Can the gold industry avoid the sins of the past? - AusIMM Bulletin
Over the past few years, the gold industry has implemented some of the more painful restructuring in its history in the face of a falling gold price. This has led to improved financial positions and returns for investors. But as the gold price is beginning to stabilise and fundamental economic factors are trending in the sector’s favour, there are red flags emerging that the industry needs to heed as it prepares for the upturn. Firstly, are the recent changes sustainable enough to avoid the same errors of the past from creeping in? Secondly, has our cost-cutting been too indiscriminate by underspending on capital to sustain future production in the industry?
Before I examine the current danger signals in greater detail, let me go back over the past four years and analyse the fundamental changes the industry has experienced over that period. In mid-2012, the global gold industry was riding the wave of a gold price that was trading in a narrow band at record levels of around US$1800/oz. We were chasing production because we thought bigger was better and growing production was creating value.
But therein lay the problem. The industry was chasing growth at almost any cost. Executives, including at Gold Fields, were standing on podiums at investor conferences promising rising production. It was a message that the market was loving and encouraging. But few in the industry were bothered about whether production growth was actually profitable. That was the assumption, but the reality was different. While the gold price was going up, our profit margins were not. The industry was not offering shareholders leverage to the gold price, and investors were gradually wising up to the fact.
Capital optimisation was another issue. What we saw at the time was a plethora of investments in projects that have still not been built today. Such projects include Pascua-Lama in Chile, Conga in Peru and Rosia Montana in Romania, though not all of these were stopped for economic reasons. Shareholders’ money was spent unwisely or balance sheets were leveraged to fund growth and acquisitions in the belief that they could be locked in for future returns. Finally, dividend payments by the industry were poor.
These trends are backed up by the statistical performance of the industry prior to 2012. Capex per ounce was going up by 32 per cent per year over ten years (on a compound annual basis) leading up to 2012. Merger and acquisition (M&A) spending was rising by 17 per cent per year (again on a compound annual basis) over the same period. But production targets were being missed on a regular basis by most gold producers. We at Gold Fields realised in mid-2012 that we had lost our way and that we needed to make changes. That proved prescient as in early 2013, the gold price started its long decline from levels of around US$1800/oz to just over US$1000/oz in December 2015. Investors quickly followed suit, with the bullion holdings of gold-focused Exchange Traded Funds almost halving from 85 Moz in 2013 to 47 Moz last year. And the value of the top nine gold funds slumped from US$24 billion to US$5 billion over the same period.
Amid the sharp fall in the gold price and the investor flight, the industry had no choice but to react, and react it did. We carried out an analysis of key production and financial metrics of 11 of the largest global gold mining companies for the period 2012-15. These 11 firms, which include Gold Fields, account for nearly a third of global gold production. The numbers from this analysis are revealing.
The financial position of most gold miners has improved amid the drastic restructuring. The combined net cash flow of the industry’s 11 largest gold miners was negative US$4 billion in 2013. A year later, it had recovered to US$2 billion, and it improved further in 2015 to around US$5.8 billion. Similarly, the net cash flow margin for these producers recovered from negative eight per cent in 2013 to nearly 14 per cent in 2015. The improved cash flows have led to stronger balance sheets. The net debt for these mining companies hit a peak of US$29 billion in 2013, but had improved to around US$22 billion in 2015. This is still high, but is more manageable, with net debt to earnings before interest, taxes, depreciation and amortisation (EBITDA) sitting at a ratio of 1.45 in 2015 compared with 1.89 in 2014.
Shareholders have yet to experience the full benefit of the improved financial position. On a per share basis production, EBITDA and cash flow have gone backwards between 2012 and 2015, though some of the metrics have at least stabilised of late. What the overall deteriorating position reflects is both the sharp fall in the gold price and that these companies have issued additional shares to repair balance sheets. The industry has always been a poor dividend payer, and this has gotten worse amid the decline in the gold price. Average dividend yields by the 11 miners ranged from 0.5-1 per cent in 2015, falling from a peak of around 1.8 per cent in 2012.
By our calculations, all-in sustaining costs fell by 22 per cent over the period 2012-15, and all-in costs (AIC) fell by 36 per cent (AIC includes all capital and exploration expenditure). Both these cost metrics were the result of the industry, through the World Gold Council, deciding to provide more cost-inclusive measures.
But much of the improvement in costs has come from factors outside of producers’ control. In the peer group of 11 companies, about 50-60 per cent of production is in so-called commodity currencies, namely the South African rand, the Australian dollar and the Canadian dollar. These have depreciated markedly between 2012 and the end of 2015 – 47 per cent in case of the rand, 26 per cent for the Australian dollar and 21 per cent for the Canadian dollar. So while the US dollar gold price has slumped over the past four years, gold revenues in these countries were cushioned by the weaker currencies. This currency weakness has a flipside to it, namely an eventual follow-on impact on future imported cost inflation for much of the mining industry’s equipment and other input materials.
Cost reduction has also been aided by the lower oil price over the past four years. In our estimates, oil accounts for between 10 and 15 per cent of operating costs for the mining sector, meaning that the lower price would have provided a significant tailwind. Record low interest rates have also significantly benefitted over-indebted companies.
But besides fat, it appears that the industry has also been cutting muscle. As a per cent of operating expenditure, stay-in-business (SIB) capital decreased from 46 per cent in 2012 on a per ounce basis to 26 per cent in 2015. This trend is of concern as it suggests that many companies have merely deferred capital that is going to have to be spent some time in the future.
To accurately understand the changes to costs that have come from external factors, as well as the unsustainable reduction in SIB capital, Gold Fields did a calculation on what the impact on costs would have been if all of the factors stayed the same. The result was that costs would have only declined by four per cent over the period, falling from US$1115/oz in 2012 to US$1060/oz in 2015. This means that if the benevolent tailwinds that the industry has enjoyed reverse (higher oil prices and interest rates and the strengthening of currencies in operating countries), the current picture will not be so rosy and more fundamental restructuring may indeed become necessary.
Growth and exploration spending
Perhaps the most worrying trend we have witnessed over the past four years is the sharp drop in project capital and exploration expenditure by the industry, which is on top of the cutting of corners on SIB capital. Capital spending has been annihilated, both from the amount of money spent and from the decline in reserves being seen in the industry. The capital spending by the 11 companies studied (both project and SIB) decreased from US$20 billion in 2012 to US$7 billion in 2015. This is also reflected if those numbers are mapped onto the industry’s production.
Exploration spend has been halved to US$36/oz in 2015 from an already low US$78/oz in 2012. This is a big concern as we are not spending enough to sustain the industry into the future. It is inevitable that gold companies are going to get back to judicious exploration in the near future, though this is likely to be in conjunction with some of the junior miners, who, unlike the majors, have stayed in the game over the past few years.
One of the reasons why there has been such a competitive dogfight for acquisitions of late is that some of the miners are trying to fill future gaps in their production profile that they are not managing to fill through brownfields exploration or organic growth. They are willing to pay an M&A premium to buy these ounces. There has already been a pick-up in M&A activity, with US$2.9 billion worth of deals done so far in 2016 compared with US$2.1 billion for the whole of 2015. With the gold price higher than it was last year, I expect a few more transactions before the end of 2016.
More concerning than the decline in exploration spending is the fact that the average reserve life of the 11 companies studied has fallen from 24 years to 17 years as a result of underspending and the lower gold price.
High-grading is also partly to blame, with the average head grade of the peer group higher than the reserve grade for the past three years. In 2015 alone, 52 per cent of production was mined at grades above the reserve grade, which indicates a deliberate bypassing of lower-grade ore. If and when the lower grade is mined, costs will be pushed up again.'
As a result of these trends, the global gold industry may well be facing a ‘hiatus’ in output and may be close to hitting a peak in production. The supply shortage will be exacerbated by the fact that ‘above ground’ gold stocks, such as in central bank vaults, look like they are not coming back to the market anytime soon. Indeed, the central banks of countries such as China and Russia are continuing to buy bullion as a counter to the US dollar. Investor demand is also looking strong, with a 127 per cent year-on-year increase in demand in the first half of 2016.
While the higher gold price is to be welcomed, there is a case to be made that the industry has not completed cleaning up its act. As an industry, we have responded to the decline in the gold price over the past four years, but as Gold Fields’ research has indicated, without the tailwinds of lower oil prices, low interest rates and weak commodity currencies, the gains would not have been that substantial.
These economic trends will not persist so we have to remain cost conscious despite the rise in the gold price this year. Our investors have indicated that they want us to show profit margin expansion as the gold price rises, which requires a continued focus on growth in cash rather than production ounces.
At the same time, we need to embrace innovation to cope with grades that are likely to be lower than those mined currently. Given the dearth in exploration, technology is also required to cope with the increasing complexity of mostly lower-grade orebodies.
Eventually, we also need to start reinvesting in exploration. But set against the likelihood that commodity currencies will start to strengthen against the US dollar, the incentive gold price for new reserve discovery and production is still above current trading levels of around US$1500/oz. We are not there yet.
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