The illusion of gold mining profits

Like rabbits in strong headlights, equity investors with a gold bent continue to chase increasingly challenging cash margin compression.

JOHANNESBURG -

The recent round of gold mining profits (and losses) reporting for various periods to 30 June 2009 has shown up a global mining subsector barely scraping a living out of the dirt unearthed at countless locations across the world. Like hamsters on a treadmill, gold miners continue to chase the illusion of profits, backed by a commodity that draws more support than the search for intelligent life in outer space.

The conundrum faced by gold miners and, more tellingly, by investors with a gold bent, who like rabbits in a spotlight, continue to blindly invest in listed gold stocks, is adequately examinable at Barrick, the world's biggest gold digger by production and market value. According to its own advertisements, courtesy of its 2008 annual report, Barrick stands as "the gold industry's only ‘A' rated balance sheet" It also lays claim to "the largest production, reserves and market capitalization".

All this is no doubt true, but also true is that Barrick increasingly scrapes closer to the bottom of barrels, just to stand still. What this says about lesser gold diggers could be illuminating. The key to unlocking a looming potential crisis faced by gold miners is conveniently published cash flow statements: Barrick's show that the world's leading gold miner earned US$2.2bn in operating cash flows during its 2008 financial year. The first wobbly leg is that gold companies are miners, and miners always face material capital expenditure bills; Barrick's total for 2008 was US$1.8bn.

Like most gold miners, Barrick faces dwindling production at existing mines and remains under constant pressure to find or buy, or develop, unmined gold ounces. On this note, Barrick's acquisitions cost US$2.2bn - in cash - during 2008 alone. Barrick's operating cash flows for 2008, less capital expenditure, and less acquisitions, produce a deficit. This was financed by Barrick from existing cash reserves, and new net debt raised, during 2008, of US$1.1bn.

As some kind of a yardstick, BHP Billiton, the world's biggest diversified resources stock, this week posted annual results for its financial year to 30 June 2009, for which operating cash flows are reflected as US$25.2bn. Cash capital expenditure was US$9.5bn, and US$1.2bn was spent on exploration, leaving billions of dollars in free cash flow from the year's activities.

Back in the gold pits, challenges posed by bullion prices continue to mount. For nearly six months now, gold companies everywhere have been facing the year-on-year effects of a dollar gold price that's been churning between roughly US$700 and US$1,000 an ounce since March 2008. While prices have traded around the upper end of that range for most of 2009, and energy prices and other costs have fallen from record levels seen around mid-2008, gold companies are struggling to make profits. This hardly reflects favourably on a mining subsector that has benefited from a commodity that fell less, and has been more stable relatively, than any other.

The pattern that continues to emerge from reported cash flows posted by gold companies so far this year indicates an industry battling to even break even, when cash capital expenditure is deducted from operating cash flows. The pattern is apparent among even the biggest and best-established gold miners, which have had years to focus on what may be broadly defined as top-tier, long life, low cost, gold mines, and to close or sell those that don't crack the nut.

Almost uniformly low "cash costs" as reported by individual companies in the gold industry are increasingly loosing veneer. The definition of "cash costs" for gold miners is anything but uniform, but uniformly ignores cash capital expenditure and cash spent on acquisitions. Even so, cash costs are rising for most gold miners.

The overall compression equation includes the two basic legs of capital expenditure: unavoidable stay-in-business capital expenditure, and capital expenditure used to build new mines. Few gold miners, of any size, are free of pressure to build new mines. Earlier this year, Barrick announced that it had given the go-ahead for Pascua Lama, a build that will absorb around US$3bn in pre-production capital expenditure. First gold is only anticipated in 2013, leaving an accumulating pile of capital expenditure locked, literally, in the ground until then.

Gold miners, long attuned to loyal investors trained to continually pour cash into fresh stock issues, have used relatively buoyant gold prices to raise billions of fresh dollars on equity markets during 2009. Individual issues, inevitably in the form of direct placings by intermediary stock brokers, that have raised at least US$100m each this year have been seen out of the likes of Harmony, Red Back, Osisko, Agnico-Eagle, Kinross, Newcrest, Newmont (more than US$1bn), Lihir, Iamgold, Royal Gold, and Centamin Egypt.

There have been dozens upon dozens of smaller issues. Convertibles, a form of hybrid debt-equity have not been uncommon; AngloGold Ashanti issued securities in this format to the tune of US$733m. At least one pure debt bond has been issued, by Barrick, to the tune of US$750m. For the uninitiated, it may seem that gold miners spend at least as much time mining equity and debt markets as they do digging the precious stuff out.