A Look At The Rigidity Of Silver Wheaton’s Cost Structure

SLW: Wheaton Precious Metals logo
SLW
Wheaton Precious Metals

Silver Wheaton (NYSE:SLW) is the pioneer of the precious metals streaming business. The company’s business model makes its costs predictable and largely fixed. Like companies involved in actual mining operations, this enables Silver Wheaton to profit from an increase in precious metals prices. However, since Silver Wheaton is not directly involved in mining operations and its costs are largely fixed, the company cannot rationalize costs in response to a fall in precious metals prices. When precious metals prices fall, unlike mining companies, Silver Wheaton is unable to reduce operating costs due to the nature of its business model. In this article, we will take a look at this aspect of Silver Wheaton’s business model and how it compares with conventional precious metals mining companies.

Silver Wheaton’s Business Model

Silver Wheaton signs long-term purchase agreements with mining companies producing silver or gold as a by-product. It provides funds for capital expenditure upfront when a project is being developed and obtains the right to buy precious metals produced at low, largely fixed prices. The silver or gold obtained at a fixed price is sold at market rates. The company does not pay for any ongoing capital or exploration costs at the mines. Such a business model greatly lowers its business risk, as compared to companies that are directly involved in mining.

The latest streaming agreement signed by the company is a convenient illustration of these aspects of the company’s business model. Silver Wheaton signed a streaming agreement with Vale in March for rights to 25% of the life of mine gold by-products produced at Vale’s Salobo copper mine. [1] The company made an upfront, one-time payment of $900 million to secure rights for the streaming agreement. In addition, the company will pay Vale the lesser of the prevailing market price or $400 per ounce of gold supplied under the streaming agreement, subject to 1% inflationary adjustment starting from 2017. [1]

After the signing of the streaming agreement, Silver Wheaton does not have to make any additional payments to sustain mining operations. Silver Wheaton’s purchase costs will rise at a predictable 1% over the course of its streaming agreement with Vale, which is the case for all of the company’s streaming agreements. The company’s purchase costs under its streaming agreements account for over 80% of its cash operating expenses. [2] Thus, though Silver Wheaton’s cash operating costs will rise at a predictable rate, these costs cannot be reduced in response to a fall in prices. This situation is unlike that for precious metal mining companies, which are actually in control of their operations.

Comparison with Precious Metal Mining Companies

Precious metals prices have fallen over the course of the last year, reacting to cues pertaining to the tapering of the Federal Reserve’s Quantitative Easing (QE) program. Gold as an investment is often viewed as a hedge against inflation and economic weakness. The tapering of QE implied strengthening U.S. economic growth, which reduced the investment demand for gold and led to a fall in prices of the metal. Further expectations of an interest rate hike are also weighing on gold prices. London PM Fix gold prices have averaged $1,206 per ounce so far in 2015, as compared to $1,266 per ounce in 2014. [3]

Gold Prices in 2015, Source: Kitco

As opposed to streaming companies, precious metal mining companies do rationalize their operating costs in response to a fall in precious metal prices. This is reflected in the all-in sustaining costs (AISC) metric for these companies. The AISC metric includes operating costs, sustaining capital expenditures, selling, general, and administrative costs, mine site exploration and evaluation costs, mine development expenditures, and environmental rehabilitation costs. It provides a comprehensive view of costs related to the company’s current mining operations. As a result of a combination of cost reduction initiatives and asset sales, Barrick Gold’s AISC for the full year 2014 stood at $864 per ounce of gold, around 6% lower as compared to the figure in the previous year. [4] Similarly, through a combination of cost reductions and asset sales, Newmont Mining reduced its AISC to $1,002 per ounce of gold in 2014, around 10% lower than in 2013. [5] These cost reductions better aligned these companies to a subdued pricing environment. In comparison, Silver Wheaton’s cash costs per ounce of silver sold stood at $4.14 in 2014, virtually at the same level as compared to $4.12 in 2013. [6] Since the company does not actually operate its own mining operations, it cannot reduce its operating costs.

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However, despite the relative rigidity of the streaming business model, it is inherently a higher margin business than the mining business. The level at which Silver Wheaton’s streaming agreements are priced ensures higher margins as compared to mining companies. Silver Wheaton’s EBITDA margin stood at 71% in 2014, as compared to 41% for Barrick Gold.

See our forecasts for margins for Silver Wheaton’s Penasquito mine

Further, cost reductions for mining companies are essentially incremental improvements in cost structures, such as workforce rationalizations or renegotiated supplier contracts. The scope for reduction in these costs is limited, considering long-term trends in rising labor and energy costs. Thus, though the streaming business model is inherently rigid, significantly higher margins as compared to the mining business, offset the impact of this disadvantage.

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Notes:
  1. Vale to sell a portion of the gold by-product stream from its Salobo copper mine, Vale News Release [] []
  2. Silver Wheaton’s 2014 20-F, SEC []
  3. Gold Price Chart, Kitco []
  4. Barrick Gold’s Q4 2014 Earnings Presentation, Barrick Gold Website []
  5. Newmont’s Q4 2014 Earnings Release, SEC []
  6. Silver Wheaton’s 2014 40-F, SEC []