Barrick Gold: The Ultimate Window Into a Misunderstood Industry

Gold clearly means very different things to different people. Some have embraced gold exposure to defend against the devaluation of competing currencies, while others cling to a dogged dismissal of the metal's relevance and value. Depending on which window they peer through when examining gold, it seems one can draw all manner of conclusions to suit a given financial worldview.

As the investment world stomps its way through the never-ending debate over the nature of gold and its long-term price outlook, the miners continue to go about their business of extracting the stuff from the ground in return for enormous profits. The largest gold miner of them all -- Barrick Gold (NYSE: ABX  ) -- saw its adjusted second-quarter income climb 36% over the prior-year mark to reach $1.1 billion. The miner's cash margin surged 33% to $1,068 for each of the 1.9 million ounces sold, while remarkable pricing strength from byproducts like silver allowed Barrick to lower full-year guidance for net costs all the way from a range of $340 to $380 per ounce, to a revised target of between $290 and $320 per ounce.

Despite that powerful performance, the scale and geographical scope of Barrick's wordwide operations offers investors the clearest possible window into a trend of rapidly accumulating cost pressures facing the gold-mining industry at large. In other words, even Fools who have opted for gold exposure through my top picks like Brigus Gold (AMEX: BRD  ) or AuRico Gold (NYSE: AUQ  ) are encouraged to pay close attention to major producers like Barrick for insight into these important industry dynamics. As the preeminent golden goliath, Barrick Gold offers the ultimate window into these trends as they unfold.

Mine construction sticker shock
We'll save an in-depth look at the factors pressuring operating costs for another time and focus instead today on the significant uptick in the capital costs for mine construction and development.

Fools may recall that Kinross Gold (NYSE: KGC  ) balked at the rising price tag for the Cerro Casale project in Chile, selling a further 25% interest in the project to Barrick last year, when the construction budget rose to $4.2 billion. But Barrick last week conceded that the project will probably cost $6 billion before its 23.2 million ounces of gold can begin to be tapped. Corrobortating this inflationary trend, NovaGold Resources (AMEX: NG  ) recently indicated that its price tag for the storied Galore Creek joint venture now stands at $5.2 billion (or 373% more than the companies envisioned back in 2006).

Less than two years ago, Barrick expected to incur capital costs of $2.8 billion to construct its world-class Pascua Lama gold mine on the border between Chile and Argentina. Even just a couple of months ago, the anticipated tally stood at $3.3 billion to $3.6 billion. In its second-quarter earnings release, however, Barrick revealed another major increase to between $4.7 billion and $5 billion. As a poignant aside, the change underscores part of the genius inherent in Silver Wheaton's (NYSE: SLW  ) unique business model, since the silver stream holder is 100% isolated from Barrick's rising cost structure for Pascua Lama.

Barrick identified the major culprits in the trend as "continued inflationary effects on costs for key consumable inputs and labor," including "re-estimations of materials such as steel, cement, fuel, and equipment." Noting that these increasing costs are also accompanying increasing projected rewards, Barrick explained: "The mining industry is facing global cost trends which reflect a substantially higher commodity price environment, stronger local currencies, tighter labor markets and higher inflation in some regions compared to several years ago, when many projects were at the feasibility stage. For Barrick, stronger metal prices have significantly improved project economics and overall rates of return despite higher estimated capital costs."

Under the circumstances, the last thing Barrick needed was a weather-related disruption at another major gold-development project. But when the rains fell in the Domincan Republic last May, Barrick was forced to add another $1 billion to the budget for the Pueblo Viejo joint venture with Goldcorp (NYSE: GG  ) ; while pushing back the mine's scheduled startup to mid-2012.

What the rising cost of gold production means for Fools
While presenting a potential sharp thorn in the side of companies possessing projects with only marginal economics at prevailing gold prices, these inflationary forces are likely to bolster the performance of gold-mining shares and fuel the fire of gold's longstanding price momentum.

Over the long term, the average total ("all-in") industrywide cost of extracting an ounce of gold from the ground acts like a cement floor beneath gold prices that combines with underlying demand dynamics to exert upward pressure on gold prices as the cost structure rises. When gold prices collapsed back in 2008, I used Barrick Gold's estimation of an industrywide breakeven price of $700 to $800 to target the range where gold investors could safely make their stand to position for the next upward leg. Judging by the scale of Barrick's capital-spending revisions since that timeframe, it's clear that the cement floor beneath long-term gold prices has been rising steadily alongside the prices for gold and common byproduct metals such as silver and copper. Unfortunately for Fools, all-in cost metrics are closely guarded by mining companies, with Gold Fields the lone gold miner I'm aware of that routinely divulges its own breakeven benchmark.

Meanwhile, rising capital costs increase the likelihood that marginal projects will be shelved and raise the barrier to entry for junior or non-producing development companies struggling to find financing for a new mine. In other words, these cost pressures are bound to constrain global gold supply, combining with persistently bullish demand dynamics to exert substantial upward pressure on gold prices over time. Unless the trend Barrick bears witness to reverses course dramatically, I believe the supply-side impact will offer a further impetus for gold prices above $2,000 per ounce that few doubting onlookers are likely to have properly considered.

Finally, I wish to point out that the cost pressures Barrick referenced are visible throughout the metals-mining complex, similarly affecting the markets for silver, copper, lead, and zinc. Those metals present bullish, price-inelastic, demand-driven outlooks of their own, which similarly combine with the bullish supply-side scenario resulting from rising costs. I believe rising byproduct revenues will continue to defend the feasibility of quality gold-mining projects against the onslaught of higher capital expenditures, much to the delight of investors who select the best-positioned miners in the industry.

Fool contributor Christopher Barker can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He tweets, and he owns shares of AuRico Gold, Brigus Gold, Silver Wheaton, and Teck Resources. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (23)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 03, 2011, at 9:37 AM, Gonzhouse wrote:

    The 'cost floor' for mining is also starting to show up in other industries, particularly extractive industries. Consider oil: yes, there is a new Saudi Arabia sitting off the coast of Brazil but it is in thousands of feet of water. The cost model for getting oil to a pipeline when drilling in 2,500 feet in water miles offshore is a lot different than going 500 feet on dry land. Another added cost is the impact for environmental mitigation.

    The impact of new findings being more expensive to productionize combined with increasing emerging country demand also means that mines and oil rigs abandoned when they became uneconomic are now being re-started because the revenue can now justify the costs.

    Bottom line: we're not running out of resources but the days of cheap resources are over.

  • Report this Comment On August 03, 2011, at 4:29 PM, speedybure wrote:

    Good article as always Chris! Personally I would never buy Barrick because I don't think they believe in its product. For example, the silver streams and gold royalties sold at Pascua-Lama, the latter being an NSR so it will end up having a larger effect than 5.23%. Instead of replacing gold reserves and trying to reach double digits in (in millions) in gold output, they go and acquire equinox. I can't remember the exact buyout offer 6-7B to the best of my memory, could have been spent buying up quality gold companies with lots of organic growth. You and I have liked a lot of the same companies over the years (if you remember the days I used to write here) and Barrick should have acquired both Aurico and Brigus, likely for half the equinox price, or at least close. I know your a fan of the new northgate, which barrick could have possibly been able to buy in addition to Aurico and Brigus. While I think Barrick will make someone money, I see mgmt making mistake after mistake and investors will be much better served in the companies mentioned above. Keep up the good work! BTW, I've been a scorpio mining investor for a while and it still looks very cheap, any thoughts on them given the potential 300% expansion by 2013?

  • Report this Comment On August 03, 2011, at 10:36 PM, skypilot2005 wrote:

    http://www.pilotgold.com/news/pilot-gold-announces-new-gold-...

    Pilot Gold announces new gold discovery at Brik Project in emerging Stateline District, Nevada.

    Can anyone spell Fronteer Gold? :)

    Sky Pilot

    Official Web Link Assistant to Sinch

  • Report this Comment On August 03, 2011, at 10:40 PM, skypilot2005 wrote:

    On August 03, 2011, at 4:29 PM, speedybure wrote:

    "I know your a fan of the new northgate, "

    Speaking of Northgate....

    http://finance.yahoo.com/news/Northgate-Minerals-Announces-p...

    Northgate Minerals Announces Positive Preliminary Assessment for its Kemess Underground Project

    Sky Pilot

    Official Web Link Assistant to Sinch

  • Report this Comment On August 03, 2011, at 11:17 PM, Frankydontfailme wrote:

    Fascinating Stuff.

    The incipient wealth of emerging market nations is a key catalyst that is often discounted. These nations are replete with natural resources, hard working people and strengthening currencies (strengthening because of these factors... and a reasonable lack of faith in 'developed nations' currencies').

    Along with the populous' (of many EE nations) deep desire to own gold, the strengthening of these currencies could be enough to push gold to and past 2,000 /oz.

  • Report this Comment On August 04, 2011, at 7:02 PM, speedybure wrote:

    Skypilot,

    Saw you started following me on SA, nice. I don't know if you like the PEA but I don't care for it at first glance (although im not familiar with the deposit and potential upside) because of the Cap-ex requirements, thus lower IRR. I know this is a base case so there is a good chance I could be wrong.

  • Report this Comment On August 04, 2011, at 10:11 PM, skypilot2005 wrote:

    Speedy,

    I like the Primero purchase a lot.

    I’ve owned both NXG and Primero for sometime now and have a low cost basis on each thanks to Sinch. I had just recently increased my NXG position 5 fold before the Primero announcement.

    To me, Kemess Undergound is just “icing on the cake”. I could be wrong, too. That’s why I am an assistant. :)

    As far as the PEA, I glanced at it and here’s what I liked:

    12 year mine life

    $115 oz gold cost

    1.1 million pounds of gold

    490 million pounds of copper

    Plus, Silver production

    Then, a P. E. E. payback of 6.1 years with $1,100 gold, $2.80 Copper

    I had to start following you after your Sandstorm “heads up”. Even after today, I am up +20% on the Gold and holding even with the Metals. I’ve owned both for just a few months.

    Completely unrelated to the investment potential, there is something that feels good about pulling the trigger for several K shares at a time… :)

    I agree with you that Metals is the better buy. But, I am still accumulating both. I’ve obtained a sizable position, now. The key to me is the smart people managing both companies.

    I hope the market keeps dropping. There are several companies I’d like to buy on “sale” that I should have purchased earlier.

    Thanks again,

    Sky Pilot

    Official Web Link Assistant to Sinch

  • Report this Comment On August 05, 2011, at 2:17 PM, speedybure wrote:

    Yeh same, I put on my whole Sandstorm Gold position in 2009 and although I would like to buy more, it has appreciated hundreds of percent (as you prob know). I;m still adding to SND even though its above my costs basis but am really impressed with the last two deals. Management told me they plan to close 2-3 more deals this year, so it makes it that much more appealing. I;ve always like NXG due to the price you pay per ounce in the ground and it was not until they acquired or (likely will close the deal), It has become very attractive to me. Personally, I think the Primero warrants are the best way to play, which when adjusted for the acquisition, lowers the strike price to around 5.40 or so.

  • Report this Comment On August 05, 2011, at 9:51 PM, skypilot2005 wrote:

    On August 05, 2011, at 2:17 PM, speedybure wrote:

    "I;ve always like NXG due to the price you pay per ounce in the ground and it was not until they acquired or (likely will close the deal), It has become very attractive to me."

    http://finance.yahoo.com/news/Northgate-Minerals-Reports-prn...

    Northgate Minerals Reports Second Quarter Results

    An excellent "read".

    Sky Pilot

    Official Web Link Assistant to Sinch

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