VANCOUVER — It’s been a rough run for gold equities over the past few years, but recent performances by major and intermediate producers seem to hint at an industry that’s getting its balance sheets and cost structures in order.
The Northern Miner had the chance to speak with BMO Capital Markets’ managing director of Mining Equity Research Andrew Kaip to catch up on current trends in the gold space and what investors can expect moving forward.
In mid-June BMO Research initiated coverage on six North American-based gold miners after it concluded that following “two years of cost cutting, balance sheets are showing improvement, and debt is less of an obstacle toward a new stage of growth focused on return that will drive the next cycle.”
The companies are Agnico Eagle Mines (TSX: AEM; NYSE: AEM), Barrick Gold (TSX: ABX; NYSE: ABX), Eldorado Gold (TSX: ELD; NYSE: EGO), Goldcorp (TSX: G; NYSE: GG), Kinross Gold (TSX: K; NYSE: KGC) and Yamana Gold (TSX: YRI; NYSE: AUY).
“Prior to the current downturn there had just been so much emphasis on growth, which is typically the case when you’re in a rising market. People are looking at how quickly a company can increase production rates and subsequently benefit from increases in gold price,” Kaip explained during a phone interview.
“The reality was that costs kept in lockstep with the rise in the price of gold. So essentially that margin wasn’t captured, and that really exposed the deficiencies and problems within the space,” he added.
Gold producers were caught up in a mergers and acquisitions boom when gold prices topped out near US$1,900 per oz. in 2011. The frenzy led to a series of deals at top valuations that triggered a plague of writedowns and rising debt, after precious metal prices plunged. Barrick said the average realized price for its product fell from $1,273 per oz. in 2013 to $1,201 per oz. in 2014, while Goldcorp reported an average US$1,035 per oz. last year.
The impairment charges kept on hitting hard over the past six months, with Goldcorp reporting a US$2.3-billion writedown on its Cerro Negro mine in Argentina and Barrick taking a US$2.8-billion hit due to its investment in the Lumwana copper mine in Zambia and the Cerro Casale project in Chile.
Meanwhile, Kinross took a $1-billion writedown related to property, plant and equipment, and Yamana absorbed an US$800-million impairment in 2014 due to declining mine production.
The writedowns are non-cash accounting considerations that carry limited impact on day-to-day operations, but they have damaged investor faith in the gold space and driven equity valuations downward. The more pressing issues have involved the erosion of free cash flow and working capital, after miners operated with all-in sustaining cost profiles that put a severe dent in earnings per ounce.
“When we talk about flaws we’re looking at bloated cost structures where a lot of costs didn’t need to be there, and yet they found a way into the system. Every company suffered from it, but some suffered more substantially,” Kaip said. “When you look at some of the senior gold companies you see their general and administrative expenditures literally ballooned during that time frame. They also became inefficient on the operation side, and there was less of a focus on costs. I think management teams just weren’t sharp enough, and that allows waste to find its way into a system over time.”
In response to investor and market criticism, many senior gold producers have initiated cost-cutting programs to identify core assets and streamline operations. The measures have included layoffs at the corporate and operational level, deferment of development projects, asset sales, and raising cut-off grades on mineral reserves and resources.
For example, Barrick has divested nearly US$3 billion in assets over the past year to cut debt levels, “further reorganized” its operations in January and cut more jobs. The company already slashed 100 positions at its Toronto offices back in 2012, as gold prices first deteriorated.
In addition, megaprojects like Barrick’s Pascua Lama, Goldcorp’s El Morro and Kinross’ Tasiast expansion have been put on hold. BMO Research says the three projects represent more than 1.5 million oz. in new gold production, but would cost US$9 billion to develop.
“There have been strides made, but there is definitely room for improvement in cost structures. That’s not only on the sustaining capital side, but in terms of the operating costs. We’re seeing these companies looking closely at operations, but those costs haven’t come down enough over the past few years,” Kaip noted.
“Most of the benefits of optimizing sustaining capital have been achieved. One of the things we haven’t seen come into play is wage depletion. Labour wages are still at the level they were two years ago. The average miner is still employed because, quite frankly, we haven’t seen enough operations shut down. Reserves have definitely come down and they will come down further. That’s just a fact of life, and we expect to see more of it. Some of the miners are trying to offset reserve contraction by purchasing exploration or advanced-stage projects, but the reality is that operating reserves continue to decline year-over-year,” he said.
BMO Research noted in an Aug. 9 update that the six North American senior miners in its coverage space reported free cash flow of US$309 million, with Eldorado, Agnico, Goldcorp and Kinross reporting “better-than-expected” cash flow on lower capital spending. Operating costs also trended downward, as Barrick registered a 2% drop in all-in sustaining costs, Agnico managed a 1.1% decrease, Goldcorp’s all-in sustaining costs dropped 4.1% and Eldorado reported a 5.4% cost decrease.
“You have to layer into all of this execution. For example, when we compare Goldcorp and Agnico, you see that Agnico has been doing a better job executing over the past few years. Barrick had a similar premium and stumbled, but they look to regain some of that. Goldcorp also has an opportunity to recapture that premium with its Canadian production assets,” Kaip said.
Long term, BMO Research forecasts a US$1,250 per oz. nominal gold price, though it notes that another round of cost cutting may be required for some miners to adapt to a potential sub-US$1,100 per oz. price environment.
“While positive inroads have been made at assessing growth opportunities, the senior miners still struggle to demonstrate reasonable returns on capital allocation. It will take investors a while to forget the [US$29 billion] in writedowns incurred by the six gold miners in 2013 and 2014,” Kaip noted in a research report.
Though producers have made progress in controlling capital spending and operating costs, there are concerns about the health of project pipelines after a drop in exploration investment.
In-situ gold reserves have declined over recent quarters, and the Canadian Mineral Industry Federation noted in a recent report that exploration expenditures in 2014 were are at their lowest levels since 2002. In Canada, junior companies accounted for only 40% of exploration expenditures in 2013, down from a high of 65% in 2007.
“There’s a misconception that all the seniors are in trouble in terms of exploration. Take Barrick for example, which made the Goldrush discovery in Nevada over the past five years or so. It’s a 15 million oz. go
ld deposit that’s still growing, and it’s one of the most significant gold discoveries in the next decade,” Kaip said.
“The cuts in exploration budgets are becoming a problem, but you have to remember not to look at the physical dollars. There was a huge amount of money wasted in exploration during the peak cycle. Many of these exploration programs should never have had the amount of dollars thrown at them — that’s a lot of waste. From a senior perspective we’re looking at exploration dollars being spent more efficiently, and you could argue that even though we’re seeing less being spent, there’s still the potential to make significant discoveries. Another example is what Agnico is doing at Meadowbank with its Amaruq deposit in Nunavut.”
BMO Research notes that investors are “waking up” to the realization that senior miners have made big changes, yet share prices remain near multi-year lows.
Shares of Barrick were down 55% year-on-year to $8.89 at press time, while Goldcorp lost 38% and traded at $18.19 per share. Meanwhile, Agnico fell 23% to $31.91 and Yamana is down a whopping 73% to $2.35 per share. By comparison, December contracts for gold bullion have dropped just 11.5% since September 2014, and last closed at US$1,139.30 per oz.
“I think what investors want to see are large business combinations, and I don’t know if we’ll see that in the near term. What I think will happen is a healthy pace of small companies being acquired by intermediate producers and the odd major coming in and taking a piece, or making an acquisition,” Kaip said.
“For the most part it’s a balance sheet issue, but we aren’t seeing that issue snowball to the point where we’ll see major changes. There need to be more deals like the AuRico-Alamos deal, because one of the problems is that there is simply too much product … we need to simplify the product for broader investment by limiting the amount of companies out there.”
BMO Research expects an “inflection point” for the senior gold space in early 2016, with generalist investors returning to the sector.
In particular, Goldcorp, Barrick and Agnico screen as having the top “core portfolios” by BMO’s calculations.