Gold has seen a nice run the past few days, with gold bullion climbing to the $1,340-per-troy-ounce area.
Some speculators attribute this action to dollar weakness. There’s also the matter of traders short-covering now that the economic reports that were delayed while the government was closed are starting to come back into play.
Short-term trading action aside, many more variables influence the price of gold than whatever’s happening in Washington or on Wall Street.
News stories usually focus on factors like inflation, central bank buying and selling, geopolitical events and other current news.
And while those factors do drive gold in the short term, gold prices depend much more heavily on production costs. Frankly, when it comes to gold or any other high-demand natural resource, the cost to produce (or replace) an asset is the best way to determine its fair market price.
When it comes to the value of gold, you only need to know one simple thing …
Producers Want to Make Money
Let’s start with a basic economic principle. Manufacturers and producers of all kinds want to make a profit.
They certainly don’t want to lose money. They may be willing to operate near breakeven costs, at least temporarily, if they expect profitability will return soon.
This is why investors need to understand the total cost to produce or replace an asset. To illustrate, let’s take a brief look at oil, housing and silver.
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Linn Energy (LINE) recently bid to acquire Berry Petroleum (BRY) for $4.2 billion. Berry’s reserves are about 134 million barrels of oil equivalent. That means the price works out to about $32 a barrel — a very good deal for Linn.
As recently as 2011 and 2008, acquisition costs were much higher — closer to $50 a barrel. Currently domestic crude sells for about $100, which is about three times what Linn Energy will pay for Berry’s oil reserves.
The National Association of Realtors says the median cost of building a new home in the United States is around $181,300. The range is from $80 to $110 per square foot.
The average home price in the U.S. is about $180,000, close to cost, but there are substantial regional differences. Since builders want to make money, they will avoid areas where home prices are at or below total cost.
In the West and Northeast, the average home prices are about $240,000. In Orange County, Calif., it’s around $600,000.
A recent Wall Street Journal article said the average cost to produce silver was about $9. The current price for silver bullion is about $22. This means silver sells for about two-and-a-half times its cost.
Miners who can produce silver for less than $22 will keep operating and try to expand.
What Happens When Prices Fall
To Production Costs or Below?
When prices fall to breakeven or below, producers will normally cut back on production. They may even stop completely.
That’s because they have no incentive to produce more until prices go back up.
Sometimes producers switch to producing another asset when one asset falls to cost or below. For example, natural gas companies may decide to produce oil, or homebuilders build apartments instead of houses. Precious metal producers might switch from gold to copper, palladium or platinum.
Let’s look at natural gas as an example.
The natural gas production cost currently ranges from $1.50 up to $4 per million cubic feet. When natural gas prices fell to the $2 level, producers shifted to oil and natural gas liquids.
With a glut in natural gas supplies, production is falling. One of the best ways to determine the potential supply of natural gas is to look at rig counts.
Baker Hughes (BHI) tracks the number of rigs operating all over the world. This table from its website shows the decline of rigs used for natural gas drilling:
The U.S. natural gas rig count fell by 240 rigs in the last year, a 40% decline. Notice how the number of oil rigs rose slightly since a year ago. Those are producers switching from natural gas to oil.
Now look at this natural gas price chart.
When prices hit $2.00, producers cut back on production. Then demand picked up, especially from utility companies. Prices recovered and have now doubled to the $4 area.
The Cost to Produce Gold
The chart below is shows the price of gold from 1968 to 1999.
Gold spent almost two decades (1982-’99) between $300 and $500 per troy ounce.
From time to time, I study the cost to produce gold for different precious metals companies. Below is a study I did in 2003:
At that time, the highest-cost producer was Eldorado Gold (EGO) at $230 per troy ounce. The lowest-cost producer was South Africa’s Randgold Resources (GOLD) at $74. The average production cost of all these producers was about $164.
Now look at the gold price chart again focusing on the period from 1982 to 2000:
- A few times prices reached $500.
- Prices briefly fell below $300, when global central banks were selling their reserves.
- Gold basically traded from $300 to $400 for close to 20 years.
Think about the "premium" gold traded above its production cost.
- At $300, gold traded about 82% above the $164 average production cost.
- At $400, gold was about 143% above production cost.
The average premium price above gold’s production cost is about 112%.
Gold Production Costs
Understanding gold production costs is the best way to understand the gold price. If producers can’t make a profit selling their gold, they will reduce or stop production and supplies will fall. (We see this in the Breakeven section of this article.)
Like many industries, the mining business has consolidated through mergers and acquisitions in recent years. As the companies get bigger, they expand beyond gold to other precious metals and mining activities.
Just as there are no pure oil exploration and production public companies, there are now very few pure large-cap gold miners. Determining the cost to produce gold is harder for these diversified mining companies.
Another important development is the industry’s effort to re-evaluate costs because:
- Precious metals companies routinely understated their costs for decades.
- Major gold producers and the World Gold Council are now developing an industry standard to better represents the total cost of producing gold.
The biggest changes will include long-term costs like capital expenditures.
Below is the cost breakdown for Barrick Gold (ABX):
Barrick’s total cash cost is $584 per ounce, but adding the other expense categories pushes its cost to $945 per ounce. The biggest expense is mine-site sustaining capital expenditures.
I analyzed the total costs of producing gold from four large precious metals companies and two small precious metals companies. Here is what I found.
The average cost to both small and large precious metals companies is $1,104 per ounce of gold. As you might expect, smaller companies have a higher cost per ounce — but not by much.
In 2003 gold production costs averaged $164. They were up to $1,104 in 2012.
For a more apples-to-apples comparison, Barrick’s cash cost rose from $177 in 2003 to $584 in 2012. Cash production costs roughly tripled in nine years, far exceeding inflation.
The Price of Gold: Total Cost Plus Historical Premium
We learned that whenever prices went below cost, producers normally cut production until prices recover. The breakeven point is another good support for an asset.
Can prices go below breakeven? Sure, they can, but normally not for very long. Prices can also move above historical premiums.
Bottom line: The market price of an asset is its production/replacement cost plus a premium.
If we add the historical premium, we can forecast price targets for gold:
The average total cost to produce gold is about $1,104, and should act as support. This cost is a moving target. It rose much faster than the global inflation rate over the last decade.
Using this methodology, I calculate a $2,340 target price for gold. This number is based on the total production cost for gold plus the average historical premium.
I believe that the price to produce gold will move higher over time, and so will the price of gold futures and bullion itself.
All these factors can move sharply in the shorter term, so gold prices will stay volatile.
The long-term trend will follow production costs — and it points much higher.
P.S. Some called James DiGeorgia crazy when he predicted the tech wreck of 2000 … the housing and banking bust of 2007 … and $1,000 gold and $100 oil. Now, he’s eyeing gold at $2,340 … and oil at $117 — with a straight shot to $250 if this powerful world leader gets his way. Take action now before it’s too late.