The gold market's cash cost conundrum - Aldis

US Global's Ralph Aldis discusses the recent trend towards better disclosure of costs by gold companies but, maintains there is still a long way to go.

GEOFF CANDY: Hello and welcome to this week’s edition of Mineweb.com’s Gold Weekly podcast. Joining me on the line is Ralph Aldis – he is a portfolio manager at U.S. Global Investors. Ralph I spoke to you towards the end of last year and we talked a lot about cash costs and the desire from US funds but not just from U.S. Global but from a whole host of people getting into the industry saying we want a better way of measuring cost in the gold industry because there is a sense that perhaps we are not necessarily seeing a true picture. Two weeks ago we saw Goldcorp and Yamana coming out saying they are looking at reporting a better all-in sustaining cost measure and they are trying to get the rest of the industry to get behind that as well. The World Gold Council is involved and this is similar to some extent to what Gold Fields has been doing for some time in their notional cash expenditure measure. Why is this such a hot-button issue?

RALPH ALDIS: I think for me, as an investor, and, I think, the industry hasn’t fully come to grips with, the implications of this cash cost concept that they’ve been talking about. It impacts them tremendously when governments look at them and think about taxation rights. They [governments] look at these companies coming out with $800/oz or $300/oz or whatever cash cost number they quote they think,  well and you must be making windfall profits at our expense and we need to raise our tax rates on you. So, as an investor, we’ve seen taxes go up for these companies, either through royalties or a variety of different schemes; it’s bad for the companies and it certainly hurts their returns in the long run because governments have just looked at this and said this is why we need to raise taxes on you.

GEOFF CANDY: How did it get to this point? Why has the reporting of costs become such a complex issue within the financial statements?

RALPH ALDIS: The companies talk about this cash cost measure with these ridiculous levels but you don’t see it ever come down to the bottom line as a profit. Companies are reporting profits now but, 'cash costs' was a concept that came up because at one point, when gold prices were low, nobody made any money and no-one wanted to talk about being underwater although they were. To me that’s why it’s the hot topic issue; now these companies are profitable and I think they really need to talk about what their all-in costs are.

I appreciate what Yamana did and what Goldcorp did when they talk about this all-in cost but they are still calling it all-in cash cost and it doesn’t include what you would call sustaining capital - they call it sustaining capital but it doesn't include new project capital. There is a fine line between sustaining capital and new project capital; one example that was mentioned to me by George Topping at Stifel was that of Newmont. He looked at Newmont Mining and their production has fallen from 7.5 million ounces to just 5 million ounces.  the group has spent $14.5bn in capex since 2006 and seen a 15% decline in production over the same period.*

Maybe a better way to look at this is for these companies to think about what level of spending they need to lay out there just to maintain current production levels. That might be a better measure of sustaining capital because that would include some measure of cost to build new projects because other projects are being depleted.

GEOFF CANDY: Because to get a little bit more clarification in terms of the current reporting the cash cost number which seem to be the most well used at this stage, it doesn’t include things like sustaining capital as you have been talking about but what does it actually measure. If I were a layman and I read the cash cost number what should I be expecting to understand from that?

RALPH ALDIS: To me it’s been more of a marketing gimmick for these companies to compete for investors’ dollars. People, investors hear these numbers that are very low and they think that this company is obviously the most profitable because their costs are so low, but it really says nothing about the bottom line, what they deliver in terms of the margin, in terms of net income they actually produce.

Right now, for 2012 which just finished up, the average all-in costs that we look at (which includes other outlays that they have to do to maintain production) that came in at $1337. The average gold price in 2012 was $1677. That’s basically almost a 25% margin which is a fantastic margin for a company because overall the average return that companies generally make over time is about 6%. These margins expanded quite a bit because the gold price went up in the prior year.

GEOFF CANDY: But in terms of the measurements where is that difference coming then. Clearly you get by-product credits that come in there and they are not necessarily reporting all the costs that go into producing an ounce of gold.

RALPH ALDIS: Whether you are talking about by-product, co-product to me again it’s a sort of smoke and mirrors and I know that in Yamana’s recent stuff they were trying to mention costs exclusive of copper; trying to do this cash cost allocation exclusive of copper. The simplest thing an investor can do, particularly when these companies produce a variety of metals, is just take whatever that revenue number is and divide it by the average gold price for the period and you have a pretty good number then in terms of what the gold equivalent ounces number is in terms of the revenue that they just produced. We tend to look at the net income minus revenue and divide that by the average gold price and that gets us to what we look at as an all-in cost that the company went through in their net period and that number that I quoted for 2012, that $1337 is basically an all-in cost that the industry has right now.

For instance, when you look at Goldcorp their all-in cash cost number that they’ve highlighted for 2012 was $865 in their slide presentation. Our number would be about $1178, which is still below the industry average of $1337. Goldcorp would still look great giving a more realistic number. Yamana would still look good compared to all its peers but I think this cash cost stuff, hopefully they phase this out within the year because Goldcorp is talking about continuing to quote all-in cash costs, by-product cash costs, co-product cash costs. It serves no purpose except for governments to look at those numbers and just think that these guys are making profits that deserve windfall profit taxes.

GEOFF CANDY: In term of the way forward from here clearly Goldcorp has made that move, Yamana has made that move, World Gold Council is in communication according to them and they are talking to these companies and their members repeatedly to try and get to a group wide agreement. Gold Fields has also been doing similar things with their notional cost cash expenditure. Are we likely to see an almost IFRS kind of standard or what would be the ideal?

RALPH ALDIS: Maybe we could get to something like that, but this part where they are saying they want to exclude new project capital, from the calculation, that’s where they have a lot of leeway to say things. You may be splitting new project capital at a current operation to actually sustain production or maybe to put an additional improvement, maybe get the production up a little bit but that little leeway that they are giving themselves really takes away from the integrity of the number that they are trying to get to.

GEOFF CANDY: I suppose that’s going to only increase as it becomes harder and harder to find replacement ounces.

RALPH ALDIS: Yes potentially so. You have had some of these costs numbers come down a little bit because of people reigning in new project development basically to produce an additional ounce of gold at probably a lower margin, and now these guys are thinking about let’s actually try to focus on producing ounces more profitably and not focus so much on growth which I think is a great move in the industry. You’ve probably seen more embracement of that in terms of investors who want to see profitable ounces; we don’t want to just see ounces of production growing because the historic result of that has been companies that are producing ounces at lower margins and that’s not healthy for the company in the long term.

GEOFF CANDY: I suppose that is clearly the trend that we’ve seen over the last few months. We’ve seen Newmont's Richard O'Brien, Barrick's Aaron Regent and Kinross's Tye Burt to some extent as well although slightly different in that respect but a lot of these managers getting put on the chopping block because they’ve seen growth perhaps more than performance if you will. In terms of going forward is this likely to usher in an era of perhaps more conservative managers where you are looking for quality ounces but that could be a problem down the line or is this completely a good thing do you think.

RALPH ALDIS: I think it’s probably a good thing in that it certainly an improvement on the way these guys have been going in the past. I know at one point, and this is going years back, where Kinross, the managers were paid bonuses based on the number of ounces that they grew that the company had control of, so they went out and just bought more ounces, not that these ounces were going to be profitable, but because that's how they got their bonus.

They were compensated for growing the number of ounces that the company had in their resource base. So, I think anything that gets towards tightening down the profitability and focussing on that I think will ultimately get the companies better results and I think that will help bring in the average investor,

One that is not a gold stock investor, but one that sees a company that he can understand the financials of rather than one that talks about producing gold at $300 an ounce and then reports a net income that basically doesn’t make sense for the cash cost that they were talking about.

GEOFF CANDY: In terms of the type of investor that we are seeing, are we seeing a shift and is that likely to change the way in which gold companies are valued. For a very long time we saw a significant premium attached to gold companies that has diminished somewhat and perhaps understandably so given the rise in the price of bullion but are the days of the massive premium to gold companies over?

RALPH ALDIS: I don’t think so much at the moment because interest rates are so low right now that also has the effect of depressing the forward curve in gold. I don’t want to get too much into our financial models but, the NAV premiums for gold companies have now contracted to base metal company-style NAV premiums, they are basically trading at 1 x NAV or less. That’s largely a function of the forward curve and being that gold is normally in Contango and base metals are normally in backwardation and because interest rates are so low right now that basically makes even NAV premiums look like the gold companies have contracted. The problem also that we had up here on these gold companies is that they are not outperforming the price of gold. That’s been a big problem for the industry that the gold price continues to go up, the companies have been underperforming, the gold price, while historically you would have a 2 or 3:1 leverage of the share price to the gold price movement.

I think that has been muted because these companies have not delivered. They talk about these low costs that doesn’t show up in the bottom line and I think that’s what has had investors saying why should I own this company that actually isn’t making good profitable decisions.

GEOFF CANDY: In terms of the expectations, U.S. Global’s expectations for equities over 2013, do you see this changing given the efforts being made currently by management teams to try and arrest some of these issues.

RALPH ALDIS: If you look at the Federal Reserve’s balance sheet and the correlation of the gold price and what the Federal Reserve is going to do we are going to see gold prices $200 to $300 higher by the end of the year. That’s pretty certain. Now, which companies perform is a little bit more nuanced but what I would say is that when people look at the gold index its largely dominated by the four to five major, largest gold companies that have really struggled in terms of producing profits but if you look at let's say 60 companies of whatever there’s about 20 of them that have just knocked it out of the park when it comes to price action but they are not the biggest weights in the index so I think there is plenty of opportunity out there for more price appreciation in a number of companies, Dundee Precious Metals is one that we think will do very well this year. There are 10 or more that I could name off that we feel very positive about in terms of further price action this year.

*In the audio version, Ralph Aldis said the figure spent by Newmont on capex was $5bn but, after rechecking the figures after the interview asked that this number be corrected in the text.

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	About Geoff Candy With a particular focus on the macroeconomic linkages between the commodities sector and the broader economy, Geoff is the host of Mineweb's podcast series and the site's Director of Content and European Editor. Email: geoff@mineweb.com Follow @geoffcandy

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