Gold's low-cost glow

PORTFOLIO POINT: The best way to gain an exposure to gold is to treat it like any other commodity and invest in low-cost producers.

Gold’s 20% price fall from its all-time high of $US1923 an ounce last September to a low of $US1537.50/oz at the Wednesday morning fix on the London bullion market last week pleased critics who do not believe the metal is a valid investment.

The anti-gold brigade will have been less pleased with the remarkable rebound in the gold price later in the week as Europe’s financial woes deepened.

By the close of business in London on Tuesday, gold was back up to $US1582.50/oz, not far off its price at the start of 2012 when the morning fix in London was $US1590/oz.

Many investment lessons can be learned from the fall in the gold price from its all-time peak, and the remarkable two-day bounce which delivered the recovery, but the most important is that gold remains in a class of its own – a safe haven when conventional assets are sliding.

There is, however, another lesson encompassing both the fall and the rise in the gold price, which investors would do well to follow if they prefer equities over physical metal: focus on the cost of production, because miners with low costs will always outperform their high-cost cousins.

Before looking at Australia’s lowest-cost gold miners, which can ride out any major price correction and rebound fastest in a recovery, here are a few more thoughts on what last week’s gold rally meant.

Firstly, the $US1592/oz World Gold Council price means gold has outperformed average share prices on the ASX, thanks to the All Ordinaries index closing last week at 1.4% below its opening in January.

On conversion to Australian dollars, the picture is even better, with the local gold price up 4.8% since the start of the year, thanks to the US4c fall in the Australian dollar from $US1.03 on January 3 (first trading day) to its latest rate of US97.72c.

'Swings and roundabouts’ is one way of interpreting the gold price, with winners and losers generated depending on the buy/sell dates, but the underlying point is that during times of financial uncertainty, gold is performing on cue.

Newcrest, Australia’s gold sector leader, has followed the gold price. After tumbling from its 12-month high of $41.26 last July, it hit a 12-month low last Wednesday of $23.56, before climbing back to a closing price on Tuesday of $25.24 – a long way short of its high, but rising nevertheless at the end of the week when most other stocks were falling.

All other gold producers and explorers hit by the sell-off since September recovered late last week.

For investors who appreciate how gold stands apart from government-created money, the question becomes when to buy, and what.

Timing is the hardest part of those two questions, because although someone who bought gold at its absolute peak is now 20% poorer, an Australian investor who bought gold at the start of 2012 is still ahead.

Fiddling with the currency factor, while interesting, is not a reason to be attracted to gold. A far better reason is gold’s immunity from government monetary manipulation, which remains a big threat as Europe tries to shake off its financial crisis.

But if gold does sometimes behave like any other commodity, which can be the case, then the key to the second question – what to buy – is the same as for any other commodity: focus on the cost of production.

With gold producers, the cost question leads to a small group of companies operating on a profit margin of more than $US1000/oz, even after the 20% fall from the price peak.

ASX-list members of the $US1000/oz club in the March quarter were Kingsrose Mining (KRM), Troy Resources (TRY), Regis Resources (RRL) and Medusa Mining (MML).

A second group of miners came close, but with their cash cost of production slipping above $US600/oz, and the gold price falling below $US1600/oz, they just failed to make the cut-off. That group includes Integra Mining (IGR), Northern Star (NST) and Endeavour Mining (EVR).

• Kingsrose. A stock mentioned several times over the past year, Kingsrose continues to enjoy remarkable success at its small, but ultra-low cost Way Linggo mine on the Indonesian island of Sumatra. In the March quarter, the company produced 13,718 ounces of gold equivalent (a mix of gold and silver) at $US298/oz for a gross margin on every ounce of around $US1300. High-grade veins of gold are the key to the low costs, and while the Way Linggo project appears to have a relatively short life, a recent site visit I made with a group of stockbrokers added to my confidence that production from the company’s tenements will continue for much longer than is currently forecast, thanks to significant ongoing exploration success. Last week, Kingsrose fell to a low of $1.04, but traded up to $1.12 on Friday. It closed at $1.10 today (Tuesday, May 23).

• Troy. This is another favourite which continues to deliver low-cost gold from its two mines in South America. During the March quarter, the Casposo mine in Argentina produced a mix of gold and silver at $US330/oz, while the more expensive Andorinhas mine in Brazil lifted the company’s total cash production cost of 32,774oz to $US407/oz. Last week, Troy fell to $3.70 before rising to $4.11 on Friday, and closing today at $4.08.

• Medusa Mining. This company, which operates the Co-O mine in the Philippines, topped the low-cost league in the March quarter with cash costs sliding to just $US239/oz. As with Kingsrose, the key to that ultra-low figure was the high-grade nature of the vein systems being mined, with the 18,258oz produced in the quarter coming from gold grading a very respectable 8.1 grams a tonne. Last week, Medusa fell to $4.76 before rising to $5.34 on Friday, and closing today at $4.98.

• Regis. The only Australian-located producer in the $US1000/oz club snuck in on a cash cost of $US519/oz for its 26,683oz produced during the March quarter. Regis operates a number of mines, including Moolart Well and Garden Well, as part of its Duketon project located 350km north of Kalgoorlie in WA. Unlike the other low-cost producers, the Regis mines are relatively low grade but benefit from cost efficiencies from large scale, open-pit mining of shallow seams of ore. Last week, Regis fell to $3.34 before rising to $3.80 by the end of the week, and closing still higher today at $3.90.

As with the rest of the gold sector, and most other investment classes, the four low-cost producers have all retreated from their 12-month share price highs posted last year, when the gold price was heading towards $US2000/oz.

Kingsrose is down from $1.87, Troy is down from $5.05, Medusa is down from $8.71 and Regis is down from $4.43.

Those price movements indicate that followers of the listed gold sector are keeping a close eye on production costs, for two reasons.

Firstly, the lower the production cost, the higher the profit and secondly, if gold really does crash as its detractors have been predicting for the past 10 years, then the low-cost producers will also be the survivors.

A third possible reason for following the low-cost producers is that they are potential takeover targets as the gold sector enters a merger phase, thanks to high levels of cash in many miners which now have low share prices.

A recent calculation of worldwide listed gold stocks by the Bloomberg financial information service noted that while the gold price had retreated from its all-time peak of last September, it was still close to 10% higher than at this time last year, whereas gold equities were down 30% over the same time.

The chief executive of Nordgold, a miner focussed on Russia and emerging markets, told the Financial Times newspaper two weeks ago: “I think a wave of merger and acquisition should be inevitable”.

Investing in the hope of a takeover bid is rarely a wise strategy, even with gold stocks widely seen to be moving into a phase of M&A activity.

A more sensible reason for including gold in a portfolio – as a commodity, exchange-traded fund or via a gold producer – is because of its status as an investment class of its own.

Europe’s financial crisis, which has driven investors out of equities and commodities, is showing few signs of ending soon, creating a financial climate reminiscent of 2008 when the US was struggling to deal with the aftermath of its sub-prime crisis.

The solution then was to flood markets with cash to keep banks open and restore some confidence to the system.

A similar situation exists today, with investors in full flight to safe havens such as US Treasury notes, as well as German and British bonds, with the result being that so much money has rushed into government paper that yields have dipped below the inflation rate, meaning that real yields have turned negative.

Gold, in its metallic form, also provides no yield, but does have the appeal of not being exposed to the flood of government paper hitting the market, as European governments try to save their common currency.

But just as it is unwise to invest in gold equities in the hope of a takeover, so too is it unwise to invest in gold in the hope of an outbreak of rampant inflation, or a wholesale flight from Europe as it remains bogged in recession.

A far wiser approach, if treating gold as any other commodity, is to focus on the low-cost producers because they will be the survivors if the gold price continues to fall, and the biggest winners when it rises again.