Gold Production and Reserves
Scott Wright February 2, 2007 3784 Words
Nearly seven years into this mighty gold bull, it is important for investors to occasionally step back and revisit the fundamental nature of this secular uptrend. And though there are a myriad of fundamental drivers that build the case for gold, economics still reign superior.
The delicate balance of supply and demand is ultimately the driving force of all financial markets and serves critical to any market cycle for any tradable asset. This holds ever-so-true for the Ancient Metal of Kings.
Because gold not only serves a utilitarian purpose but crosses the boundaries of fiat influence, it is globally desired as a store of wealth and security. And global investment demand through such mediums as physical accumulation and ETFs is on the rise.
With demand on the rise supply has struggled to keep pace. And when demand chronically exceeds supply, an imbalance occurs which leads to the rising prices that are commonplace in a bull market. As the price of gold rises, there are natural forces that kick into gear to straighten out this imbalance.
The forces designed to correct an imbalance are quite simple. Rising prices encourage suppliers to increase their output, and rising prices also serve to quell demand. But for commodities, precious metals in particular, supply and even demand-side tendencies cannot change overnight.
Today I will focus on the supply side of gold. And since gold-mining output is the number-one supplier of gold to the market each year, the key factors that need to be considered are production and reserves.
Since gold mining is so pivotal to gold supply, this industry has captured increasing exposure among investors and speculators trying to capitalize on this strategic trend. And because of this, gold stocks have become the best vehicle for investors to catch this trend.
So in order for us investors to maintain a strategic investment perspective on gold-stock investing, it is healthy to exercise an occasional assessment of how this industry is faring not only through the eyes of some of the elite individual companies, the industry leaders, but the global aggregate.
Production: Since the process of mining gold is extremely capital- and time-intensive, supplying the markets and meeting demand has been a challenge all throughout history. And since mankinds lust and desire for this rare and precious metal is unwavering, people in all ranks of society have and will demand more and more of this beautiful metal.
And history can do a fine job illustrating gold’s supply crunch. For example, in 1900 when there were only about 1.6 billion people roaming the earth, a whopping 13 million ounces of gold was mined to meet demand. This equates to about 0.008 ounce per person on the planet mined that year.
It took about 65 years for the world’s population to double from there. During that time the global mined production of gold nearly quadrupled to a 1965 volume of 47 million ounces. This equates to a 75% increase in the per-person quantity of annual gold ounces mined.
And more gold per person makes sense as a number of studies have revealed that since 1800 per capita income has grown at a 50% faster rate than the population growth rate. So since wealth grows faster than the population, it makes sense that more people with more money want more gold.
Well in just the last six months or so the world population has achieved another double from 1965 to a global population of about 6.6 billion. And in 2006 mined gold supply is expected to come in at around 77 million ounces (using true production data provided by the World Gold Council and GFMS for the first three quarters of 2006 and projecting full year using simple average), which is an 18% decrease in annual gold ounces per person.
Is this decrease a supply dilemma, a demand dilemma or just a healthy balance? Confused yet? Now I know this is hardly a standard metric, comparing the world population with annual mined gold supply. But stick with me here because this does help paint a partial picture of what we may be faced with in the years to come.
It is indeed a fact that the world today is a lot wealthier than it was one hundred years ago. Vastly more money per person is floating around today than ever before. It is also a fact that over 60% of today’s global population resides in the fastest growing economic region of the world, Asia.
One hundred years ago the fractional gold demand that came from poverty-stricken and economically-weak Asia was from a handful of aristocrats that squandered the wealth of their nations. But today the 4 billion people in these growing economies, those taught by their parents to save big and store their wealth in gold, will command a sizeable share of today’s and tomorrow’s gold demand.
This long-repressed Asian populace will participate in a greater share of global wealth. And the Asians are not the only ones who will be plowing more money into gold. The Middle East petrodollars pouring in from this 21st century oil bull will also need to continue to find refuge. Middle Easterners are culturally attuned to gold investment and simply adore the shiny-yellow metal.
So as the world grows not only in population but industrially, technologically and economically, this wealth is and will be distributed among a portion of the world that has historically had little opportunity to buy gold. In fact, the per-capita growth rate mentioned above had very heavy weightings from the US and Europe with insignificant growth from Asia.
So as per-capita growth rates now rise faster driven by the Asian people, there could be a huge market impact on gold demand. To put this in perspective, people that earned say $500 per year in the expanding Asian economies can sustain a large year-over-year income growth rate for an extended period of time. Even if only a small fraction of this income growth transfers into gold investment, it will surely be felt. More gold per person will be demanded.
Now in order to meet growing global demand, mined supply must continue to rise. When the world reaches a population of 8 billion people, projected for 2025, just to sustain the 2006 per-person consumption of mined gold, over 93 million ounces will need to be mined. And if per-person demand rises as expected, even more ounces will need to be produced. These are lofty figures for the gold miners to achieve, and I suspect gold will need to be priced much higher in order for them to have a shot at this.
But as you can see in this trending decrease in gold mined per person in addition to a more recent trend as revealed in the chart below, there continues to be a structural problem with the mined supply of gold. A supply dilemma indeed seems to be driving the rising gold prices.
As indicated in blue, the global mined supply of gold has been falling in recent years. It is apparent that the producers tasked to bring gold to market have been greatly challenged. So with global gold production continuing its struggles from a macro perspective, economics dictate that investment opportunities still abound in the micro-scene among the gold miners.
If the supply side of a product is pinched, overweight demand drives up the unit price of the product. And who better to benefit from this situation than the suppliers, the gold producers/miners, that bring the metal to market. As the price of gold rises, positively leveraged gold producers should be well-positioned to earn great fortunes for their shareholders as they earn more money for their gold.
And there is no better measure to gauge the gold-mining industry than the elite miners that comprise the venerable HUI gold-stock index. Some of the biggest and best unhedged gold producers populate this index, and its 996% trough-to-peak gain gives it an incredible 5.4x leverage to gold’s 183% gain in this bull.
At Zeal we have traded in and out of various HUI components a number of times in this gold bull and these stocks have scored our newsletter subscribers outstanding gains. And as the price of gold continues to rise, the shares of these gold producers ought to continue to perform quite well.
And with the likelihood that we are still in the first half of a secular bull market in gold, the best gains may yet to be won. Even with the amazing gains we’ve seen thus far in the gold stocks, it is still a relatively unknown sector and has not yet begun to tap mainstream capital. Case-in-point, the 15 elite miners that comprise the HUI are responsible for 26% of global gold production yet have a combined market capitalization of only $91 billion.
The entire HUI market cap is about $60 billion lower than that of Google alone. At $604 gold (the daily average gold price for 2006), the $12 billion plus of revenues these miners brought to market last year will exceed even a double of Google’s 2005 revenues. If you think Google is growing fast, wait and see the growth of these gold producers when gold continues to catch its bids. With revenues and profits for the unhedged miners positively leveraged to gold, any rise in its price will greatly benefit their financials.
But even though the HUI components continue to slide up the scale and capture a greater portion of global gold production, the structural problem of overall global production declines cannot be ignored. Global gold production is down 7% since 2003! This is a bigger problem than most people realize.
Since gold demand isn’t likely to ever go away, the weight of this problem lies on the shoulders of the gold miners. So in order to once again achieve a market balance, gold producers will have to extract more gold from the ground until their supply can meet demand at a stable price.
This chart paints a picture of the slow-moving nature of this industry which provides ample reason for being in the midst of a bull market. But seven years into this bull, the supply and demand spread doesn’t appear to be closing. So with the price of gold more than doubling in recent years, why hasn’t gold production increased? Wouldn’t it behoove a gold producer to step up its production in order to take advantage of these higher prices?
Well in short, gold’s rare existence in nature plays a large contributing factor. This natural resource only has so many identifiable reserves housed within the earth’s crust. And the lead time in turning raw gold minerals within an ore body into a fine shiny ounce is significant. You can’t just speed up an assembly line or open a spigot to increase gold production.
And to further contribute to the problem, significant underinvestment in gold exploration in the 1990s places producers behind the curve for ramping up their output. During this time gold prices were low and the miners were forced to cut expenses, slash exploration budgets and cease production at unprofitable mines.
From discovery to production, it can take up to ten years to develop a producing gold mine! So today as existing and long-producing gold mines continue to deplete their resources with many shutting- or ramping-down production, a strong pipeline of replacement mines is just not there. New mines are not coming online quick enough to pick up the slack as is apparent in the chart above.
Thankfully producers are facing these handicaps head on, it’s just going to take time. With gold prices high, mining companies can now afford to explore for the next generation of gold mines. In fact, it is estimated that a record $7 billion was spent on gold exploration in 2006.
So as it is expected to take years for the gold miners to ramp up production and for the supply/demand imbalance to equalize, gold-stock investors would benefit greatly by using the HUI components as a guide for the entire industry. The charts in this essay should serve well to showcase the HUI’s growing global influence in the gold-mining sector.
Reserves: In order for gold miners to sustain, grow and secure their future production, they need to have a bank of reserves to pull from. The lifeblood of gold miners is their reserves. Because active mining works as a constant drawdown on the reserve base, these companies often feel like they are swimming against the current.
Since each ounce of gold extracted from the earth depletes an ounce from the reserve base, renewing and growing reserves stands as the most important business objective for any mining company. And since the market weighs mining life and reserve growth so heavily, there is constant pressure on these companies to skillfully manage their reserves.
In simple terms, gold reserves are defined as economically recoverable gold ounces. Most gold producers update their reserve figures at least annually. They are calculated through extensive technical studies conducted by highly-trained geologists. But even though a lot of “rock-jock speak” goes into the formula for proving reserves, existing market conditions probably play the most important role.
The most influential yet most variable component in the economic viability of in-ground gold is the price at which the metal is trading. The cost of extracting an ounce of gold and preparing it for market readiness is immense. So once gold is identified, it is typically accompanied by a feasibility study that has these costs forecasted at a semi-fixed rate. If mined gold can be sold for more than it costs to produce, then it is economically viable.
When researching gold producers you will find that reserves are measured by the ounce and by years of mining life remaining at current production rates. For example, if a gold miner is producing 250,000 ounces of gold per year and has 2 million ounces of gold reserves, then it has a mining life of approximately eight years.
But here is the challenge for the gold producers. If the miner in this example continues to draw off its reserves without replenishing them, not only will it quickly lose favor in the eyes of investors, but it will run out of gold in eight years and be dead. As mentioned earlier, it is of utmost importance for gold miners to maintain and grow the longevity of their companies. Investors must consider mining life in strategic context before they risk their hard-earned capital in these markets.
And a good gold company is adept at growing its reserves. Since the producers that comprise the HUI rank among the best in the business, I thought it prudent to update their reserve figures from the last time I penned an essay on this topic to see how they were doing.
By scouring the annual reports and websites of each HUI component, I was able to compile historical production and reserve data dating back to the beginning of this gold bull. This next chart displays this combined data for the HUI components along with the index’s effective average mining life.
The 2006 production data, also displayed in the first chart, is projected based on the latest guidance numbers that each of the HUI producers reported. And the 2006 reserve data is projected with a calculated growth rate based on historical data. I eagerly anticipate the full-year data from each of these companies that should be reported in the next couple months, but these projections should be relatively close to reality and should serve just fine for our purposes.
As you can see, the HUI has done an excellent job of not only renewing, but growing its reserves. Since 2000 the HUI has increased its production by just over 30%, but it has increased its reserves by an incredible 57%. This is a very healthy increase and should definitely catch the attention of investors.
Generally mature and top-tier gold producers maintain enough reserves to provide a mining life of about ten years or greater based on their current rate of production. As you can see, the HUI gold miners have averaged well over 15 years of mining life in this gold bull and have been steadily increasing this as reserve growth has outpaced production growth.
Now there are several different ways for gold miners to renew and grow their reserves. One common way to accomplish this is through organic growth, in which reserves are harvested from within a company’s existing portfolio of land holdings and projects.
Upgrading resource classes is a large part of organic growth and usually comes as the result of further technical studies within development-stage projects or through the expansion of an existing mine. Preliminary technical studies may identify mineral resources within an ore body, but resources are not proven to be economically feasible, or reserves, until more advanced and thorough studies are completed.
Higher gold prices play a large role in upgrading resources, because reserves are only reserves if they are economically recoverable. For example, three years ago it wasn’t economically feasible to recover gold if its costs were greater than about $400 per ounce. Now with $600+ gold, these resources that were not economical three years ago may in fact be economical today.
Organic growth occurs within gold companies that employ or contract top-notch geologists and explorationists. This is more important now than ever before as discovering gold has become increasingly difficult. The world is a lot smaller than it was one hundred years ago and those parts of the world that remain underexplored present increasingly-high barriers of entry.
Another popular path gold companies are taking to grow reserves, especially of recent, involves acquisitions. The M&A realm has been quite active in this industry with even the elite HUI gold miners entrenched in its dealings. Merrill Lynch recently reported that 2006 M&As in the gold-mining industry had a transaction value of greater than $19 billion, an all-time record, and triple that of 2003. So since reserves and hence mining life are so important for the viability of these companies, many miners deem it necessary to partake in the occasional acquisition in order to bolster their portfolios.
Some gold producers may not be high-caliber explorers, some may not have the land holdings and some reason that it is financially prudent to buy reserves rather than find them. Any way you look at it, reserve growth is instrumental and gold companies will do whatever they must in order to stay ahead of the competition.
But even though the HUI is experiencing remarkable reserve growth as its components try to position themselves to capitalize on this secular bull, an alarming trend has emerged when reserves are measured globally. This next chart reveals that global gold reserves are actually declining.
Interestingly, according the USGS, global reserves in 1980 were estimated at 1.13 billion ounces. As of the end of 2005, global reserves were estimated at 1.35 billion ounces. So in 25 years global reserves have grown by about 19%. Though not as impressive as the reserve growth rate of the HUI, it still equates to a global mining life of about 17 years.
This trend is not appealing though for the longevity of the industry. Throughout history reserve renewal has kept ahead of production. But with reserve growth down, supply pinched and demand rising, the future of the gold industry could get really interesting.
I am not usually an alarmist, but a lot of gold is going to need to be found in the years ahead in order to maintain this mining-life cushion. 17 years is not a long time and this whole situation really shows the importance of high gold prices in order to continue to support aggressive exploration and development across the industry.
The good news is the HUI miners are among a group of elite gold companies that are positioning themselves to take advantage of this continuing bull market. As a result of the aggressive reserve growth of these miners, the HUI portion of global reserves has jumped 75% since 2000 and is now host to nearly a third of the total global reserves.
Conclusion: With global production and reserve growth down and demand poised to perpetually rise in this growing global economy, the suppliers are going to have to kick it into gear in order to support the markets. And gold miners are not foolish. They understand the long-wave cyclical nature of the commodities markets and realize that this is not just a temporary problem.
This is why we are seeing an environment of aggressive exploration, mergers and acquisitions and ultimately rising gold prices. It is going to take many years for the gold mining industry to noticeably increase supply as it continues to explore, discover, develop and construct gold mines. The gold producers should greatly capitalize on this trend.
And it is not too late to take advantage of this gold bull. The elite miners of the HUI are poised to lead the way as they ramp up their production and reserves, but they are not the only gold companies positioning themselves for success. Hundreds of gold companies are jockeying for investor attention and capital.
There are gold companies of all sizes, from junior to mid-tier to major producers in addition to the highly speculative junior explorers that play such an important role in the gold cycle. I recently published a research report profiling Zeal’s favorite junior gold stocks that are poised to make an impact on the near future of the gold-mining industry. This report is available now for purchase on our website.
At Zeal we have been bullish on gold since its bull market began at the turn of the century and we are just as bullish today as we were back then. In the February issue of our monthly Zeal Intelligence newsletter just published, we provide our subscribers several new gold-stock trade recommendations as we ready ourselves for the next gold upleg. Please subscribe today if you are interested in cutting-edge commodities-market analysis and stock picks.
The bottom line is gold supply is not going in the right direction to support demand as seen by the recent global production and reserve trends. The mining production is struggling to bring enough gold to market and the companies that are tasked with this responsibility have incredible upside exposure to rising gold.
As the price of gold rises, gold miners are in line to greatly profit on the sale of their goods. As a result, the gold-stock sector should remain one of the strongest market sectors in the next decade or so. Once mainstream interest and capital starts to flow into the gold stocks, prudent investors that were already deployed should be in for a wild ride.
Scott Wright February 2, 2007 Subscribe at www.zealllc.com/subscribe.htm