Falling Gold Prices Take The Shine Off Mining Majors

The last few days have been extraordinary for the gold market. The price has plunged dramatically and the panic generated in the market is leading to yet higher selling and lower prices. Gold prices plummeted by $204 or 13% per ounce over Friday and Monday, the biggest percentage drop witnessed since 1980.

This phenomenon cannot be explained by a single event. In this article, we take a look at the factors driving the gold market, the expected future outlook and most importantly, the impact on major gold mining companies like Barrick Gold Corporation‘s (NYSE:ABX) and Newmont Mining (NYSE:NEM). ^[1]

See full analysis for Barrick Gold Here | Newmont here

Factors Responsible For Crashing Gold Prices

1) Federal Reserve Bank’s Monetary Policy

The Federal Reserve Bank has been purchasing $85 billion worth of Treasury securities and mortgage-backed securities since the start of the year as part of its Quantitative Easing (QE) policy. Based on the minutes available of the Federal Open Market Committee (FOMC) meetings, there are fears that the bank may stop its purchasing program well before the end of 2013. This isn’t great news for gold prices because investors buy gold as a hedge against inflation that is expected to result from the monetary stimulus program. ^[2]

2) European Economic Woes

The market is abuzz with rumors that as part of the $13 billion bailout deal, Cyprus will have to sell gold worth 400 million euros (about $522 million) in order to raise funds. While this translates to just about 10 tonnes of gold at current market prices, the larger fear is that going forward, other troubled euro zone countries like Italy, Portugal and Spain may be asked to do the same as part of their bailout deals. These countries will need much larger bailout packages and will therefore be asked to sell a much higher quantity, potentially flooding the market with gold. ^[3]

3) Inflation Data

According to JPMorgan Chase’s global consumer price index, which covers more than 30 countries that collectively represent more than 90% of the global economic output, inflation is falling. According to this index, global inflation peaked at 4% in 2011 and has been steadily falling since then to reach the current value of 2.5%. The Consumer Price Index declined by 0.2% and the Producer Price Index declined by 0.6% in March on a year-over-year basis. JPMorgan Chase claims that low inflation is partly a result of easing of supply side constraints and partly due to slowing demand growth in the economy. Inflation expectations for the rest of the year are quite low. ^[4]

Low inflation expectations tend to reduce the demand for gold which is seen by investors as a hedge against inflation.

4) Slowing Chinese Growth

China reported a Gross Domestic Product (GDP) growth rate of 7.7% in Q1 2013, which was much lower than market estimates and the previous quarter’s figure of 7.9%. This belied the belief that the Chinese growth rate had bottomed out last quarter and would only go up in the future. As a result, the prices of commodities, including gold, took a further beating and are expected to slide further.

How Much Does It Cost Miners To Produce Gold?

The cost of production has been rising rapidly due to a combination of lower grade ores and increased finding costs and compliance and remediation costs.

In 2012, Newmont reported an all-in sustaining cash cost of $1,149 per ounce of gold produced. The figure in 2013 is expected to remain flat compared to 2012 levels despite a roughly 5% expected increase in cost applicable to sales (CAS) due to inflation and the impact of lower grades of ore. The company aims to achieve this by reducing its combined general and administrative costs, exploration cost, advance project cost and sustaining capital expenditures by approximately 15% to 20% compared with 2012. Thus, there is minimal scope for further cost reduction below this level in response to falling prices. ((Newmont Mining Q4 2012 Earnings Presentation, Newmont Mining))

In 2012, Barrick reported an all-in sustaining cash cost of $945 per ounce of gold produced, up from $745 per ounce in 2011. The figure in 2013 is expected to be around $1,000-1,100 per ounce. The profit figures are likely to be hit hard given that the company has assumed an average price of $1,700 per ounce for 2013. ^[5]

How The Latest Trend Will Impact Gold Mining Companies

The tumbling gold prices have major implications for financials of mining companies. Although lower prices are not likely to wipe out the companies’ profits, free cash flows may come under severe pressure if they don’t scale down their capital spending commitments drastically.

Most of the big mining companies are struggling with acquisitions made at steep prices which have made investors wary. In response, mining companies have vowed to control costs and focus on shareholder returns instead of growth. In the present pricing environment, looking at the investor sentiment, most companies are likely to focus on positive free cash flow generation.

If prices keep plunging, rating downgrades are feared for Barrick Gold and Newmont Mining. A tight cash flow situation would need companies to raise more debt for capital spending and a rating downgrade would make raising debt costlier. In such a case, companies would be better off deferring projects. ^[6]

If prices drop below $1,200 per ounce, companies may have to shutter high cost mines and slash dividends. ^[7]

Is There A Silver Lining For The Miners?

Investors seem to be of the belief that the U.S. economic recovery is sustainable. The optimism may well be overdone given that the latest job data released by the Labor Department suggests that the number of jobs created in March was the lowest in nine months. The U.S. added a seasonally adjusted 88,000 jobs, which represents the smallest increase since last June. Also, nearly 500,000 people stopped looking for work last month. Hence, while the unemployment rate fell to 7.6% from 7.7% and marked the lowest level since December 2007, this was largely due to the participation rate falling to 63.3%, the lowest since 1979. ^[8]

This data suggests that the economy may slow down again in the middle of the year, as witnessed in 2011 and 2012. The Federal Reserve may thus decide to prolong its bond buying program to keep interest rates low in order to boost the economy. This may again fuel inflationary expectations, sending investors running back to gold and pushing up prices.

Our price estimate for Barrick Gold is $26 and that for Newmont is $41.

Understand How A Company’s Products Impact Its Stock at Trefis

1. Plummeting gold hits Barrick, Einhorn, Paul & Paulson, MineWeb [↩]
2. Gold Prices Drop 3.3% After Fed Minutes Suggest Quantitative Easing Could Cease “Well Before” End of Year – 4 January 2013, BullionVault [↩]
3. Gold Is Crashing…And The Storm Begins, Seeking Alpha [↩]
4. The Price of Gold Is Crashing. Here’s Why, Bloomberg Businessweek [↩]
5. Barrick Gold Q4 2012 Report, Barrick Gold [↩]
6. Gold miners face new challenge in plummeting gold price, Reuters [↩]
7. Serious financial risk for gold miners, Financial Post [↩]
8. U.S. jobs gain in March lowest in 9 months, MarketWatch [↩]