Looking For Torque in the Gold Space, Think Again

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.

Capital Allocators

Intuitively I’ve known that the gold mining industry doesn’t allocate capital well. I’ve touched on some of the return performance of royalty companies in the past. Their low return royalty model looks angelic compared to other actors. As I browse through company balance sheets I note the scars of the past (dramatically negative retained earnings). I’ve never really looked at this information in much detail. I know Kinross made some bad bets, I know Barrick lost its track with Pascua Lama. The full magnitude of the capital destruction, however, was way worse than I thought it would be.

Take a look at this snapshot. In 2013, this group -which is by no means comprehensive- wrote off over $24B in 2013.

Over this same time period, the group destroyed $70B worth of capital. Barrick alone tallied $30B.

If we look how much was written off, compared to these company’s current enterprise value the data shows the Kinross leads the pack. Between 2005 and 2018 the company wrote off $12B, which is 50% more than the current valuation…

Interesting stuff. Terrifying really. There are, however, a handful of companies that did pretty well during this time period. All of the streamers kept write-down % under 10%. Kirkland Lake was one of the only companies that survived the period without an issue.