Gold investors have it pretty sweet these days. There ain’t no way around it.
A picture is worth a thousand words, and this one is worth millions of dollars to investors as well:
Even with the S&P 500 up double digits for the year, an investment in the oh-so-popular SPY ETF is still trailing the easily accessible gold investments based on the gold price (GLD), major miners (GDX), and junior miners (GDXJ).
It should go without saying that the price of gold is mostly responsible for the outsized gains we’re seeing in gold miners.
Past a certain price point — the prices a company can get for its gold, minus the all-in sustaining costs of the mines, debt, overhead, etc. — they’re just minting money.
Nothing makes that inflection point easier to reach than climbing gold prices. But forget about gold prices for a couple minutes.
Let’s talk about the other side of the equation. A whole lot has been happening on that front, and a whole lot more is coming.
The Lean Years
Though the all-time high gold prices came during a massive spike in 2011, annual gold prices kept posting solid gains. 2011 saw a rise of 7.8%, and 2012 saw a gain of 8.68%.
2013 saw the real bloodbath, with prices falling 27.6%. After that it was -4% for 2014, and -11.6 % for 2015.
The effect on gold miners was devastating. At the time, and outside of a couple tepid years, gold prices hadn’t seen a year close out in the negative since 2000.
Gold miners were chasing more and more expensive projects to develop, driving up costs. Shedding about 60% of their primary revenue sources’ value brought that to an end, to the point where many gold mining companies went bankrupt.
Those that survived had to refinance debt at higher prices, slash exploration and acquisition budgets, and freeze or delay development.
More often than not, it was all of these at once, and staying solvent mattered far more than anything else. Companies had to drive down their all-in sustaining costs any way they could.
The gold miners that are left are now grizzled veterans of the nasty wealth destruction phase of a classic commodity stock cycle.
Now, they are starting to recapitalize and consolidate as the cycle restarts. Too bad it isn’t enough.
The Long Game
While the money concerns mining companies face are immediate, the implications pan out over years or decades. All the while, current mining operations are constantly being depleted.
What ends up happening as a result is production becomes only tenuously related to gold prices.
Take a look at global production data from GFMS Thomson Reuters from April. Production kept climbing when prices tanked, and leveled off right as gold prices started to rise.
As the GFMS team pointed out:
“For instance, examining recent production trends, 1997 to 2007 saw mine production essentially ‘flat-line’ with a compound annual growth rate (CAGR) of 0.04% compared to the gold price which returned a CAGR of 6.5%. Growth finally ‘kicked-in’ and from 2008 to 2016 mine production posted a CAGR of 3.4% compared to a CAGR of 8.7% for the gold price. As noted above, however, we think the latest stage of growth has now run its course. 2016 marks the third consecutive year of falling year-on-year growth rates and we maintain our near term forecast for mine supply to decline in both 2017 and 2018.”
Now we’re seeing real data that supports that view. Metals Focus, a specialist analysis consultancy, is reporting that global mine production declined by 0.4% year-over-year in the first quarter.
That’s the first time there has been a drop in eight years. Metals Focus agrees with the GFMS team that production will decline through the end of 2018, at least.
Meanwhile, global all-in sustaining product cost rose 4% quarter-over-quarter and 8% year-over-year.
Right as gold prices are beating the stock market, gold miners are incapable of capitalizing on the trend by producing more, and it is costing more to get what they can out of the ground.
Take Kinross Gold Corp. for example. The world’s fifth largest gold producer is investing $800 million — about 14% of its market capitalization — just to maintain the 78 tonnes it produces per year.
Kinross is hardly alone, and this is happening at a time when underground reserves among major mining companies have sunk by one-third, from a peak of 27 years of production in 2013 to just 18 today.
All of those cutbacks during the lean years are taking a heavy toll. Capital investment is at an unsustainable level. A whole lot more is needed, unless the major miners want to put themselves out of business.
How This Will Play Out
From this we can draw a few conclusions.
First, major miners are going to start having to buy quality deposits at a much faster rate. We’ve seen some acquisitions already this year, but we will see more.
Second, quality deposits with robust economics are going to enjoy a premium in the market.
There is no way around it. Gold producers cannot possibly push through development of projects fast enough to replace dropping production and capitalize on rising prices.
They will have to pay a premium for smaller projects that are close to production to small miners that have made it through the lean years.
Meanwhile, with gold prices above $1,200, we’ll continue to see junior miners’ shares appreciate in value as their projects progress. The major miners will only have to pay more the longer they wait.
All of the data supports the third and final conclusion: Now is an ideal time to own a basket of the best-of-breed companies.
