NEW YORK (ResourceInvestor.com) -- The present bull market in gold has offered surprisingly narrow windows of opportunity for gold investors to make a substantial profit. If you weren't already long at the cycle bottom around $250 an ounce in March/April 2001, then you had to pick your moments shrewdly.
Most of the gains have been concentrated in two periods - December 2001 to June 2002, and April to December 2003. There was another period from August to November 2004 that was good, but not nearly as impressive or explosive. And it was very much a stock pickers game rather than the broad, sector-wide advances that characterised the previous periods.
With hindsight we see that gold stocks entering the bull run with high betas and, therefore, carrying the greatest expectations for exceptional profits and free cash flows have badly disappointed investors. Likewise, hedged gold producers have not grossly under-performed their unhedged counterparts as was predicted.
The bulk of the prophecies rendered for equities at the start of the gold cycle have come to nought. And it is almost entirely to do with a failed appreciation for the inflationary impact of a weak American dollar. More particularly it is the fact that gold prices are lagging the increase in other commodities that must be consumed to produce it.
Hence the abiding caution about gold equities that has manifested in decelerating financings, stock multiples that are weaker relative to previous periods at lower gold prices, feasibility studies sagging under larger front-loaded costs that have watered down returns, and projects schedules lengthening appreciably.
One of the most prescient warnings about idealistic expectations for the gold bull came from Chris Thompson of Gold Fields. Speaking at the Denver Gold Forum in September 2001, Thompson, then CEO, warned investors that too many management teams were taking credit for lowering operating costs when it was actually a by-product of US dollar strength.
Not only had he reframed the industry's central weakness more plainly - the inability to set margins, not just prices - but his work on the true replacement cost of consumed gold reserves remains seminal for what it foretold.
Remember all those companies promising to start building mines as soon as the gold price tipped $350 an ounce; the optionality thereon boundlessly promoted? Thompson showed years ago that not only was it an unrealistic "trigger" price, but that the sensitivity analysis shown for most projects is skewed toward the positive impact of high gold prices, but not the negative impact of commensurately higher operating and capital expenditures.
In other words, until the gold price breaks out against all currencies, bullion producers will remain margin challenged unless they change the status quo. What has happened to South African gold producers is just a magnification of sector-wide challenges.
Finely spun copper
Ironically, gold producers that were "naturally" hedged with base metal exposure have fared best until now, garnering by-product credits that better compensate for inflation stressed gold production.
This was illustrated this week by equity analyst Barry Allan of Research Capital in Toronto. He noted that companies with a large chunk of by-product output such as Agnico-Eagle , Wheaton River  and Northgate  have enjoyed a whopping reduction in cash costs of $31 per ounce every quarter (-14.7%) over the past two years. By contrast, companies with modest by-product contributions have suffered quarterly inflation averaging 2.9% ($5.60/oz) over the past couple of years.
BMO Nesbitt Burns's covers a larger universe of stocks and records overall cash costs rising 41% ($170-240/oz) over the past three years. CIBC World Markets estimates that industry cash costs rose 13% in 2004. Resource Investor data shows that the top four gold producers managed to restrain total cash cost inflation to 4% last year, but that was after a 30% blowout over the course of 2003.
CIBC analyst Barry Cooper calculated that currency pricing contributing about 50% of the rise; higher energy prices and consumables around 30%; and declining grades related to lower cut-offs and high-grade depletion contributing some 20%.
Gold sector inflation plays out very clearly when the industry is contrasted with its base metal cousin - the latter group has seen profits swell on a nearly exponential basis whereas the gold sector is plodding.
That begs a question about the gold multiple that equity investors are prepared to pay. That's especially so given that the top-four London listed miners - BHP Billiton, Anglo American, Rio Tinto and Antafogasta are paying out more than $3 billion in dividends this year, or about one-third of net profit, and enough to buy a top-rated intermediate gold producer.
Gold producers that resorted to the stock printing press in this period have only made the task harder as per-share metrics continue to tumble.
Investors provide the tolerance for dilution and feeble rates of returns, but that may be on the verge of changing as anecdotal evidence suggests less willingness to have scrip stuffed down their throat at every breath. That's bad news for some companies, but in the long run it is positive for reducing total gold supply, especially the riff-raff ounces that act as a hidden super-tax on investors.
Non-hedging comes home to roost
Hysteria over gold hedging is also coming home to roost in cost inflation.
Investors decried the practice of selling gold forward to secure a revenue stream on the basis that it diminished exposure to a rising gold price. That was perfectly valid, but only on the assumption that costs would not rise and sap margins.
That's not what happened - there was an unreasonable assumption that the gold price would go up and everything else would stay the same.
Unfortunately the opposition to hedging ended any rational debate on the tool, which left companies too confident about their gold price leverage and oblivious to the shifting cost base until it was too late. Companies should have been aggressively hedging input costs when they were promoting their exposure to the gold price.
Not so. Very few companies have meaningful hedges in place covering consumables and currency impacts. Those that do have generally only managed to secure deals in the short- to medium-term.
That is compounded by an urgent need not to disappoint the market with project delays, "issues" or cost shocks that investors have punished harshly to date. Those can wipe out half a stock's value as illustrated in the accompanying chart.
Goldcorp chairman Rob McEwen told Resource Investor last week that complacency and a misunderstanding of the low gold price cycle had led many companies to move to just-in-time inventory management. It worked well in an era of slack demand, but vendors were annoyed at having the working capital burden shifted to them. That caused suppliers to under-invest resulting in the shortages now becoming evident.
It is difficult to get drill rigs to projects because the global fleet has aged and manufacturers are nowhere near meeting the near-term demand the bull market in metals has creataed. The juniors are suffering especially because they did not have the ability to sustain supplier relationships through the cycle. For example, juniors operating in Nevada report that Newmont  and Placer Dome  have contracted nearly every available rig in the state.
Related information highlights a worldwide shortage of tyres. A Canadian company reportedly has half its drill rig fleet immobilized because tyre makers cannot source sufficient rubber. That is consistent with news filtering out from mine sites where it is apparently more and more difficult to keep fleets rolling according to maintenance schedules.
Complaints about shortages of civil engineering and mining equipment are now common. Even if you can source such equipment, it is considerably more expensive with dominant supplier Caterpillar raising prices twice last year in response to demand and problems in its own supply chain.
Richard Marshall, spokesman for Crystallex  which is currently developing the large Las Cristinas project in Venezuela confirms the bottleneck in mining fleet delivery. Crystallex got a break by ordering its mine fleet and shovels ahead of the peak in demand that is lagging metal prices by a few months.
The implications are obvious for companies that placed their orders only recently; and it's not just heavy equipment being affected.
Processing plants are under the gun, cyanide and a host of other chemicals are in short supply, laboratories cannot keep up with demand, fossil fuelled energy prices are cannibalizing project economics, and shipping rates are volatile when they're not prohibitive. Labour and skill shortages have gotten so bad in some areas that they've killed off projects such as Australia's Bronzewing mine. Graduates from the Western Australia School of Mines are being hired at nearly double the salary that their peers got a year earlier.
Investors must also contend with much higher steel prices that are about to work through the supply chain.
Iron ore suppliers have increased prices almost three quarters in recent contract negotiations, and that means sharply higher costs for structural steel that will hurt capex budgets. But the most severe impact is likely to be on steel consumables such as grinding media for mills which can cost tens of dollars an ounce for some mines, whilst mundane things like drill rods are shooting up in price - if you can buy them.
It's literally the worst of worlds as costs rise faster than the product's selling price, and delays lengthen payback to dangerously unattractive periods. The money that miners raised so plentifully early in the cycle is being consumed by inflation, and will never earn the return once earmarked for it. It is more painful because so much of the cash was bought with equity.
Project risk rising
BMO Nesbitt-Burns's top analyst, Geoff Stanley, highlighted in a recent report to clients that the Construction Cost Index rose more than a fifth in 2004. If a more modest inflation rate of 6% is used then the 14 largest North American gold producers can expect their aggregate bill for development and sustaining capital to rise by $883 million from the present $7.4 billion.
That potential increase is shocking if you consider that it will consume 13% of the group's aggregate net earnings from 2005-7.
Stanley warns that the mega-projects owned by the senior gold producers are most threatened by capex inflation. Investors should keep an eye on the development costs of bellwether projects like Cerro Casale, Cortez Hills, Pueblo Viejo, Donlin Creek (Placer); Minas Conga, Phoenix, Aykem, Ahafo (Newmont); Cowal, Pascua-Lama (Barrick); Boddington (Newcrest); and Cerro Corona (Gold Fields).
There is also an impact on companies that want to optimise existing mines as they find themselves competing with new projects. Optimization plans are having to be constantly reworked to take into account higher prices and tight markets for key components and skills.
Then there are permitting and social licensing frictions that are becoming problematic across most new projects and even some old ones. If it's not a problem it's because the project has no infrastructure nearby, or stone age mining codes, which can be altogether worse.
Remaking the business
The outcome is a continued partiality to extending mine life rather than maximising profits by mining at higher grades. Actually, they have little choice because most of the mines that dominate global production have little flexibility to raise grades which have been in decline for years.
The higher gold price is simply not high enough so everyone is maintaining a conservation mode even as they talk up the benefits of a higher gold price.
CIBC's Barry Cooper says that the industry risks going ex-growth "without the advent of some material technological breakthrough." That is just one in a litany of issues he raised in an extensive report published in late January which should be essential reading for investors.
Cooper also touched on an issue that Ralph Bullis has highlighted best - the simple scarcity of large scale gold deposits, a fact more notable in recent years with the rate of discovery drying up dramatically.
Producers have had to fall back on small deposits which are generally not suitable to the corporate structures of the very largest companies. And leaving the deposits in the hands of juniors risks inefficient financing and operations that degrade returns. Where large deposits are being found, they are typically copper-porphyries.
Cooper cautions that gold stock multiples are jeopardized by this increasing prevalence of copper in the product mix. "Almost half the ounces found in the past decade are in this type of deposit [copper-gold]. Multiples are in jeopardy of dwindling as these become developed especially if they offer similar leverage as the gold [exchange traded funds].
One potential bright spot is the fact that there is a fundamental mismatch in how reserves and costs are reported under SEC regulations. Companies have to use a trailing three-year average gold price for their reserve calculations, but report current costs. That has to be addressed, most probably in favour of matching current-with-current which would allow reserve growth that might add considerable value.
Yet with evidence that gold production has gone into secular decline when measured by total output, companies have to overcome the addiction to "more ounces". Having more reserves is one thing, but they are not necessarily available to develop, nor are they necessarily going to add much to the bottom line.
Gold companies, because of margins that remain static over the long run, can only grow by adding new ounces. One in a thousand will find a deposit of such high grade that additional ounces are irrelevant, but for most of the industry it comes down to a simple choice of offering the market a growth story, or being content with stable to declining profits.
The best hope is the long awaited break out in the gold price relative to all currencies and competing commodities. Until that happens, investors are currently witnessing the opening act of a very long and complicated drama. When it's over, the encore will be notable for how few of the current cast of players are still around.