The Modern Day Gold Rush

Recap, the past two blogs show:

• A high cost producer has a higher rate of leverage at the beginning of a gold rush.
• A low cost producer already has an enormous premium to their share price.
• Buying in at bubble valuations levels (25 - 30 times earnings) for late entry investors has reduced leverage outcomes that result in utterly marginal effects on the earnings per share.
  

In the normal life cycle of a mine production costs start higher, then they come down as the mine becomes efficient and then increases as the more profitable parts of the mine have been mined out.  This next example looks at the leverage when the cost of production increases by $100/oz.

The first table is what the leverage would be with constant costs, and the second table has the increased costs.

Gold Price	% Up	Company A (Cost $100/oz)	% Up	Company B (Cost $200/oz)	% Up	Company C (Cost $300/oz)	% Up	Company D (Cost $375/oz)	% Up
$600		$500		$400		$300		$225
$700	17%	$600	20%	$500	25%	$400	33%	$325	44%
$800	33%	$700	40%	$600	50%	$500	67%	$425	89%
$900	50%	$800	60%	$700	75%	$600	100%	$525	133%
$1000	67%	$900	80%	$800	100%	$700	133%	$625	178%

Gold Price	% Up	Company A (Cost $200/oz)	% Up	Company B (Cost $300/oz)	% Up	Company C (Cost $400/oz)	% Up	Company D (Cost $475/oz)	% Up
$600		$400	-20%	$300	-25	$200	-33	$125	-44
$700	17%	$500	0%	$400	0%	$300	0%	$225	0%
$800	33%	$600	20%	$500	25%	$400	33%	$325	44%
$900	50%	$700	40%	$600	50%	$500	67%	$425	89%
$1000	67%	$800	60%	$700	75%	$600	100%	$525	133%

This table shows the leveraged reduction in earnings as costs go up.  Company A would go from 4% earnings to 3.2% earnings if the price of gold remained constant.  Company D would see earnings decline to 2.2%, and now the bubble valuation levels have increased, to 31 time earnings for A and 45 times earnings for D.

If costs go up $100/oz, gold must go up by $100/oz for earnings to remain constant.  And what happens if gold goes up to a whopping $1000/oz?  Well, company A sees earnings go from 4% to 6.4% and company D sees earnings go from 4% to 9.3%, yet gold has gone up 67%.

Another important question to ask is"

• How reasonable is a $100/oz increase in the production costs for gold?

The last paragraph on page 2 of the link at the bottom of the post states that GoldCorp had Q2/06 production costs of -$123/oz and for Q3/06 had production costs of +$84/oz, or a net increase of +$207/oz.

The average realized gold price for Q2 and Q3 was identical, $620/oz, production was up 6%, yet earnings per share declined from $0.50 to $0.14.  With adjustments, the earnings per share declined from $0.36 to $0.22.  The math easily explains why earnings plummeted.

For GoldCorp in a particular, the leverage increase in earnings caused dramatic increases to earnings through copper, which experienced 4-500% increase in price, a dramatically higher bull than gold has seen ($300 to $650, ~120%) and is responsible for much of that -$123/oz production cost in Q2, and is currently responsible for 54% of GoldCorp's earnings/share for the first 9 months of this year.

Indeed, as gold companies become more diversified in copper, silver and other metals, the leveraged increase and decrease in earnings for these metals dramatically interfer with the simple analysis of gold production costs, versus gold price and earnings leverage, and, as in the case of Goldcorp, can completely hide the pitiful returns on the gold if the gold is looked at in isolation.

In this particular example, production costs increased dramatically not because of "real" increases in mining costs, but more of the increase in costs is due to the decline of the bull in copper.  There are also some real increases in production costs in that $207/oz change.

Conclusion:  Increasing gold costs means that gold price must go up in an amount equal to the increasing costs, or, the level of bubble valuation will increase.

Gold stocks represent businesses that mine gold and sell it off, and as such, they gradually sell off their gold, and are left with empty holes in the ground.  Reserves must be replaced in order to keep the "machine" going.  Next post will have a closer look at how this looks for the whole ideology that bubble valuations for gold should remain constant through the gold rush.

http://research-ca.bmocapitalmarkets.com/documents/BD5A862F-EAFB-463A-8A19-2EB5D93032A6.PDF