Last week, the gold price dropped below a psychologically important barrier at $1,500. Since mid-2011, the SPDR Gold Shares ETF (NYSEMKT:GLD) has lost almost one-fourth of its value, while the Market Vectors Gold Miners ETF now trades at half of its former valuation, raising the question of whether mining stocks are a bargain now.
The drop in the miners’ shares can partially be explained by the fear that the profit margins are under heavy pressure by the sliding gold price. The key quantity to understand here is the miners’ production costs: in short, miners who control their costs will make the best investment. Additionally, it has also been suggested that gold will not drop below its production costs; hence, understanding these may give a hint at the future valuation of gold.
After a short excursion on the different notions of costs, I will thus compare the production costs of the two major mining companies Barrick Gold Corporation (NYSE:ABX) and GoldCorp Inc. (USA) (NYSE:GG).
Different notions of production costs
Before we turn to these companies, let us quickly compare the different notions of production costs:
Cash costs per ounce: The money needed to produce one (troy) ounce of gold in your existing gold mines.
All-in sustaining cash costs per ounce: The money needed to produce one ounce of gold if you prorate all costs incurred during the life cycle of a mine.
The second number looks like the number to go for. In detail, Barrick Gold Corporation (NYSE:ABX)’s current definition of all-in costs
“… adds [to the total cash costs] sustaining capital expenditures, corporate general and administrative costs, mine site exploration and evaluation costs and environmental rehabilitation costs.
This measure seeks to represent the total costs of producing gold from current operations … [but] is not representative of all of the Company’s cash expenditures.”
Barrick Gold Corporation (NYSE:ABX) 2012 annual report, p. 31
A caveat is that the World Gold Council is yet to finalize this standard, which is expected not before the middle of 2013. A comparison of costs among different companies should thus taken with a grain of salt. This new measure is also critized that it does not include taxes nor the costs to get new projects rolling. For this reason, I will offer at the very end of this article an alternative all-embracing metric (for what it’s worth).
The first notion, cash costs per ounce, looks rather simple. But what happens if you produce gold for, say, $1100, but while doing so, you stumble across a silver nugget that is worth $150? Do you report production costs of $1100 or $950?
If you do the latter, you report gold cash costs on a by-product basis. You would do this if you see yourself primarily as a gold producer. On the other hand, if you want to account your gold and silver sales separately, you would report gold cash costs on a co-product basis. In this case, you would assign a fraction of your ongoing costs to your silver department, but which fraction?
Here the term on sales basis comes in. Assume that you can sell your gold for $1500, i.e. ten times the silver price. In other words, the silver nugget contributes 1/11 to your income. You would then attribute 1/11th of your production costs to silver and 10/11 to gold. You end up with gold production costs of $950 on a by-product and of $1000 on a co-product basis.
The difference looks negligible, but only because I took simple numbers. (This explanation is based on the footnotes on p. 32 of GoldCorp Inc. (USA) (NYSE:GG)’s annual report.)
Production costs for Barrick Gold Corporation (NYSE:ABX) and GoldCorp
Our excursion on production costs can be summarized that the by-product costs are lower because the profit generated by other metals (like silver) is taken to subsidize gold production. The all-in costs are higher because they take into account also the costs incurred in early and late stages of a mine’s life cycle.
How do the numbers look in practice? The numbers for GoldCorp Inc. (USA) (NYSE:GG), according to their 2012 annual report, in dollars per ounce:
|cash costs (by-product)||271||223||300|
|cash costs (co-product)||447||534||638|
|all-in sustaining cash costs||874|
These numbers appear to be sufficiently below the gold price even if the latter slips further. But be aware of the 10-20% annual increases in the cash costs.