Cash cost fairytales and the need for management discipline in the gold sector

According to US Global, gold companies need to focus on capital discipline and start reporting costs more transparently.

Author: Geoff Candy
Posted: Thursday , 22 Nov 2012



Gold companies need to start focusing increasingly on providing shareholders with a good return on capital, says US Global Investors.

Speaking on's Gold Weekly podcast, US Global CEO, Frank Holmes said that the major gold mining companies face the dilemma of trying to grow their production profile while they are simultaneously depleting their current resource base. Faced with a critical shortage of technical skills and rising costs, Holmes says that while companies don't want to show that their production profile is in decline, the "idea of growth for growth's sake is flawed."

An idea, he adds, that has seen these companies bite off more than they can chew and has "created massive congestion, delays and disappointment, that has hurt investors and hurt the capital markets."

US Global portfolio manager, Ralph Aldis, adds that at the same time as companies were chasing growth they were also marketing themselves using cash costs as the main metric of performance.

This measure, which Aldis terms outdated, was coined, he says, when none of the gold companies made a profit and when gold prices were low.

"Today," he says, "with high gold prices they are booking profits yet they still mark themselves on this cash cost measure. Of course governments are the only people that believe that gold companies are producing gold at $1000-plus margins and in their view this is a windfall profit the company is reaping at the expense of the state. Companies need to talk in terms of total cost to produce an ounce of gold."

Aldis continues that, if one looks across the 65 largest gold companies it monitors, the all-in cost to produce an ounce of gold this year is about $1300.

"There was a recent study by CIBC that put the replacement cost for an ounce of gold right at $1700 and when you drill down what is interesting about the breakdown of the cost structure between operating costs, sustaining capital, construction capital discovery costs, overhead tax and acceptable profit is that the estimated tax bill to produce an ounce of gold is $200 per ounce and the acceptable profit is $200 too. This is where you’ve got to thank your cash cost marketing for basically taxing 50% of your gains away in the form of taxes when the government has risked no capital on the project and not borne any of the risks during the construction of the project," he adds.

The implications

Apart from the obvious bottom line implications, US Global is of the opinion that this estimate for replacement costs means that a lot of marginal projects will just not get funding from smart investors and, as a result, "you are going to seeing a supply of gold that’s not going to come on stream as forecasted."

He adds that while the demand for better capital management on the part of investors will hopefully mean management teams will become more disciplined it will also impact the long term supply of gold coming on stream.

As Aldis points out, "we’ve had a four to five-fold increase on the gold price over the last 10 years but gold production worldwide is basically flat - that tells you that even though we have higher prices, there's not a supply response from the production side that has been stimulated or has been able to rise because of the large increase in regulation and the threat that governments are going to always want to raise their taxes or royalty structures because they think they're getting windfall profits."

Of course, government regulation is not the only issue at play, among others are labour costs and other input costs that have risen as well, increases that make marginal projects more marginal.

Another key factor is that many of the biggest deposits have already been discovered.

As Holmes says, while the market may want more higher grade deposits, "if you look at all the research and exploration success, there have been very few three million ounce discoveries at 5 grams. It’s just very, very difficult to find these types of Mother Nature properties. That’s another factor going down the pipe we think will impact the supply of new gold production coming into the market place."

It does however, also present companies that do offer dividends a great opportunity. As Aldis points out, we are currently in a yield-starved world and such companies are in a position to "capture market share in this new paradigm if they start to focus more on how to make a sustainable profit versus living in this very fairytale land of cash costs."

Holmes agrees, adding, that companies should seriously consider monthly dividend programmes because it demonstrates clearly to shareholders that the company in question "has a heartbeat and that it is doing things and there’s a higher likelihood of shareholders maintaining a long term position in that company when management shows return on the capital in the form of the dividend."