In a recent Sprott Money podcast, Eric Sprott discussed the merits of investing in high-cost producers during gold bull markets (https://www.sprottmoney.com/Blog/when-you-contemplate-negative-interest-rates-i-would-rather-own-gold.html). The intuition is simple, a high-cost producer may only produce $100/oz of cash at a $1,200/oz gold price. When prices jump to $1,300/oz, net income effectively doubles; why wouldn’t the share price jump with it? The math does not lie, but I thought it would be worthwhile to investigate the validity of this statement in the context of current market performance.
YTD, gold prices are up approximately 5% or $60/oz. That is a sizeable amount, enough to produce a material increase in profits for high-cost gold producers.
Let us take a look at Detour Gold as an example. In 2018, the company produced 610,000 oz of gold at an all-in-sustaining cost of $1,158/oz (https://www.detourgold.com/investors/news/press-release-details/2019/Detour-Gold-Reports-Fourth-Quarter-and-Year-End-2018-Financial-Results/default.aspx). With this production, cost, and a realized price of $1,268/oz, they produced adjusted net earnings of US$64.2M. At today’s gold prices, using last year’s production costs, we could expect earnings to increase by 65%. This statement is a simplification of reality as production costs are inherently variable as is production. The underlying notion, however, that low-cost producers have more leverage to the gold price is true (a small increase in gold prices can make these miners much more profitable).
So given the increase in gold prices, my hypothesis is that we should see a positive correlation between production costs and 2019 returns. Well, let us see what the data shows.
This YTD price return tornado shows some promising results. I see high-cost producers like Detour in the green, but there are many similar peers that are in the red.
This chart is much more useful. It plots 2019 YTD price returns against 2018 AISC per oz. The relationship, however, is the exact opposite of what I would expect. The lower the cost the producer, in general, the better they have done this year.
Before you start challenging this chart, I will acknowledge a few caveats. First, this is the GDX peer group. The silver price has been hammered this year, and some poor performing companies (Hecla) have a large exposure to the silver metal. There are also notable idiosyncratic factors that have resulted in poor (St. Barbara Feasibility study disappointment) and better than average performance.
The underlying premise, however, that high-cost producer will outperform in a rising gold environment appears to be less certain than the underlying logic would propose.
So how should you think about this information in the context of your investment framework? To start, the data suggests that jumping into high-cost producers does not make sense at the moment. Perhaps the gold price needs to consolidate before market participants rerate these companies. The data suggest that less risky, lower cost producers, may be the first to benefit (in terms of stock price) during a bull market.
In this case, Kirkland Lake stands out as the obvious choice; being the lowest cost producer in the GDX index.