Where next for precious metals?
What are the companies saying?
Part of the reason precious metal equities de-rated in Q1 was concern that cost inflation was eroding margins. From our company meetings, cost control overall is actually generally quite good. Some companies are guiding to all-in-sustaining-cost (AISC) increases of 0-5% on average for calendar year 2018 over 2017 (excluding volume effects). Pockets of cost pressure are noticeable, however. One management team noted that the availability of high quality drilling crews has become noticeably tighter in North America as exploration activity has picked up. Another noted that the lead times for Caterpillar trucks have begun to move higher, necessitating better planning of capital goods purchases. This is in stark contrast to two years ago when second hand (but unused) kit could be picked up for “30¢ on the dollar”.
Diesel costs have also shifted higher in line with the energy complex, something that can be a more pronounced issue for open pit operations. Labour issues appear most pronounced in South America where a high percentage of mining operations are unionised. Against that backdrop we feel companies are doing a good job of managing costs, albeit aided in some places by high base metal by-product credits.
Capital discipline and cash generation
Overall sector balance sheets are now conservative, and cash generation is solid. Generally balance sheets have been de-levered significantly. Even companies carrying legacy reputations of “stretched” balance sheets and high leverage are now generally below 1x net debt/EBITDA (Kinross for example) or even in net cash positions (IAMGOLD).
Although this event was lightly attended by Australian producers, it is worth noting that this group has moved into a substantial net cash position, with seven out of the ten Australians we follow now in a net cash position - we are on watch for a pick-up in M&A activity from this region where valuations now look stretched.
Chart I - Gold sector net debt/EBITDA by company
Source: Bloomberg, April 2018
What to do with the cash?
For companies in the process of sinking significant capital to bring on greenfield projects, the focus rightly remains on project execution. For those in or entering free cash harvesting periods we find a mixed picture. Some are committed to expanding returns to shareholders where possible (Pan American Silver, Alacer).
Share buybacks are generally thought of as unwelcome as a concept among the management teams as a format to return funds back to shareholders. This is disappointing to us, given our net present value (NPV) analysis suggests that a lot of these companies’ equity is undervalued and a share repurchase programme (as a portion of free cash) would be accretive.
Without returning money back to shareholders, the risk, as we discussed above, is that improved balance sheets trigger increased M&A. While we believe that there is certainly room for consolidation in Canada, Latin America and parts of Africa, the purchase price remains the key hurdle to assess how disciplined management teams are remaining.
Jurisdictional risks a perennial issue but also offer opportunities
There are several recent instances of companies in the gold space whose equity values have already been significantly negatively impacted by protests and/or licence disputes in higher risk operating jurisdictions. Examples of this include Acacia (Tanzania), Eldorado (Greece) and Tahoe (Guatemala). In general, caution is always paramount. However, there are instances where equity selloffs are so severe that a longer-term investment becomes warranted. An example of this in the past year has been Oceana Gold, whose equity was severely impacted by poor perception of Philippine environmental risk during the brief reign of Gina Lopez.
We met with management of Tahoe Resources. The Guatemalan mining licence for its 100%-owned Escobal asset was suspended in July 2017 and the equity has underperformed considerably since the announcement. Management has a good operational track record and the CEO indicated that discussions with the government are productive and that they are close to a resolution (a return of the mining licence from the Constitutional Court is near).
The experience of Acacia highlights that a ‘fair’ resolution is not always the outcome, but we are a little more optimistic towards the outlook for Tahoe.
What does the macro picture tell us about gold and silver?
Gold price being supported by a shift in investor attitudes to risk
Previously dominant gold market correlations have fundamentally broken down. For more than the last decade, gold prices have been closely tied to US real rates. Since about October last year that relationship has, directionally at least, collapsed. Even accounting for pronounced USD weakness a simple multi-linear regression would suggest gold prices should be slightly lower than current spot prices.
We think the main change in the market is renewed exchange traded fund (ETF) purchases. These flows have picked up substantially (chart II below), with around US$4.4 billion coming into ETF products since the start of the year (calculated using average year to date (YTD) gold prices).
While we don’t have a crystal ball, we think this North American flow is almost certainly related to the pick-up in equity market volatility, the deterioration in the global geopolitical environment (the two obviously interlinked) as well as continued pressure on bond markets as quantitative tightening picks up in the US.
Chart II - Gold ETF flows vs. prices
Source: Bloomberg – May 2018
Source: Bloomberg – May 2018
Silver price is puzzling – the fundamentals remain positive
The gold/silver ratio now sits above 80x, a level which has only been reached three times in the past decade. Two obvious sources of silver price weakness have been extreme money manager negativity and very weak physical investment demand in the US.
Futures net managed money positioning on Comex has reached extreme short levels. In terms of physical coin demand, the collapse in US silver eagle coin sales removed around 20 million ounces (Moz) of demand from the silver market in 2017 and so far, dismal sales have continued in 2018; down 36% year-on-year in Q1. Put in context, that represents a similar level to the output of a mid-cap silver producer such as Hochschild; not huge but important at the margin.
We don’t know precisely why the collapse has been so deep (some combination of Trump election, strong equities and possibly the rise of crypto currencies are most likely). What is important is that this is all in the rear-view mirror; some recovery is to be expected on a forward looking basis. Similarly, record net short positioning exists and it is already in the price. More importantly, the industrial backdrop to silver demand remains firm, particularly from the solar sector where additions of Chinese solar capacity continue at a very high growth rate.
On the supply side, global mine production is registering only small increases and it is difficult to see how silver supply accelerates upward from current levels given current pricing.
On a relative basis we still expect silver to outperform gold and point out that a silver price of US$20/Oz (>20% above spot) would be low in historical context. Against that backdrop maintaining exposure to higher quality silver producers continues to make sense.
Chart IV – US silver eagle coin sales
Source: Bloomberg – April 2018
Chart V – Gold/silver ratio
Source: Bloomberg – April 2018
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