Gold Mining 101

AISC, ore grade, LOM...WTF?

Gold miners are the genuine central banks. For the past 5,000 years, they have created money that has been used as a store of value. Unlike traditional banks, they invest time and energy in extracting every ounce of gold and silver.

I am not saying traditional banks are evil. They are definitely not. However, with reserve requirements below 5% or, in some cases, zero, banking is fraud. Conversely, a full reserve requirement transforms banks into safe deposit boxes. Remember, the dose alters a medicine into poison and vice versa. This maxim is more valid than ever for banking.

Banking stocks can be a lucrative investment. That being said, I have articles on banking stocks: Banking 101, Primer on Brazilian Banks, and Banking Ideas across the globe.

However, today, we grab a pick and shovel on a quest for sound money. The topic is gold miners. Exposure to tangible assets is a must in turbulent times, and gold and gold miners are vital parts of any portfolio. 

Today, my goal is to introduce gold mining basics, like ore grade, AISC, LOM, etc. Those terms and concepts are a must for every investor interested in mining.

Mining 101

Let’s start with creatures that inhabit the gold-mining universe.

Mining companies are classified according to their development/production stage. The main types are:

·       Explorers are companies whose activities are entirely focused on finding new deposits. They do not build or operate mines.

·       Developers are enterprises concentrated on developing and operating mines. This stage is the prerequisite for the next.

·       Producers are companies that own operational mines. The major producers have several projects, which means they fall into all three categories. Nevertheless, having a single operational mine is enough to consider the company producer.

·       Royalty and streaming - these companies neither manage nor develop mines. They offer upfront funding to enterprises in the above three categories. In return, they receive a percentage of revenues or profits (royalty) or a portion of production at a price much lower than the market (streaming). This type of financing is specific to the gold mining industry. There are infrequent exceptions for other minerals.

Having introduced the types of gold mining companies, it is time to examine a mine's life cycle. Pierre Lassonde developed the famous Lassonde curve which describes the stages a deposit goes through.

The chart below shows how the company's share price correlates with the mine's development. After the first ounces are discovered, euphoria follows, and the share price rises significantly. The situation is similar after the mine starts production.

During the capital raising phase (Orphan period), everything looks hopeless. The share price drops sharply and may bottom for a long time.

The Lassonde curve is an invaluable tool. It helps us understand the stage of development of the company we are researching. We should always consider this when investing in any mining companies.

Vital metrics

Cash Cost is the cost of mining one ounce of gold or silver. It is very close to COG (cost of goods sold) as a concept.

AISC - all-in-sustaining cost. Includes Cash Cost plus exploration and development, G&A, and Sustaining Capital. AISC considers all costs plus those to expand current deposits enough to maintain present production levels. Energy prices, inflation, cut-off grade, and deposit type influence this cost.

AIC - all in costs. This includes AISC, with costs added for expanding present operations and discovering new ones that would increase annual production above current levels.

Grade is how many grams of gold one ton of rock contains. Winnie the Pooh's rule applies in full force here: the more, the better. For gold, the average is about 1 gram per tonne for open pit mines and 3 grams for underground mines.

Cut-Off Grade - how many grams of gold per tonne is the minimum concentration to make it economical to mine? If it goes below a certain threshold, the AISC becomes unacceptably high. Mining, therefore, becomes unviable.

Resources are ore deposits that may eventually become economically viable for extraction. They are divided into measured, indicated, and inferred resources. When a deposit is discovered, the resources are first defined and gradually screened to determine which are economically viable. Then, a portion of the resources becomes reserves.

Reserves mean the ore in the ground is economically viable for extraction at an estimated cost. They are also divided into groups: Proven and Probable. The goal of any mining company, no matter the ore, is to increase reserve to ensure its sustainability over time. In other words, the reserve growth rate must exceed the reserve depletion rate.

LOM—Life of Mine—How many years will the reserves last? The LOM is ten years if we have 10 M oz gold reserves and mine 1.0 M oz annual production. For gold mines, the LOM should be a minimum of 10 years. This increases the company's chance of surviving difficult periods.

Annual Production is the number of ounces of gold produced per year. The Winnie the Pooh rule doesn't help here because if we extract too much ore, we shorten the life of the mine faster than desired. That means we are not giving enough time to fill reserves with discoveries or expand current ones.

Depletion—depletion of ore reserves. Along with depreciation and amortization, this is the third and most critical element draining the company's capital. The miner must continually expand current deposits or develop new ones to offset mine depletion. If 1,000,000 million ounces are mined annually, the same amount must be added to reserves.

Tier One deposit contains sufficient reserves for at least 500,000 ounces of annual production; LOM of at least ten years; AISC below industry median (in 4Q23 is $1328/oz); located in a country with low political risk or Tier One jurisdictions.  

How to pick mining stocks?

MML - mine, management, location - the holy trinity of mining. A team of experienced managers operating assets containing reserves for at least 15 years ahead, with above-average grades and below-median AISCs, located in politically low-risk locations. This sentence describes the essence of investing in resource companies.

·       Management—Of the above triad, people are the most important. We always have to choose who we do business with because, as investors, we entrust our money to the company's top brass. They can ruin the best-quality mine, although they can never transform an alarming low-grade deposit into a Tier One mine.

·       Mine - covers several parameters: LOM, reserves, resources, grade, and cut-off grade. The combination of a top mine managed by top managers immensely increases our chance of a successful investment. The opposite is true, as well.

·       Location - in which country does the company operate? It is no coincidence that this is the third element of the triad. If everything else is perfect, but the company operates in high-risk countries, everything can go down the drain. The best source for assessing risk in different countries is the Fraser Institute Annual Survey.

This article aims to introduce readers to gold mining by providing the essentials. It is not an exhaustive list of metrics and methods for analyzing mining stocks; it is simply a primer that maps how NOT to get lost in miners' presentation decks.