TORONTO (miningweekly.com) – Following the recent announcement by the Chinese central bank of a seemingly underwhelming 57% increase in gold reserves, the gold price plunged to below the psychologically important $1 100/oz level, during a broader commodities sell-off.

A new report by commercial intelligence firm Wood Mackenzie (Woodmac) suggests that these price levels put about 10% of gold miners in lossmaking territory on a total cash cost plus sustaining capital expenditures basis.

However, this week's gold price drop only exacerbated a trend that gold miners had been dealing with for some time, as highlighted by Woodmac in a new analysis of the divergences observed across the relative valuations of gold and copper miners.

In its report ‘Value creation in the mining sector: a long-term divergence between copper and gold producers,' Woodmac revealed that, in 2000, gold miners commanded a 50% market premium over copper miners. But following a decade of generally poor capital allocation, cumulative net losses and poor shareholder returns, by June this year, the market priced the gold mining sector at just a fraction above its net tangible worth.

In contrast, at the same juncture, copper miners commanded a 25% premium over gold miners on a price-to-net worth basis, somewhat surprising given the broad sell-off in base metals mining equities from their peaks back in 2011.

Woodmac senior research analyst for copper mine costs Dr Ryan Cochrane explained that copper miners had generally enjoyed higher operational and residual cash flow margins than gold miners despite copper prices underperforming gold prices over the past 14 years.

“Relatively pure-play copper miners outperformed the copper price, with share prices rising at an annualised rate of 10%, excluding dividends, over the same period – an outstanding result considering the losses since the 2011 bear market began,” he said.

Woodmac highlighted that, in contrast, ten of the largest gold miners significantly underperformed the gold price, with share prices rising by just 1.4% a year since 2000.

The analysis showed that the average dividend yield for a selected copper mining population was 4% over the 14-year period, compared with 1% for selected gold miners.

According to Woodmac, a significant factor was the approach and success of capital allocation, resulting in the copper mining segment growing its net worth per share at a much faster rate than that seen in gold mining.

"For copper miners, a conservative managerial approach of capital allocation meant that project development was financed largely through internal cash flow, while equity and debt financing was used relatively sparingly. Gold miners, however, aggressively pursued production growth and hedged significant portions of their production at relatively low gold prices, effectively missing large portions of the gold market bull run,” Cochrane said.

He added that the gold industry’s quest for production growth – especially in the latter portions of the bull market – meant that many gold miners developed increasingly marginal projects and paid excessive premiums for acquisition-driven production growth through the extensive use of debt and highly dilutive equity financing.

Woodmac believed that gold mining companies maintaining large dividend payments despite recording cumulative net losses over the period, with payouts funded partly through external financing, had compounded this.

LOOKING AHEAD
Significant challenges remained, with Cochrane pointing out that interest rate hikes and a generally bearish metal price outlook were likely to outweigh short-term mining cost savings made possible by the stronger dollar, the lower prices of key input commodities and active steps by management such as high grading reserves.

"Further, most of the current projects in the gold mining pipeline were evaluated on the basis of prices above $1 200/oz and the fall in prices to $1 100/oz will result in a significant cut in future supply. We estimate that nearly 40% of project production capability is uneconomic at current prices,” Cochrane said.

Against this challenging backdrop, Woodmac said producers had reacted by implementing a number of value-realisation measures. These included only developing projects that met stricter (10% to 15% internal rate of return) hurdle rates throughout the metal price cycle; slashed capital expenditure budgets; and active cost cutting to free up cash flow in the metal price downturn.

With this approach and despite the challenges outlined, the gold sector might be poised to start performing more in line with the historically more successful copper sector.

"With major gold miners struggling to replace reserves, production may begin to decline and higher prices will be required to justify the next round of large capital expenditures. Meanwhile, within the copper sector, producers remain committed in their drive to divest noncore assets, slash expansion capital expenditure and free up cash flow to return to shareholders,” Cochrane said.