EDINBURGH/SINGAPORE/HOUSTON, 22nd July 2015 – Following the recent announcement by the Chinese central bank of a seemingly underwhelming 57% increase in gold reserves, the gold price plunged to below US$1100 per ounce ($/oz) amidst a broader commodities sell-off.
Wood Mackenzie data suggest these price levels put approximately 10% of gold miners in loss-making territory on a Total Cash Cost plus Sustaining Capex (TCPS) basis. However, this week’s price drop only exacerbates a trend which gold miners have been tackling for some time, as highlighted by Wood Mackenzie in a new analysis of the divergences observed across the relative valuations of gold and copper miners.
Wood Mackenzie’s report, titled ‘Value creation in the mining sector: a long term divergence between copper and gold producers’ reveals that in 2000, gold miners commanded a 50% market premium over copper miners. But following a decade of generally poor capital allocation, cumulative net losses and poor shareholder returns, by June this year the market priced the gold mining sector at just a fraction above its net tangible worth.
In contrast, at the same juncture, copper miners commanded a 25% premium over gold miners on a price to net worth basis, somewhat surprising given the broad sell-off in base metal mining equities from their peaks back in 2011.
Dr Ryan Cochrane, Wood Mackenzie’s Senior Research Analyst – Copper Mine Costs, explains that copper miners have generally enjoyed higher operational and residual cash flow margins than gold miners despite copper prices underperforming gold prices over the past 14 years. He notes; “Relatively pure-play copper miners outperformed the copper price, with share prices rising at an annualised rate of ten percent (excluding dividends) over the same period: an outstanding result considering the losses since the 2011 bear market began.” Wood Mackenzie highlights that in contrast, 10 of the largest gold miners significantly underperformed the gold price with share prices rising by just 1.4% per year since 2000.
Wood Mackenzie’s analysis shows that the average dividend yield for a selected copper mining population was four percent over the 14 year period, compared with one percent for selected gold miners. So what is behind the divergence in returns between the copper and gold sectors? According to Wood Mackenzie a significant factor is the approach and success of capital allocation, resulting in the copper mining segment growing net worth per share at a much faster rate than that seen in gold mining: “For copper miners, a conservative managerial approach of capital allocation meant that project development was financed largely through internal cash flow whilst equity and debt financing was used relatively sparingly.
Gold miners, however, aggressively pursued production growth and hedged significant portions of their production at relatively low gold prices effectively missing large portions of the gold market bull run.
“Furthermore, the quest for production growth – especially in the latter portions of the bull market – meant that many gold miners developed increasingly marginal projects and paid excessive premiums for acquisition-driven production growth through the extensive use of debt and highly dilutive equity financing.” Wood Mackenzie believes that this has been compounded by gold mining companies maintaining large dividend payments despite recording cumulative net losses over the period, with pay-outs funded partly through external financing.
Looking ahead, Wood Mackenzie says that significant challenges remain: “Interest rate hikes and a generally bearish metal price outlook are likely to outweigh short-term mining cost savings made possible by the stronger dollar, the lower prices of key input commodities and active steps by management such as high grading,” Dr Cochrane qualifies, “Furthermore, most of the current projects in the gold mining pipeline were evaluated on the basis of prices above US$1,200/oz and the fall in prices to US$1,100/oz will result in a significant cut in future supply. We estimate that nearly 40% of project production capability is uneconomic at current prices.”
Against this challenging backdrop, Wood Mackenzie says that producers have reacted by implementing a number of value realisation measures. These include: only developing projects which meet stricter (10-15% IRR) hurdle rates throughout the metal price cycle; slashed capital expenditure budgets; and active cost cutting to free up cash flow in the metal price downturn. With this approach and despite the challenges outlined, the gold sector may be poised to start performing more in line with the historically more successful copper sector.
Dr Cochrane concludes: “With major gold miners struggling to replace reserves, production may begin to decline and higher prices will be required to justify the next round of large capital expenditures. Meanwhile, within the copper sector, producers remain committed in their drive to divest non-core assets, slash expansion capital expenditure and free up cash flow to return to shareholders.”