Peter Epstein, CFA March 9, 2015 Twitter: peterepstein2
The following interview between Mickey Fulp, the Mercenary Geologist and Peter Epstein was conducted by phone and email in the first week of March.
You wrote one of the single best articles I’ve seen on the topic of the all-in sustainable price of gold. Can you summarize that detailed piece before I delve deeper into it?
Thanks for the kind words Peter. It was a monumental undertaking and the final product is longer with much more detail than my usual missives. It’s important to note that I use data and analysis provided by Cipher Research Ltd, an independent Vancouver- based research company that covers the metals and mining sectors and develops proprietary valuation models and investment strategies for its clients.
The musing The Real Cost of Mining Gold shows how and why seven of the largest gold miners have not been profitable from 2003 to 2013 despite the 11-year long bull market for gold. From the beginning of 2003 to the end of 2014, gold was up 266%. Yet, the share price of the three largest miners we looked at was dismal: Barrick Gold (ABX) was down 33%, Newmont Gold (NEM) down 13%, and Goldcorp up only 55%. A lot of the under-performance had to do with ill-advised and overpriced acquisitions, many of which have resulted in asset write-downs. We show that in many cases dividends were paid by taking on debt; that’s never a good sign in any industry.
Why did research analysts, sophisticated hedge funds and gold market pundits fail to see that the emperor had no clothes until the price of gold collapsed by $400/oz?
I think it is largely due to the fact that during the bull market, companies adopted a Wall-Street type of capitalism as a core business philosophy. This growth for growth’s sake paradigm has proven to be a disastrous strategy. A few other newsletter writers and I have been beating this drum for quite some time. But as long as quarterly EPS increased and the resource and reserve bases weren’t in decline, no critical questions were asked by most analysts or major shareholders. The Wall, Bay, and Howe Street analysts and company management teams have blamed problems and write-downs on the decline of the gold price. However, in true Street fashion, analysts only look at the current quarterly report and forward to the next one. They never look backwards and have largely ignored the periodic write downs.
Your article is quite detailed, perhaps over the heads of some investors. To reiterate, what are the remaining difference(s) between your approach and company reporting of all-in costs?
I understand the content is a lot to take in. That’s why I also produced 3 video’s that can be found here. [video 1] [video 2] [video 3]. Company cost reporting remains non-standardized and still does not tell the whole story. From the mid-1990s to 2013, an item called “cash costs” were all that was reported by the industry. But over the years, that has been exposed as having little value. So, in 2013 the World Gold Council, composed of 21 major and mid-tier gold miners, came out with new “all-in sustaining cost” guidelines that clouded the matter even more. Today, there are still no consistent reporting standards. We give some examples of that: no company reports exactly alike and some companies even change their reporting standards from year to year.
There’s a lot of discretion by accountants regarding the classification of cash outflows into operating expenses or capital expenditures. These accounting variances are commonly used to move “OP-EX” into a category we call, “Investment in Mining Properties”, or “IMP.” IMP items are never shown on the income statement except as depreciation expenses until they are written down as bad investments. What this means is that by capitalizing expenses, the company can look more attractive in the short-term, which means higher quarterly earnings and growth, bigger bonuses for senior management, and analysts who can set higher-priced targets. To be fair, this is not just a gold company problem, it happens with many capital-intensive industries, e.g., other mining sectors and oil and gas.
Did the World Gold Council’s proclamation of their new version of how the all-in price should be determined help the cause or add to the confusion?
Remember that the World Gold Council is a promotional and lobbying industry group composed of gold mining companies. Not surprisingly, I think the new guidelines have added to the confusion. These are still non-GAAP measures and in our opinion, they are inconsistent, inadequate, and confusing and still leave too much latitude into what gets classified as expenses versus capital. As a result, we encounter some bizarre discrepancies in the statements. For example, co-product versus by-product accounting of other metals results in different $/oz cost numbers for the same company.
Cipher Research has offered a new and simple way to calculate and compare real-world all-in $/oz costs. They divide operating revenues by the average gold price over a year to get a $/oz Au-equivalent cost.
Do you think that the gold majors were hiding the truth from investors and analysts for years, or blind to the realities of the situation?
I certainly think that North American accounting practices allowed them to do this. So they used aggressive (and non-GAAP) accounting that made them look more profitable in the short-term because they could. That way they pleased analysts and shareholders and managers got their big salaries and bonuses. I will argue though that most management and director teams were blinded by the gold price going exponential from just over $300 to $1900 in eight years. But we know that all markets that go exponential soon reach a parabolic top and then inevitably collapse and that’s exactly what happened with gold.
What’s needed is a simple and constant methodology of analyzing and evaluating individual companies as well as the group of companies on a standard, internally-consistent basis over a long period of time. And that is exactly what Cipher Research has done with this work on the major gold miners.
You are referring to Cipher’s “Adequacy Ratio’. What is it?
Cipher Research has developed a new, simple, and powerful tool to analyze profitability, the Adequacy Ratio (AR). It is cash inflows (revenues) divided by cash outflows (OP-EX + IMP + debt repayment + dividends paid). Note it does not include equity raises or cash spent on acquisitions. If the ratio is greater than 1.0 a company is healthy; if less than 1.0, unhealthy. Of the seven companies we looked at over 11 years, none had an average ratio greater than 1.0 over the period. Only for one year, in 2011 when gold hit its all-time high, did the average adequacy ratio for the companies as a whole exceed 1.0. To compare for example, Apple has a 1.3 adequacy ratio over the past 5 years.
This industry-wide failure means the major gold miners have not generated enough cash flow to meet their obligations despite the amazing 11-year run for gold.
We found that companies have been going into debt to pay dividends. For example, Newmont took on an additional $5.8 billion in debt and paid out $5.2 billion in dividends over the period. We know of small-tier junior miners that have paid out dividends with equity raises… that’s unholy and in my opinion, should be illegal.
Does your analysis imply that many emerging projects with PEAs, PFSs and BFSs are overstating their forecasted NPVs?
That’s outside the scope of this article but your question gets into a whole ball of wax that is one of my pet peeves. As it currently stands, a Preliminary Economic Assessment (PEA) is a flawed document. It is merely a report that used to be an internal company document called a “scoping study” and was used by company engineers, management, and directors to determine if an advanced project warranted a budget for further work. Now because of misguided and inappropriate 43-101 regulations, they have become public documents that enable juniors to routinely use PEAs to apply economic parameters to Inferred Resources, which by definition are not technically reliable enough to analyze economically. PEAs have become promotional tools for the company with little basis in reality.
Remember that for every failed mine, there was a positive Feasibility Study. Also, four out of five mines never pay off their initial capital costs. That, my friend, is a failed mine.
Conventional wisdom is that a number of emerging projects are off the table indefinitely. What jurisdictions, geological settings, and mining methods are likely to be in big trouble? Which are poised to flourish?
I would say that the geology, mining methodology, infrastructure, geopolitical risks, and ultimately the costs should be viewed on a case-by-case project basis. Certainly it is cheaper and easier to develop a new gold mine in Nevada than in the Northwest Territories. Simply put, the gold grade to be potentially economic has to be a lot higher in the Yukon than in Mexico.
In terms of jurisdictions, more and more miners are having problems with resource nationalism, corrupt and/or unstable governments, and radical NGOs and therefore, are reverting back to the good old U.S. of A. I saw this start to happen two to three years ago. Smart money was coming to me and wanting a high-grade, advanced gold or copper or uranium project in the U.S. I’m not saying we don’t have our problems here with mineral development, but at least we are protected by the takings clause in our Constitution.
All countries and political jurisdictions have increased risk but miners want to operate in countries where mineral tenure is secure and there exists the rule of law.
Without necessarily predicting the timing or the future price of gold, (unless you would like to) is the concept that gold supply will inevitable drop, perhaps by a lot, valid?
I learned a long time ago that predicting a price and giving a time for it to happen is a no-win game. There is little doubt that gold supply will drop over the next few years. But that’s because there is always a time lag between discovery, development and mining. 2011-2012 was the all-time peak in the gold price but world gold production hit another high in 2014. For the most part, new mines were discovered and development and permitting started 5-10 years ago. Now with the downturn in gold price and continuing write-offs, more mines are reaching economic Armageddon. Therefore, production will come off. Majors typically turn to the juniors for discoveries to add to their project pipelines and production profiles. But most juniors are moribund and can’t raise money to advance projects, so naturally supply will decline over the next few years.
Do the majors have to replace depletion by acquiring assets or can they continue to develop their own pipeline or high grade existing production?
Our data shows that the majors are not depleting their reserves and resources, but these bases have flat-lined for the most part or grown only through expensive and often failed acquisitions. However, production has been declining at increasing rates, especially for the big boys, Newmont and Barrick. These two are carrying huge inventories of resources & reserves. In 2013, Barrick had 235mm ounces divided by about 9 million ounces of production, equal to a 25-year mine life. Newmont had about the same, 22 years of current production in its R&R base. They certainly have no lack of resources and reserves, but are they high-margin mineable ounces?
I don’t care if production goes down, it should down when gold prices are weak. Management and potential investors alike need to learn that gold mining is not a growth industry. Cipher Research and I are problem solvers and as good scientists and engineers, we have presented a solution to the current dilemma. Gold mining companies must stop presenting themselves as growth companies. Mining is a value industry not a growth industry. They should maintain the same operating margins in good times and in bad times and strive to be in the lowest quartile of the gold production cost curve. Gold miners should be about quality of ounces not quantity of ounces mined.
Regarding high-grading, yes companies are “high-grading” right now as they should be. They should be mining high margin ounces and that likely means mining higher grade material. The problem during the boom was that as the gold price went up and up, the majors lowered and lowered their cut-off grades. Then when the gold price corrected, the low margin mines lost money and investments in those mines, i.e., plant, property and equipment, was written down. Note however, if a mine is temporarily high-graded to increase production and lower costs over a short period, that will always come back to bite them in one way or another.
Veering off course for just one question, why do junior gold companies report project NPVs with a 5% discount factor? Shouldn’t it be 8%, 10% or even 12%?
Once again because for every failed mine, there’s a positive Feasibility Study. The underlying problem is the industry’s hired guns, that is, the consulting engineering companies, are in competition for jobs and one or the other can be persuaded to use high precious and base metals prices, report pre-tax versus after-tax IRRs, use lower discount rates, or unrealistically low cut-off grades, etc. There are a plethora of fudge factors that can make a project look economically positive. A feasibility study presents the best case scenario. Have you ever seen a negative feasibility study published by a junior company?
I can peruse any flawed Feasibility Study and point out all sorts of red flags immediately. Low discount rates are just one of them. Discount is increasingly being used to assess project risk but that factor is baked into the capex cost contingency, as a percentage dependent on the level of the study. The actual discount rate used should be the cost of capital to build the mine in constant dollars. If it costs 8% to borrow the money or alternatively, you could invest it in a 10 year T-bond at 2%, and there is 2% inflation, then a 12% discount rate should apply.
Now that companies have implemented some austerity, moving the industry cost curve lower, might that cap the upside of gold prices going forward?
No I don’t think so. The gold price is largely based on paper market speculation. The physical gold market, i.e., real demand for jewelry or hoarding, has little to do with the gold price other than to buffer the moves of the paper speculators and ETF “investors” who are driving it up or down. Gold is really only money and there’s only demand for gold because it’s not used for much other than a safe haven. The paper market is probably two orders of magnitude bigger than the physical gold market.
Sometimes you’re comfortable talking about individual companies, sometimes not. Any names that we should discuss? How about Brazil Resources?
Sure, I will gladly talk about Brazil Resources (BRI.V). First of all, it’s a company that sponsors my website, so of course I’m financially biased. That said, I’ve been a loyal supporter since pre-IPO via two private placements. It recently did a $0.55 private placement, which was 10% above the stock price at the time. I put more money in and actually averaged up significantly from my previous cost basis. It has a full warrant at $0.75 with a five-year duration, and that was great incentive for me to buy more. As of Friday, BRI was trading at $0.67, despite the lower gold price. Management is led by Amir Adnani, who I think is an amazing young entrepreneur. Investors include a virtual who’s who of smart money in the junior arena and a major Brazilian private equity fund. Now Brazil Resources has a nice cash kitty to acquire more distressed mining assets in Brazil and perhaps other parts of Latin America. I think it’s future is bright.
What happened to the pre-PDAC rally this year? Are any sectors up meaningfully over the past few months?
The price of gold cratered, it’s as simple as that. It was around $1,300/oz when the Swiss decoupled their current in late January. The gold price still drives the TSXV and always has on the sentiment side. Gold took a big hit late last week and the TSXV Index was down 2%over the week on abnormally high volume. Over the next month, we’ll see if the usual post-PDAC curse hits the juniors again.
Uranium is up nearly 40% since its summertime lows but equities have not followed. I like the US domestic uranium producers as the sweet spot for a mid-term play. Copper likely bottomed at $2.50 because that’s below the production costs of marginal mines. My contrarian choices at this juncture would be well-run companies in those commodities.