In an environment of rising capital expenses, gold producers big and small are left with little or no free cash flow. Instead of investing in exploration to maintain production, too many companies are cutting costs and high-grading their current resources. Joachim Berlenbach, fund adviser with Switzerland's Earth Resource Investment Group, believes this kind of short-term thinking will lead to decreased production and a higher gold price. In this Gold Report interview, Berlenbach shares his ideas on how to succeed in this stock-picker's market.
The Gold Report: Goldman Sachs recently downgraded its 2013 gold forecast from an average of $1,800/ounces ($1,800/oz) to $1,610/oz due to interest rates rising in the U.S. Could this bearish sentiment actually be bullish for gold?
Joachim Berlenbach: I think the report was very one sided. Focusing solely on the U.S. interest rates does not provide a full picture. I would have liked to see a balanced look at where the real demand is coming from. If the report had said, for example, how much gold the Chinese central bank is actually buying compared to its reported purchases, it would have been a much more interesting discussion.
TGR: You have a chart that suggests that by 2016 the all-in costs to produce an ounce of gold will reach $2,120/oz. How would that change the space?
JB: This graph includes all of the costs that make up a company's free cash flow: operating cash costs, sustaining capital expense (capex), expansion capex, exploration and finance costs, plus a bit of general and administration expense (G&A).
Total costs are sitting at $1,600/oz for the 13 biggest companies, which has been our universe for the last 13 years. Over the last two to three years, we have seen total costs rise an average of 15–17%. At a gold price of $1,600/oz, the industry does not produce a single dollar of free cash flow. If we take a cost inflation of only 10%/year, we will need a gold price over $2,000/oz to maintain production.
The critical point is—and I believe it is poorly understood by the market and the investors—that the natural resources industry is different than any other industry. When a gold producer builds a new mine, it is not to increase production, it is to maintain production. And unfortunately, the new mine will likely have lower grades, because the high grades have been mined out.
Grades are drastically lower in the new deposits. That means companies have to build bigger mines outside the established mining areas like the Carlin Trend in North America or the Witwatersrand Basin in South Africa. Companies have to go into Indonesia, West Africa, the Democratic Republic of the Congo (DRC), Colombia or Guyana. New mines require higher capex.
Unlike other industries, capital spent for new production is not intended to increase shareholder value; it is done to maintain the company's value.
In the coming months, we will see a huge effort by the industry to reduce costs. To become profitable again, the industry has to increase cash flow. To do this, a company could write off or stop capital projects already committed to. Instead of investing, it will try to preserve its free cash flow. And remember, the industry is under huge pressure from investors who want dividend yields.
The industry also could go back into high-grading the ore bodies. High-grading means picking out the high-grade parts of an ore deposit to reduce costs in the short term. I saw this happen when I worked in the South African gold industry at the end of the 1990s. The gold price was below the breakeven price. Companies stopped exploration and started high-grading.
In the short term, high-grading might result in more profitable mines and better cash flow. But in the longer term, it means that we cannot mine enough gold. Gold production has not increased over the last 10 years, despite the rising gold price; it remains at 2,600 tons, or 80 million ounces (80 Moz), per year. If companies do not invest in new mines, gold production will drop drastically.