Newsletter #123 06/28/2013
To invest successfully, investors must understand the value of an asset, and the total cost to produce or replace it.
The price of most assets is basically:
Price = total cost to produce/replace
plus the historical premium above total cost.
Historically, the average premium for gold has been about 112 percent above total cost.
Ten years ago, production cost was reported to be about $164 per ounce. However, the average total cost to produce gold has soared over the last decade, as low-cost mines have been depleted (and few new ones are being discovered).
Recently gold producers have re-analyzed all their costs. Using these new total cost models, the average total cost to produce gold for 2012 was about $1,104.
Therefore, gold’s target price today is about $2,340 ($1,104 average total production cost plus 112 percent average premium above total cost.)
Recommendation: Investors without a sufficient gold position should buy a quarter of total desired position now.
If the price dips to $1,320, you should add to your position. A dip below $1,170 (50 percent of the price target) is the time to go in with the balance of any gold position.
When gold was dropping last month, all forms of media were trotting out “experts” explaining why gold was falling, and how much further it could fall.
Some technical analysts (also known as “technicians”: analysts that focus on technical price charts) were helpful with their perspectives. Below is a long-term chart for gold.
A technician would look for support, where the selling stops and the buyers take over. Once support is broken, a sell signal occurs.
In gold, for about two years there was some support at the $1,500 level. The next support areas could also include round numbers like $1,300 or $1,100 or (especially) $1,000.
For the past few months, I’ve been writing in my weekly energy Updates about the likely prospect that oil and natural gas prices will rise during the summer.
There are two causes for this: the summer vacation driving season, and hurricane season.
According to American Express, 69% of Americans plan to travel this summer, up from 51% in the summer of 2010.
Vacation spending is expected to increase this summer. Spending has risen above pre-recession levels.
As families board airplanes or fill up their gas tanks to drive to vacation destinations, this demand will probably have upward pressure on prices.
The National Oceanic and Atmospheric Administration is predicting a 70% likelihood of 7 to 11 hurricanes during this year’s hurricane season.
Three to six of these hurricanes are expected to be major storms. This is higher activity than normal.
Some of these storms will probably head towards the Gulf of Mexico, where more than 20 percent of US energy supplies come from.
Here is a map that shows the drilling activity and infrastructure of the Gulf of Mexico.
The states of Texas and Louisiana have the most energy structures in the US because many areas of the country have NIMBY (Not In My Backyard) regulations and opposition. This important area is vulnerable to storms and hurricanes.
The little pink dots are the thousands of drilling rigs in the Gulf of Mexico.
The on and off shore blue veins are the pipelines that bring the oil and natural gas to the refiners and storage facilities that then transport through pipelines to the rest of the nation.
The green and purple dots onshore are natural gas and oil processing plants. The little purple boats are oil seaports.
When hurricanes slam through the Gulf, energy companies have to close offshore rigs and some processing plants onshore.
Hurricanes and storms do disrupt supplies from the Gulf, and they are a main cause of prices rising during many summers.
However, a better way to determine the support level for gold is to focus on the factors that historically have determined its price.
There are many variables that influence the price of gold:
For the better part of the past decade, gold’s price was driven up by fear of inflation, central bank money printing, and similar factors. These forces are by definition situational; although they can last for many years (and have done so), they won’t last forever.
Conversely, gold has several pricing factors that are permanent, because they’re inherent to gold itself. As with most physical assets, gold’s most important pricing factor is the total cost of production (or replacement).
This is an important point, so let’s discuss it further.
It’s very important for investors to understand the total cost to produce (or replace) an asset.
To illustrate this, here are three examples: oil, housing, and silver.
I have profitably recommended Berry Petroleum (symbol BRY) several times. Linn Energy recently made a bid to acquire BRY for $4.2 billion. BRY has about 134 million barrels of oil equivalent, so this bid works out to about $32 a barrel.
(This was a very good deal for Linn. In 2011 and 2008, acquisition costs were much higher—closer to $50 a barrel.)
The current price for domestic crude is about $93. Therefore, oil is being acquired at about one-third its price. Put another way, the price of oil is about three times the cost.
The National Association of Realtors calculates that the median cost of building a new home in the United States is around $181,300. (The range is from $80 to $110 per square foot.)
The average home price in the US is about $180,000, which is close to cost. There will probably be no home building in areas where houses are selling at or below total cost.
In the West and Northeast, the average home price is about $240,000. In areas like Orange County California, it’s around $600,000.
A recent article in the WSJ stated that the average cost to produce silver is about $9. The current price is about $22. Thus, silver’s price is about two times its cost.
When prices fall to break-even or below, producers will normally cut back on production, and switch to producing a different asset. When supply drops more than demand, prices will go back up, which gives producers the incentive to produce again. Let’s look at a few examples.
The cost to produce natural gas is anywhere from $1.50 to $4.00. When prices fell to the $2.00 level, producers cut back gas production and shifted to oil and natural gas liquids instead.
We can see this by looking at current rig counts. Baker Hughes (symbol BHI) keeps track of rigs all over the world. Here is a table from their website showing the decline of rigs used for drilling for natural gas:
We can see from the table that the rig count in the US for natural gas is down 240 rigs from last year, a 40% decline.
Notice that the rig count increased for oil; producers are switching from producing natural gas to oil.
Here is a price chart for natural gas:
When prices hit $2.00, energy companies cut back on production. As prices dropped, demand picked up (especially from utility companies) and prices have started to recover.
When the housing bubble popped, home prices fell more than what most analysts anticipated.
The following is a chart of housing starts:
Housing starts collapsed about 50% during the Great Recession. As housing prices fell, demand picked up, and housing starts have rebounded to pre-recession levels.
Here is a chart of the long-term housing price trend:
Housing prices bottomed in 2009. Prices and interest rates went low enough to attract buyers and investors.
Now investors have been buying up homes to rent out, and flippers are back to make quick profits, so there is a growing shortage of homes in key housing regions.
This has caused builders to start building again as demand picks up and prices are recovering.
During the financial crisis of 2008, oil prices collapsed to the cost of producing a barrel of oil.
Below is a table that shows the trend for OPEC production. (I focus on OPEC because it’s a cartel meant to influence oil prices.)
Total Oil Supply
(Average Thousand Barrels Per Day)
|United Arab Emirates||2,948.47||2,947.50||3,046.45||2,794.69||2,810.28||2,500.00||2,650.00|
Source: International Energy Agency
Let’s review the table:
The following chart shows the impact of production on prices:
Let’s review the chart:
When prices get too high, which causes the global economy to slow, OPEC has raised production to increase supply and lower prices.
The following chart is from my book, The New Bull Market in Gold, page 96.
From 1982 to 2000, gold basically traded from around $300 to $400.
On page 175 of my book, I provided the cost to produce gold for different precious metals companies. This table is shown below.
|Company Name||Market Cap (Mil. $)||Cash Cost ($/oz.)||
(millions of ounces)
|Anglo American PLC (ADR)||23271.49||203||72.30|
|Newmont Mining Corp.||11525.06||155||87.20|
|Barrick Gold Corp.||9858.98||177||86.90|
|Gold Fields Limited (ADR)||5867.43||183||79|
|Placer Dome Inc.||4893.7||195||52.90|
|Harmony Gold Mining Co.||2567.75||225||49|
|Kinross Gold Corp.||2190.31||220||13.20|
|Compania de Minas Buenaventura (ADR)||1793.03||180||1.10|
|Glamis Gold Ltd.||1489.34||170||5.70|
|Meridian Gold Inc.||1118.54||87||4.20|
|Randgold Resources Ltd. (ADR)||490.22||74||11.50|
|Hecla Mining Company||446.31||137||7.69|
|Eldorado Gold Corp.||367.80||230||5.80|
The highest cost producer was Eldorado Gold at $230, and the lowest cost producer was Randgold Resources at $74. The average production cost of these producers was about $164.
Let’s look at the price chart again, focusing on the period from 1982 to 2000:
Now let’s look at the above-cost premium at which gold traded. At $300, gold traded about 82% above the average production cost of $164. At $400, gold traded about 143% above the average production cost of gold. The average premium price above gold’s production cost is about 112%.
The best way to understand the price of gold is to calculate its production cost. As we saw previously, if producers can’t make a profit selling their gold, they will reduce or stop production, and supplies will drop.
Since I wrote my gold book in 2003, the precious metals industry has consolidated through mergers and acquisitions. As they get bigger, these companies expand their operations beyond gold production and include other precious metals and mining businesses.
Just as there are no pure oil exploration and production public companies, there are very few pure gold mining companies. It is difficult to determine the cost to produce gold for some diversified precious metals miners.
Another important recent development in the precious metals industry is the re-evaluation of their costs. For decades, precious metal companies were understating their costs.
Major gold producers and the World Gold Council are working on a standard for the industry that better represents the total cost of producing gold. The final standard is expected in the middle of this year. The biggest changes will include long-term costs like capital expenditures.
Below is the cost breakdown for Barrick Gold:
The total cash cost is $584 per ounce, but when they add all their other expenses, the cost climbs to $945 per ounce.
Here is another look at Barrick’s gold production cost, including a breakdown of its total cash costs:
Here are the total costs for Gold Corp, the lowest cost producer we analyzed:
Gold Corp’s total cost was $874 per ounce.
Here are the costs for Newmont Mining:
The total cost for Newmont to produce an ounce of gold is about $1,149.
I analyzed the total costs of producing gold for six precious metal companies (four large and two small). Below is the analysis:
|NEM||Newmont Mining Corp.||$1,149||US|
|ABX||Barrick Gold Corp.||$945||Canada|
|AU||Anglogold Ashanti||$1,259||S. Africa|
|RIC||Richmont Mines Inc.||$1,203||Canada|
The average cost of both small and large precious metals companies is $1,104 per ounce of gold. As expected, on average, smaller companies have a higher cost per ounce than large companies, but not by much.
Compare the total cost for gold in 2003 ($164) to the 2012 total cost ($1,104).
If we compare apple to apples and Barrick’s cash cost in 2003 of $177 to its 2012 cash cost of $584, we see an increase of about three times. This is much higher than the rate of inflation.
We’ve seen that whenever prices go below cost, producers will normally cut production until prices recover. Therefore, the breakeven point is good support for an asset’s price.
Can prices go below breakeven? Sure—but normally not for very long. Prices can also move above historical premiums.
We’ve also seen that the price of an asset is its cost to produce (or replace), plus a premium. For housing the premium can range from a small amount up to three times the cost. For silver it’s two to four times. For oil, the premium is normally about three times its cost.
If we add the historical premium, we can forecast price targets for gold:
The average total cost to produce gold is about $1,104, and this should act as price support.
If prices fell to the break-even price for gold producers, supply would decrease like we saw for houses, natural gas and oil.
Note that this is a moving target and has been moving higher (much greater than the global inflation rate) as costs have jumped.
As for demand, it comes from:
In general, investors need protection from the many financial risks in the global economy:
These and other factors should provide strong demand for gold in years to come.
Gold demand promises to remain strong. Meanwhile, gold’s cost of production provides a floor under prices, and historical premiums indicate a price target of $2,340.
Investors should use today’s lower prices to invest in gold or add to their gold positions.
James DiGeorgia, Editor
THE GOLD AND ENERGY ADVISOR
The GOLD AND ENERGY ADVISOR is a newsletter dedicated to educating investors about the investment opportunities in precious metals and energy. Unless otherwise stated, all charts, graphs, forecasts and indices published in the GOLD AND ENERGY ADVISOR are developed by the employees and independent consultants employed by Finest Known, LLC. The accuracy of the data used is deemed reliable but is not guaranteed. There’s no assurance that the past performance of these, or any other forecasts or recommendations in the newsletter, will be repeated in the future. The publisher, editor, and staff of this publication may hold positions in the securities, bullion, and rare coins discussed or recommended in this issue. The publisher, editor and staff are not registered investment advisers and do not purport to offer personalized investment related advice; the publisher, editor and staff do not determine the suitability of the advice and recommendations contained herein for any subscriber. Each person must separately determine whether such advice and recommendations are suitable and whether they fit within such person’s goals and portfolio. GOLD AND ENERGY ADVISOR is affiliated with Finest Known, LLC, a dealer in rare coins and bullion. Mining companies, oil & energy exploration and/or oil & energy service companies mentioned or recommended in GOLD AND ENERGY ADVISOR may have paid or may in the future pay the publisher a promotional fee.
The GOLD & ENERGY ADVISOR is published 12 times a year by Finest Known, LLC, 2424 North Federal Highway, Suite 401, Boca Raton, Florida 33431 (800-819-8693 or 561-750-2030). Subscription rates: Single issue, $19. One year (12 issues), $189. Two years (24 issues), $279.
© 2013 Finest Known, LLC. All rights are reserved. Permission to reprint materials from the GOLD & ENERGY ADVISOR is expressly prohibited without the prior written consent of Finest Known, LLC.
Copyright ©2022 Finest Known, LLC. All rights reserved.