From the year 2000 to the year 2012, the price of gold rose six-fold. Of course, this was great news if you were invested in the yellow metal. However, it was also covering up something much more sinister, and now investors are paying the price.
You see, while investors and shareholders alike were mesmerized by the rising price of gold, gold miners could, in a sense, do whatever they wanted to. As a result, costs and debt shot up at miners like Barrick Gold (NYSE:ABX), and Newcrest (NASDAQOTH:NCMGY). But this is something Goldcorp (NYSE:GG) has apparently avoided.
Nevertheless, what goes up usually comes down, and the falling gold price has given these miners a stark warning: Cut costs and start behaving, or go out of business.
During the past decade the gold industry has changed. Mega-miners now span the world with operations on multiple continents. In particular, Barrick Gold has grown from a relatively small company with sales of $2 billion during fiscal 2002 to a corporate giant reporting sales of $14.5 billion for fiscal 2012.
Unfortunately, this growth has created what Barrick has called "management layers," which is essentially a lack of integration and a fragmented management structure -- not an efficient way of running a business. To solve this problem, Barrick has cut 30% of its head office staff along with staff from regional offices around the world. These cuts, among others, helped Barrick to push down its all-in sustaining cash cost of production, or AISC, by 10% year on year at the end of the fiscal third quarter, to $916 per ounce.
Still, the company had to raise $3 billion in equity during November of last year to remain afloat, so it's not all good news. Although, with these changes taking place, Barrick should be in a better position to profit in the future.
Bigger is not always better
In addition to the creation of management layers, miners have also gotten caught up in the 'bigger is better' mentality. Sadly, Newcrest was the first to discover that, as it turns out, this strategy does not always work. Newcrest took a $5.5 billion writedown on the value of its mines last year when it was forced to acknowledge that due to the falling gold price and high cost of getting mines into production, some reserves would cost more to extract than they were worth.
Newcrest's confession was quickly followed by Barrick with an $8.7 billion impairment charge and admission that the company was selling some of its high-cost mines.
Further, it would appear that more writedown pain could be coming the way of Barrick and Newcrest.
All mining companies place a value on their reserves. This value is supposed to represent how much each mine is worth based on the recoverable gold within the mine. Of course, to value these reserves, mining companies use an indicative gold price. So, if a company believes that its mine contains 10,000 ounces of recoverable gold and the gold price is around $1,500 per ounce, then the company can value its mine at $15 million. Of course, this is only an example.
In Barrick's case, the company's gold reserves are valued at $1,500 per ounce, and Newcrest currently uses a figure of $1,400 per ounce to value its reserves. But with the price of gold falling, these miners will have to revalue their reserves, and this is likely to result in a writedown in the value of gold assets.
How much are these writedowns likely to cost? Well, according to Financial Times, Newcrest's management previously stated that a $100 per ounce fall in the price of gold would cut the value of the company's reserves by 7.6%. Barrick has said that a $300 per ounce fall in the gold price would see the value of its reserves fall by less than 10%.
The past decade has also seen a number of mergers in the sector, and for the most part these have been miners acquiring new reserves for often over-inflated prices. For example, Kinross Gold's acquisition of Red Back Mining for $8 billion back in 2010 eventually resulted in a multi-billion dollar writedown, and Newcrest's $10 billion takeover of Lihir Gold in 2010 also resulted in a $4 billion writedown .
But with valuations on the decline, Goldcorp, a company that has seemingly avoided much of the pain in the industry, is looking for vulnerable prey. Osisko Mining was Goldcorp's first target.
Obviously this move by Goldcorp was designed to take advantage of low industry valuations, but the offer for Osisko has been turned down, blasted by Osisko's management as "an immaterial premium which is well below those paid in relevant precedent transactions."
Osisko owns one low-cost gold mine within Canada and the company's management has argued the case that smaller miners like itself often generate smaller returns than larger peers. Nevertheless, I doubt Goldcorp will give up on this deal, as a Canadian mine will help the company diversify away from Mexico and the Dominican Republic, where the company has been hit by tax increases.
In conclusion, gold miners have been misbehaving over the last decade or so but they are now getting their house in order. Luckily, Goldcorp has missed most of the pain and is now preying on smaller peers, which should pave the way for future growth. What's more, hopefully Barrick and Newcrest have learned from previous mistakes, and recent measures to cut costs and place suitable valuations on their assets will lead to long-term gains.
Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.