Why Read: Because as a generality mining capital and operating costs are increasing significantly, and because those who say the equity markets are under-pricing gold (and other) mining stocks can be far to general in their prognostications. That said, there are always exceptions to generalities.
Commentary: I have a number of 10,000 foot observations in the current world economic and financial markets. Those who invest in and trade in the mining and the oil and gas sectors might want to think carefully about those observations. When doing so, remember the adage I repeat periodically in these njewsletters when referring to the financial markets – rising tides raise all boats, falling tides drop them all.
I believe it is important to observe mining cost increases from at least the following perspectives, some of which are clearly negative, and some of which over the longer term I think may be quite positive if one invests in or trades carefully researched and selected companies – and has the stomach for substantive share price volatility through their “hold period.” My current thoughts are:
- Increases in project costs being experienced by some miners are both significant, and likely “here to stay.” They also are likely to increase further going forward for a number of reasons related to country risk and the environment, to note but two – see observation following.
For example, Barrick just last week announced cost overruns on its massive Pascua-Lama gold project located on the border of Argentina and Chile. These increases apparently were not expected by all analysts, and therefore may not all or in part have been “priced into” the Barrick share price – today’s market activity will tell the tale on that;
- Operating costs are broadly escalating for both mining and oil & gas companies, and this will be reflected in their after-tax discretionary cash flows and earnings going forward. This will make access to required capital more difficult and more expensive – both in the context of the businesses of those companies, and in the context of shareholder interests – which may well face greater share dilution than they would have expected to experience;
- Country risk and environmental issues are both likely to escalate going forward. If I am right in this, time delays and operating costs will increase further, as will corporate taxes including royalties, with the specter of ownership expropriation hanging in the background in some jurisdictions;
- Some projects that are in the development stage will be postponed until cost and market conditions aligning – or perhaps will be simply not be ultimately pursued at all. For example, Barrick also announced it is postponing projects in Alaska and Chile;
- The exploration and development projects that will go forward are those with high mineral grades and “acceptable” plant and cost structures that will result in satisfactory rates of return on capital in a “high risk environment” – meaning that projected internal rates of return on capital will have to be higher than they have been in the recent years on new projects;
- The positive arising from this from a shareholder perspective is that over time:
- precious metal prices (particularly gold) ought to rise as supply falls, and
- prices for both base metals and oil & gas ought to rise in the face of lower supply levels, barring a serious slowdown in the developing countries including China, and even more serious economic malaise in the developed countries that now exists;
- The good news for companies exploring for, developing, and producing physical silver, is that a good deal of physical silver production goes into consumer product applications. That, combined with the fact that about 70% of all silver currently produced is generated as a by-product of mining operations aimed principally toward extraction of other minerals (copper, gold, nickel, to cite three) where that production may drop, in theory ought to auger well for the silver price, and for the companies who primarily explore for, develop, and produce physical silver;
- The bad news for companies exploring for, developing, and producing physical gold is that those investing in and trading in the gold space may well be more inclined to purchase and trade the physical metals (or derivatives thereof such as ETF’s and bank certificates) than they are the shares of the companies mining them; and,
- That said, that ‘bad news’ may prove to be very good news for those who carefully research and select ‘the right’ gold explorers, developers and producers (high grade, reasonable cost structure, etc.), as those companies ought to have a chance – subject to country risk and environmental issues – of doing well in an ‘escalated gold price’ scenario.
I plan to expand on these thoughts in subsequent newsletters over the next weeks and months.
Context: In the end, company share value and hence price are forward looking. Anyone participating in the equity markets needs to carefully consider the possible or likely consequences of changes in capital and operating cost structures, country risk, country taxation structures, and expropriation risk – particularly in capital intensive operations, which includes both mining and oil and gas companies.