by Steve Todoruk, Daily Reckoning
After three years of brutality in gold and gold equities, are we near the bottom? Could we see them start to head higher?
In my 35 years in the mining industry, I have experienced many bear market cycles where metal prices and mining company share prices have been down and out… Each of those painful down cycles was followed by rising metal prices, which is usually a precursor to a bull market in the equities.
So where are we today and what should we expect next?
It all starts with the major mining companies. To build and operate big mines takes a lot of engineering and managerial prowess.
If my reasoning is correct, we are about six months into a low gold price environment.
These companies take a tremendous amount of risk (and so do their shareholders). It now costs several billion dollars to build big mines. It takes years longer than ever before to permit and build them.
If a mining company wants to build a new mine that will last 20 to 50 years, they must prepare for bear markets and low metals prices at some point during the course of that mine life.
They need to be ready for those future hard years. They also have to be prepared for rising costs at their mining operations over the course of the mine’s life. This can be extremely difficult to predict ahead of time, as evidenced by all the harsh cutbacks and project delays across the mining industry.
So these mining companies need to make strong profits to justify the risks of their activities. Marginal profits are out of the question.
Once the big mining companies build these huge mines, they are very reluctant to shut them down before the entire resource has been extracted. They have too much invested in them. But if metal prices drop and mining operations start to lose money, questions about keeping the mine running are inevitable.
It’s not a simple thing to just shut down a mine. You have to lay off all of the miners who may be under contractual obligations and part of a union. A lot of mines are leasing all those big yellow mining trucks and shovels. The company would have to pay a lot of money to send all that equipment back to its owner.
Then, with a lot of very expensive equipment and infrastructure still at the mine site, they would have to keep a lot of employees there for ‘care and maintenance’ in the hope that one day, not too far down the road, metal prices will rise so that they could re-open their mine.
Then, they would have to re-hire all the employees and bring back all those trucks and shovels.
Because of this, mining companies are prepared to operate a mine at a loss for a little while, but most definitely not for a prolonged period of time.
My guess is that mining companies will shut down money-losing operations in less than a year and maybe closer to six months.
We know that there are very few overall really high grade mines in production. Those rare and cherished mines are still making good strong profits today at these low metal prices.
We also know that a number of the big mines have an overall average grade by industry standards, but somewhere in that big deposit are some high grade areas of gold, silver, copper or uranium. In order to show investors that their company can make a profit and in order to keep the operation going, they switch from mining the average mine grade to the high grade areas of the deposit.
Short-term profits are maintained, but this is usually harmful to the long-term well-being of the mining operation. If metal prices stay low and the company gets to the point where they have mined all of the high grade, their only choice is to go back to mining the lower grade mineralization (if they haven’t ruined the overall mine plan), which is a money-losing proposition.
If a mine gets to this point, the likely action is to shut the mine down. If lots of mines get to this point, then lots of mines start shutting down, at least until higher metals prices make the lower grade ores profitable.
Before closing down existing mines, the bigger mining companies cut expenses on replacing reserves. They delay building what they thought would be attractive, profitable mines when gold prices were higher.
There are many examples of this happening today. For instance, New Gold Corp. has recently announced that two of their planned new gold mines in Canada are uneconomic at the current gold price; so there’s very little likelihood they are going to build them. Those projects will have to sit on the shelf waiting for better days.
The reality is that if we get to the point where lots of mines are being shut down, then simple supply and demand fundamentals will start kicking in; buyers will have to pay enough for the metals that the mining companies can turn a profit producing them.
If my reasoning is correct, we are about six months into a low gold price environment. That means that sometime in the next six months something has got to give. We will either see lots of mines shutting down or gold prices going up, allowing mining operations to run a profit.
Once strong profits start hitting the bottom line of the major mining companies’ balance sheets, the next bull market will take off.
In the meantime, investors who believe that this year will treat us better than the horrific performance of 2013 should position themselves for a rebound.
Look for the mining companies with the most well-run and profitable operations. Own the juniors with the most attractive deposits – the big high grade deposits.
Reservoir Minerals Corp., Mag Silver Corp., Fission Uranium Corp., Papillion Resources Inc. and possibly Pretium Resources Inc. all own discoveries that some investors may find attractive. A more conservative approach would be to own shares in the royalty companies, which own rights to a future share of the revenue from mining operations without bearing the costs of running the mines.
The price of metals will play a major role in the price of juniors across the board. But some companies probably have a stronger chance of making it to the next bull market and being the biggest winners. Some companies, those that make or grow a significant discovery, could even go higher without higher metals prices. Looking ahead, these are the kinds of companies that I would want to own.