Gold Miners Trapped By Falling Price, Rising Costs

This story features REGIS RESOURCES LIMITED, and other companies. For more info SHARE ANALYSIS: RRL

The company is included in ASX200, ASX300 and ALL-ORDS

-Gold grades questioned as price falls
-Mine plans change substantially
-Merrills sees better margin potential
-Near-term forecasts bearish on price
 

By Eva Brocklehurst

Gold. The search for the precious metal has always seemed more attractive than for other metals but miners are learning the pitfalls in going after quantity, regardless of grade. In modern times it comes down to the increased cost of doing business and the lengthy and detailed planning that is now required. It's never been easy to turn the Queen Mary around. Even more so perhaps if it's gold plated.

As the gold price assumed an uptrend from 2001 to 2010 it propelled companies to mine lower grade ore. Many took on extra cost burdens to do this. As the price reached its zenith in the last year or so this became problematic. What if the price fell substantially? Would these marginal mines deliver? The price did fall. Welcome to the real world.

Gold prices have suffered a 25% fall this year and supply is tight, with current prices now below the highest cost of production. Miners have sprung to attention, writing down asset values and looking to cut costs. ANZ analysts expect a point will be reached where the supply/demand equation takes over. The rout started in April amid heightened expectations that the US economy was on the verge of a sustained pick-up in growth. Prices then stabilised before another bout of weakness emerged in mid June. On this occasion, all markets were affected by the US Federal Reserve's announcement that quantitative easing (QE) may be wound back. ANZ Bank analysts suspect the cycle-low for gold prices is around US$1,050-1,200/oz. Gold prices are seen finishing 2013 around US$1,300/oz and to rise mildly from there.

BA-Merrill Lynch suspects gold miners were restricted in their ability to full participate in the rise in the gold price. Margins increased, but not dramatically and certainly not in keeping with the rise in the price. The reasons were because they were mining lower grades and hence costs were going up and there was increasing consideration given to the development of large, expensive projects. Merrills has looked at changes to mine plans that were made during the gold price rise and noted the falling grades. The quirky nature of ore bodies may have played a part but it was substantially because miners were lowering cut-off grades.

Mine plans cannot change as quickly as the gold price but many miners have had to react fairly smartly to gold's latest fall, reassessing marginal ores and lifting cut-off grades. Merrills assumes some mines could endure 20-30% reductions in life and finds the impact on lost ounces would not be nearly as significant. Higher cut-off grades and shorter mine lives would also result in an improvement to cash costs. If gold prices rebound, and it's likely, Merrills hopes miners will be disciplined and not bring forward a new wave of aggressive mine plans. If miners remain conservative there's the potential for real margin expansion.

Best placed in this regard among Australian gold miners are Regis Resources ((RRL)) and Perseus Mining ((PRU)). In Merrills' analysis these two have most resisted the urge to increase reserve price assumptions and are best placed for a reversal of mine plans. Companies most exposed to a reversal are Kingsgate Consolidated ((KCN)), Saracen Minerals ((SAR)) and Evolution Mining ((EVN)), followed by Alacer Gold ((AQG)) and Newcrest Mining ((NCM)). Evolution's Mt Rawdon and Saracen's Carosue Dam are the two mines singled out as having the potential for the biggest lift in profit if reserve grades are raised.

As retail investors step back from the market amid continued price declines, the question is as to when prices become attractive enough to re-enter the market. While investor liquidation continues and retail gold demand remains subdued, the balance of demand points to further downside in gold, in the ANZ analysts' view. A sustained recovery would spark renewed retail interest, if the market shifts to the view that prices have bottomed. At this point the emerging market central banks may decide to increase their gold holdings, as they internationalise financial systems. They are patient entities and the analysts expect buying to resume once prices stabilise. The analysts do not expect a long-term bear market in gold. Investor selling has been relentless over the past six months but the pace of liquidation of gold positions is expected to abate, or even reverse, over the year ahead.

Citi is bearish on gold and has downgraded gold forecasts, expecting US$1,185/oz on average for the rest of 2013. Sideways trading is expected throughout 2014 as global economic conditions improve. Events in the US and related US dollar-inflation are seen as the most pivotal events for gold. In this regard, inflation concerns are being pushed further into the future and low interest rates and growing liquidity is favouring other asset classes such as equities. As QE-driven inflation fears recede so too will the gold price, in Citi's view.

On the gold equity side, Citi notes many ASX gold mining equities are trading at levels which imply an extended period of gold price weakness and adverse outcomes for high cost operations. Furthermore, against this backdrop strategic plans are undergoing rapid change and the sector will likely face more reserve downgrades and impairment charge but, if gold recovers, high cost names are most highly leveraged to the upside.

At a technical level, Macquarie observes the gold market is in backwardation, which means the forward price, currently out to six months, is lower than the spot price. This is not a common occurrence and Macquarie does not think it will last. The best explanation is strong physical demand has met reduced lending capacity. There has been an associated rise in gold lease rates, modest but noteworthy, according to Macquarie.

On the supply side there are two main sources of liquidity, central banks and private stocks. A reduction in lending from either of these sources would increase lease rates. There are no signs of further reductions in lending this year but, in Macquarie's view, given the small amount on loan at present just one central bank changing policy could have an impact. On the demand side there are traditionally three consumers of loaned gold – jewellery fabrication, speculators that are short selling and mining companies forward selling. An increase in demand from any of these sources would see lease rates rise.

The final explanation for backwardation comes from that bastion of strong physical demand for all things metal – China. Macquarie observes the premium on the Shanghai Gold Exchange over the international price has risen significantly since the price fall in April. Turnover on the exchange, imports and jewellery retail sales have all been very strong. So, what are the implications for the spot price? Hard to judge, says Macquarie, but probably moderately bullish. While strong demand is obviously bullish, high levels of short selling are less so. All this technical speculation partly reflects just how low LIBOR rates are at the moment and that almost any increase in gold lease rates would mean the market going into backwardation.

While backwardation is a very rare event in the gold market, and likely to reverse, a modest rise in gold lease rates is not rare, and might not reverse. Either way it is unlikely to be of significant consequence, in Macquarie's view. So that's alright then.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms