By Scott Wright
In 2011 gold-mine production came in at an all-time record high. And in 2012 experts anticipate production to be even higher, edging above the previous year’s 87m-ounce tally. From the looks of it, the major source of gold’s supply is in fine fettle. But is the gold-mining industry truly healthy?
In attempting to answer this question it is important to understand how we got to the production levels we’re at today, and then take a look at some of the structural fundamentals that may impact this industry going forward. And in terms of how we got here, it was nothing short of remarkable.
Interestingly mine production had actually been on a pretty alarming decline for a large portion of our current secular bull. Many folks forget that it was just in 2008 that production volume had fallen to a 12-year low, and that the miners were producing a full 10m ounces less than what they were at this bull’s 2001 beginning.
Finally after many years of increased capex towards exploration, development, and overall upgrades to this industry’s infrastructure, 2009 delivered the first production increase in years. And a now-three-year-running increase is something to behold.
Since 2008 gold-mine production has experienced an average annual growth rate of a staggering 6%. And this is especially impressive considering the relatively static nature of mine production. Increasing output is not as simple as turning a dial on a factory floor, as it takes many years of development to build a new mine and/or increase capacity at an existing mine. And when you take the natural depletion cycle into account, this 6% growth rate is all the more impressive. A lot of big new mines and expansion projects have come online in the last few years!
But though impressive, it doesn’t take a rocket scientist to realize that this recent production growth rate is unsustainable. In fact, some recent fundamental unveilings raise questions as to whether even the existing rate of production is sustainable over time.
One major tell on the inner workings of the gold-mining industry is exploration spending. Exploration spending is essential in feeding the pipeline of next-generation mines, those that will be built to replace the ones that are depleting. And depletion is of course accelerated on higher production volume like we are seeing today. Faster-depleting reserves lead to more pressure on the replenishment front, which naturally leads to the need for more exploration spending. It’s a simple formula!
As one can imagine, gold’s secular bull has spawned a huge increase in exploration spending. According to prominent research house Metals Economics Group (MEG), gold exploration spending had seen a whopping 400%+ increase from its 2002 low to 2008 (~$3.2b). And though there was a huge dip in 2009 as a ripple effect of the global economic crisis, spending has been strong and on the rise ever since. But has it been enough?
Provocatively there’s an alarming trend unfolding on the exploration-spending front that is likely to have a major fundamental effect on the gold market. MEG points out that while exploration spending hasn’t declined, there’s an interesting shift in the types of projects attracting the capex.
It notes that over the last few years only about a third of exploration spending has been directed towards greenfield (early-stage/generative) exploration, with the majority going towards brownfield (near-mine) exploration. Even more troubling than this historically-low ratio is the fact that this industry-wide shift hasn’t resulted in a proportionate increase in assets advancing through the development pipeline. Typically in brownfield work the availability of infrastructure allows for fast-track development, yet we aren’t seeing this.
On one hand I can see why the miners have become more risk-averse considering the state of the global economy. It’s definitely less risky to prove up reserves where positive mining economics are known to exist. But this trend will have consequences on the reserve-renewal front.
While miners will occasionally make big discoveries via brownfield efforts, for the most part the biggest discovery in a brownfield zone has already been made. In general the major multi-million-ounce discoveries that this industry needs in order to effectively renew reserves are a product of greenfield exploration. And this brownfield bias has led to a lack of major discoveries.
Interestingly there are a couple different ways we can put this lack of major discoveries into context. First is some fascinating intelligence from MEG’s latest study on gold-reserves replacement. According to this study, there have been 99 gold discoveries of significance (deposits containing 2m+ ounces) since 1997. MEG added up all the reserves, resources, and production from these discoveries as of the end of 2011. And assuming a 75% resource conversion rate and 90% production recovery rate, the total sum only had the potential to replace 56% of the gold mined during this timeframe.
As MEG’s data clearly implies, gold discoveries are not even close to keeping pace with mine production. There are of course numerous factors contributing to this revelation. But the one that likely trumps them all is the simple fact that large gold deposits are getting harder and harder to find.
As gold’s scarcity rears its face, miners must expand their exploration efforts. They must drill deeper, venture to places with rougher terrains, and enter borders that may be hostile to their endeavors. These conditions are characteristic of greenfield exploration, and are obviously much more costly than brownfield work. And this cost differential perhaps explains why spending is not where it needs to be on the greenfield front.
Drilling down on MEG’s study even more, this 56% replacement rate is likely well on the high side considering some very liberal assumptions. Even MEG acknowledges that the viability of this discovered gold is subject to a lot of variables that could hamper its mineability.
Economics is of course the biggest variable. Many of these deposits are of low-enough grade or high-enough geological complexity that their higher extraction and/or processing costs require a much higher gold price to be economical. If the price of gold retreats much, these reserves/resources would quickly lose their economic viability.
Geopolitical risk is also a major variable. There are numerous amazing deposits that have been discovered over the last decade that will likely never be mined due to their location. Miners are constantly thwarted by deep-pocketed environmentalists, unruly locals, over-regulation, and greedy governments.
So you see even though 99 major discoveries seems like a lot over a period of 15 years, in actuality it is nowhere near what is needed to replace the gold that is being mined. And if the major deposits at best are only able to replace just over half of production, I can only imagine how many smaller deposits need to be discovered to fill the gap.
Speaking of gap fillers, this MEG research got me wondering more about the world’s gold deposits. Wouldn’t it be nice to have a better understanding of the asset base that supports current and future production? And wouldn’t it be nice to have some intelligence on the biggest tier of gap fillers, those in the 1m- to 2m-ounce range?
Thankfully our friends at Natural Resource Holdings were in this same wonderment. So CEO Roy Sebag and his team actually took to the task of compiling this information! After painstaking research that likely took thousands of hours, NRH now has the most comprehensive database of the world’s large gold mines and deposits that I have ever seen. And its 2012 ranking offers an invaluable fundamental read on the world’s asset base of gold deposits.
As part of its research NRH identified 439 deposits throughout the world that currently contain over 1m ounces of resources (all categories). And in looking at this data, I was smacked by the reality of how scarce this precious metal really is. Of the tens of billions of dollars being spent just to find gold, there are only 439 deposits of meaningful size on the planet to show for it!
Interestingly in scrubbing up with MEG’s data NRH identifies 312 deposits that hold 2m ounces or more, which tells us that over two-thirds of the world’s largest deposits had been discovered more than 15 years ago. And of these 312 deposits, provocatively only 150 are currently being mined.
On one hand it can be seen as encouraging that there is a large pipeline of undeveloped major deposits for future use. But on the other hand it can be seen as disturbing that there are so many deposits, especially numerous over 15 years old, that haven’t found their way to production in the current market environment. The fact is many of these deposits will never see the bottom side of a shovel, for reasons discussed above and more.
Of the world’s 127 gold deposits in the 1m- to 2m-ounce range, 39 are currently being mined. Again it is encouraging to see so much potential for the next generation of mines. But I’m afraid the same variables of uncertainty will again prevent many of these deposits from ever coming online.
This NRH data also allows me to put into perspective the relevance of deposits in this 1m- to 2m-ounce range. Interestingly these 127 deposits hold a combined 181m ounces of resources. If all of these resources were converted to mineable reserves with a 100% recovery rate, this would only be enough to cover just over two years’ worth of mine production.
And to put deposits of this size into even more perspective, consider their average annual run rates. To be very conservative, let’s assume that these deposits are able to produce an average of 150k ounces per year. In such a case the 39 operating mines would combine to contribute only 5.9m ounces, which is less that 7% of total mined volume each year. While this next tier of deposit size seems large, in the grand scheme of things they collectively only make a small dent in the total supply. And this realization clearly shows the need for major deposits.
Per NRH, of the major deposits 33 hold greater than 20m ounces (19 in production), 41 hold between 10m to 20m ounces (24 in production), 74 hold between 5m to 10m ounces (40 in production), and 164 hold between 2m to 5m ounces (68 in production). Though this provides the gold-mining industry with an inventory of 162 major undeveloped deposits that have the potential to replace production and reserves, it’s just not enough.
And to make matters worse, there’s another prevailing trend that doesn’t bode well for the structural integrity of the mined gold supply. With much higher input costs and uncertainty with the global economy, many miners have been holding off on the development of their major deposits. Even if these deposits are economically viable with high rates of return, lenders and investors are hesitant to fund the $1b+ it would take to build a decent-sized mine.
So circling back around, is the gold-mining industry healthy? Unfortunately if you peel away the excitement of record production in recent years, I’d say no. Gold discoveries are not keeping pace with mine production, exploration spending trends are not conducive to finding major deposits, the inventory of large-sized deposits is thin, and development capex is harder to come by. The future looks bleak for reserve renewal and ultimately sustaining current production levels.
So as investors, how can we apply this information to our investment strategies? First is these major structural issues offer huge support for gold’s long-term fundamentals. So long as the demand for gold stays strong, which it ought to, supply will be strained as the lack-of-major-discovery-spawned lower-reserve-renewal rate catches up with the gold miners. And this will keep gold prices high!
Gold stocks should also continue to be great tools to leverage gold’s strength. Most of the world’s largest producers are publicly traded. And according to MEG it is the big ones that are doing the best job replacing their reserves, with the top 26 producers (600k+ ounces in annual production each) collectively replacing 208% of their production over the last decade. But though this replacement rate is impressive, the larger gold stocks aren’t necessarily the best investments.
Interestingly only about half of these top-26 producers had actually made a major discovery over this timeframe. With a collective two-bagger replacement rate for the group, there are obviously some miners that made elephant-sized discoveries to cover more than their share. But to no surprise, a large chunk of this replacement was via acquisitions. With robust treasuries and easy access to credit, these major producers aren’t afraid to swing around their financial weight to get what they need.
From an investment perspective it isn’t actually the large slow-moving majors that offer the greatest returns, but rather the smaller mining companies that act as feedstock for the big boys. And the juniors especially offer huge potential considering their bias towards greenfield-style exploration. Some of the biggest and best major discoveries have come at the hands of the junior explorers.
Now if you’ve been at all attuned to the gold-stock sector, you know that juniors are in a tough place right now. Their stocks have been getting crushed with the rest of the commodities sector. And with a business model that relies on equity investment, their losses are way outsized. But as a critical component of the global gold supply chain, the majors simply couldn’t survive without them.
Juniors’ fortunes are bound to change soon as the gold-mining industry starts to realize its shortcomings. And because they are so beaten down, investors now have one of the best opportunities in gold’s bull to buy them for cheap.
The bottom line is the gold-mining industry has done a fine job rising to the challenge of increasing production in order to meet higher demand. But behind the curtains are some health issues that ultimately lead to a lack of fundamental support for the future of this industry.
The fact is major gold deposits are getting harder and harder to come by. And this is reflected by a global development pipeline that is woefully short of where it needs to be. Until exploration spending rises and the miners hit the hills for more greenfield discoveries, reserve renewal will continue to be a major challenge.
August 3, 2012