There are three factors that need to be present when we consider an investment in a resource company: low commodity prices, a declining supply, and poor sentiment. On this basis, we think that gold could be a great opportunity, and discuss one ASX gold producer well placed to leverage this.
Low commodity price
The chart below shows a number of the world's leading gold producers. Collectively they account for a third of world gold production. The horizontal red line is the current gold price: US$1200 an ounce; and the vertical bars are each of the total costs of the miners indexed at the bottom.
Low or a negative economic return today
Source: Allan Gray Australia and Factset as at 22nd August 2018
And you can see in a number of cases, some very respected gold companies are losing money. Goldcorp, Yamana, Kinross, Iamgold and AngloGold Ashanti all have costs in excess of US$1200 an ounce. For those that have costs lower than that, the difference between the current gold price and their costs is not sufficient to generate an economic return. So commodity prices are low. We feel quite confident of that.
Here's a chart that shows what the mine lives or reserve life of an even greater sample of gold companies back in 2008, alongside what it was in 2017.
You can see in all but a few examples that the reserve life has fallen quite significantly. The reason for that are the low prices which have prevailed over the past 10 years relative to the cost needed to incentivise production, the businesses running themselves for cash and not spending money on exploration, and of course just ongoing mining and depletion.
And so it's the combination of those things, basically underinvestment and depletion of all bodies. And this is a sure path to a result that sees mine production falling in future years.
If you look at Barrick and Newmont, Goldcorp, all of those three companies have guided to production in 2019 being lower than in 2018, and 2020 being even lower than 2019’s numbers. So supply is definitely falling.
We've always said that the most likely time to be able to buy companies very cheaply is when they are vilified in the press or have gone through some deep cyclical trough. This chart shows the derivative positions or futures positions on the Commodity Futures Trading Commission held by non-commercial traders (i.e. hedge funds). Essentially there are none, therefore there are no bullish bets out there.
Sentiment is particularly weak
Source: Bloomberg, Commodity Futures Trading Commission as at 30 June 2018
This is almost as bad as it gets. In 2000 and 2001 it was a bit worse than this, but you can see if you look at the gold price, what happened since then, and it did spectacularly well. This is a good indication of what the level of sentiment is out there.
Why we find Newcrest particularly appealing
When analysing gold producers, the three things that we look at are: free cash flow per ounce of production, mine life, and the price you pay relative to replacement costs.
Newcrest is an undisputedly low cost producer as you can see on this chart, with all in costs roughly of around US$950 per ounce. Relative to the low gold price of $1,200, it'll make a return today notwithstanding the current low price.
Newcrest: A rare gem
Source: Allan Gray as at 30 June 2018
It also has incredibly long life assets at roughly 27 years on average. Mostly across two of its mines Cadia and Lihir, which is quite a lot longer than most gold companies out there. If you recall Goldfields, Polyus and Newcrest were the three outliers on one of my earlier charts with respect to mine life. This is a company with truly world-class ore bodies and it'll be in production from the same assets for many years to come.
Finally, Newcrest is priced relatively attractively relative to its replacement cost. You can buy Newcrest for 4,500 US dollars per ounce of production, which is quite attractive and certainly better priced than most other Australian gold miners.
Going against human instinct and taking a contrarian approach to investing is not for everyone, however there can be great rewards for the patient investor who embraces Allan Gray’s approach. Find out more
Simon, Thank you for a good article. Newcrest seems accident-prone over the years. Does this come into your consideration and assessment on qualitative grounds? Insurance recoveries can’t hide this point. In contrast, debt free SBM, RRL, NST and near-debt free EVN provide substantial options.