Wednesday, August 8, 2007 0 comments ++[ CLICK TO COMMENT ]++

Leverage with high-cost gold producers

One of the most counter-intuitive things with gold mining companies is that, if you are bullish on the price of gold, high-cost producers can potentially result in greater increases in profits. High-cost producer leverage is somewhat similar to debt leverage for a typical business.

The spreadsheet below shows an example of a high-cost producer (I picked Harmony's 2007 cash cost estimate from HSBC) versus a low-cost producer (Goldcorp's 2007 estimated cash costs). I am simply picking 1 million ounces of production (that's not the actual production by these companies).

When gold goes from $600 to $700, it increases by 16.7%. GG's profit increases by 27.3%, while HMY's profit increases by 45.9%. Similarly from $700 to $800, gold increases by 14.3%, while GG is 21.5% and HMY is 31.4%.

So, for the same amount of increase in the gold price, the profit on the high cost producer increases much more than with a low cost producer. The low cost producer will still make a higher gross profit for all gold prices. But the increases (or decreases if gold dropped) will be far larger for the high-cost producer.

But high-cost producers are no free lunch. If the gold price declines or doesn't go up (if the price doesn't go up, I would assume that the market has priced in the current price into the stock price), they will suffer much more (just like how companies with higher debt suffer more if sales decline).

So, low cost miners are the safe ones. If gold does not rise or goes flat, they will do better. But if you are superbullish on gold or are a speculator then high-cost producers should yield greater results.

If someone is looking for high-cost producers, one needs to look no further than the South African gold producers. These companies tend to have high labour costs, extremely deep mines (open-pit or shallow shafts have lower costs), and low grades (this depends though). Another area to look for high-cost producers are junior production companies with marginal assets.

I am not bullish on the gold sector right now but I've been looking at Harmony (HMY) since it has sold off lately (CEO resigned; future guidance lowered; higher than expected costs). It is a large-cap (5th largest gold producer in the world) so it isn't going to move as much as the juniors but there is no exploration risk.

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