Gold Mining: Rising Costs and Limited Cash Flow

By 2016 it could cost more than $2000 to produce an ounce of gold...

IN AN ENVIRONMENT of rising capital expenses, gold producers big and small are left with little or no free cash flow. Instead of investing in exploration to maintain production, too many companies are cutting costs and high-grading their current resources. 

Joachim Berlenbach, fund adviser with Switzerland's Earth Resource Investment Group, believes this kind of short-term thinking will lead to decreased production and a higher gold price. In this interview with The Gold Report, edited by Ben Traynor, Berlenbach shares his ideas on how to succeed in this stock-picker's market. 

The Gold Report: Goldman Sachs recently downgraded its 2013 gold forecast from an average of $1,800/ounces ($1,800/oz) to $1,610/oz due to interest rates rising in the US Could this bearish sentiment actually be bullish for gold?

Joachim Berlenbach: I think the report was very one sided. Focusing solely on the US interest rates does not provide a full picture. I would have liked to see a balanced look at where the real demand is coming from. If the report had said, for example, how much gold the Chinese central bank is actually buying compared to its reported purchases, it would have been a much more interesting discussion. 

TGR: You have a chart that suggests that by 2016 the all-in costs to produce an ounce of gold will reach $2,120/oz. How would that change the space?

Joachim Berlenbach: This graph includes all of the costs that make up a company's free cash flow: operating cash costs, sustaining capital expense (capex), expansion capex, exploration and finance costs, plus a bit of general and administration expense (G&A). 

Total costs are sitting at $1,600/oz for the 13 biggest companies, which has been our universe for the last 13 years. Over the last two to three years, we have seen total costs rise an average of 15–17%. At a gold price of $1,600/oz, the industry does not produce a single Dollar of free cash flow. If we take a cost inflation of only 10%/year, we will need a gold price over $2,000/oz to maintain production. 

The critical point is—and I believe it is poorly understood by the market and the investors—that the natural resources industry is different than any other industry. When a gold producer builds a new mine, it is not to increase production, it is to maintain production. And unfortunately, the new mine will likely have lower grades, because the high grades have been mined out. 

Grades are drastically lower in the new deposits. That means companies have to build bigger mines outside the established mining areas like the Carlin Trend in North America or the Witwatersrand Basin in South Africa. Companies have to go into Indonesia, West Africa, the Democratic Republic of the Congo (DRC), Colombia or Guyana. New mines require higher capex. 

Unlike other industries, capital spent for new production is not intended to increase shareholder value; it is done to maintain the company's value. 

In the coming months, we will see a huge effort by the industry to reduce costs. To become profitable again, the industry has to increase cash flow. To do this, a company could write off or stop capital projects already committed to. Instead of investing, it will try to preserve its free cash flow. And remember, the industry is under huge pressure from investors who want dividend yields. 

The industry also could go back into high-grading the ore bodies. High-grading means picking out the high-grade parts of an ore deposit to reduce costs in the short term. I saw this happen when I worked in the South African gold industry at the end of the 1990s. The gold price was below the breakeven price. Companies stopped exploration and started high-grading. 

In the short term, high-grading might result in more profitable mines and better cash flow. But in the longer term, it means that we cannot mine enough gold. Gold production has not increased over the last 10 years, despite the rising gold price; it remains at 2,600 tons, or 80 million ounces (80 Moz), per year. If companies do not invest in new mines, gold production will drop drastically. 

TGR: Less supply means higher prices. Even with cost inflation, the margins should be thicker, right?

Joachim Berlenbach: That is why it is so important to be a stock picker today. All companies are not equal. We look at a spectrum of gold companies—mid cap, small cap and large cap—with very different costs and profit margins. You have to do your homework to pick the right stocks and make a profit. 

Gold equities will come back, but there will be more diversity in performance among companies. 

TGR: Many companies now report sustaining capex on the income statements in their quarterly statements. What does that change mean?

Joachim Berlenbach: Looking at the chart, the average cash operating costs in Q4/12 were $713/oz. But that figure does not include another $700/oz in capex: $150–200/oz sustaining capex—the capex needed to pay for tires on a mine's trucks or advance a new crosscut to a mining area—and $400–500/oz in expansion capex to build new mines and replace the ounces the company has been digging out. 

TGR: What is the difference between capex and finance costs?

Joachim Berlenbach: The financing cost is the interest a company pays on top of its debts. Exploration costs can vary. It is easy to switch exploration on and off. Sustaining capex is what a company spends on keeping its mines running; expansion capex is money used to build or buy new mines to keep up production in the mid- to long term. 

Where the mining industry differs from some of the accounting standards, especially in North America, is in looking at the total breakeven price. That is the information most companies provide when they report the costs of producing the 2,600 tons or 80 Moz gold mined per year. 

Looking at the chart, our Q4/12 free cash flow, breakeven price was $1,600/oz. Any less and the industry does not earn a single Dollar of free cash flow. You need to add 20% on top of that to motivate the industry to build new mines. Without that incentive, why would companies take the risk? That means we need a gold price around $1,900/oz to maintain production of 2,600 tons or 80 Moz.

TGR: Does this mean there might be fewer takeovers?

Joachim Berlenbach: I think so. Today CEOs are under considerable pressure from investors to be careful with acquisitions. Several recent takeovers were not well received and have even impaired the industry.

Many CEOs are focused on increasing cash margins, so a fall in production is likely over the next quarter, with higher cash margins. That could lift some equity prices. But it is not sustainable. 

TGR: How can the average investor tell if a mining company is high-grading a deposit?

Joachim Berlenbach: My advice is to look at the annual reports over a five-year span or, better yet, look at the head grades of a mine on a quarterly basis and compare with the stated reserve grade; look at where the grades in a deposit in a certain mine are coming from. Is the company mining above or below the reserve grade?

Today, a lot of mines are mining above the reserve grade. If a mine is doing that, it can only mean that over the longer term the average grade on that mine is coming down, with resulting higher costs.

The biggest cost driver in the gold industry is falling grades. Grades have come down from 7–8 grams per ton (7–8 g/t) in the 1950s and 1960s to less than 1 g/t. Of course, technology developments, like heap leaching, have helped us mine lower grades. 

At the same time, the new mines are being built in the middle of nowhere. I nearly fell over backward at the cost of one mine in Ghana. Diesel fuel accounted for 50% of its production costs because all of its power had to be provided by diesel generators—on a deposit mining just 2 g/t. 

TGR: When you first put this chart together, the obvious strategy was to overweight the "better free-cash-flow generators." Now that the gold price has fallen, where does that leave that strategy?

Joachim Berlenbach: With the gold price being so close to the free cash flow price, investors need to do their homework. You cannot put all gold companies into one basket. There are huge differences in geography, risk profile, geology. There are hydrothermal deposits, deposits with copper as byproduct, gold-silver deposits. You need to go through the technical side of the company if possible, visit the mine and speak to management, geologists and mining engineers. Do a detailed financial analysis. 

TGR: Would it be fair to call you a gold bull?

Joachim Berlenbach: No, I am agnostic when it comes to the quasi-religious camps of gold bulls and bears. I would like to see a gold price that helps us maintain the industry. We do not have that today. So, to that extent, I am bullish on the gold price. It needs to be significantly higher in the mid to longer term. 

TGR: Much of your group's strategy involves what you call bottom-up analysis. Tell us more about that, as it pertains to being a stock picker. 

Joachim Berlenbach: It is a very detailed analysis, including field visits. We all are geologists, mining engineers or geophysicists. We not only have degrees in these subjects, but field experience working for exploration companies or gold producers. At least three of us have been sell-side analysts, so we understand how to build very detailed financial models. 

We do not invest in any companies without building a detailed financial model, generally using a discounted cash-flow analysis. The whole investment team analyzes and discusses every investment case. Once everybody is happy with the financial model, it goes into a ranking system where we compare a gold company with a copper company and an oil company and so on.

We also are very transparent with the geographic locations of our investments. We have an in-house risk system. Every country gets a mark (A, B, C or D); A is the lowest risk where we go fully invested. We do not invest in D countries. A company rated C would be a maximum of 2% of the portfolio; B companies a maximum of 5%. 

TGR: There are about 3,500 publicly traded mining companies. How do you sift through all their financials, drill results and such?

Joachim Berlenbach: In many cases you can scan very quickly. For example, it does not take long to eliminate a company with an average ore body of 1.5–2 g/t on a project in the Congo and no cash. 

We generally look for a buffer on the balance sheet to support the company for the next 18 to 24 months to allow for exploration. There must be good management with a solid track record. 

TGR: Are some jurisdictions better understood and appreciated by the European investor than the North American investor?

Joachim Berlenbach: I think the North American investor is much better educated regarding natural resources than the European investor. I would like to speak more to North American investors, but we are a European fund, so we cannot market the fund in North America. 

Having said that, North American investors generally are not well educated about Africa. They might not understand the differences among Ghana, Congo, South Africa and Zimbabwe; all of Africa gets thrown into the same basket. There is a huge risk aversion to Africa in North America. The European investor is more open to Africa.

However, North American investors are generally more open to and better educated about South America. 

TGR: What did you take away from your recent trip to Africa?

Joachim Berlenbach: I noticed three trends. First, cost cutting is really coming into play in Ghana, Burkina Faso and South Africa. For example, to cut costs, companies are not putting a single Dollar into exploration. 

Second, in Burkina Faso projects are being downscaled. Prefeasibility studies that had already been presented are being scaled down 40–50% because the money is not there and capital markets are closed. This tells us we are looking at a reduction in production over the next few years. It also points to the importance of looking at the exploration and capital expenditures in Q1/13 quarterly results for the mid and large caps. Are they committed to their capital projects? What are they doing on the grade side? 

Third, a new generation of CEOs is coming in. They will have four or five years at the helm and they want to leave that company with a big check in their pockets. The only way to get that check is to make a good return for the investors. Unfortunately, that means they will not focus on investing in exploration for future production, but on cost cutting. They will start high-grading. 

TGR: How about Colombia? The Colombian government has not been generous with mining licenses, has it?

Joachim Berlenbach: That is a problem. I was very impressed when I visited Colombia two years ago. I was expecting a drug dealer on every corner in Bogota. I was worried, but it was pleasant to speak with the mining geologists and CEOs. They all agreed that Colombia is a great country to operate in. 

The government wants mining. Geologically, Colombia is a prosperous area. At one point, the northeast part of South America was hanging onto West Africa. Both regions are of the same age and have the same kind of deposit. The same is true of Guyana, where I saw the same rocks that I saw in West Africa.

Of course, there is risk. There is no guarantee of getting a mining license or of the taxes staying the same. But you have that everywhere. That is part of the game we play.

TGR: What one message do you want investors to take away from our interview today?

Joachim Berlenbach: Our industry needs to take risk. Companies are not investing to develop the new mines that will be needed to create and produce gold over the next 10 years. 

We cannot sustain the industry if the current level of risk aversion continues, and mining companies are pressed to pay more dividends and cut costs. We need to maintain production and put risk capital into the market. We cannot have a short-term view on capital gains, dividend yields and so on. 

TGR: How does a retail investor prosper today? 

Joachim Berlenbach: There is only one way: Do your homework.

If you are not a real specialist on specific projects, stay with those management teams that have a good track record. Those are the teams that will go for the better-quality projects. If you are a North American investor, look to Africa and be open minded.

If everything is equal—jurisdiction, infrastructure, tax regimes—go for high grades. Those generally provide better cash flows than lower-grade deposits. 

Finally, go for companies that are well capitalized. Exploration companies burning $1M or $2M a month, with no cash on the balance sheet, will not survive for long. 

TGR: Joachim, thank you for your time and your insights. 

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