by Alasdair Macleod, GoldMoney:

Building on our proprietary energy-proof-of-value gold price framework, we

a) present an improved gold price model;
b) provide an in-depth analysis of the energy exposure of the cost structure in gold mining and;
c) give an outlook for the gold market.

Our improved framework confirms our previous findings that energy is an important building block to understanding gold price formation. The in-depth bottom-up analysis here explains why. Given our positive forecast for longer-dated energy prices and our negative long-term view on real-interest rates, we believe that the outlook for gold prices is skewed strongly to the upside.

Introduction
In this report, we will dive deeper into the relationship between gold and energy, explain how energy markets work – particularly the one for oil – and discuss our views on the future outlook for energy prices and thus gold. The note is divided into three parts. In the first we revisit our gold price framework model from last year and add some important improvements. The new model has a better fit and is simpler as it requires only one step instead of two. In the second, we analyze the energy exposure of the gold mining industry, provide and in-depth look at the true energy costs of each step of the production process, confirming the strong link between energy prices and gold we found in our top down model. In the third, we take a closer look at the energy markets and the outlook for the coming years.

In our first framework note (Gold Price Framework Vol. 1: Price Model, October 8, 2015) we described in extensive detail how longer-dated energy prices are an important building block for understanding how gold prices form. Solving for gold in US dollars, we found that a majority of price movements can be explained by just a few key drivers: real-interest rate expectations, central bank policy and changes in longer-dated energy prices. Our analysis showed that changes in longer-dated oil prices are a statistically highly significant driver for changes in the price of gold. The revised model we present in part one of this note, confirms these findings with a statistical t-value of 28.0 (8.5 for the regression on y-o-y price changes) for the 5-year oil price coefficient.

Based on this framework, we then showed in our more recent report (see Inverted Asymmetry – Gold Price Outlook, September 20, 2016) that much of the increase in the gold price from $280/ozt in 2001 to $880/ozt in 2008 was driven by the rapid rise in forward energy prices (as reflected in longer-dated oil prices) and that the decline in longer dated energy prices since 2011 was a major contributor to the gold bear market from 2012-2015 (in USD terms). We concluded that we had most likely hit an inflection point for both longer-dated energy prices and real-interest rate expectations during 2016, implying that the outlook for gold became increasingly skewed to the upside.

The findings above are also consistent with our in-depth analysis of the cost side of gold producers which we present in part two of this report. It becomes obvious that gold mining is energy intensive when looking at the direct energy exposure, that is the fuel and power consumption of gold producers. Even comparably simple open pit mining consumes a lot of fuel for trucks and excavators and underground mining consumes electricity for cooling in addition to that. The processing of the gold ore is also highly energy intensive. Most large gold mining companies report these direct energy costs in one way or another. Typically these reported costs are somewhere around 15-25% of all-in operating costs at current energy prices. Our calculations show that costs are likely closer to 20-30% of operating costs.

However, this does not account for the indirect energy costs, which can be significant. Indeed, indirect energy costs are the energy cost of embedded raw materials and services needed for gold mining such as steel, chemicals, tires, cement etc. Ultimately even wages partially reflect energy costs as changes in energy prices affect the living costs such as housing and food of workers. While we do have comprehensive data for the direct energy costs, indirect energy consumption is much harder to find, much less estimate precisely, as the gold producers don’t disclose them in any form (and probably have no actual way to measure them to begin with). However, for this report, we meticulously dissected the expense side of the income statements of the largest gold producers in the world and found that on average, direct and indirect energy costs account for about 50% of the cost of gold production over the short run (meaning a change in energy prices has an almost instant impact on the cost side of gold producers). Naturally, this cost increase must be reflected in the gold price, otherwise producers are in effect operating at a loss and in turn will reduce output.

Importantly, while changes in energy spot prices change current production costs, what really matters for the price of gold are the longer-dated energy prices. Why is that? Imagine oil prices drop to USD10/bbl tomorrow because inventories reach storage capacity. Yet longer-dated oil prices remain at USD60/bbl because that is what is what the markets believes is required to ensure there is enough investment in future production capacity. So which price should be reflected in the current gold price? We believe that the forward gold price should correspond the forward oil price as that is what will determine long term production costs for gold. However, unlike oil, gold can be stored at almost no costs and there are no storage capacity constraints. Hence the gold forward curve slope is essentially a function of lease rates. If spot prices divert from that relationship it would open an arbitrage opportunity that would quickly be exploited and thus vanish. As a result, when the oil forward curve is in steep contango , the gold spot price cannot trade at corresponding discount to the gold futures prices. Hence both gold forward and gold spot prices should reflect forward oil prices, not spot prices.

While changes in energy costs impact gold mining costs by 50% over the short run, this becomes closer to 100% over the long run as rising (or occasionally declining) energy costs feed through every aspect of the economy and lead to a general price inflation. For example, when energy prices double, costs for a new excavator don’t double overnight. Some parts of the production costs for the excavator go up instantly, such as the steel, the synthetic parts and energy used in manufacturing process. But overhead costs probably don’t change that fast. Hence excavators may become instantaneously more expensive, but not 100% more expensive. In addition, the manufacturer of the excavator might not be able to pass on his increased costs to the miners straight away. Plus, a gold mining operation doesn’t need to replace its excavators all that often as heavy machinery tends to have very long lifetimes. When it purchases a new machine, it will amortize the cost over a very long time. Combined, this means that part of a gold miners costs is almost fixed over the short and medium term horizons and immune to changes in energy prices. Over time however, higher energy prices will trickle into every aspect of manufacturing. For example, as energy prices rise, building a factory becomes more expensive which over the long run will have to be reflected in sales prices. Administration costs go up as electricity, IT, phone bills, and wages and ultimately the price of every paper clip reflects higher energy prices. However, this may take years or maybe even decades to materialize.

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