Goldman Sachs is out with an in depth look at the latest volatility in the price of precious metals and how it impacts miners in Australia. They note that the volatility has hurt many miners who have already expanded and assumed Gold would be higher than current prices of $1367 an ounce. Below is the full report from Goldman on the impact this volatility has on Australia and its gold miners.
As a headline, we can understand the motivation of companies undertaking expansions to capitalize on increased resource and reserve tonnages which are bought about as commodity prices rise and enable lower cut off grades. So long as high (and trending higher) prices are realized, the benefits (in theory) should include:
- Increasing production (volume growth), which should lead to,
- Earnings growth,
- Additional free cash flow (depending on capital intensity of expansion),
- Lower unit cost rates as fixed costs are spread over larger volumes,
- Potentially life extension; and
- Overall higher NPV/DCF estimates of value.
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However, we would also observe the following “side-effects” of expansion:
- Higher cash costs (given it is largely a function of grade),
- Higher absolute costs (although should be offset by higher revenues),
- Typically higher D&A (to capture the additional capital),
- Execution risk of additional capital expansion (cost, time over runs),
And finally – in our view the most important …
- Lower returns (ROIC etc).
With commodity price momentum now decidedly moving downward, we highlight the resulting impact on those companies who have recently undergone expansions, and are now unfortunately more highly leveraged to volume and price than previously.
As a real world example, we compare KCN’s Chatree mine, which recently underwent an expansion, doubling the plant size, butlowering the head grade.
KCN Assumed Higher Gold Prices In Its Evaluation
What this summary shows us (Exhibit 1) is that in this instance, a plant expansion was justified as the company assumed higher gold prices in its evaluation of a potential expansion (as identified in its resources and reserve statements, by lifting the price assumption to US$1400/oz). Under this environment, the operation looks significantly more valuable at an expanded rate (16% better, than the base case under a higher gold price scenario), with volume clearly delivering additional free cash flow, even after the expansion cost.
However, if we were then to assume that prices fall back to US$1000/oz following the expansion, we can see that the resulting valuation is actually less favourable than the initial base case (-8%) and almost one third of the value of the higher gold price scenario at an expanded rate. Although we have simplified the inputs here for the sake of the discussion, we maintain that the principle remains valid whenever the cost of production (expressed in cash costs – which we know is a function of grade) increases.
Low-grading: everyone’s doing it….
The last decade has seen a prolonged period of rising commodity prices, which have been bought about through the dual phenomena of urbanization in developing economies (which has fuelled demand for metals) as well as declining supply as existing ore bodies draw to the end of previously expected mine lives. In the case of gold (where we see less fundamental demand logic, given it is typically not “consumed”), the destination as a safe haven in uncertain economic climates, as well as unprecedented fiscal stimulus by many countries has contributed to a continuous rise in the price, which only appears to be abating now.
With this rise in commodity prices, most companies have assumed higher input prices into resource and reserve estimates (Exhibit 2, 3), which in turn has lead (in many instances) to increased tonnages, often at a decreasing grade. The obvious step beyond this (assuming a larger resource base) is the expansion of existing plant and other infrastructure, which is intended to deliver a maximum NPV outcome – albeit at the expense of returns (which we will demonstrate later in the article).
While this is a natural progression through the cycle of commodity prices, our price deck forecasts generally lower prices next year than this, highlighting at least a temporary end to the continual rises we have seen for the last decade. With this in mind, we look to explore the impact of now declining prices on resource and reserve statements, and in particular those companies who are most exposed given their most recent published input assumptions.
Whilst the increase in price assumptions is legitimate, we are growing concerned about the impact within the sector if our near medium term forecasts of declining prices from here on come to fruition.
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