Gold production decline imminent

Interestingly 2013 wasn’t expected to be any different as far as the miners were concerned.  Gold’s structural fundamentals were still spectacular.  And though in 2012 its price was never able to revisit 2011’s all-time high, it was a year in which gold sported its highest-ever average price ($1669).  Given these conditions the miners were poised to do what they did best, produce gold, make money, and plow capital into developing their pipelines.

But alas, this year hasn’t quite been as hunky-dory as hoped.  And the earliest and most transparent effect of the sharply-falling gold price has been seen in the miners’ financials.  With gold’s average price in the first half of 2013 $150 lower than 2012’s ($250 lower in Q2), margins have obviously been squeezed.  And this has resulted in a lot less money being made from existing operations.

Gold’s much-lower prices are also forcing the miners to take huge write-downs and impairment charges (some projects are no longer economically viable, and others must be re-valued to the market).  In the second quarter alone major miners Barrick Gold, Newmont Mining, AngloGold Ashanti, Goldcorp, Newcrest Mining, and Kinross Gold announced over $23 billion in combined write-downs and impairments.

Given gold’s consistent rise, most miners had been valuing their assets using prices on the high side of an interim range.  They just assumed that gold’s price would continue to rise, and that the prices they used would eventually be conservative.  Gold’s recent action has vanquished this mindset though.  And these same miners are now nervous about the values of their assets.  Unfortunately I suspect we’ll see a lot more write-downs and impairment charges in the quarters to come.

These accounting phenomena are non-cash, paper losses.  And while they are tough to swallow in whatever quarter they show up on the income statement, they can be even more damaging from a sentiment perspective.  And unfortunately sentiment takes an even bigger hit when there’s a systemic issue across the entire sector.

Ultimately the barrage of financial reckonings in the recent quarter has left a bad taste in investors’ mouths.  And the miners’ stocks have greatly suffered as a result.  It’s been one of the worst stretches for gold stocks in this entire secular bull market.

So with gold prices and stock prices way down, the miners have suddenly found themselves in a sentiment wasteland.  And in this wasteland the future doesn’t look as bright.  The folks that run these companies aren’t as confident in gold’s future as they were six months ago.  And with less cash flow and a much-more-challenging financing environment, their spending plans are not feasible anymore.

For these reasons and more, most miners have been forced to revisit their development plans.  And in many cases this has resulted in the delaying or outright shelving of expansion/development projects, as well as a huge cutback on exploration.  The miners are now in capital-conservation mode, and this will no doubt have a major adverse effect on future production volume.

This will of course be a shame considering all the work put into the gold-mining infrastructure over the last decade or so.  Interestingly it was only just in 2009 that the miners finally got ahead of the depletion curve.  Years of aggressive development led to the first material increase in global mine production in quite some time.

And this was the beginning of a healthy streak, with 2012 being the fourth year in a row of production growth.  The miners delivered a record 2700 metric tons to the market.  But this hard-won streak is now in jeopardy as a result of gold’s fluky panic.  If indeed the miners curtail development and shut down higher-cost operations, production volume has nowhere to go but down.

And this production decrease could play out sooner than we think.  In the World Gold Council’s latest Gold Demand Trends report, it states “While mine production historically has been slow to react to changes in the price, the extent of the fall in the second quarter has elicited a swift response from gold producers.  Recent spending cuts and the closure of costly operations across the industry may start to have an impact on the supply pipeline by the end of this year.”

By the end of this year?!?  Wow!  This is a crazy-fast reaction by an industry where reaction is typically slow and methodical.  Gold’s 2013 panic sure did scare the miners, which is readily apparent by the tone of their recent press releases.  They are now positioning themselves so they don’t get caught with their pants down again.  And I believe the result will be prolonged lower production levels driven by three distinct phases, closure, delay, and backfill.

Closure is the first and most immediate phase that will negatively impact production.  Within this phase are two methods of closure.  The first is full closure, the outright cessation of all mining operations.  If a mine can’t make money at lower prices, it will be shut down.  This shutdown is usually temporary at first, with the hope that higher prices would again make it economically feasible.  Regardless of downtime, this is production that comes right off the market.

The next kind of closure is a partial closure, or source closure.  Some mines run multiple mining methods, multiple ore types, and/or multiple processing circuits.  If one is not economically feasible at current prices, it’ll be shut down.  And this would obviously reduce output.

Some mines also blend material, meaning lower-grade ore is mixed in with the higher-grade stuff.  At lower prices many mines won’t be afforded this luxury.  So rather than just increase the higher-grade material (which would drastically reduce the mining life), most miners will simply stop running the lower-grade material to reduce operating costs.  This would get them back in the money, but again volume would be down.

Closure is something we are already seeing today.  And we’ll likely see more at operations that just can’t turn a profit at lower prices.  Interestingly analysts have recently been estimating that all-in sustaining costs for the industry average around $1200.  If this is the average, then the topside outliers are in big trouble.

In the onset of 2013 most of us expected another record production year.  But with closures mounting, this may not come to fruition.  Reductions in output from this first phase may just be enough to offset new volume from some big operations that came online earlier this year.  And when you compound closures with development delays, we’re almost certain to see less mine production in 2014 and beyond.

Development delays have been the talk of the town.  As publically-traded companies, the miners must keep investors in the know regarding any material decisions.  And there’s been a throng of announcements over the last couple quarters that have outlined radical alterations to numerous miners’ tactical and strategic plans.

From a tactical perspective we’re seeing a lot of mining companies rein in spending for the remainder of the year.  And while it may not seem like a big deal, it actually is.  Whether pulling drill rigs from the field, holding off on equipment ordering, or anything else that would slow the advancement of a project, this type of activity delays future production.

From a strategic perspective, we’re seeing some miners outright suspend development plans they had in the works.  This includes both expansions at existing mines, as well as brand-new mine development.  As you can imagine, this development is crucial for sustaining current production levels.  Mines are constantly being shut down due to depletion and/or economic viability, and there naturally needs to be a steady flow of new development to replace the production that’s being lost.

Unfortunately a degree of paralysis has gripped many miners as a result of the shock from seeing the economics of their development projects radically change over such a short period of time.  Some projects are flat-out uneconomic at lower prices (these are the ones being written off), and the rest have IRRs and NPVs that are well lower than anticipated.

Sadly this paralysis is preventing many miners from pulling the trigger on development, even if their projects still have positive economics.  And these delays are mostly financially driven.  The miners are either conserving capital out of fear that gold prices may go lower, or they are concerned over their ability to fund these developments.

Over the last four years, new development has stayed ahead of depletion.  But it won’t take many development delays to fall behind the curve.  And if the delays already announced hold true, then there will no doubt be a negative impact on future production levels.

The final phase of future production pressure will be a product of insufficient backfill.  As mentioned depleting/closing mines need to be replaced by a constant flow of new development.  And it is a strong pipeline of development-stage projects that allow for this to happen.

In order to maintain a strong pipeline of development-stage projects though, there needs to be a steady flow of discovery and advancement at earlier-stage projects.  These projects are the ones that backfill the development projects when they are removed from the pipeline.  And if there’s a shortage of them, it will eventually be felt on the production side of things.

I truly believe it will be the lack of backfill that will smack the gold-mining industry the hardest.  Not only are the large producers cutting way back on their exploration spending, the junior sector has all but ceased exploring and advancing projects.  I discussed the huge crisis of confidence currently strangling the junior sector in a previous essay.  And it’s not hard to conclude that a lack of activity in this realm will adversely impact global mine production in the years ahead.

Overall gold’s 2013 panic makes a global mine-production decline imminent.  And I suspect this will be the case even if June’s low holds and there’s a quick reversion to the mean.  The damage has already been done.  And regardless of gold’s price, the miners will be gun-shy on the capex front for some time to come.

Declining production obviously has huge implications for investors, especially if demand remains high.  Since mine production is by far the largest source of supply, a decline would create a supply-side economic imbalance.  More money would be chasing after less gold.  And this is actually quite bullish for the price of gold, as it must rise until a balance is met.

As gold climbs higher, the miners should also attract investor interest.  Those that have survived and thrived in 2013 will take a leading role in the next leg of this metal’s secular bull.  The producers will be well positioned to leverage their profits, and the junior explorers with quality projects to feed the pipeline will sell for a hefty premium.

At Zeal we believe we’re in the early stages of a major gold upleg.  We’ve thus been loading up on gold stocks amidst the panic and its aftermath.  And we’ve already seen some excellent unrealized gains on many that we’ve recommended in our acclaimed weekly and monthly newsletters.  Subscribe today to get unmatched contrarian market analysis and to find out which stocks we’re trading.The bottom line is 2013’s infamous gold panic will prove to be a game-changer on the supply front.  It really freaked the miners out!  So much so that we’re already seeing huge spending cuts and mine closures.

We’re also seeing an onslaught of suspensions and delays in the development projects that are supposed to replace depleting operations in the near and long term.  And to top things off, exploration is at a near standstill as the miners seek to conserve capital.  This will lead to an imminent production decline, which will ultimately be bullish for the price of gold in the years to come.

Scott Wright