EDITORIAL & OPINION — Gold’s survival not in doubt — Living on the hedge

Numbers don’t lie, they say, unless politicians perform some sort of black magic on them first. That being the case, the numbers underpinning the gold mining industry tell a grim story that may get a whole lot grimmer, particularly for producers living, as it were, “on the hedge.”

The math in this case is elementary. Break-even costs in the North American gold mining industry averaged US$316 per ounce last year, versus an average spot price of US$294 per ounce. The only silver lining in this dark cloud is that break-even costs were even higher in 1997, at US$346 per ounce.

While gold prices have been falling almost as fast as sky-diver Michael de Guzman, some investors find comfort in seeing their favourite producers

slashing cash costs to well below the spot price. If the past year has been about anything, it has been about cost-cutting and optimization programs, about shutting down high-cost mines and building only low-cost ones.

Research reports show that North American producers did a reasonable job too, reducing cash costs to US$185 last year from an average of US$235 in

1996. Set against an average gold price of US$294 per ounce last year, things didn’t look too bad.

But as every sophisticated investor knows, cash costs, low or otherwise, don’t tell the whole story. Total production costs matter more, a great deal more. In 1996, total production costs for North American producers averaged US$306, set against an average gold price of US$401 per ounce. Last year, they averaged US$257 per ounce.

But total costs don’t tell the full story either. Companies have to explore to find new reserves. They must pay a range of mining and income taxes. They have general and administrative costs beyond that of their mine sites. These “total other costs” can add US$50 or more to the overall cost of finding, mining and selling an ounce of gold.

And that brings us back to break-even costs. After examining North America’s senior and mid-tier producers, First Marathon Securities’ research team found that only one senior had break-even costs below the spot gold price last year (owing more to the tax benefits of a writedown than anything else). The seniors’ average break-even cost was US$307 per ounce, compared with an average of US$346 in the mid-tier group.

However, hedge books allowed six companies to report positive earnings last year, with Barrick Gold reaping an US$89-per-ounce benefit from its innovative hedging program. Obtaining such gains is far more difficult for the mid-tier producers, which typically don’t have the financial clout and expertise to play in the same leagues as the big boys. Some producers don’t hedge at all, while others are reluctant to get into the game at these prices.

This year’s story isn’t over yet, but it’s a safe bet the numbers will be ugly — really ugly, if the current spot price is any indication. The top few senior producers have room to maneuver, owing to their sophisticated hedging programs, but others will have difficulty surviving if prices

remain below US$300 per ounce.

Low gold prices have already taken their toll on high-cost producers with heavy debt burdens, two recent examples being Pegasus Gold and Royal Oak Mines. Other corporate casualties are expected this year.

New mine projects have been pushed to the back burner, or taken off the stove altogether. Older, higher-cost mines are being shut down permanently, or put in mothballs pending higher prices. Mid-tier producers will have

an even tougher time competing with the seniors, which are currently developing a new generation of mines with cash costs below US$100 per ounce.

Gold is a metal in transition, as are the companies producing it. Living on the hedge isn’t sustainable over the long term, and, if present trends

continue, expect to see a lot fewer companies in the gold game at the start of the next century.

But at some point, something has to give. Gold may be nobody’s darling these days — particularly among central bankers — but it has industrial, monetary and romantic uses that should ensure its survival into the next century. It has endured for many millennia, serving as a buttress in a world of change and uncertainty.

That’s what gold does best. It endures. It will this time too.