It’s been a phenomenal run for gold recently, and this week topped $4,000/oz for the first time. In this environment, investors start to focus on the companies that benefit from high prices. No companies have as much direct exposure as current gold producers. Indeed, with a largely fixed cost base, any gold price rise means a geared upside for the financial results of miners.

However, many investors will have avoided this sector as a capital-intensive, cyclical commodity business full of indecipherable jargon. Others will expect the market to have priced in the rise in gold almost immediately. After all, the current gold price is no secret waiting to be discovered. However, there is a tendency for the share prices of junior gold miners to lag the changes in gold price. Here is what ChatGPT observes about these cycles when I asked it:

Some of the reasons for a lag between gold prices and share prices are logical:

• Cost inflation: The gold price often rises in an inflationary environment, which means that the input costs to production, such as labour, energy and chemical feedstocks, are also rising, squeezing margins. Despite correctly predicting that gold would do well in the mid-2000s, I didn’t really profit from it, as the oil price went up as much and wiped out much of the margins for the smaller producers I invested in.
• Hedging: A company may have hedged a proportion of their production and hence not immediately benefit from the rising gold price.

Some of the reasons are less grounded:

• Many investors (including myself) don’t like to buy things that have gone up a lot recently, as the risk of buying into a bubble at the top seems high. Yet the academic evidence is that buying recent winners is a good strategy, on average.
• Investor confidence takes time to build, and capital takes time to flow into smaller companies.
• Institutional capital can be restricted by liquidity or sector bias.
• Investors rely on brokers' notes for financial forecasts, and these are updated more slowly than the (almost continuously quoted) spot gold price.

There are several reasons to think that this dynamic applies to this cycle. Institutional capital in the UK is still not widely allocated to gold producers. On top of this, energy costs have not been rising recently, meaning the major factor that limited gains in the mid-2000s does not apply now.

While it is true that gold producers are selling a commodity product, there are also some upsides. They don’t have to spend money on sales and marketing. Plus, as I will demonstrate in my next article, they are surprisingly easy to model. But first, there is the mining jargon for investors to contend with. It can be confusing at first, but the key metrics reduce down to three factors: how much metal they can produce, at what cost, and for how long.

Key metrics

Surface or Underground Mining

Surface or open-pit mines are formed by digging down from the surface in layers known as stopes. Stope size can vary depending on rock stability, ore body characteristics, and economics. Softer material may be dug straight out with excavators and rock trucks. Harder materials will be blasted in sections before being cleared in the same way. Gold-bearing material will be sent to a processing plant, usually close by, for the ore to be crushed and processed. Any non-gold-bearing material will be stockpiled as waste. Open-pit mines can be very deep. For example, the Muruntau Mine in Uzbekistan is over 500m deep. However, the deeper a mine goes, the wider it also needs to be, meaning that at some point it becomes uneconomic to mine deeper, even if the ore body continues.

At some depth, it often becomes more economic to sink large holes down, called shafts, and then dig out the narrow quartz veins that gold tends to be found in, horizontally in levels, rather than taking all of the rock for processing. These are known as underground mines, and many surface mines transition to underground mining at some point. Underground mining is more costly and complex, so it requires higher-grade veins to be available to make it economic, but underground mining can access deeper, higher-grade deposits that make the extra effort worthwhile.

Each mine will have a mine plan, which describes how the company will access the various ore bodies in time. They are set to maximise the most economic recovery of the ore available.

Finally, an increasingly important source of gold in historically high gold-producing nations, such as South Africa, is the reprocessing of tailings dumps. These can be economic, partly due to technology improvements in recovery, but also because the tailings have had time for some of the gold to oxidise, making it easier to extract. Here is a breakdown of how the UK-listed pure-play gold producers operate:

Drilling and Grades

Since gold occurs in the ground, it requires drilling to build a mine plan and identify where to excavate ore. Reverse Circulation (RC) or Air Core (AC) drilling are cheap and quick methods that produce small rock chip or dust samples that may be used for initial resource estimates. However, for a more detailed understanding of the geology, diamond drilling is required. This brings a solid core of rock to the surface that can be viewed by geologists. It can also be crushed and analysed for gold content using either high temperature “fire assaying” or increasingly by Chrysos PhotonAssay™ technology, which uses X-rays to excite atomic nuclei, allowing enhanced analysis of gold, silver, copper and other elements much more quickly than more destructive methods.

High-grade for an open-pit mine is considered 8-10 grams per tonne (g/t), while lower-grade mines might fall between 1-4 g/t. The viability of a mine depends on the "cut-off grade," which is the minimum concentration of gold needed to make extraction profitable, factoring in operational costs and economic viability, but this typically is around 1 g/t.

It is worth thinking for a moment about what 1 g/t means. 1kg = 1000g, 1 tonne = 1000kg. So 1 g/t is one part per million. Gold can be profitable to extract even when it is a very small part of the host material. In underground mines, the average grade of the ore body, but this time just the quartz veins that will be targeted, needs to be above about 5 g/t. Ideally, good quality mines will have at least some sections that are 10 g/t or higher. Tailings reprocessing can be economically viable at grades as low as 0.5 g/t, as the hard work of digging up the ore and crushing has already been done.

Reserves

No mine goes into production without a significant amount of gold being present and the confidence that it can be economically extracted, but no one knows for certain what is underground. To close this gap, models are built from drilling results. The closer the spacing of the drilling, the greater the certainty that the mineralisation exists in between drilling.

Reserves tend to be reported based on the industry standard Australian “Joint Ore Reserves Committee” (JORC) Code and are split into two categories:

• Proven = highest confidence in extraction feasibility and have been economically evaluated.
• Probable = reasonable but lower confidence in extraction feasibility, or with economics, preliminary feasibility studies.

One common metric that can be used to compare gold miners is Enterprise Value/Reserves oz. This gives a feel for how a company’s valuation compares to the gold in the ground. This is what I calculate for the UK gold producers:

Typically, less than $100/oz is considered cheap within the industry and greater than $250/oz expensive, but of course, there are limitations to this metric. Firstly, these will have been based on gold that is not at current levels. Plus, it excludes the rate of current production, exploration potential or mineralisation which is not yet economically or technically proven to be extractable. This latter category is known as resources, and these have three categories in the same JORC standard:

· Measured: Highest confidence. Quantity, grade, and continuity are well established.

· Indicated: Moderate confidence. Quantity and grade are reasonably well understood.

· Inferred: Lowest confidence. Only general geological information; significant uncertainty.

Companies often have development drilling campaigns that seek to give greater confidence in the size of their resources, and move them up the categories, plus adding economic studies in order to move resources to reserves. Canada and South Africa have their own reporting standards, but they tend to be very similar. The models and studies done in order to book resources and reserves tend to be done by external consultants in order to provide an independent opinion on their validity. This is especially important when a company is looking to raise equity or debt to develop or expand a mine.

The EV/Reserves metric not only excludes Resources but also exploration assets that may have been drilled but not yet modelled. It may not be a great comparative valuation tool. However, what it does highlight is where higher-risk exploration is a bigger part of the current valuation of the business. For example, the very high figure at Metals Exploration (LON:MTL) shows that this company is less about the production at Runro, which will likely run out soon, but rather the company’s non-producing assets. This may be a different investment proposition compared to an existing producer with a lot of reserves yet to produce.

All-in Sustaining Cash Cost

How much profit a gold producer makes doesn’t just depend on the price of gold, but also on how cheaply they can produce the gold sold. Companies typically report and provide guidance on two cost metrics: Cash Cost and All-In Sustaining Cash Cost (AISC). The cash cost is the direct cost to produce one ounce of gold and includes mining costs, processing costs, on-site labour, energy and refining costs. However, it excludes corporate overhead, all capex or exploration costs, interest and taxes. It can be thought of like EBITDA for trading companies, useful to their bankers to protect against an extreme downside scenario, but not something to base a valuation on.

Much more useful for investors is the All-in Sustaining Cash Cost, which adds sustaining capex, admin and corporate costs, rehabilitation provisions, and adjusts for inventory movements. It still includes interest and taxes, but gives investors a good estimate of the operating profit per oz that a company will make at a given gold price. Here is the current AISC for UK gold producers:

Typically, investors like companies with low AISC, as this means that they make high margins in times of high gold prices and are protected from falling into losses should the gold price fall. However, it is worth noting that it is the companies with the highest AISC that are most geared to the rising gold price. If an investor believes that the gold price has further to rise, they may actually prefer high-cost producers to low-cost ones.

Production guidance

How much gold a company can produce depends on how much ore they can get out of the ground and process, and what grades of gold it contains. Thankfully, companies tend to provide specific guidance on their likely production in troy ounces. The Troy weight system dates back to the Middle Ages, originating from the French market town of Troyes, where merchants from across Europe traded gold and silver. It is largely tradition that means this is still used today, since its 31.1034768 grams doesn’t readily convert to metric measures or even the imperial system for most other goods. The gold price is quoted in kg, and indeed, the most common gold bar weighs 1kg, but it is the troy ounce that most people quote when speaking about the current gold price.

Production guidance needs to be taken with a pinch of salt. Gold miners tend to operate in difficult environments, and if gold were easy to find, process and refine, it wouldn’t have the value it does. The tendency to overcommit and underdeliver that plagues us all, also affects gold miners. As a case in point, Anglo Asian Mining (LON:AAZ) today reduced their production guidance for the year.

If a company has a history of hitting or exceeding its production guidance range for a number of years, we can probably trust it will do similarly in the future. However, if a company consistently misses guidance, we have to be careful about basing an investment case on taking it at its word. Production misses can be particularly impactful for gold producers as they usually also provide guidance on AISC/oz. However, because their cost base for a particular period is largely fixed, a production miss also usually means a miss on AISC. This can be a double-whammy for profitability.

Here is the current production guidance for these companies:

Life of Mine

Valuing a gold producer isn’t just a case of looking at the profitability of a single year. How long a company can produce at the current rates matters a lot for valuing a business. The Life of Mine metric helps investors get a feel for this. This is a very simple calculation taking the current reserves and dividing by the current production. When this runs to decades, then using shortcuts such as P/E ratios may be appropriate. Conversely, if the Life of Mine is just a few years, then a discount cash flow calculation would be more appropriate. However, things are rarely that simple. If a company has a very long life, you have to ask what is stopping the company from accelerating their production profile and increasing the present value of those cash flows. Also, a very low life of mine may not be a worry if it is simply a reflection of administrative delay in booking reserves, rather than a lack of resources.

Reserves are replaced or expanded through drilling more holes, either exploration to find new zones of mineralisation or development drilling to expand or improve the accuracy of known mineralisation. Drilling costs money, so spending a lot on expanding reserves and resources far into the future isn’t always the best use of cash in the near term. However, no mine lasts forever, and as mines expand, they will eventually run out of gold that can be extracted economically. Therefore, most miners focus on drilling campaigns that they expect to add enough reserves to give a 7-10 year life of mine. This is long enough to give investors confidence in the short and medium-term future of the company without unnecessarily wasting near-term cash.

Here are my calculations for Life of Mine based on current reserves and production guidance:

Note, this can be hard to estimate; some of these companies have not published reserve estimates for years. A low figure here does not necessarily mean that the company is a bad investment, just that it will require some further digging to assess how sustainable current production is.

Putting it all together

Choosing which companies to include in this list is tricky; there are other companies, such as the majors, that have gold as one of their commodities produced and will benefit from strong gold prices. Likewise, a company such as Goldplat (LON:GDP) (which I own shares in) has tended to produce as much gold as Serabi Mining. However, since it buys in mine waste material rather than owning a mine, it benefits from a higher gold price but without the gearing effect that is so desirable in a high gold price environment. It does have a fully-owned tailings dump resource of about 120koz that will be much more valuable at higher gold prices, but this is not yet in production. Perhaps most importantly, it doesn’t report gold production or AISC, making it not able to be valued on the same metrics. There will be other companies like this that I chose not to included. There are also many gold producers listed in other countries for which these metrics are key. The list I have here is not exhaustive, but it gives a spread of different UK-listed producers that investors may consider.

In my next article, I will show how to use these metrics to estimate the financial performance of these companies and get ahead of the curve in a fast-moving gold price environment.

[Disclosure: Mark owns shares in Goldplat (LON:GDP) ]