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Thursday, June 28, 2012

Gold Mining Stocks About to Crumble?

The gold mining industry is poised to go through some shock, as the little talked about rise in gold production costs is hitting the industry hard, and is only going to get worse going forward.

Taking a major hit from the fallout surrounding rising production costs was Barrick Gold (NYSE: ABX) CEO Aaron Regent, who was recently fired because of his inability to keep costs at a lower level.

While it wasn't explicitly cited as the reason, it definitely was implicitly suggested as the impetus behind the move.

That is supported by the production cost numbers, which have jumped by 22 percent over the last year, to $560 an ounce, soaring from the $460 an ounce it cost to produce an ounce of gold last year.

Even these figures are about 6 months behind the current cost levels, which are estimated to have soared to about $1,000 an ounce in production costs, and more for some gold mining companies.

According to AngloGold Ashanti (NYSE: AU) CEO Mark Cutifani, gold production as measured by total cost basis is "running at about $1,200. The industry average is probably around $1,250 an ounce."

Iamgold (NYSE: IAG) CEO Steve Letwin concurs with those numbers, saying, "It's going to be difficult for anybody to produce gold at less than $1,200 an ounce."

Not only are all the usual production costs rising in the industry, like labor, mine infrastructure, heavy equipment, utilities, fuel, permits and drilling, but the process of reaching quality gold deposits are rising as well, based upon the fact companies are having to dig deeper and deeper to reach them. Coupled together, these are the causes in increased gold production costs that aren't going to go away any time soon.

Add to that corrupt governments which can wait until all the money is spent and production begins before they suddenly change their tax structures to basically steal money from the miners, and you have another volatile situation added to the mix.

The reason I mention this is because the idea the gold miners have been lagging the rise in the price of gold has been used as a reason to invest in the miners because it is felt it is inevitable that the price of the gold mining stocks will follow the price of gold upwards.

But the real reason the gold miners haven't been doing well is the soaring production costs, which have disallowed what appeared to be a logical move up in share price of the companies.

Assuming you want are invested or want to invest in gold miners, the key number to look at on a quarterly basis are the production costs of the companies. That will be the key for profitability for them, even when gold starts to rise in price again.

Seeing that costs have climbed so high, so quickly, gold could reach about $2,000 an ounce and it would only bring the gold miners back to where they were in 2010 and 2011 as far as production costs versus the price of an ounce of gold.

If the price of gold remains level, or even drops in the short term, we'll see some gold miners begin to go bankrupt over the next few years, as they simply can't operate with a profit at these cost levels.

On June 30, 2008, Barrick Gold was trading at $45.09. As of this writing it's trading at $35.76. So unless you got in below $20 in October 2008, you would have made very little money, if any, over a four-year period. Most likely you would have lost money.

So are there any good gold mining investments? Those that will bring shareholder value will be those that are best able to manage production costs. That will be measured, for the most part, by those with the best mines, and least amount of production costs needed to extract the gold.

Some companies are positioned well in this area, so be sure to perform due diligence concerning the gold mining companies you're taking a look at.

Are there other ways to invest in a gold stock that could offer better returns? Sure. I would look at gold streaming companies such as Royal Gold (NASDAQ: RGLD), which is tied more into the price movements of gold, and incurs little risk on the production side. The risk for streamers lies in the production of a particular mine or mines, not the costs associated with it.

What about the eventual return to rising gold prices? That will happen, as central banks around the world won't allow the global ecomomy to go on as it is without putting up a fight by throwing more money at it.

There is also the surety of more bailouts in the euro zone, which will push up the price of gold. Add to that the announcement by Federal Reserve Chairman Ben Bernanke that interest rates will remain where they are until 2014, and there are all the elements in place for gold prices to rise.

The artificially bloated U.S. dollar will come crashing down again once stimulus measures are resumed, and then gold will continue its upward rise in price.

What the question is for all gold miners is if it will increase enough to significantly offset the rise in production costs.

Whatever the answer, those gold miners with those costs best under control will be the winners in the future, while those that aren't able to contain costs, will likely fall by the wayside by declaring bankruptcy.

At that time interesting things will happen, as significant gold reserves could be made available to the better run companies.

For now investors in gold miners need to be even more vigilant as usual, and be sure to know as accurately as they can, what the real production costs of the miners are, as that will determine profitability and whether or not they'll survive over the next several years.

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