Should Investors be Discouraged by Cost Inflation?

By Michelle Smith | May 9, 2012 5:00 PM IST

By Michelle Smith — Exclusive to

While gold miners have been seeing record revenues as a result of high gold prices, they are also seeing the costs of looking for the metal, pulling it out of the ground, and bringing it to market increase each year. During this time, gold miners’ stock prices have failed to keep pace with gold prices and many have wondered why. Could rising costs be a discouraging factor for investors? If so, should they be?

Mining companies have perceived strikes against them, says a report from PricewaterhouseCoopers (PwC). And one of those strikes is escalating costs.

According to Wiktor Bielski, Managing Director and Global Head of Commodities Research at VTB Capital, cost inflation for miners last year was in the range of 10 to 15 percent. For gold miners, it was about 20 percent. And he says similar rates are expected again this year.

Why costs are rising

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Thompson Creek Metals Company (NYSE:TC,TSX:TCM) has a development project underway at its Mt. Milligan copper and gold mine and a recapitalization and expansion project at its Endako molybdenum mine. In a Motley Fool interview, CEO Kevin Loughrey identified containing cash costs as the company’s greatest challenge with regard to both of these projects. And he cited labor as a significant factor in that challenge.

Gold miners at all levels are under pressure to pay more for labor. There are a number of reasons why. To begin with, workers are demanding more. As the price of gold surges, PwC says workers are pushing for higher wages, job security, and better benefits.

Failing to comply with wage demands can be costly for companies as it can lead to strikes which in turn can cause lost production. In 2011, AngloGold Ashanti (NYSE:AU) reportedly lost 45,000 oz of production during a strike. Many people fail to realize that there can also be significant additional costs associated with the shut down and start up of mines.

Furthermore, gold miners need to pay more for labor to attract skilled workers. Shortages of skilled labor are becoming more problematic and are even affecting major players such as Barrick Gold (NYSE:ABX,TSX:ABX). Companies are aware that many individuals with the ability to choose won’t select gold mining as their first career choice. Thus, the competition in the labor market and the need to provide incentives is driving up costs.

There is also a growing trend of governments looking to extract more money from their resources. Miners are finding that the costs of corporate social responsibility programs are growing. For example, costs such as licensing and permitting fees are rising in some places, and tax increases or new taxes are also being implemented or considered.

Meanwhile, the business of mining gold is becoming more difficult.

Last year, GFMS reported a 30 percent decline in average mine grades since 1999.

Just as high prices have allowed miners to pursue more low-grade projects than they otherwise would, some miners have been able to continue mining despite falling grades. Still, this situation means that companies in either case have to process increasing amounts of ore to boost or even sustain their production levels, which pushes up costs.

Bielski pointed out that for some gold miners, the processes are becoming more complex. Thus companies are required to spend more on processing and on materials such as acids and reagents.

“Environmental costs are also going up all the time,” he said. “These days you can’t allow dust to blow about. You have to build sound shields around mines. You have to make sure the water goes back into the ground cleaner than you got it out of the ground. Every day almost there’s new environmental costs these miners have to cope with.”

Following a long period of underinvestment by many gold miners, stricter safety standards are also now forcing companies to invest more in their operations.

Underinvestment means that for a long time gold miners weren’t putting money into new projects. Now, many are trying to increase their exploration and development efforts while metal prices are supportive, but cost inflation is also cranking up these price tags.

When asked about Kinross Gold‘s (NYSE:KGC) decision to delay its growth initiatives in order to reassess capital cost structures, Loughrey said that is going to happen more, and the trend will not end anytime soon. “We are living in a world where mining projects are expensive to build, and getting more expensive,” he said.

The market “seems to have penalized companies for the rising costs associated with lengthening the life of a mine operation,” Frank Holmes, CEO of US Global Investors, told Barron’s. But, he argues that though costs have increased, profit margins are the true gauge of a company’s value, and margins have grown by an average of 25 percent, offsetting costs.

Holmes is not a lone holder of the opinion that despite rising costs, gold mining companies are still of value. Some even suggest that rising costs are good for the sector based on the assumption that those costs place a floor of support beneath gold prices.

The average all-in cost for gold miners in 2011 rose by 22 percent year on year to $1,044/oz according to GFMS. Gold prices are currently about $1,605/oz.

 

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Securities Disclosure: I, Michelle Smith, do not hold equity interests in any companies mentioned in this article.

Should Investors be Discouraged by Cost Inflation? originally posted on goldinvestingnews.com

This article is contributed by goldinvestingnews and does not represent the views or opinions of International Business Times.
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