Gold Juniors Strong In Dark Q4

With gold miners’ stock prices surging dramatically this year, investors’ attention is starting to return to the gold juniors.  These smaller miners and explorers suffered terribly in recent years, all but abandoned as gold slumped to major secular lows.  But even during gold’s darkest quarter, the fundamentals of the juniors actually mining gold remained quite strong.  This portends explosive profits growth as gold recovers.

Most investors think of junior gold stocks as the Wild West of commodities stocks, with good reason.  The legendary American humorist Mark Twain allegedly described a gold mine as a hole in the ground with a liar at the top!  There are literally hundreds of gold juniors, a number that swells whenever gold grows more popular.  And the great majority of these tiny companies truly are junk, they are indeed doomed to fail.

That grim reality is seldom due to nefarious intent, but to the almost-insurmountable challenges involved in finding an economic deposit of gold and bringing it to production.  The whole process of exploring for gold, drilling to confirm it, designing a mine, securing the myriad of governmental permits necessary to mine, and then constructing a mine is exceedingly time-consuming and excessively capital-intensive.

As I did the research for this essay, I waded through the 2015 annual reports of dozens of junior golds.  One that really stuck out came from elite explorer NovaGold, which owns a couple of the world’s biggest and best undeveloped gold deposits.  Its chairman wrote an amazing article included in its annual report that outlines the extreme difficulty inherent in bringing any gold deposit to production, an essential read.

Last year, the average time it took to bring a gold deposit to production was 15 years.  Think about what your own life was like 15 years ago, and it’s apparent that is a vast span of time.  It is almost as long as the great 17-year secular-bull and -bear cycles in Long Valuation Waves that drive stock markets.  Can you imagine how hard it would be to captivate investors’ attention for 15 long years?  It seems impossible.

Yet that’s what junior golds have to accomplish.  Banks won’t even think about loaning money to gold explorers yet to find a great deposit, so the equity markets are their only source of capital.  They need to explore for years, while keeping investors interested enough to buy their periodic stock offerings.  And then it takes another 15 years after a deposit is found to bring it into production.  And that’s getting worse.

Industry projections of the time from discovery to production are expected to swell near 24 years in 2016, and 33 years by 2018!  Tapping equity markets for a quarter to a third of a century before cash flows start coming in defies belief, especially considering the bull-bear cycles in gold are way shorter.  Great junior gold explorers able to maintain investors’ interest during gold bulls usually lose it in subsequent bears.

So gold’s relentless weakness in recent years, driven by the Fed’s surreal stock-market levitation, has had a catastrophic impact on the junior gold explorers.  Many didn’t survive as investors abandoned this sector and left it for dead, unable to raise enough capital to continue operations.  And nearly all the rest had to vastly cut back their exploration, doing everything they could to survive a gold-stock apocalypse.

That culminated just months ago, with gold slumping to a dismal 6.1-year secular low in mid-December after the Fed hiked rates for the first time in 9.5 years.  Gold stocks followed gold as usual, plunging to a fundamentally-absurd 13.5-year secular low in mid-January.  Investor sentiment, and therefore juniors’ ability to raise capital, had never been worse according to countless battle-hardened industry veterans.

This has huge implications for future gold supply.  The junior explorers are critical to the entire gold-mining industry since they discover new deposits essential for feeding the gold-mining pipeline.  Since all existing gold mines are constantly depleting, the miners have to replenish their reserves with new deposits.  With exploration plummeting in recent years, that pipeline will be severely impaired for many years to come.

That NovaGold annual report showed gold discoveries peaked way back in 1995 near a 3-year moving average of 140 million ounces.  Despite soaring gold-exploration budgets as this metal was very strong between 2009 to 2012, 2014’s gold discoveries had plummeted 96% to around 5m ounces!  The terrible plight of the junior gold explorers guarantees gold supplies are going to be constrained for at least a decade.

Global peak production near 102m ounces was hit last year, and industry projections show it falling for all foreseeable future years.  The venerable World Gold Council recently confirmed this new trend in its Q4 Gold Demand Trends report.  It showed that global mine supply dropped 9.3% YoY in Q4, which was its first quarterly decline since that once-in-a-century stock panic battered the gold miners in late 2008!

While the nightmare for the junior gold explorers couldn’t be worse, it’s super-bullish for gold.  The near-total collapse of the gold exploration pipeline in recent years means it’s going to be almost impossible for world miners to ramp up gold supply no matter how high gold mean reverts as global investors deluge back in.  Even after exploration spending rebounds, it will still take decades to start mining new deposits.

As a group, junior gold explorers are almost unanalyzable.  They all burn capital relentlessly to search for new gold deposits or prove up reserves in ones they’ve found.  They have no revenues with no gold to sell, so all their cash comes from stock offerings.  The better ones always have a chance of being bought out by a miner, but explorers have no future cash flows to crunch until they get to the mine-build stage.

So while there are the rare super-successful explorers certainly worthy of investors’ hard-earned capital, I’ve always preferred the actual small miners over explorers in the junior-gold realm.  By definition, the miners have overcome the odds to actually produce gold.  So they have sales generating operating cash flows and profits, along with mining costs that make it easy to estimate their upside as the gold price recovers.

The definitive benchmark for junior gold stocks, including miners and explorers, is of course the GDXJ Market Vectors Junior Gold Miners ETF.  As of the middle of this week, it included a whopping 52 of the world’s best junior gold stocks!  In addition to miners and explorers, GDXJ also includes gold-streaming and royalty companies as well as silver miners.  GDXJ’s managers do a great job finding excellent juniors.

Since recent years’ brutal gold weakness culminated in Q4’15, I’ve been very interested to see how the actual gold miners among the elite GDXJ components fared.  Q4’s average gold price of just $1105 was the worst quarter seen since not long after the stock panic in Q4’09.  With gold-mining-sector sentiment as hyper-bearish as it’s ever been in Q4’15, the junior gold miners’ stocks were pounded down near oblivion.

So I’ve been eagerly awaiting their Q4 financial reports.  But as discussed in my essay several weeks ago on the Q4 performance of the larger gold miners in the GDX Market Vectors Gold Miners ETF, final full-year reports aren’t due until 90 days after year-end.  They require fully-audited results right in the heart of CPAs’ busy season, which then have to be woven into complex annual reports that take time to produce.

But as these results gradually emerge, we can finally gain an understanding of how junior gold miners were actually doing in gold’s worst quarter in 6 years.  These tables look at the top 34 holdings of GDXJ, over 91% of its total weighting.  I dug into their latest reports to build a spreadsheet with a bunch of data to assess junior gold miners’ fundamental health when their stocks were being crushed in that dark Q4.

These tables show each GDXJ component stock’s symbol, exchange, current weighting in that ETF, market capitalization, cash costs per ounce, all-in sustaining costs per ounce, AISC projections for 2016, cash on hand, its percentage of market cap, Q4 cash flows generated from operations, along with Q4 production.  This hard Q4 data proves that the junior gold miners’ deep stock-price lows were never justified.

Because of that quarter-long deadline on releasing Q4 audited results, unfortunately not all the GDXJ components have reported as of the middle of this week.  Where data wasn’t published, nothing could be put into this table.  Interestingly GDXJ’s largest holding, the amazing OceanaGold which I analyzed in depth a couple weeks ago, is also included in GDX.  There’s some overlap between juniors and larger miners.

Despite the miserable gold conditions and horrendous sentiment utterly dominating Q4, the junior gold miners proved to be amazingly strong.  The first metric for their health is cash costs per ounce, or how much they have to actually spend to produce each ounce of gold.  They include all direct production costs, as well as mine-level administration, smelting, refining, transport, regulatory, royalty, and tax expenses.

Cash costs have dominated gold-mining cost reporting since the 1990s, and are an acid-test measure of gold-miner survivability.  As long as the gold price stays above cash costs, gold miners can continue to produce gold and pay their bills necessary to survive.  After filtering out GDXJ’s explorers, the streamers and royalty companies, and silver miners, the elite junior gold miners reported average Q4 cash costs of just $628!

These smaller miners needed $628 to wrest an ounce of gold out of the ground, yet the lowest gold fell in Q4 was $1051 the day after that Fed rate hike!  So unlike the extremely-bearish commentary that the falling junior-gold-stock prices fueled, this sector was never in jeopardy at all.  The junior gold miners as a sector actually had cash costs in line with the larger gold miners’, as GDX’s Q4 average cash cost was $587.

But cash costs are misleading, as they don’t include many major expenses essential for mining gold.  So in June 2013 the World Gold Council introduced the comprehensive all-in-sustaining-cost metric.  This includes everything necessary to maintain and replenish gold-mining operations at current production levels.  All-in sustaining costs are a monumental improvement over the deceptive cash-cost reporting.

All-in sustaining costs include all direct cash costs of mining gold, along with much more.  Corporate-level administration is included, as the high-level people running companies are a sizable expense for mining gold.  AISC also include exploring for new gold to mine, developing and constructing new mines, remediation, and reclamation.  These costs are indispensable since gold mines are constantly depleting.

During dark Q4 when everyone abandoned the elite junior gold miners of GDXJ, they were operating at AISC levels of just $812 per ounce!  Remember gold averaged $1105 in Q4, and fell to $1051 at worst.  So even when Wall Street shrilly argued that gold was doomed to spiral lower during Fed rate hikes, an irrational notion contrary to market history, the junior gold miners were still earning large operating profits.

At gold’s secular nadir of $1051, the GDXJ junior gold miners were still earning a hefty $239 per ounce of gold mined!  That equates to a very healthy 23% profit margin that many industries would die for.  It is also interesting to see the junior gold miners’ all-in sustaining costs even better than the larger miners’ in GDX, which came in at an $836 average in Q4.  The gold juniors never faced any existential threat at all!

The junior gold miners’ impressive profitability during gold’s worst quarter in 6 years is evident in their strong operating cash flows.  The great majority of these elite miners were still earning plenty of money even as the gold price languished.  As long as businesses can generate positive operating cash flows, and they haven’t been profligate in borrowing, they can continue operating as going concerns indefinitely.

Such strong operating cash flows naturally fed impressive quarter-end cash coffers in many of the elite junior gold miners.  The majority of these GDXJ miners reported large cash positions in the double-digit percentages of their market capitalizations.  More cash on hand obviously improves survivability in any scenario where profits are temporarily impaired, like an artificially-low bearish-sentiment-driven gold anomaly.

And if the junior gold miners could fare so well even in dark Q4, imagine how awesome their coming Q1 results will prove!  As of the middle of this week, gold prices have averaged $1167 so far in Q1.  That’s 5.6% above Q4’s average.  Yet at junior gold miners’ Q4 average AISC of $812 per ounce, profitability in Q1 will already surge 21.3% to $355 per ounce.  Gold miners’ profits leverage to gold is why they’re so alluring.

For the most part, gold-mining costs are essentially fixed during the mine-planning stage.  So as gold prices mean revert higher, that translates directly into higher profits for the gold miners.  This relationship is certainly not linear, with gold-mining profits rising far faster than gold prices.  And throughout all the stock markets, any company’s underlying profitability ultimately determines how high its stock price can go.

With investors finally rushing back into gold for the first time since 2009, this battered metal is heading a heck of a lot higher.  The last time investors returned at the magnitude seen so far in young 2016, gold was early in a mighty bull market that would see it soar 167% higher in less than several years.  Another similar bull market off gold’s recent mid-December secular low would catapult it radically higher near $2800!

But there’s no need to be that optimistic to see the epic opportunities today in junior gold miners’ stocks.  The last normal year before the Fed’s unprecedented open-ended QE3 campaign levitated stocks which decimated gold was 2012, where gold averaged $1669.  Gold would merely have to rally 59% out of its mid-December lows to regain those levels, which is very conservative and tiny as far as gold bulls go.

The elite GDXJ junior gold miners also forecasted their 2016 AISC in their Q4 reporting, which averaged $850 per ounce.  The miners always have strong incentives to overestimate costs and underestimate production in their forward guidance, giving them an opportunity to beat which investors tend to reward with a flurry of stock buying unleashing sizable rallies.  But let’s assume that $850 AISC number proves true.

At 2012’s average gold price of $1669 and AISC of $850 per ounce, the junior gold miners would earn staggering profits of $819 per ounce!  That is 180% higher than Q4’s levels on a mere 59% rally in gold.  So the investment opportunities inherent in the junior gold miners remain vast today as gold inevitably mean reverts far higher out of its central-bank-conjured anomaly of recent years.  These stocks will skyrocket!

And the future tense is very appropriate here.  Since the junior gold miners are much smaller and riskier than the larger gold miners, which have multiple mines to greatly mitigate operational risks, junior gold stocks tend to vastly outperform their larger peers.  Yet as of the middle of this week, GDXJ had only rallied 39.7% YTD compared to GDX’s 42.2%!  That means the inevitable amplified junior-gold buying is still coming.

Gold and the gold stocks have blasted so dramatically higher in recent months that traders remain very skeptical about the staying power of these rallies.  Unbelievably, sentiment remains quite poor in gold-stock land despite an extraordinary early year!  And after any major gold low, investors first come back to the less-risky larger miners before finally growing comfortable enough to redeploy in the riskier junior miners.

Investors can certainly play this in GDXJ, which is the world’s premier junior-gold-stock ETF for good reason.  But GDXJ certainly has issues too.  With its 52 component stocks, it is seriously over-diversified which will really erode its potential gains.  20 holdings is about as far as diversification can be pushed before it becomes counterproductive.  GDXJ is also diluted with those gold-royalty companies and silver miners.

I’ve been professionally analyzing and trading gold stocks for 16+ years now, and each time I delve into GDXJ’s holdings I’m amazed.  It contains some companies that have fantastically-bullish fundamentals, the best of the junior-gold-mining world.  But its managers also include other companies that leave me shaking my head in disbelief.  I wouldn’t touch some of GDXJ’s stocks with a ten-foot pole, they’re really iffy.

So the best gains in the coming years from the super-high-potential junior-gold realm won’t come from an over-diversified and performance-diluting ETF like GDXJ, but from carefully-handpicked portfolios of the best of the junior golds.  There are amazing junior gold miners and even explorers out there sporting superior fundamentals that all but guarantee their coming stock performance will trounce that of their peers.

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The bottom line is the junior gold miners thrived even in dark Q4, gold’s worst quarter in 6 years.  They were still mining gold at all-in sustaining costs hundreds of dollars below prevailing gold prices even at its secular lows.  Their newly-reported strong Q4 fundamentals prove that the deep secular lows that their stock prices suffered were purely emotional, driven solely by traders’ extreme irrational bearishness.

Gold is only starting to mean revert higher as investors aggressively return, a process that tends to run for years once it gets underway.  Gold’s new bull market will catapult junior gold miners’ profits radically higher, which investors will eagerly chase.  So the battered junior gold stocks are right on the verge of soaring to lofty levels in the coming years that few could’ve imagined in Q4.  It’s not too late to get deployed.

Adam Hamilton, CPA

March 11, 2016

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