Cost Inflation a Big Problem Globally - Stay Local
Peter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It's well known that the gold majors are suffering from elevated all-in costs after years of reckless expansion into high risk countries and exploration overkill. Over the past six months, silver, gold, copper and platinum prices are down 35% and 23%, 14% and 12% respectively. Over the same period, oil prices are up 8%. Mining cost inflation is as big a problem as weak demand and resource nationalism.
Typically When Commodity Prices Fall, Mining Costs Fall
Since demand for commodities is tied to global growth, when prices fall, the cost of mining typically falls. However, in the past several years this has not been the case. In addition to oil prices, (as a proxy for diesel costs), labor, materials and power costs, (per unit of production) have increased or stayed the same. Margins are under severe pressure.
Hard to Meaningfully Improve a High-Cost Mine
In many cases, mines in the fourth-quartile of the cost curve were designed with much higher commodity price expectations. Commodity prices soared twice in the past five years, in 2008 and 2011. For example, gold prices touched $1,920 per ounce in September 2011, compared to $1,275 per ounce today.
As the majors retrench, less new gold supply will support and eventually lead to an increase in prices. The beneficiaries of higher prices will be high-quality, mid-tier and junior companies with low-cost operations and simple, clean business models. Make no mistake, hundreds of gold companies will fail in the coming years, but the strongest will thrive.
Producers in Safe Jurisdictions Will Be Especially Sought After
There have been many recent articles about the growing challenges of, "resource nationalism." In addition to causing significant challenges on multiple fronts, acts of resource nationalism cost companies a great deal of money. The majors have learned this the hard way. Barrick Gold (NYSE: ABX) has reportedly spent several billion dollars on a $9 billion gold/silver mine in Chile that's now on indefinite hold. There's a real possibility that the Pascua-Lama project will never make it into production.
Likewise, Newmont Mining's (NYSE: NEM) $5 billion gold/copper project in Peru is being aggressively opposed by thousands of locals who fear the mine will damage the water balance in the region. This, even after Newmont has taken significant, proactive steps to alleviate any possible threat to the water supply. Dealing with resource nationalism is a rapidly growing cost of doing business.
While Not Immune From Cost Pressures, U.S. Mining Projects Are Superior
Key costs that are killing projects in places like Africa and central Asia are simply not meaningful factors in the U.S. For example, resource nationalism is not a threat in Nevada. The U.S. has well established, low-cost and reliable infrastructure, wage rates are relatively stable, and tax and royalty regimes are benign. These factors make the U.S. a low-risk jurisdiction to operate in. Therefore, the cost of project capital is lower.
Given ample investment opportunities in the U.S., some of which appear to be true bargains, why invest anywhere else? A great example of a U.S. company to consider is Coeur Mining (NYSE: CDE).
Coeur is primarily a silver producer but is also producing an increasing amount of gold. The company is trading at less than a 4x enterprise value/2014e EBITDA multiple. Despite having recently spent $300 million for the acquisition of a Mexican Silver developer, Coeur still has solid liquidity and is generating ample free cash flow.
Coeur's operations are in the U.S. and Mexico. With Coeur's strong balance sheet, it is one of the few companies in the position to make acquisitions. As the majors continue to actively reduce risk from operations in places like Africa, Coeur Mining stands out as an increasingly attractive acquisition target itself.
Allied Nevada (NYSEMKT: ANV) is an interesting, albeit very high-risk, opportunity. 100% of the company's assets are in Nevada. Allied's stock has been under extreme pressure because the company is in the midst of a billion dollar expansion. Management budgeted for a $1,600 and $1,400 per ounce gold price in 2013 and 2014, respectively, when planning this expansion. With gold at $1,275 per ounce, Allied is coming up short on funding. As a result, the company raised $150 million at $10.75 per share two months ago. Today the stock is trading at $6 and change.
Still, there is a workable solution for Allied. It will be forced to slow its expansion to conserve capital. Instead of a 2015 completion date, Allied's new mill will probably be completed in 2016-17. While disappointing, this news appears to be priced into the stock price.
Major gold and silver producers followed an aggressive growth strategy for years. Despite rampant cost inflation and other growing problems such as resource nationalism, the majors continued to make acquisitions in far flung corners of the world. Gold prices are down by a third and silver by half since September 2011. The majors are in big trouble and are down 50%-65% from 52-week highs. Investors may benefit from looking at U.S. companies that are largely insulated from the headwinds facing the majors. Coeur Mining is a great company to look at. Allied Nevada is a very high risk name, but one to consider.
Peter Epstein has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!