Thursday, September 13, 2012

High gold prices mask difficult future for miners-S&P

Although gold prices have nearly tripled over the past four years, gold miners are not able to capitalize on their good fortune, says Standard & Poor's.

With the current capacity in the mining pipeline and the hefty position in gold ETFs, Standard & Poor's warns that gold miners' profits and free cash flow are at risk "from an abrupt downward correction in the gold price as occurred in the late 1990s following years of production increases and healthy prices."

In an analysis made public Tuesday, S&P suggested such a correction could "lead to the closure of high-cost mines and reduced investments to stem negative free cash flow, even though gold miners have adequate liquidity to withstand low gold prices over an 18-month period." Long-term credit facilities, loose financing covenants, multiple projects at different stages, and generally low leverage give miners this financial flexibility.

S&P analysts Elad Jelasko and Karl Nietvelt noted that, although the price of gold has almost tripled over the past four years, "gold miners' struggles have prevented them from capitalizing on good fortune."

For example, Newmont saw its gold production decline to 5.9 million ounces last year from 6.2 million ounces in 2007 as operating costs jumped 50% during the same period. "In other words, Newmont generated only $24 per ounce sold," said the analysts.

"Overall, we estimated that cost inflation has doubled the miners' total cash cost (cash operating costs plus all capital expenditures) over the past five years to $1,100 per ounce on average."

S&P rates a number og investment-grade gold mining companies globally, whose ratings have broadly remained unchanged. They include Barrick, Newmont, Goldcorp, Newcrest, AngloGold Ashanti, Gold Fields, Kinross and New Gold. The ratings agency maintains a stable outlook for the industry.

In their analysis, Standard & Poor's observed the amount of gold backing ETFs is almost equal to the annual production in gold. However, the situation could change if Europe's sovereign debt crisis is resolved, or if signs of recovery in the U.S. and the global economy prompt investors to move to riskier investments.

PRODUCTION/PRODUCTION COSTS

At first glance, the gold mining industry looks robust as world gold production reached 88 million ounces last year. However, S&P believes production will only increase by single digits and then start to decline in the next two or three years as mining tries to overcome the challenges of deteriorating quality of mined ore; taking longer to initiate new projects; and few new reserve discoveries.

"There is no consensus among gold miners about the likely direction for gold production," S&P advised.

"If our assumption of a single-digit rise in output over the years is conservative, and the industry majors and junior miners increase production by 5.7 million ounces and 1 million to 3 million ounces, respectively, we doubt the current price would remain sustainable."

In their analysis, S&P warns that "cost inflation is an ever-present threat" for gold miners. "The commodities boom has...created inflation across the mining industry, pushing costs up by 10%-15% a year." The main factors behind this inflation are crude oil and subsequent electricity prices; competition for skilled labor; general country inflation; and equipment costs.

When comparing the cash costs of low- and high-cost producers over the past five years, S&P found that the gap between them increased from about $100/oz in 2007 to almost $400/oz this year.

In a lower price environment, S&P believes mining companies will become "far more selective in their mining plans", thereby decreasing cash costs somewhat.

"Moreover, the healthy price of copper, which is found in some mines as a by-product, supports a lower cash cost structure, thereby improving competitiveness," said the analysts. "For example in 2011 Goldcorp reported a cash cost after by-products credit of $223 per ounce, compared with a cash cost of $535 per ounce before the by-products credit."

"In this respect, any improvements in the copper price should increase the cash cost structure. The main beneficiaries of such a move include Barrick, Newmont, Goldcorp and Kinross. The South African miners, by contrast, have insignificant by-products," the analysts advised.

Standard and Poor's views total cash cost as an indication of the floor level for the price of gold. "In our view, the investment needed to support existing production lies within a range of $150-$200 per ounce per year on top of the industry's median cash cost ($600-$650 per ounce)."

"However, gold miners are in a middle of ambitious capex programs at present, translating to actual capex of $400-$450 per ounce and pushing the total cash cost for the average gold miner to $1,000 to $1,100 per ounce," said the analysts. "As a result, under current conditions, a decline in the gold price below $1,200 per ounce would create a material pressure on FOCF [Free Operating Cash Flow] across the industry," as well as resulting in negative FOCF for some miners.

"Hence, a price drop of this magnitude would be unsustainable," the analysts asserted.

If gold prices decline substantially, S&P advised it would assess a mining company's credit profile for its financial flexibility including its ability and willingness to execute a change in mine plan to focus on gold seams; limit exploration costs; cut dividends; curtail capex programs in pre-feasibility/feasibility studies; and shut down expensive shafts.

RISKS

Other risks constraining the gold mining industry include country risk, safety regulation, introduction of new tax regimes, and shareholders pressures on dividends, said S&P, adding these factors would limit the industry's growth prospects "and therefore support healthy prices over the next three to five years."

Under country risks, S&P factors in changes in mining licenses; a lack of infrastructure (water, electricity and logistics), and a country's ability to nationalize assets as has occurred recently in Argentina and Zimbabwe. "At this stage, the risk of nationalization in South Africa seems to us to have reduced."

Although mine safety has substantially improved over the years, S&P said ultra-deep underground mining "stretching the industry's engineering capabilities and exposes miners to extremely conditions, increasing fatalities."

"Safety regulations force mining companies to slow down the mining process, resulting in lower efficiency," said the analysts. "Production also suffers from regulatory investigations into fatalities. AngloGold, for example, lost production totaling 76,000 ounces in the first quarter of 2012 due to safety breaches."

As gold prices increase, there is a risk that governments will seek a higher portion of mining companies' income, observed S&P. Profit sharing can include higher royalties, a super tax (an additional tax on top of the regular corporate tax), and partial ownership in the assets.

"In this respect, we see royalties concealing a larger issue because expenses are calculated on revenues and not profit. By contrast, we see taxation levied as a percentage of free cash flow as being far less credit negative," the analysts advised.

However, they added, "We believe that negotiations over new tax regimes taking place in several countries (such as South Africa) push miners to defer capex and to adopt a ‘wait and see' strategy until they gain better visibility on the likely changes."

Gold miners are under increasing pressure by shareholders to up dividends. But, S&P observed "shifting cash flow from operations to the shareholders pushes back new mine development and constrains supply. In this respect, we take a positive view of Newmont's recent intention to link its dividends to the gold price."