a “galloping” effect.

Among RBCCM’s key findings is that gold industry margins remain healthy; that large projects may be deferred or cancelled; that it may become less expensive to buy production than to build it; that producers with large capital in the past tense are better positioned (this includes Goldcorp, Agnico-Eagle, Eldorado, Osisko, and Alacer; producers with substantial capital to spend from 2011-2013 are at risk of cost escalation, including Kinross, Newmont, and Yamana); small projects can add value but are prone to being overlooked; dividend yields can continue to rise (gold producers are nearly the poorest on earnings-payout ratios, as measured on the TSX, beaten only by materials and infotech stocks).

The notion that it may be better to buy than to build can be viewed from many angles. RBCCM analysts say “a common complaint that we have heard from large-cap producers is that both capital estimates and operating costs claimed by junior companies are understated, which inflates valuation and makes an acquisition more difficult”.

Barrick’s recent bid for Equinox may become a prime example of how big gold miners are evolving. Barrick has long produced copper, and is building its own copper and copper-gold mines, and is clearly more enthralled by the value offered up by Equinox than anything in the “gold universe”. The main attraction of pure copper miners are the fabulous margins available, and the relatively cheap market valuations of listed stocks. These are two characteristics that have long been rare in the “gold universe”.


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