Saturday, 26 January 2019

Miners will continue to disappoint

Last Friday we witnessed a magnificent miner rally as gold broke above $1300 for the first time since mid June 2018.  However, miners have been disappointing for most of the past 18 months. There is no obvious reason why this dire situation would suddenly improve. 

Miners are quoting lower at any next time the same gold level is revisited. As we recall the last few times gold broke above $1300/Oz, those were the HUI gold miner index levels attained on those days:

Date
HUI
Gold
6/08/2014
241.7
1305.9
24/06/2016
237.9
1315.6
3/11/2016
219.0
1302.2
28/08/2017
209.1
1309.5
13/10/2017
202.8
1303.3
29/12/2017
192.3
1302.5
14/06/2018
182.1
1301.9
25/01/2019
158.6
1302.6

It looks even more obvious on a simple scatter graph:

HUI on the right axis, Gold on the left axis
Moreover, while the 'degradation' seems moderate at first, it accelerated since summer 2017.  This is nothing less than HUI dropping below its 'linear regression' it managed to uphold for about five years.

Last years' article "Gold miners persistently lagging the metal" exactly pinpointed what's going on.

The broken down linear regression 

A linear regression is expressing the dependency of HUI on the gold price in USD. This regression held for about 5 years since summer 2012 and until early 2017.  
HUI - Gold regression line, the blue dots cover the July 2012- July 2017 period
Before summer 2012, the (orange) HUI/Gold dots were above the regression line as the miners were valued higher for a given gold price, but the HUI was unable to keep track of the gold price as it ascended to its Aug 2011 all time high (in USD). Since Aug 2017, the (HUI, Gold) dots are systematically below the regression line, invalidating the linear relationship for the near future.

Linear regression parameters allow designing a graph with the HUI mimicking the gold price while the relationship remains valid:

Gold (left axis in red) and the HUI (right axis in blue)
While a regression relationship holds, the residuals (differences between the 'expected' HUI value and its observed value) are either positive or negative, but residuals tend to cancel out.  That no longer is the case since summer 2017.  Residuals have been negative ever since even though the gap temporarily narrowed early last summer.

Regression residuals have last been positive during summer 2017.
About the best we've got ever since is a reading close to zero.

Miners are not delivering to expectations

The idea sell-side analysts want investors to believe is 'leverage to the gold price'.  Indeed as the gold price is rising, the turnover of the gold miners may rise proportionally.  As costs usually don't escalate in the same way, earnings will rise which will trickle down to the bottom line:  higher margins yield higher profits. "Optionality" most often is the key-word chosen, suggesting that miners should perform as a gold future. 

Flaws are manifold:
Turnover may rise proportionally:  indeed if all production is sold at market price this is the case. However miners may have sold a production stream for an upfront payment needed to finance the mining investment. That production stream will typically sell at a price only little above production cost.  Miners may also have sold forward part of their production, locking in revenue certainty.  If during spring 2018 a miner has sold forward 12 months production for $1300/Oz, he has benefited during the downturn, but he will need to continue selling at $1300 no matter what gold rallies to during the months to come.

Most costs are in the local currency of the mine location.  Inflation may escalate production costs.  Both equipment and energy costs generally are USD denominated.  Rising fuel costs may erode mining margins.

Production costs at open pit mines tend to drift up as deeper ore layers are accessed. Eventually the mine will no longer be profitable at current gold prices, though there may still be gold ore left.  Mining indeed is 'a wasting asset'.

Ounces produced and sold are gone:  miners will need to find new deposits or find extensions of deposits being mined in order to stay in business. Especially during the gold bull market, many miners have overpaid for new deposits, many of which didn't deliver to expectations.

During the miner bear years, the main focus has been on cutting costs.  Exploration costs are about the first to be reduced.  Though production can continue,  reserves are being depleted.  Mining sites with above average production cash costs may attempt high grading their deposit to bring the cost down. This most often shortens the mine life dramatically:  a soon as high grade ore has all been mined, cash costs will escalate since only lower grade ore is left.

Conclusions

Gold rallying is like the weather getting better: it brings short relief for the miners, but it doesn't fundamentally alter their outlook.

This time we need a climate change: miners need to deliver on expectations:  grow their reserve base enabling profitable production for decades to come. Moreover production and earnings growth is needed on a per share basis. Raising capital and diluting shareholders is a recipe to scare away investors.

Past and ongoing mergers often only bring down general management and administrative costs. Real synergies are realized only if both parties involved have adjacent mining sites. Do insiders know more than seasoned investors?  They probably feel the need to cut costs to gain a competitive edge and without jeopardizing the reserve base. Mergers among majors then are a plausible outcome. 

As 'peak gold' is luring behind the corner and more mining majors are lowering their production volume forecasts, investors have grown wary; they are anticipating more possible unpleasant surprises and have become more reluctant than ever to overpay for miners.


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