by Aaron Levitt | April 17, 2013 12:29 pm
It’s getting rough out there for gold bugs.
After the price of gold crossed the $1,900 mark per ounce back in 2011 — mostly fueled by fears of hyper-inflation and the undoing of the global economy — the precious metal has fallen hard in recent weeks. But nothing hit as hard as this weekend’s wraparound trading days.
Gold prices plunged roughly 4% last Friday, only to suffer a much bigger 12.6% loss when the market opened on Monday. That massive drop has many investors questioning the metal’s[1] portfolio appeal and status as a safe haven.
Those same questions have extended to the gold miners as well[2].
This makes sense, given that gold miners’ profits increase and decrease with the rise and fall of gold prices. However, it’s not just the plunging cost of gold investors need to worry about when it comes to the miners. There’s a whole laundry list of issues to consider.
Part of the appeal of betting on the miners rather than physical gold or futures pricing is that the miners’ production cost structure — often with considerable fixed expenses[3] — allows them to act as a leveraged play on rising gold prices. The spread between where gold is trading at and what it costs to dig the metal out of the earth is pure profit. And over the last few years, as gold has surged, that spread has been quite juicy.
Lately, though, not so much.
Mining companies finally are beginning to report “all-in sustaining costs” during earnings reports. Previously, the firms only used so-called “cash costs,” based on a standard developed in the 1990s. This metric excluded expenses like exploration budgets and waste rock removal, among others.
For example, the two biggest gold producers by market cap — Barrick Gold (NYSE:ABX[4]) and Goldcorp (NYSE:GG[5]) — spent an average of $941 in the fourth quarter to dig up an ounce of gold. That compares to $626 in reported cash costs. Using this new metric, investors are able to get a better understanding of the risks and rising costs facing gold producers.
And things aren’t exactly pretty.
First, fuel and energy costs continue to rise. Mining takes an awful lot of energy to complete, including grid-based electricity for smelters and diesel fuel for generators and equipment. In fact, the mining sector consumes about a third of Chile’s total power output.
In the face of all that power demand, energy costs have been surging. Depending on the nation, diesel fuel[6] costs have increased anywhere between 100% and 500% for miners since 2003. Meanwhile, the cost of electricity has jumped an average of 20% in that time frame.
Of course, that’s assuming miners can get reliable energy at all.
Mines in South Africa have been plagued with severe power outages[7]. The worst was in back in 2008, when work at several miners gold operations — including major producers AngloGold Ashanti (NYSE:AU[8]) and Harmony Gold (NYSE:HMY[9]) — was stopped for several days. This prompted many mining companies operating in South Africa to begin investing in their own power generation facilities. Again, that results in higher costs and lower profit margins for producers.
Labor costs have also been rising. Wages have been rising rapidly since 2003, accounting for more than 50% of mining companies’ costs. And many producers have been forced to shell out above-inflation pay increases in recent years as workers have “taken to the streets.” Again, South Africa has been the heart of the recent labor movements[10], but those strikes have spread to other gold producing areas in Latin America.
Finally, gold miners have to contend with higher royalty rates, taxes and the threat of resource nationalization[11]. As gold prices have surged, many governments have increased their share of the profits from firms mining on their soil.
Recently, the Dominican government made moves to review and change a contract with Barrick over the development of a $4 billion mine, while Burkina Faso has amended royalty and tax regimes. Tanzania — Africa’s third largest gold producer — is another example. That nation enacted wide-sweeping legislation back in 2010 that increased the royalty rate by a full percentage point. That might not seem like much, but every dollar counts when profit margins are already shrinking.
Some nations have taken this a step further and have been confiscating mines. Crystallex International‘s (PINK:CRYFQ[12]) Las Cristinas project in Venezuela is a prime example. The mine is one of the largest undeveloped gold deposits in the world; however, moves by the Venezuelan government to nationalize natural resource production in the country quickly sent Crystallex to penny stock status.
Given falling gold prices, it’s easy to see why the miners have fallen even harder than gold itself. As production costs continue to rise, many of these firms are going to find themselves in hot water for the next few years. Analysts now predict that many will scale back production and cut dividends if gold falls any further.
For investors, the sector could become a value in due time. However, that time isn’t now. The best decision might be to stay away or short the sector — via a vehicle like the Direxion Daily Gold Miners Bear 3X Shares (NYSE:DUST[13]) — at least in the near term.
As of this writing Aaron Levitt did not hold a position in any of the aforementioned securities.
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