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Economics of a Gold Mine

TOM BUTCHER: Joe, could you tell me a little bit about the economics of running a gold mine?

JOE FOSTER: Gold companies typically design a mine to last between 10 and 15 years. That's the mine life that you can expect out of a gold deposit. Companies generally select a gold price to design the mine around, and this price is usually below the prevailing gold price. For example, if gold's trading around the $1,300 level, the company might design the mine around a $1,100 gold price. That ensures that the mine remains profitable, and if there is a drop in the gold price, then of course the mine can sustain itself. Some mines are more profitable than others, and that's largely a function of grade. Management can be the same; it's not a reflection on the skills of management. But higher-grade mines tend to be more profitable, simply because they're richer and in higher-quality ores. In 2013, we saw a major revision in the mine plans of several mining companies. Mines are redesigned yearly if they need to be, and with the collapse of gold in 2013, we saw widespread revisions. Today, the industry is geared at a $1,100 gold price in terms of mining plans, with all-in sustaining costs for the mines at approximately $920 an ounce.

BUTCHER: How do gold mining companies control costs?

FOSTER: There are a number of sources of costs in the mining industry. About 40% of costs is labor and contractors, and that number is split between the twoIf you have a larger workforce, you don't need as many contractors, and vice versa. About 20% is energy costs, and the remaining 40% is miscellaneous costs like tires and chemicals, belts, carbon; all the materials it takes to run one of these industrial operations. All-in mining costs have declined recently, over the past several years from about $1,100 an ounce to closer to $900. To control these costs, companies are using better, more efficient mining methods. The problem with the industry a few years back, when the gold price was higher, is they were concentrating on growth projects and not paying enough attention to the mines. Mining costs got out of control. Now they have re-implemented better mining practices to rein in costs. They have also negotiated better pricing levels with contractors and suppliers to control costs.

Another cost center that we focus on is development costs, and this is another area where companies have achieved significant savings. Many miners have been able to reengineer projects. In the recent past, projects were really too big. Companies were designing projects to produce the maximum amount of ounces, not the maximum amount of profits. Now in this low price environment, they've reengineered projects to make them smaller, to require less capital, and to be more profitable. Not only are gold mining companies saving capital, they're generating better profits with streamlined projects. Those are the big savings we've been seeing over the last couple of years.

BUTCHER: Are there any other costs worth discussing?

FOSTER: There are costs that miners just can't control. These include energy costs. As you know, the price of crude oil is down now. The price of diesel, fuel oil, and electricity are lower than they were a few years ago, and that is helping mining companies quite a bit. Also, currencies are down around the world. If you look at the Australia, Canada, South Africa, and Mexico, for example, their currencies have dropped between 20% and 50% over the last several years. Gold mining is a U.S. dollar-based business, and they get revenue in dollars, yet most of their operating costs are in local currencies. This in effect drives their cost down in U.S. dollar terms.

BUTCHER: Does the cost structure you have just described provide both mining companies and investors with good leverage to the gold price?

FOSTER: That is a good point. Actually, even though miners are generating cash at these levels, most of that cash is going back into exploration, new project development, dividends, G&A [general and administrative corporate costs]; so most of the cash is being consumed.

There is very little free cash at these gold price levels. If we get an incremental increase in the gold price, we will see some tremendous operating leverage, where miners are able to generate much more free cash at higher gold prices. Of course, this works in reverse. Gold prices are low, and if they go even lower, say down towards the $1,000 level, I think we'll start to see some of the unprofitable mines shut down, and obviously that would not be great for gold mining stocks.

BUTCHER: Thank you Joe.

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