There still seems to be a great deal of confusion about the true cost to mine silver. After I wrote my article “Can the Primary Miners Survive $18 Silver”, I received a lot of replies that were all over the place. By that I mean, there seems to be no consensus of what is an accurate cost to mine silver. That is why I decided to write this article.
As I mentioned in prior articles, the reason why I started to research declining ore grades, fuel consumption and mining costs in the mining industry back in 2009, I really didn’t see much in the way of good analysis on the subject. It wasn’t until the last year or so, did these aspects of the mining industry really become mainstream.
In researching declining ore grades in the top primary silver miners, I wondered what kind of impact this would have on the cost to mine an ounce of silver. This was explored in my previous article “Silver Price to Rise as Top Miners Production Evaporates”. The graph below was taken from that article.
As you can see from the chart, the average yield of the top 6 primary miners declined from 13 oz/t (oz/tonne) in 2005 to 8.1 oz/t in 2012. As these average yields declined, these top miners had to increase their processed ore 67% from 9.4 million tonnes in 2005 to 15.8 million tonnes in 2012, just to keep silver production at the same level it was in 2005.
Furthermore, as some of these top mine’s average yields declined substantially, additional new mines were added by the company just to keep production flat. It is certainly true… as ore grades decline, costs increase.
To get an idea how the percentage of costs have increased relative to pure silver revenue, let’s look at one of the top primary silver miners.
A Different Cost Approach for Pan American Silver
There are several ways the mining industry breaks down the costs to produce a metal. One is cash costs, where the mining company deducts by-product credits and change in inventory (plus a few smaller items) from the production cost. Then we have total costs which adds back in depreciation, amortization and other items on top of cash costs.
However, I believe those two methods do not provide the PROFITABILITY of the company as it pertains to costs of production to silver sales revenue. I have used Pan American Silver as an example on how production costs impact their bottom line from their silver revenue only.
If we look at the chart below, we will see a break-down in production costs to silver revenue. I obtained the silver revenue figure by subtracting by-product credits from total revenue. Then, the production cost was divided by the silver revenue to show a percentage (shown in the white line):
I decided to use this approach because there has been some commentary that the primary silver miners could survive for a while selling silver below their cash costs. I find that very hard to believe, but let’s look at the results of the chart.
The quarter in which the ratio of costs to silver revenue was the lowest was during Q2 2011 at 56%, when the average price of silver hit a new average high of $38.17. In the next two quarters the percentage fluctuated, but remained relatively in the same range.
Then all of a sudden the ratio shot up to 93%. How on earth could this increase 33% over the quarter before? It was due to several factors:
1) Average Realized Price of silver fell approximately $3.00 compared to Q1 2012
2) By-product revenue increased $11 million compared to Q1 2012
3) Production costs increased $16.5 million compared to Q1 2012
4) Silver Sold was 700,000 less oz, than was produced that quarter.
I would imagine, if Pan American had sold about the same amount of silver as it produced during Q2 2012, silver revenue would have been approximately $25 million higher and the cost to revenue ratio would have been 75-77% instead of 93%.
In Q3 2012, the production cost to silver revenue declined as Pan American sold more silver than was produced that quarter. By the first quarter of 2013, you can see costs (in red) declined a bit, but silver revenues fell even more, pushing the cost to revenue percentage up to 81%. But, the real problem will occur in Q2 2013 as the average price of silver declined nearly $7 compared to the previous quarter (Kitco).
If production costs remain the same in Q2 2013 and Pan American sells the same amount of silver as it did the previous quarter, silver revenue is estimated to decline by 26%. Based on these assumptions, silver revenue will fall from $159 million in Q1 2013 to $122 million in Q2 2013, putting Pan American’s silver revenue below its cost of production. (NOTE: this is just based on production costs to their silver revenue obtained from subtracting by-product credits).
The production cost per oz in the table above was calculated by dividing total production costs by payable silver ounces. Of course, this does not include any by-product credits, but it was an attempt to gauge the rise in this ratio since Q1 2011.
Regardless, the most important indicator to look at is the decline in estimated Q2 2013 silver revenue compared to production costs (remaining the same). We must remember, this is based on an average price of $23 for Q2 (according to Kitco). Currently the average price of silver in July is $19.50, and if the price remains at this level or lower, Pan American will see its silver revenue decline even further.
Primary Silver Miners Cannot Survive at Cash Cost Prices
As I mentioned in the beginning of the article, investors actually believe the primary silver miners can produce silver at or below Cash Costs. I have received replies to my previous article and listened to analyst commentary stating that the primary miners could survive at cash cost prices.
According to Pan American’s Q1 2013 Report, their stated silver cash cost was $11.33 oz. If we consider the CLOBBERING that Pan American is going to receive during the second quarter of 2013 with average prices of silver at $23 an ounce, how are they going to deal with $20, $18 or even lower?
The big problem with by-product accounting is that it artificially reduces the so-called CASH COST of silver by deducting the by-product credits. So, the higher percentage of by-product credits a company has, the lower its supposed Cash Cost.
A perfect example of this is Hecla. In Q1 2013, Hecla stated a low cash cost of $5.02. If we look at a screen-shot of their Greens Creek Unit, we can see how a high percentage of by-product credits can lower ones cash cost:
Hecla’s Greens Creek unit was the only mine in production in 2012 for the company. Even though Lucky Friday came back into production in Q1 2013, it was a very small amount. So, I decided to focus on the figures from their majority producer.
Here we can see that by-product credits were $44.9 million in Q1 2013. It turns out that Greens Creek by-product metals (gold, zinc & lead) account for nearly 55% of the total revenue, whereas silver is only 45%. So, it is no surprise that deducting $44.9 million from the production costs, would give Hecla a very low cash cost.
However, low cash costs do not guarantee a high degree of profitability. Hecla stated a positive $11 million net income in Q1 2013, but that was due to a gain of $21 million of derivative contracts. Even with the large derivative gain, Hecla’s net income to revenue margin was only 14% during the first quarter.
Furthermore, that 14% margin was accomplished with much higher metal prices. Hecla had average realized prices of over $30 for silver and $1,620 for gold. Hecla will more than likely be suffering net income losses in the second quarter — along with Pan American Silver.
That is why investors should not confuse a company’s $5.02 cash cost with the ability to produce silver at $5.02 an ounce. Just because a mining company can substantially reduce its cash cost with a great deal of by-product credits, doesn’t mean they can successfully produce silver at that amount.
By-product accounting has given the investor an illusion of a “Low Silver Cash Cost” in Hecla’s example above as well as many other primary silver miners. It doesn’t matter how low a company’s cash cost is, but rather how high their profit margins can be that’s important.
It would be one thing if Hecla was making substantial net income profits based on a $5.02 cost, but that just isn’t that case. If it wasn’t for Hecla’s by-product credits consisting of approximately 50-55% of total revenue (Greens Creek Unit example) , they would be stating huge net income losses each quarter. Thus, Hecla’s gold, zinc and lead revenue was just as important as its silver revenue.
I don’t believe the majority of primary silver miners can survive selling their silver anywhere near cash costs as some analysts have commented. As I have shown in the two examples above, Pan American Silver & Hecla will more than likely be suffering large net income losses when the Q2 2013 results come out — the quarter where average prices of silver dropped to $23.
So, what happens to the miners at sub $20 silver? Well, according to this new article, “The Miners Best to Survive a Downturn – Dundee”:
A survey of the silver sector released Wednesday by Dundee Capital Markets suggests Silver Wheaton and Tahoe Resources are best positioned going into the lower silver price environment, while Silver Standard, Pan American Silver, Coeur Mining and Endeavour Silver will require “more significant alterations to the current business plan” to adapt.
…While Endeavour Silver has three operating mines, the analysts suggested “it is only the company’s Bolanitos Mine which could survive silver prices significantly below $17-18/oz. …Of the three mines, El Cubo is at the greatest risk of needing to be put onto ‘care and maintenance’. Furthermore, with just over $40M of available credit at the end of Q1, we forecast the company could require additional funding during 2014 if spot prices remain below.”
To lower cash costs at Fortuna Silver Mines, the company could close the Caylloma mine in Peru and cut exploration and corporate G&A by 30%, the analysts suggested. “We believe management is open to putting Caylloma on care and maintenance if lower metals prices are sustained.”
Lichtenheldt and Morrison advised that, of Pan American’s seven operating mines, “we believe at least 3 of these mines would be burning cash during 2014 if silver prices remain below $20/oz and could therefore be candidates for ‘care and maintenance’ if prices do not recover.”
With only one operating mine, Pirquitas, Dundee suggested that Silver Standard’s business and asset portfolio is better suited to a silver price of more than $25/oz. The analysts advised the company could operate at Pirquitas at a loss for a short time; “however we believe management is ultimately committed to profitability and would put Pirquitas on ‘care and maintenance’ if the outlook were for ongoing cash-burn.”
If the price of silver remains below $20, the analysts at Dundee Capital Management believe the two best companies to weather the storm would be Tahoe Resources and Silver Wheaton. This is interesting because Tahoe is not yet in commercial production and Silver Wheaton makes its margins on $4-5 silver.
Furthermore, Dundee states that upwards of 6 or more mines from four companies quoted in the article above would be candidates to be put on “Care & Maintenance” if silver prices remain below $20. Also, as these companies burn cash by keeping some of these marginal mines producing silver at a loss, they are consuming funds that would have been future Capex spending for exploration, plant and equipment.
While this article only focuses on the cost based on primary silver miners, base metal and gold mining companies that produce by-product silver need their silver revenue to fortify their balance sheets. For example, GoldCorp’s Penasquito mine sells 25% of its silver to Silver Wheaton at $4.02 an ounce. This doesn’t mean that GoldCorp can afford to just give away all its silver at that price.
The table below shows how a decline in production and price can greatly impact Penasquito’s gold cash cost:
In just 3 quarters, Penasquito’s gold cash cost increased $1,036 an ounce, from a negative $425 in Q2 2012 to a positive $611 in the last quarter. Even factoring in 25% of the silver sold to Silver Wheaton’s at $4.02 an ounce, Penasquito had an average realized price of silver of $25.54 during Q1 2013. What will Penasquito’s gold cash cost increase to with the average price of silver $7 lower in Q2 2013?
Lastly, it is a shame that the silver producers are being hurt by the actions of the Fed & Central Banks. The silver mining companies are producing both a necessary industrial metal as well as an excellent store of value. Even if industrial demand has declined recently, investment demand should be enormous. However, as the Fed prints money, purchases U.S. Treasuries and props up the broader stock market, this has created artificial demand for increasingly worthless paper assets and less demand for physical silver (presently).
At some point in time, this sort of charade will end forcing investors to purchase physical assets such as the silver miners and silver bullion to protect their wealth. Thus, the death in artificial demand in one will cause a skyrocketing demand in the other.