- Date Posted: November 26, 2020
- Research Reports
- Precious Metals & Macro Report
Disclaimer: The views expressed in this report are not financial advice. The mention of particular securities, funds or financial products is not a recommendation to buy or sell. The information provided is educational only and does not consider the personal objectives, circumstances or needs of the reader. The reader is advised to obtain professional financial advice before making any investment. All investments carry risks and have potential for losses. While all care is taken, no warranty is made in respect of the facts and figures in this report. We are not liable for any loss suffered by the reader with respect to their use of, or reliance on, any information contained in this report.
Precious Metals Charts
Despite being under some pressure in the lead up to the U.S. election, the gold price has been quite resilient. In the previous issue of this report, a number of possible support levels were shown all the way down to $1680. In reality, the price held at $1860 and now appears to have made a good double bottom there. After the result of the U.S. election became clear, gold surged above the key level of $1920 and appears heading to $2000 again.
Figure 1 – Gold price chart as of 7 November 2020The result of the election was never really likely to be a major long-term issue for the gold price. Neither side of politics will turn around the fiscal problems in the U.S. and monetary policy will continue to be supportive. Also, the split Congress probably means there will continue to be gridlock over major structural economic reforms. A Biden presidency may at least remove short-term tweet-generated noise from macro markets.
Figure 2 – Result long term irrelevant for gold price (Source: Forest For The Trees LLC)Over the last seven years, precious metals have tended to be weakest in the three months to early December, often finding a bottom there and moving well in January and February.
Figure 3 – Seasonal weakness often until early DecemberThe silver chart continues to mimic gold with the expected extra volatility. Price has regained the uptrend line since the March bottom but in the short term does appear slightly less bullish than the gold chart. There may still be some work needed to remove some of the excesses of the hyper-move in August when the price briefly reached US$30.
Figure 4 – Silver price chart as of 8 November 2020Commodities
One of the more interesting movements since the March COVID bottom has been in commodities. At the time of the March downturn, conventional market wisdom was that the demand destruction from limited economic activity would mean lower commodity prices. While that has been true for some commodities, such as oil, the vast majority have appreciated. In fact many commodities are now trading well above pre-COVID prices.
Of course the one thing linking all commodities is the currency they are priced in: the U.S. dollar. The action of the Federal Reserve to devalue the U.S. dollar has really overridden any preconceived demand destruction for commodities. And demand has actually stayed strong in many commodities for reasons that are not entirely clear. Government stimulus across the world and perhaps general boredom from being stuck at home may be propping up retail and creating perverse shortages in a whole range of items. Home renovation, electronics, bicycle riding and golf for example have seen massive increases in Australia at least. You can see this in the results being reported by local listed retailers.
The increase in demand is surely only temporary but the monetary devaluation is permanent (QE forever). This devaluation should continue to support commodity prices and particularly base metals.
Dr Copper
Copper is often used as the bellwether for the commodities space and for economic activity in general. The phrase ‘Dr Copper’ is used because it supposedly has a ‘PhD in economics’. The phrase is from a quaint time before markets were dominated by central banks and fiscal stimulus, and when commodity demand was linked to productive growth.
Copper can also be a signal for inflation expectations and right now the chart is very much signalling inflation is coming down the pipe. The copper price has spent six years in the doldrums below US$3.30/lb after peaking at US$4.50/lb in 2011. After the March spike low to US$2/lb a clear double bottom has formed on the long-term chart with the potential of strong upside if the price can break above US$3.30/lb.
Figure 5 – Copper price chart as of 8 November 2020The weak price environment of the last six years has meant a lack of supply from new projects coming into the market. Some incremental production growth is forecast from existing mines but the mega green-fields projects needed out past the next few years just aren’t there. Given the long lead time to develop a large project this situation is now ‘baked in’. If the copper price does start moving it will take years for supply to catch up meaning the prospects of a sustained bull market are good. This is similar to what happened in the early 2000s.
Figure 6 – 25-year copper price chart (Source: TradingEconomics.com)The broad situation for many of the other base metals is similar. Zinc and nickel have strong fundamental outlooks underpinned by a shortage of quality projects.
All of this is considering only the supply side of the equation. Demand for base metals is still a story of growth in developing markets (mainly China), but if the ‘green-tech’ story continues to play out with electric vehicles and the like it should also underpin demand for base metals in developed markets for many years.
Copper Miners
Given the rallying copper price some of the mining stocks have performed well over the last few months. One of the largest pure-play copper producers in the world is Freeport McMoran and its stock has doubled in the U.S. since June. Oz Minerals on the ASX, a medium-sized, pure play copper producer is up more than 60% over the same time period.
The speculative end of the market has seen some decent moves from developers/exploration plays like Hot Chili on the ASX (up >200% since June at the time of this report) and SolGold on the LSE (up a more modest 20% at the time of this report).
Most of the largest mining companies in the world such as BHP, Rio Tinto and Barrick have a decent amount of copper exposure in their portfolio but all have publicly signalled a desire to obtain more. These companies have a good look-through on the supply difficulties given they get to see the struggles of profitably mining and exploring on a daily basis.
Figure 7 – Copper miner and developer chart over last 6 monthsNote that this chart is shown for historical purposes only and is not a recommendation or prediction of price movement for any of the stocks mentioned.
M&A Activity Lights Up the ASX Gold Sector
On the 6th of October there was big news for the ASX gold mining sector with the announcement of a merger-of-equals between Northern Star Resources and Saracen Minerals. Both companies have grown in recent years to be the 2nd and 4th largest listed Australian producers, respectively. The proposed merger still needs to be voted on by Saracen shareholders with formalities expected to be sorted out by February 2021.
Northern Star will absorb Saracen, with Saracen shareholders offered 0.3763 NST shares for each SAR share held. This makes the transaction a ‘nil premium’ deal as the share conversion matched the company share prices the day before the deal was announced. This is similar to some of the other mega mergers in the gold sector like Barrick–Randgold in 2019.
The merger comes after each company bought a half of the Kalgoorlie KCGM (‘Super Pit’) assets at the beginning of 2020. Each company had been gushing in praise for the other during the year in presentations as they realised that their operational philosophies were quite similar.
The combined FY21 production guidance for the ‘MergeCo’ is 1.62 Moz making it the 8th largest producer in the world by output and 6th largest by market cap. This makes it a true ‘major’ world gold producer joining Newcrest on the ASX. (Majors are generally defined as having greater than 1Moz in annual production.)
Importantly, the combined entity will have all its production from ‘tier 1’ jurisdictions in Western Australia and Alaska. Many of the other major companies have at least partial production from riskier jurisdictions in Africa or the Pacific. In a time when many of the other majors do not have production growth, the MergeCo has also defined a path toward 2Moz over the next five years. This is from its existing assets only and ignores potential processing synergies from adjacent infrastructure in the WA Goldfields.
Figure 8 – Proposed NST–SAR merger puts combined entity into top-10 world producers (Source: NST)ASX Specs Retrace from Highs
Commenting on previous precious metals bull markets, many analysts have mentioned the cascading effect where money flows to the biggest companies first; then to mid-cap producers; then to the junior producers, developers and explorers. Gold also tends to outperform silver in the early stages of a bull market and silver then plays catch up. The general reason for the cascading effect is that the early investors sell some of their holdings and use the profits to buy other precious metals stocks whose share prices have not yet moved.
Mid-year, a wall of money hit the sector across the board and there was minimal cascading. If anything, the mid-caps and junior producers under-performed as money flowed to the more speculative end of the market. Many exploration companies had huge moves to the upside, increasing three- or four-fold within a few weeks on the back of excitement from the drill bit. Often a single high-grade intersection would be enough to get the market frothing. (Never mind that the intersection was narrow, deep and/or with insufficient adjacent hits to form a mineable resource.)
One common theme for these companies is that they do not have published feasibility studies or reserves to give the market a guide on potential project value. In fact, some have not even defined indicated resources. (Recall that the key difference between resources and reserves is that reserves require the consideration of economic extraction and the study of all enabling factors such as geological confidence, engineering, metallurgy, environmental and social.)
A pre-feasibility study (PFS) or Definitive Feasibility Study (DFS) will provide a sum of the discounted cash flows once in production and an estimate of the capital cost to build the mine. The output of this process is known as a net present value (NPV). Without an NPV, project value tends to be more subjective and the share price is more likely to be speculation-driven. Sometimes early stage valuation relies on rule-of-thumb ratios such as market cap per resource ounce, but these ratios can be misleading as the quality of resources varies significantly between companies.
Figure 9 – Selection of junior exploration plays on the ASX over last 6 monthsNote that this chart is shown for historical purposes only and is not a recommendation or prediction of price movement for any of the stocks mentioned.
Rising Costs of Australian Gold Producers
Given the price of gold in Australian dollars has moved from A$2150 to near A$2700/oz over the last 12 months, it is notable that the shares of some local gold producers (i.e. with majority of production in Australia), such as Regis Resources (RRL) or St Barbara Mining (SBM), are down on a 12-month basis. Investors often focus on the gold price expecting the miners to follow. Margin is ultimately the most important number in any business, and that means looking at costs not just revenue.
All-in Sustaining Cost (AISC) is an industry standard way to measure per ounce costs of gold production. (The methodology can be applied to other metals as well.) Importantly the AISC covers some of the capital cost of sustaining operations. Before ~2013 the industry standard was the ‘cash cost’ measure which was inconsistently applied across companies and a poor guide to actual profit margin. Ironically the AISC measure has somewhat gone the same way and larger producers are now using the ‘All In Cost’ (AIC) which is the most transparent and includes all costs the company incurs even green-fields exploration or expansion capital.
The AISC of the top-five local producers (excl. Newcrest) has generally increased by 20–50% in the last three years. There are a few factors behind this:
- General depletion of higher quality ounces with new production being lower grade or with higher stripping (waste to be moved to get to the ore).
- Some companies under-invested in exploration around existing operations
- A decision to prioritise growth in production (via acquisition) rather than focus as much on costs.
- Lower capital investment by companies in the gold market downturn of 2013–17 to maximise free cash flow and pay down debt.
Figure 10 – Rising costs for many Australian gold producers in recent yearsFrom a revenue standpoint, many ASX-listed gold producers still have legacy hedging arrangements at much lower gold prices. Hedging means they have committed to sell a certain number of ounces at a certain price and time.
Generally, the main ASX-listed producers are selling 20–35% of their gold into hedges (the latest quarterly report for each company lists hedging commitments). In the September 2020 quarter the five companies above had an average selling price for their gold of between A$2150/oz (SBM) and A$2500/oz (NST). New hedge commitments are not being added at the same rate as those being delivered into, meaning the overall hedging rates are coming down and companies have more exposure to spot prices.
Regis has a particularly low hedge still selling about 25% of production below A$1600/oz. That’s more than A$1000/oz it is missing out on, or millions in quarterly revenue. On the other hand, Northern Star has 13% of the next three years of forecast production hedged, the lowest of the group.
Outside of the mid-cap producers, West African Resources (WAF) and Medusa Mining (MML) on the ASX have no hedging commitments giving them full exposure to spot gold prices.
