Rick Mills isn't looking for huge producers with so much overhead that they can't profitably mine an ounce of gold. Instead, Mills, the publisher, editor and president of Aheadoftheherd.com, seeks out the smaller mines with low capital costs. That's where the money will be made in the next two years, he tells The Gold Report.
The Gold Report: Rick, is this a good time to be buying gold?
Rick Mills: There are three key reasons to have exposure to gold bullion. The traditional reason is to protect against inflation. We're printing money. More quantitative easing has taken place and inflation looks to be coming down the pike. I buy groceries. I pay for gas. I can see inflation. I firmly believe it's going to get higher over the coming months and years. Buying gold as a protection against inflation is realistic.
The second reason investors have traditionally bought gold is as a safe-haven investment. There's a lot going on in the world – from secession talk in the US to turmoil in Israel, Iran, Syria, the South China Sea region and Turkey.
One of the things that most investors don't know about gold is that adding a gold allocation to your portfolio, especially over the last decade or so, has provided substantial enhancements to the portfolio's return.
Gold helps minimize the downside deviations in an overall portfolio. In 2002, the S&P 500 was down 23%. Emerging market equities were down 6%. International equities were down 16%. Yet gold was up 25%.
TGR: That was early in the bull run in gold.
RM: Even in 2008, the S&P 500 was down 37%, international equities were down 43% and emerging market equities were down 53%. However, gold was up 8%.
TGR: It felt like the end of the world in 2008. Gold has saved the portfolios of a lot of investors who were smart enough to start collecting it in 2001 and onward. However, there are investors who don't believe that gold has the multiples now.
RM: It's true. I believe gold producers have shot themselves in the foot because of their reporting methods. They use cash cost for reporting. In 2001 and 2002, miners were producing gold for below $180/ounce (oz). By 2005, cash costs had risen 45% to $250/oz. Data from research consultancy Thompson Reuters GFMS shows that world gold production costs for the first half of 2009 averaged $457/oz. In 2011, they were $657/oz. GFMS' Gold Survey 2012 says it's now $727/oz.
But if investors have been looking at that, they've been misled because that's not really the cost of producing gold. These average cash-cost figures include only the costs directly associated with the production of gold, such as wages, energy and raw materials. The problem is that gold cash costs are not the only costs associated with mines. Investment bank CIBC just produced a complete breakdown of costs. Yes, operating costs are $700/oz, but there is also sustaining capital, construction capital, discovery costs and overhead. CIBC pegs those at an average of $600/oz. Add in $200/oz for taxes on average, and you're looking at $1,500 to produce an ounce of gold.
TGR: In that environment, many of the gold mining producers would be out of business.
RM: The gold price is $1,700/oz. Companies are not making a lot of money here. The funny thing is that the sustainable costs for gold – the sustainable number gold miners need – according to CIBC, is $1,700/oz. You can see why investors are leery to jump into the space with numbers so tight.
TGR: But you're a gold bull. You believe that people should be investing in bullion. The bullion has to come from somewhere. What's an investor to do when he believes in the fundamental reasons for owning gold, but doesn't understand how the equities can perform?
RM: Historically, the precious metals equities have given investors the most leverage to a rise in gold and silver prices. We need to have a rise in gold and silver price. We need to get into that environment again, like it was from 2001 to 2006 when gold equities went up 900%.
Let's look at why companies aren't making a profit. One of the biggest reasons is capital expenditures (capex), which is the basic cost of building a mine and its supporting infrastructure. There are lower grades being mined – down 23% over the last five years and expected to drop another 4% this year – and more complex metallurgy. Companies are increasingly going into more remote areas that lack infrastructure. Environmental regulations are increasing. We are seeing more money-grabbing governments and resource nationalization. There's a serious shortage of skilled personnel and labor unrest is pretty much everywhere: strikes, protests and unions demanding higher wages. Everything you can imagine is working in a perfect storm to increase costs and risks on mining companies.
Costs are going through the roof, yet gold is stuck in a holding pattern at $1,700/oz. Then, when people want exposure to the sector, they buy an exchange-traded fund (ETF). In the past, a lot of that money would have gone into mining equities.
There's a huge increase in exploration spending – more than $8 billion ($8B) in 2011 – but a serious lack of new discovery. There have been very few large, high-grade deposits discovered during the past few years. Barrick Gold Corp. (ABX:TSX; ABX:NYSE) said at the Precious Metals Conference 2012 that of the "super giant" discoveries, those that are more than 20 million ounces (Moz), 18 were discovered in the 1900s. Fast-forward to the 1980s when 14 were discovered. In the 1990s, 11 were discovered. In the 2000s, only five were uncovered.