Think gold has been a bad investment this year? Try gold miners.
The FTSE Gold Mines index of gold equities has tumbled 46 per cent since the start of the year. Some shares have fallen even more: London-listed African Barrick Gold is down 76 per cent.
“The sentiment is terrible – worse even than the sentiment towards gold,” says Patrick Chidley, analyst at HSBC.
Neil Gregson, who runs JPMorgan Asset Management’s natural resources funds, says the current mood among gold mining investors reminds him of the aftermath of the Bre-X scandal in the mid-1990s, when a company’s claim to have found a huge Indonesia gold deposit was exposed as a fraud. “We’re in pretty bombed out territory,” he says.
Does that mean miners are due a rebound? The gold price itself, after dropping nearly 30 per cent from the start of the year to a low of $1,180 a troy ounce last month, has since bounced 10 per cent, on Wednesday briefly hitting $1,300.
Evy Hambro, co-head of natural resources investment at BlackRock, said: “We have seen a 50 per cent fall in gold mining shares in six months: common sense would naturally say we are in very oversold territory.”
But investors have been burnt by gold miners before. Indeed, many stocked up on gold mining equities while gold prices were rising, reasoning that share prices ought to outperform gold thanks to the companies’ leverage.
Instead, a combination of soaring costs and misguided acquisitions meant that few gold equities even succeeded in keeping pace with the price of the metal. Between the start of 2010 and gold’s record high in September 2011, the FTSE Gold Mines index underperformed the metal by 40 percentage points.
“Very few gold mining companies performed in line with the metal in the bull market, and most underperformed dramatically as they failed to generate any free cash flow despite the higher gold price,” says Jake Greenberg, metals and mining specialist at Jefferies.
Now that prices have fallen rapidly, witnessing their sharpest quarterly decline in decades between April and June, investors have other concerns.
At today’s levels of $1,200-$1,300 an ounce, many miners will struggle to be profitable, analysts say. According to Thomson Reuters GFMS, the industry average “all-in” cost – which includes spending on new projects – stands at around $1,200.
Indeed, many gold industry investors are braced for an uncomfortable results season as miners reveal the impact of a falling gold price.
First, they are expecting a wave of writedowns as companies revise the value of their mines in the light of the fall in prices. Many companies, inspired by the rally in gold prices towards $2,000 in 2011, have assumed gold prices well above today’s spot prices when valuing their reserves. Moreover, many will have to write off money spent mining lower grade ore that they now hold in stockpiles but which will no longer be profitable to process, analysts say.
Analysts and investors surveyed by the Financial Times estimated that across the global gold mining sector writedowns could exceed $20bn over the current reporting period. “I expect to see some pretty painful numbers coming through,” says one large investor in the sector.
Already, several companies have warned investors to expect multibillion dollar impairments. Barrick said it would make “significant” writedowns, including $4.5bn-$5.5bn on its Pascua-Lama project alone. Newcrest, an Australian producer, said it would take impairment charges of A$5bn-A$6bn. And this week AngloGold Ashanti of South Africa announced an impairment of $2.2bn-$2.6bn.
Likewise, several gold miners are likely to cut dividends, analysts say. Newmont, for example, has explicitly linked its dividend to the gold price.
“Over the next three to six months there will be writedowns, and some of the miners will be cutting their new found dividend religion,” says JPMorgan’s Mr Gregson. He has roughly halved his fund’s allocation to gold equities since the start of the year.
More worryingly for investors, perhaps, is the possibility that the fall in the gold price holds an existential threat for some companies. Already, the sector has seen its first casualty, with Apex Minerals, an Australian miner that in 2008 was valued at about A$440m, falling into administration last month.
“Gold is not going to zero, but some heavily indebted, high cost miners certainly could,” says Mr Greenberg of Jefferies.
But the investment case is not universally bleak. While some more marginal miners are likely to struggle unless the gold price recovers soon, others may be able to respond to the fall in prices by mothballing projects, cutting costs and focusing their mining activity on high grade, profitable ore.
“I would guess you would see a lot of production that is going to be reviewed,” says Mr Hambro of BlackRock. “I do expect to see a total change of strategy from the gold mining companies.”
Those companies best able to bring down costs may be able to outperform even without a gold price bounce. Kate Craig, gold mining analyst at Liberum Capital in London, says investors will focus ruthlessly on miners’ ability to generate cash. “For those that can respond to the gold price, it’s not about the gold price it’s about the margins.”
As Mr Gregson of JPMorgan observes, with a flicker of gallows humour: “It’s darkest before dawn”.