The ‘production cliff’ becomes reality for gold
Plunging prices, political risks and debt hammer senior miners. But it’s not necessarily all bad news
When Steve Parsons and his colleagues published their first report on the gold “production cliff ” in early 2013, they thought the thesis was obvious, even though almost no one was talking about it.
“It’s not a matter of if or even when the production cliff will happen,” the National Bank analyst said in an interview this week. “It’s really a matter of how companies respond.”
Gold miners hardly ever spoke up on this issue over the last several years. It may be that they didn’t agree with the conclusion, or perhaps they just didn’t want to think too hard about the implications. But there’s no avoiding it now.
Parsons’ thesis, in short, is that global gold production is set to fall in a big way. He calls it the “production cliff ” while Goldcorp Inc. and others call it “peak gold,” but it amounts to the same thing.
The cliff appears to be imminent. According to numerous professional estimates, gold output will top out in 2015 or 2016 and then go into decline for several years at least. Using consensus figures, Goldcorp estimates that global production will drop six per cent in the next three years, and almost 18 per cent in the next nine years.
This may seem mind-boggling to the casual investor who watched hundreds of gold companies pop out of the woodwork during the bull market from 2000 to 2011. But it speaks to the numerous challenges facing the sector. There has been a shortage of new discoveries in the past decade, leaving the industry’s pipeline relatively bare. At the same time, companies have been deferring or cancelling projects because the execution risk is just too high. That is due to soaring construction and operating costs, political risk, permitting challenges and numerous other factors.
And of course, gold prices have plunged almost 40 per cent in the past three years. That accelerated the move to the production cliff because miners have been forced to shelve many big projects. They have also focused on higher-grade ores at their mines, which means their reserves and mine lives are shrinking fast.
The production cliff puts the senior gold miners in a precarious position. The notso-secret problem with these firms is that their current production rates are not sustainable for very long. They have a couple of uncomfortable options: let production decline, or go on an acquisition frenzy to fill up their project pipelines. And those options are complicated by the excessive debts that many of them are carrying.
Two of the miners at the forefront of these challenges are Toronto-based Barrick Gold Corp. and Kinross Gold Corp.
Five years ago, Barrick predicted that it could reach nine million ounces of gold production a year and remain at that level for a sustained period. It never came close. The company expects to produce 6.1 to 6.4 million ounces this year, and analysts have warned it is poised for a steep decline after that. J.P. Morgan analyst John Bridges said production could sink to 4.5 million ounces by 2020. In the long term, he thinks a sustainable level for the company is around three to four million ounces.
The situation at Kinross is similar: gold production is set to plunge about 50 per cent over the next five years, according to Greg Barnes of TD Securities. Kinross thought the enormous Tasiast expan- sion project would fill its production pipeline, but it was put on ice this year because of weak gold prices.
Kinross has been looking for acquisitions to fill out its pipeline. But not everyone thinks that is the best course of action. Given the production cliff and the other constraints in the industry, Parsons thinks Barrick and Kinross are too big and should get smaller. “When you get over 2.5 million ounces, which is Kinross’s size, it is clearly very tough to grow, and do it in jurisdictions where investors like to be,” he said.
Going forward, he thinks a sustainable production level for a gold miner is around 1.5 million ounces a year. If you go beyond that, you have to move into risky jurisdictions, you end up owning low-quality assets, and you have to frequently buy new assets to fill up the pipeline. That often means you dilute shareholders, lever up your balance sheet or both. Barrick is the apotheosis of all those problems.
“You can produce 1.5 million ounces a year and still have a concentrated portfolio of assets,” Parsons said. “I think that’s a manageable level for which investors would still be willing to pay a premium.”
He pointed to Agnico Eagle Mines Ltd. as a company in that sweet spot. Agnico produces 1.6 million ounces and has a big concentration of assets in miningfriendly Quebec. Not surprisingly, the firm enjoys a very high valuation compared to most of its peers.
If the senior gold miners do continue to shrink amid the production cliff, it is not necessarily a bad thing. Gold companies got much too big last decade because investors wanted them to grow production at almost any cost. Today, the focus is on profitability rather than growth. And if that means output continues to nosedive, most companies and investors do not seem to have a problem with it.
“They have no choice. It’s market dynamics,” said Paolo Lostritto, who co-authored the first “production cliff ” report with Parsons and is now a consultant with Red Cloud Mining Capital.
Ultimately, the production cliff may be just what the gold sector needs. Lower supply could translate into higher prices, which would encourage new mines and ultimately drive production back up again.
More companies are finally starting to talk about this issue. Goldcorp, for instance, has been using a “peak gold” chart in its recent investor presentations because it sees the trend as bullish for prices.
But even if that’s correct, the “peak gold” chart reinforces just how challenging it will be for Goldcorp to maintain its current production (about 3.5 million ounces a year) over the long term, never mind increase it. The production cliff brings real opportunity for the gold industry, but if history is any indicator, every opportunity in this sector comes with thousands of pitfalls.