We have reached one of those rare market moments when gold bugs and value investors actually agree.
Shares of gold miners are so beaten down, so unloved, that they look like they have to be a buying opportunity.
But bargain hunters should tread carefully.
It's undoubtedly true that a rebound in the price of gold would cause miners' shares to surge.
The opposite, however, is also true. The rising cost of mining gold, and miners' increasing reliance on debt, mean a gold price that settles below $1,500 (U.S.) an ounce would punish the sector's outlook.
Analysts have run "stress tests" to assess investors' risks if gold falls to $1,300 or $1,200 per ounce – a 15- to 20-per-cent fall from current levels.
Companies like Goldcorp Inc. that combine healthy balance sheets with relatively low costs seem best able to weather such a storm. Others with higher debt – Barrick Gold Corp. and Newmont Mining Corp. – appear to have more potential problems.
"You don't want to be too reactionary, but at the same time, people need to understand the risks involved in a lower gold price, because there are now more balance-sheet-related risks than there were three years ago, before the sector became more levered," says Jorge Beristain of Deutsche Bank.
Mr. Beristain issued a report on Monday in which he cut his price targets on major North American miners by an average of more than 30 per cent. He reduced his ratings on Barrick and Kinross Gold Corp. to "hold" and on Newmont to "sell." (Goldcorp remained a "hold.")
Mr. Beristain built his model on what's called "net present value" analysis. In calculating net present value, or NPV, an analyst estimates all the future cash flows from the business and discounts those cash flows to a present-day value.
Of course, cash flow estimates for a gold miner are closely tied to the price of bullion. As the price of gold drops, cash flows suffer, leaving miners less money to pay expenses.
What are those expenses? For years, the industry emphasized "cash cost" numbers that focused on the direct expense of extracting current production; now it's moving to much higher "all-inclusive" or "all-in" costs that also include administrative and exploration expenses and capital expenditures that sustain existing production.
But Mr. Beristain says "even that's not all the costs. People need to understand there are other costs that need to be paid." Among those expenses are debt interest (an important consideration for Barrick, with $14-billion in debt, and Newmont, with $6-billion), as well as taxes and capital expenses for new projects.
All told, he estimates the four majors' total spending to produce an ounce of gold in 2013 to be between $1,500 and $2,000. That includes "growth capex," of roughly $200 to more than $600 per ounce, to support new production.
In estimating cash flows, Mr. Beristain uses Deutsche Bank's gold price forecast, which calls for gold to average $1,600 per ounce over the long term. This yields NPVs of $45 for Barrick and Newmont, $33 for Goldcorp, and $9 for Kinross – figures well above their current share prices.
Mr. Beristain, however, is setting his target prices at a discount to this NPV, in part to cover the possibility of lower gold prices. As an exercise, he then goes further in his stress test, cutting the gold price to $1,300. This yields an average decline of 78 per cent in the NPVs, with Newmont's falling to $3 and Kinross shares approaching zero.
Mr. Beristain notes some of these declines are "illogical outcomes" because his top-down model does not account for companies shutting down their highest-cost mines, which would turn unprofitable with significantly lower prices.
This is exactly Kinross's objection to the analysis. Spokesman Steve Mitchell says the analysis "incorrectly assumes that in a lower gold price environment, we would continue spending at current or higher levels, when in fact, we would expect to reduce spending."
He also says "contrary to this analysis, our portfolio has significant value even at gold prices that are much lower than they are today."
But even more bullish analysts agree there are downside risks. George Topping of Stifel Nicolaus' Canadian research arm has a generally favourable outlook for bullion prices and "buy" ratings on Barrick ($34 target price) and Goldcorp ($36 target). He also has "holds" and no target prices on Newmont and Kinross.
Despite those recommendations, his analysis – which assumes mines will be shut if gold prices decline – indicates gold miners will be hard-pressed if gold prices fall.
A drop in gold to $1,200 per ounce yields a drop in net present values for the miners' shares of roughly 60 per cent, according to Mr. Topping's model. Goldcorp falls the least in his stress test; Barrick declines the most.
Mr. Topping calls Barrick "highly exposed to lower gold prices," while he says Newmont is troubled by high costs and high debt. He estimates a drop in gold prices to $1,200 per ounce would mean nearly 60 per cent of Newmont's 2014 cash flow would go to covering interest payments.
The gold producers disagree. Barrick spokesman Andy Lloyd says four mines produce 55 per cent of the company's production, with "all-in sustaining costs" of $579 per ounce. "Those mines will drive the higher returns and free cash flow we're expecting in any gold-price environment." As for debt, he says the company's loans have lengthy maturities that mean Barrick's principal and interest payments through 2017 are less than last year's operating cash flow.
At Newmont, spokesman Omar Jabara says the company is keenly aware of the need for financial discipline: "Since last year, Newmont has taken the lead in the gold sector on reining in total costs, and we will continue to do so."
Mr. Topping, like Mr. Beristain, says the point of his exercise is to "stress-test the companies on a relative basis to see who are the survivors, and highlight those that will perform the worst."
He adds, "If you think the gold price is going down to $1,200, you don't want to own any gold companies whatsoever."
Investors may not believe $1,200 gold, or even $1,500 gold, is a certainty. But they should definitely consider the possibility.