When you read about mining companies, you'll often see "cash cost" figures given for production. "XYZ Gold Corp. produced 25,000 ounces of gold from its mines this quarter at a cash cost of $676 per ounce." This is a non-GAAP figure similar to the general idea of "cost of sales" – what it takes to calculate a gross margin.
Why would anyone report something so near the top line when it's the bottom line that's, well, the bottom line? Because it's useful. The bottom line can be subject to major fluctuations from quarter to quarter, even in large companies if they get hit with one-time write-downs, changes in taxes, changes in accounting, etc. that are separate from the actual profitability of mining operations. By looking at cash costs, we can make our own estimations of how rich a company's mines are, and hence how much abuse a company can take on non-mining costs and still deliver to the bottom line over time.
For exploration and development companies, of course, there is no EBDITA, and the bottom line is almost always negative. Reasonable cash cost projections can give us a basis for evaluation when normal metrics don't apply.
With rising costs, we've been hearing industry talk about shifting away from reporting cash costs, which can make mining companies seem more profitable than they are to the financially illiterate – like politicians. Political leaders in some countries are pursuing windfall profit taxes, higher royalties, etc., because they see higher metals prices and relatively low cash cost figures, when in reality there may be little or no windfall profits to be taxed.
At a recent meeting at the Denver Gold Forum sponsored by the World Gold Council, the idea of moving away from the traditional cash cost reporting figures was proposed. A more standardized, "all-in" cost figure has been proposed, to include operating costs, sustaining capital expenditures, and general and administrative costs. If adopted, this figure would provide a more accurate and definitive picture of actual mining costs.
Here at Casey Research, we aggregate our own "all-in" costs when not reported by a company, so such a change would not impact the way we look at companies much. However, for others who are used to looking at cash costs, the "all-in" figures could come as a bit of a shock, and could result in negative investor reactions toward companies that make the change. That's probably just as well; the smart money will be back – it already knows there's much more to the picture than cash costs.
More on this shortly. First, let's have a quick look at cash costs for gold producers today.
Cash cost update
The latest update to the Thomson Reuters GFMS Gold Survey reports that in the first half of 2012, average cash costs for gold producers increased to a new high of US$727 per ounce. However, higher year-on-year gold prices have seen producer margins increase by 11%. Still, GFMS also points out that "on a quarterly basis, margins have in fact declined for the last three quarters."
The chief reasons cited for cash costs increasing are declining ore grades, labor cost increases, higher energy prices, and other input factors. Our expectation is that on average, these costs will continue to rise throughout this year and beyond.
However, profit is not a one-variable calculation. With the underlying commodity – gold – rising faster than cash costs for over a decade now, many mines that were previously unprofitable have become profitable.
Sharp investors have noticed that many profitable mining companies aren't seeing fatter margins. Why? Because mines with higher-grade material start processing previously uneconomic lower-grade ore while they can do so at a profit, adding to the life of their mines and total cash flow while maintaining their bottom lines today. In other words, what was once waste becomes ore, leading to increases in overall production and profit. It's a good business strategy, but it also contributes to the rise in average mining costs.
Still, while costs have risen in nominal terms, gold has continued upward as well. As a result, average operating margins, based on the spot gold price, have gotten wider in recent years. The below quarterly comparison of the average cash cost vs. the average price of gold over the past seven years shows this quite clearly.
A real eye-opener, however, comes from another chart we built using the same data set. Here you'll see that wider margins mean that cash costs – stated as a percentage of the price of gold – were at multiyear lows earlier this year.
This year we have observed rising costs, so it will be interesting to see how this chart looks going forward. If gold continues trading sideways, the window of profitability will shut down for marginal operations. However, if gold heads much higher – as we expect it to – the trend in the chart above could keep margins fattening.
Capital expenditure – "capex" – is also a cost of doing business for mining companies, but as the name implies, it's capitalized. That means it's subject to depreciation and not treated as an expense, and doesn't show up in operating costs. You still need to pour this money into the ground to build and operate your mine, of course, so it does affect the bottom line, where depreciation, taxes, and other costs are all taken into account. For exploration and development companies, you look for the impact of capex in internal rate of return (IRR) and net present value (NPV) figures.
Capex has been ballooning of late, due to higher labor and material costs and much greater regulatory burdens. There's nothing new in this trend, but it seems to be accelerating substantially, especially for larger projects. We don't have updated industry-wide average figures for this, but one of most striking recent examples of skyrocketing capital costs is Barrick's Pascua-Lama project on the Chile-Argentina border.
Business News Americas reports: "A previous cost estimate for Pascua Lama was US$3.3bn-3.6bn, but this was revised up to US$4.7bn-5bn after a review in 2011." The current cost estimate is about US$8 billion.
Barrick's situation is a vivid example of why capex has become a significant detriment to building new mines – more so than rising operating costs. When it comes to calculating a project's IRR, the size of the initial investment has a huge impact. So, in spite of the rising gold price, we're not seeing as many new mines being built as we might expect.
Indeed, the relatively low pace of mergers and acquisitions among mining companies this year may be principally due to concerns about rising capital costs. Many of the larger companies that might have been snapping up successful exploration companies while they were on sale over the summer had their plates full with huge projects they were already committed to.
That will change at some point; the majors must replace depleting ounces or cease to be major mining companies. However, that tipping point does not seem to have been reached yet.
Operating costs are rising, but on a yearly basis over the last 10 years, production margins have been rising faster. The industry, recognizing problems with cash cost reporting, is considering a new metric that would provide a more accurate picture. However, many in the industry hesitate: some executives want to keep using the cash cost figure since it reflects how much it costs to mine right now.
We don't know how that issue will turn out, but unless and until the industry does adopt a more comprehensive and accurate figure, we'll keep using our own "all-in" estimates. All investors in the sector need to remember that the real cost of any mining is going to be higher than what companies report as cash costs.
And – obviously – there's much more to evaluating a precious metals producer than just costs. Does its management team have a track record of success? Does it have enough money (or access to it) to move its projects forward? Is the company likely to be taken over by a major producer?
That last point is particularly important, because when juniors are bought out, their investors usually get big windfalls.