Volatile Gold2

We speculated nine months  ago that gold mining companies’ successes in cutting costs might be coming to an end as most of the easy cuts had been made and anything beyond that would largely be window dressing – See: Has Gold Mine Cost Cutting Gone As Far As It Can Go?.  However we were wrong, although some of the key reasons that most gold miners have continued to be able to show both lower operating costs and better margins than the up-to-now falling gold price would suggest have been from factors completely outside the companies’ controls, with the oil price suffering a huge decline, which may only now be bottoming, and from the strength of the US dollar against producer nations’ own domestic currencies.

An interesting analysis from precious metals consultancy Metals Focus in a recent client newsletter, goes a little further.  It opens by pointing out that a few years ago when gold had started its decline from its 2011 high point of around $1,900 an ounce, a speaker from a prominent resource fund at one of the numerous gold conferences, expressed a wish to see the price fall further (it was around $1600 at the time), on the grounds that this would force the mining companies to tackle the then ever-rising operating cost scenario and ultimately make the companies financially stronger in the longer term.

A complex industry like mining can weather many storms.  It tends to get lax in its controls in good times, carried away by euphoria and pressures from greedy institutional shareholders who always want more, but who will then knife the miners in the back if things turn around adversely and their ever-growing profits start to fade.  But, as the resource fund speaker noted above suggested, such occasional severe setbacks do force the companies to at least start to put their houses in order and ultimately make their companies stronger.  That is until the cycle reverts and these things are long forgotten by a new generation of directors and managers and a degree of profligacy returns along with higher metal prices.

We are currently in the repair stages in the gold mining industry, but again we are of the opinion that there may no longer be much leeway in further operating cost cutting, as some of the external factors which have enabled many gold miners to stay afloat despite the big US dollar revenue falls, could be beginning to bottom or reverse.  Metals Focus notes that ‘looking at the industry as a whole, the average total cash cost has fallen $130/oz from the peak reached in Q2.13 down to $652/oz as of Q3.15. The average all-in sustaining cost (AISC) over the same period has been cut from $1,128/oz to $824/oz. In spite of the much lower price, this has resulted in improved margins. Basic margin between gold price received and AISC stood at $302/oz in Q3.15 which is actually higher than that recorded in Q2.13, $289/oz, when gold prices averaged $1,417/oz.’

But a large part of the industry’s problem has been that, in addition to allowing operating costs to rise faster than they should have done, many of the major miners had been embarking on hugely costly big low grade new gold mine capital programmes which, while looking potentially very profitable at a higher gold price will have led to real profit margins (in terms of free cash flow) decline sharply with the lower one.  A switch to mining higher grade sections of orebodies may have been possible in some cases (although this impacts adversely on future profitability and mine life) – but the real problem here was the massive build-up of the debt needed to finance the capital programs in the first place.

Debt servicing thus became an intolerable burden at the lower metal price, so it is no surprise perhaps that the biggest turnaround in the miners’ financial restructuring has been in reducing these huge debt levels, often by selling off non-core and low profit assets, and cutting back or eliminating any major future such expenditures.  This debt restructuring continues to have a significant positive impact in helping reduce All In Sustaining Cost (AISC) figures.

Companies like world No. 1 gold miner Barrick, for example, which had been building up enormous debt levels have very successfully been reducing these substantially – at a cost to the balance sheet, but providing a significant benefit to operating margins and lowering unit costs.  This will likely carry on at least until the miners see debt servicing costs returning to sensible levels and the finance sector may again be prepared to provide the wherewithal to develop big new projects again.  This may not be for some years yet.

One suspects that the asset disposals and more circumspect capital spending patterns will continue for the time being, all helping make for leaner and meaner mining companies, but it does also mean that output growth is now plateauing, and beginning to turn down according to the most recent available data.  Barrick, in demonstrating this, is targeting a production fall of around half a million ounces of gold in the current year compared with 2015, and more cuts looking further ahead.  With cuts in exploration and in building new operations to replace aging mines which would need to close anyway, output is set now for a continuing fall at many gold mining companies – perhaps for several years yet.

Now whether a fall in new mined output will seriously impact the gold price positively is debatable.  There are many other factors out there which can have an even bigger effect, at least in the short to medium term – See a recent article I’ve written on this subject: What does peak gold mean for the gold price.  However a fall in global gold output will at least have an effect on sentiment towards gold investment while, as we see it, demand, particularly from the East where the ever-growing numbers of middle class consumers, with a traditional inbuilt propensity to use gold as a store of value against hard times, is continually growing.  Falling gold inventories in the West suggest that there is a looming crunch on physical gold supply as a result of continuously rising demand and potentially falling supply.  This will positively impact the gold price, and that of silver and the other precious metals, at some point in time.  It may already have started, but with a metal where the price is so dependent on the futures markets where sentiment and vested interest big money rule, we can’t be sure yet.  Gold and silver’s time will come – but when?

But back to the beginning of this article.  Can gold miners continue to cut costs further – indeed do they now need to given the recent gold price recovery if this is sustained?  Many analysts had predicted the demise of perhaps 50% of the global gold mining sector by now.  This hasn’t happened.  Indeed many look at gold’s 40% plus fall from its 2011 peak forgetting that the peak was a brief one and gold only averaged $1,572 that year – so the fall to the current price level from the 2011 average has only been 25%.  This has thus been a less serious fall than generally reckoned.  We suspect operating margins will still come down further, with the miners in cost-cutting mode, failing a decent gold price increase, despite oil prices beginning to pick up (but bear in mind many miners buy oil forward which means they can lock in current prices for a number of months ahead).  Cutting debt levels will also continue.  Meanwhile the huge cuts in capital programmes and exploration will mean there will be little new production coming on stream to replace shuttered operations.

Currency movements against the dollar are harder to predict.  For resource economies, low metal prices could still mean further depreciations against the US dollar, even though the Dollar Index itself could fall back given that this is most heavily weighted against non-resource currencies like the Euro, the Swiss Franc, the Japanese Yen and the British Pound.  There is no simple answer here.

Some major asset disposals will likely continue for the next year or so further bringing down debt and improving margins at the expense of balance sheet impairments.  So the outlook for the gold miners is perhaps more positive than many might imagine in terms of overall day to day profitability and free cash flow – even at current lower gold prices.  However there will be a continuing emphasis on improving margins which will lead to more low profit, or unprofitable, mines being shut or divested to smaller companies which may be more flexible in their approach.

As the fund manager quoted earlier was predicting, the shock of a falling gold price after 11 years of continuous rises, has certainly focused gold mining company management’s minds, while the stresses involved in doing so will continue to bear fruit for some years ahead.  The industry is definitely already meaner and leaner and now may well be the time for investors to climb back in – even though actual operating costs may start to trend upwards again as inflationary pressures begin to impact.