In a previous article, I discussed one of the most important metrics to analyze the silver industry -- the actual cost of mining an ounce of silver, which can help an investor figure out whether it is time to buy SLVand the silver miners. In that analysis, I used the 3Q 2012 financials to calculate the combined results of a number of publicly traded silver companies and come up with the average cost it takes to mine each ounce of silver.
Since many of the gold miners have now released their 4Q 2012 and full-year earnings, it is time to start calculating the true cost of mining each ounce of gold, and I will assure you, it is not close to the "cash costs" that are reported by the miners in their quarterly statements.
In this post, I will be analyzing Barrick Gold (ABX), one of the largest gold miners in the world. By analyzing ABX's cost of production, investors should have a better understanding of ABX as an investment, and get a better idea about what it generally costs to mine every ounce of gold. All results have been taken from ABX's publicly available financial statements, which can be downloaded from the company's website.
Calculating The True Mining Cost of Gold - Our Methodology
Publicly traded gold companies offer investors a quick non-GAAP formula to give investors a glimpse at their costs per ounce, called "cash costs." This measure may vary slightly from company to company (it is non-GAAP, after all), but it is generally their "mining costs" (cost to operate their mines, process the ore, pay miners, etc.) divided by the amount of gold equivalent ounces produced.
This measure is completely misleading, and selectively reports costs without really giving investors a true picture of the cost it takes to produce an ounce of gold. Fortunately, ABX has started reporting a new measure of costs called the "all-in sustaining cash costs," which is significantly higher than the previously used "cash cost." But it still does not accurately reflect the cost it takes to mine an ounce of gold -- though it is a good start, and at least it shows ABX management is starting to recognize that using unrealistically low gold cost numbers do not fool educated investors.
To calculate the true costs to mine an ounce of gold, we use the total costs reported for the quarter, and then we subtract gains or losses on derivatives -- since these really have nothing to do with running the company.
Then we calculate the number of gold-equivalent ounces produced by converting other by-product metals (such as silver, copper, zinc, etc.) into gold by dividing the gold price by the price of the by-product. For example, if gold is trading at $1650 and silver $30, then every 55 ounces of silver would convert into one gold-equivalent ounce. We prefer to use the average cost of the byproduct over the reporting quarter or year because that accurately reflects the by-product's value during the comparison timeframe, but investors can choose to use whatever ratio that they feel is most appropriate.
Finally, when doing year-over-year comparisons, we use the same conversion ratio, even if the price of the byproduct was different in each of the comparison's quarters. The reason we do this is because this allows an even comparison when determining the cost of production -- we do not want one quarter's jump in copper prices to affect a year-over-year comparison in gold prices.
The final thing that we have to deal with is write-downs. Companies do not use these in calculating their gold production costs, but this is the wrong way to look at total expenses, and investors should use write-downs when assessing the miner's true costs of production.
For example, a company makes a $250 million acquisition, and then a few years later, finds out that the mine is not economically feasible and then writes down the acquisition. Should this really not be included in the cost of production? It is true that it did not directly affect the production costs of the current quarter, but the acquisition was done with the intent of increasing gold reserves, and so it was done for the long-term sustainability of the company. Since the goal of our methodology is to determine the total costs to produce an ounce of gold, acquisitions are as much a part of this process as drilling and mining costs, and so we do include these in our calculations.
We do have to be careful, because a write-down taken during one quarter (and expensed only during that quarter), may give us an inaccurate estimate of the costs of production. Though not perfect, one remedy to this issue that we like to employ is to amortize the expense for the year and only attribute 25% to the current quarter. We also have to make sure that if we remove the write-down, we remove the tax benefit (since most write-downs result in losses, they are beneficial for the company's taxes). There is no exact way to do this, so we just use a flat 30% tax rate and deduct the appropriate amount from the tax benefit the company gained on the write-down. Not perfect, but it does the job.
Real Costs of Production for ABX - 4Q 2012 and FY2012
Now that we have gone through the methodology, let us take a look at ABX's results and come up with its average cost figures. When applying our methodology to ABX for the most recent quarter and FY 2012, we standardized the equivalent ounce conversion to use the average LBMA copper price for Q4FY12 of $3.59/lb, which comes out to approximately 480 lbs per gold ounce.
(click to enlarge)
We prefer the write-down cost per ounce to analyze nominal costs, since it more completely shows how much is spent to produce one equivalent ounce of gold, but for the investors who want to remove the write-downs from the per ounce calculations, we have included the costs without write-downs. To analyze how much costs are rising from quarter-to-quarter and year-to-year, we prefer to use the cost that excludes write-downs, since this is a fairer comparison when comparing the rise/fall in costs.
The first thing that stands out is that production costs of gold are rising on a per-ounce basis, even when removing write-downs. In Q4FY11, it cost ABX $1253 to produce an ounce of gold equivalent, while in Q4FY12, it cost $1318 to produce that same equivalent ounce, which is a 5% rise in costs on a quarterly year-over-year basis. This rise in costs is also evident on the annual basis, where it rose from $1101 in 2011 to $1277 in 2012 -- around a 15% increase in the cost per ounce.
Investors should also expect costs to continue to rise, as evidenced by the fact that 4Q costs were higher than the yearly average, which suggests costs are still rising. Since the 4Q costs were also in excess of $1300 per oz, investors should not be surprised if FY13 costs average more than $1300 per ounce for ABX, which goes along with management's prediction of rising total costs for FY13 from the year-end report.
ABX's average annual cost was around $1300 per ounce and rising anywhere from 5-15% per year, which suggests that at current gold prices of $1600 per ounce, its profit margins are shrinking fast. Investors should be wary of ABX if current gold prices hold at these low levels.
Finally, for GLD investors who are more interested in the general costs it takes to produce an ounce of gold, ABX's report is indicating that gold mining costs are still rising. Also, since ABX is one of the largest miners in the world and has significant economies of scale, but still is only able to produce gold at $1300 per ounce -- the gold price may have a very solid floor when it comes down close to the costs of production. We do not think that the gold price will come anywhere close to the $1300 level, but investors who are looking to see gold drop below $1000 per ounce are probably living in the past. The costs of production make mining a losing proposition at anything below $1300 gold.