Commodities & Metals

Is Gold Fields Too Good to Be True?

Gold Fields Ltd. (NYSE: GFI) continues to benefit from record gold prices, reporting a sequential 15% gain in second-quarter profits. Although the South Africa-based gold producer is diversifying its geographic footprint, future profitability and cash flow generation remain highly sensitive to commodity trading prices of bullion, given continued dependence on high-cost domestic mines for production volumes.

The world’s fourth-largest gold producer posted net earnings for the June quarter of $186 million, against $158 million in the March quarter. Cash-operating cost increases of 6% (to $816 per ounce) were offset by gains in production and gold prices of 5% (to 872,000 ounces) and 7.7% (to $1,496 per ounce).

Gold Fields has quality gold reserves of some 77 million equivalent ounces, with eight operating mines in Ghana, Australia, Peru and South Africa capable of pumping out about 3.6 million ounces in annual production.

Though the company has a diverse global growth pipeline, with four major projects in resource development, plans to grow annual production to 5 million ounces by 2015 are underpinned on expanding base load capacity in South Africa, home to its biggest and longer-lived mines. The KDC, Beatrix and South Deep complexes — average mine lives of 18, 13 and 42 years, compared with 5.5 years in Australia or 15 years in Peru — produced in the aggregate 446.6 million ounces of gold, or 51.2% of total processed output in the quarter ended June 30.

Operating Costs Are Rising in Largest Production Areas

However, the richest of these shafts are aging, with some veins from KDC 50 to 75 years old! Ramping up production at these world-class mines requires the miners to dig deeper — more than two miles down in many places — to find more gold. Consequently, total notional costs (extraction, general and administrative and capital expenditures) are rising. Weighted-average total costs at the South African operations have increased to $1,401 per ounce, double the cost of two years ago.

Increasing transport distance costs are being compounded by rising energy costs. Electricity costs as a portion of Gold Fields’ total operating costs are expected to rise from 12% to an estimated 20% in the next few years, due to power tariff increases (averaging 25%) granted last fall to utility companies.

Labor-related costs could continue to pressure margins too. A recently settled miners’ strike in South Africa will see wages climb from 7.5% to 10% in the next two years.

Additionally, Gold Fields could see employee-related costs skyrocket due to a little publicized ruling by the high court last spring. In March 2011, the South African Constitutional Court ruled that legislation that limited employees’ rights to claim compensation for certain diseases, including miners’ lung disease (silicosis), were unconstitutional. The company is among South African producers now threatened with costly court battles as rights groups enlist thousands of former miners with work-related lung disease for a class-action suit. According to recent regulatory filings, the company said it was “assessing the potential effect of a claim.” To date, however, no litigation reserves have been set aside for potential losses.

Chief Executive Nicholas Holland reminded industry analysts on the quarterly earnings call that cost pressures are not just limited to South African operations. For example, open-pit mining operations in Peru are heavily dependent on diesel power, the price of which is rising with oil (to about 15% of total cash costs).

Is Gold Price Overextended?

Many pundits are predicting $2,000 per troy ounce for gold in 2012. That is good news for Gold Fields, as the company does not hedge any of its production.

Nonetheless, some analysts remind us that the sky was the limit for oil prices once too.

“Gold is too extended over price-averaging algorithms, is 7.5 times what it was worth ten years ago and is the subject of relentless sales pitches on cable TV and radio,” Elliot Wave International chief marketing analyst Steve Hochberg noted in an interview with the 10Q Detective:

Trading volume is surging, suggestive of froth — and trader optimism has just reached 98 percent out of 100 percent, according to MBH Commodities. Major world central banks, which were sellers of gold at the lows in 1999, are now buyers, a dangerous sign since government is always the last to act upon a trend and usually near the trend’s exhaustion point. Further, Exponential price rises are always dangerous because they go further than anyone thinks and then they crash. Oil is a recent classic example — When it spiked to $147 in July 2008 and then crashed 78 percent in just five months. Anyone remember the “Peak Oil” arguments near the top, when oil bulls were telling us the world was running out of oil?

Hochberg did note that $2,000 gold is only about 10% above current prices. “I don’t know if the blow off ends before that level, or after,” he said, “but gold should be closer to $1,000 than $2,000 sometime over the next year or more. This is one venue that is ripe for reversal.”

Credit Facility Preserves Financial Flexibility

Gold mining is a capital-intensive business. With net debt of $2.7 billion just 44.1% of stockholder equity at Gold Fields, the mining company can take on incremental debt to meet costs of development programs. The company recently secured a five-year $1 billion revolving credit facility to support drilling programs (in places from the Philippines to Finland) meant to lessen dependence on domestic production.

Expanding global production is necessary to help ease margin pressures at home. For example, notional costs at the recently purchased Damang Mine in southwestern Ghana are forecast to be about $900 per ounce this year. At present, however, quarterly capacity at this open-pit operation is estimated to be only about 60,000 ounces.

“All that glisters is not gold,” wrote Shakespeare in The Merchant of Venice. Core gold operations threw off free cash flow of just $100 million last quarter. With operating costs likely to remain onerous, look for Gold Fields to tap its credit lines in coming quarters to meet its stated capacity goal of five million ounces by 2015.

Should the spot price of gold lose its growth luster, the company will end up mining plenty of “fool’s gold,” especially in South Africa.

David Phillips