Gold Has Now Hit Marginal Cost of Production

In this post I will try to explain how important it is to watch the total marginal cash cost of gold mining to predict where the gold price (GLD) will be headed to. This marginal cost can be divided in two parts: cash cost of production and other costs (exploration, construction, maintenance, etc...) and stands at around $1300/ounce. With the recent decline in the price of gold, I believe we have finally hit the bottom.

The gold price has always followed the marginal cost of suppliers throughout history (Figure 1). The correlation between gold prices and gold mining cash costs between 1980 and 2010 stood at 0.85, which is pretty highly correlated (Source: CPM Gold Yearbook 2011).

With the price of gold at $1400/ounce today I'm pretty sure we can't go much lower if this correlation proves to be correct.

The following chart is the most important chart every gold investor needs to be aware of. As I mentioned before, there is a high correlation between the all in cash costs of gold mining and the gold price (Chart 4). So investors need to monitor the total cash cost of gold mining in order to predict the trend in the gold price itself.

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Chart 4: All in Costs Vs. Gold Price

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Correlation: Gold Bottoms out on Marginal Cost of Suppliers

The gold price has always followed the marginal cost of suppliers throughout history (Figure 1).

The correlation between gold prices and gold mining cash costs between 1980 and 2010 stood at 0.85, which is pretty highly correlated (Source: CPM Gold Yearbook 2011).

With the price of gold at $1400/ounce today I'm pretty sure we can't go much lower if this correlation proves to be correct (Chart 1).

Chart 1: Marginal cost suppliers of gold (Source: Eurekareport)

If we only look at the cash operating costs, we have this picture (Chart 2):

Chart 2: Production cash cost

Let's analyze these charts further. While cash operating costs only went up a little bit to $700/ounce (Chart 2), the total marginal cash costs went up to $1300/ounce in 2013 (Chart 1). So the biggest move in total cash cost came from overhead, discovery, construction and sustaining capital. In the 1980's, we see that cash operating costs contributed the most in the total cost of mining, but today, the biggest chunk of the costs go to overhead, discovery, construction and maintenance. A summary of the cost structure is given in chart 3.

Chart 3: Replacement cost for an ounce of gold

For investors, the key point to keep in mind is that cash operating costs aren't a good indicator for the gold price. You need to look at the overall costs of replacement and that includes all additional costs to mine gold. That total cost will dictate the price of gold.

I hear many analysts say that gold will go to $10000/ounce. I don't think this will happen soon, unless the total marginal cost goes up the same amount. This could happen when energy, labour, exploration, maintenance, construction costs go up or when ore grades go down. At the same time, some people say gold will go back below $1000/ounce. This is not possible because marginal cash costs are rising and we know that there is a high correlation between marginal cash costs and the gold price. 

The following chart is the most important chart every gold investor needs to be aware of. As I mentioned before, there is a high correlation between the all in cash costs of gold mining and the gold price (Chart 4).

Chart 4: All in Costs Vs. Gold Price

The gold price will therefore always follow the cost of mining which proves another important point. The rising gold price is an indicator of inflation because the higher cost of mining is a direct result of inflation.

Now consider the following. We see that many development stage gold mining companies have had increases in their exploration spending and many of these companies have had upward revisions in their feasibility studies. To name a few examples: Kinross Gold (KGC) and Novagold Resources (NG). So if capital spending on all of these projects go up, it isn't too difficult to see that the gold price will keep rising in the future.

Chart 5: Gold Exploration Spending

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A little background on the effect of gold mining supply on the gold price

In a previous article I pointed out that the marginal cost of gold production including exploration, feasibility studies, construction, maintenance, production and taxes has doubled since 2009 up until now. That has placed a large burden on gold mining companies over this period. The result was a decline in the gold mining index (GDX) of around 10% since 2010. Even when the gold price steadily went up from $800 to $1600/ounce, there wasn't a lot of profit to be made by the gold mining companies themselves. This means that gold mining companies are very dependent on the gold price for their margins and profits. At the same time, I want to make a case that the gold price is also very dependent on the mining companies.

If anyone ever says that gold mining production isn't going to affect the gold price, you can use these charts to prove them wrong.

In 2012 we had 4000 tonnes of total gold supply per annum, while gold mine production was around 2812 tonnes per annum in 2012. That's a 70% interest of gold mine production as compared to the total gold supply.

If the gold miners continue to have lower prospects for production due to the marginal cost of production rising above the gold price (total marginal cost is currently $1500/ounce), then the supply of gold will drop. As a result we will see a rising effect on the gold price when this supply breaks down.

Mine supply had been going up since 1974 (Chart 1), but has peaked since year 2000. I believe mine supply is going to stay flat or even drop going forward due to decreasing ore grades and higher marginal costs of production.

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Chart 1: Annual Gold Production

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The Marginal Production Cost of Oil

There is a theorem about the marginal production cost of oil. The price of the commodity in question should always be slightly higher than the marginal production cost of oil. If not, then many companies that produce the commodity will start going bankrupt.

Wikipedia has this definition for marginal cost of production:
The change in total cost that comes from making or producing one additional item. The purpose of analyzing marginal cost is to determine at what point an organization can achieve economies of scale. The calculation is most often used among manufacturers as a means of isolating an optimum production level.

In the case of oil, it would take over $100 now to produce an additional barrel of crude oil. The oil production cost was only $85/barrel in 2009. So, if we see a crude oil price of $85/barrel today at a marginal cost of production around $100/barrel, a light should spark in every investor's mind. Especially when we hear news that Iran is threatening to stop exporting crude oil.

I'm going to bet on this by buying stocks like USO and UCO.

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