While we might KNOW the answer to this question, I kind of wanted to put some of the numbers out there for some of the newer investors to the sector. I have done two Palisades interviews, and for the most part, I love interacting with the comments section. You get the bad with the good, but I like seeing if there’s any comments in there to make an article about. I started this a few days after the interview when I saw the comments, and as I mentioned, I might have 5-10 of these up at any given time when I add in the early AM, lunches, or sleepless nights. Sometimes I can bang one of these out in an hour or so.
“Would it be possible on the next chat with Nate to discuss how higher hydrocarbon prices could impact (i) physical gold prices as a store of energy (ii) gold equities with higher all-in costs of extraction?”
So I’m going to get my nickel’s worth here and go over this stuff in a few parts and break this down for you.
(i)physical gold prices as a store of energy
What I did was go down a rabbit hole with this in my financial energy series (here is a link to the full slide show) that I don’t know if anyone in this space has looked at as deep as I have. This is original work and someday I may write a book about this if I ever have time. Let me be precise – you hear people like Steve St. Angelo call gold a store of energy, and it’s left there. I’m not picking on him here. Furthest thing from it. He says things that make me think. I don’t agree with him on some things, and he makes a living writing a report I’m not a subscriber to – so I cannot tell you what all he says to his insiders and how deep he has the rabbit hole. But when he talks about gold as a store of energy, it’s the same fallacy the Proof of Work (PoW) concept is for the bitcoin miners.
See, they are looking at this as somehow being a physical representation of the energy used to make that gold or bitcoin and not the financial energy used to make it. Let me show you the difference.
Physical energy – here, you have a lot of joules of energy to make equipment move to dig up gold and process it. Let’s just say you used 2,500 kWh of battery usage to make one ounce of gold at $.13 per kWh. This is about an AISC at $1,000 per ounce, with about 1/3 of that AISC usually fuel. For argument’s sake, I’m converting all of this to a battery usage rather than a gallons of fuel. With bitcoin, it costs about $11,000 per bitcoin to mine – but I have also seen it takes about 1500 kWh in energy to make bitcoin. That’s roughly $200 in energy bills. To mine bitcoin, you need expensive rigs and the finance cost of that is severe.
So gold uses about 1/3 of its production costs in physical energy where bitcoin has 1.8% of its production costs as energy.
This is the PHYSICAL energy needed to create these things.
Financial energy – I call this JEWELS of energy that are locked in “financial batteries”. If you want to make an ounce of gold, you have to unlock jewels of energy. You can cash in stocks, sell real estate (or sell bitcoin), or use money (or get money by selling a current asset in the money store).
When you unlock these jewels, you do it for a reason…
- Grow your wealth by extraction – this takes something from the end which is greater than what you put in (ROI). For example, with gold you put in $1,000 into the hopper and expect $1,800 back. For bitcoin, you put $11,000 in and expect $60,000 back.
- Store a part of your financial energy into a risk class. When times are right for growth, you move financial energy from one class to another. Many like to call this “re-balancing your portfolio”.
- Do this as a profession – think of being a business owner. Your job is to take cash and get more back for the stakeholders. Whether it is a family restaurant or a Fortune 50 company – the same thing is at play. You are a generator of wealth by taking in more than you put into the system. Mining dollars, if you will.
So this is how this looks, when you look at financial energy mining something.
Comparing physical energy to financial energy.
Steve and others think of gold or bitcoin as a “store of energy” which is where it gets its value. I very much disagree. I get the concept, and I understand the concept. But energy is an INPUT COST to mining, NOT THE EQUIVALENT.
Meaning, if fuel is 1/3rd the cost of gold, and fuel prices dropped, would gold necessarily drop in price? Let’s say it does not. And fuel costs are now 1/4th of mining gold and we produce gold bar A. Does this mean gold is now storing less energy? What if fuel prices triple next summer and fuel costs are then 1/2 of mining costs to produce gold bar B? Does it mean it stored more energy?
Now, put two bars of gold next to each other. Gold bar A and B are identical in all characteristics. Which one stored more energy? Well, that’s now a problem isn’t it? Meaning – the information is lost with how much physical energy went into it. Now, let’s put that next to gold bar C, which was produced in the year 2000 at a cost of $200 per ounce. Gold bar C looks identical to all of them?
“But Nate, you are missing the AMOUNT of fuel was the same!”
This is what then baked my noodle. Perhaps the gallons of diesel to produce bars A, B, and C are relatively identical. “See!!” Well, I started thinking. Commodities are produced more and more efficiently every year. How many trees used to be burned in order to melt gold? How many BTUs was that? Today, San Dimas for First Majestic has a hydro dam there and uses that to power a lot of the plant, but not the trucks. Less diesel used. “But Nate, that dam has a cost”. Yup.
My point is though, over time, there’s less and less PHYSICAL energy needed to make all commodities. You get better understanding of chemistry, metallurgy, engines become more efficient and can do more work.
Gold bar D was made 400 years ago and is also identical to bars A, B, and C. However, this bar used a LOT more physical energy. Remember, humans also are a physical battery and they used picks and axes. So while they may not have had diesel fuel 400 years ago, you had humans eating lots of calories (produced by farming) that went into sweat and blood of mining, along with chopping down all of those trees.
Overall, using PHYSICAL energy to describe it’s store of value fails on so many levels.
Now, look at the business process above. In mining, what do you see with PEAs? IRR. Internal Rate of Return. If it’s less than 20%, you don’t do it, usually. You have risks with mining (in the business process) and have discounts of perhaps 5% or 8%, depending on jurisdiction. Overall, whether you are mining gold or copper or making beef – ALL have the same thing in common…
- All need financial jewels to have a process put in motion. All have physical energy to a degree, even if it is calories burned thinking and typing, but all have an ROI at the end, with a risk associated with it.
Meaning – gold, or copper, or oil – when mining, have an ROI/risk with it, or else you do not do the business process. Period.
In IT, I have worked in many industries, and you note how well IT is paid in different industries. Finance, insurance, and defense pay the best. Non profit and manufacturing amongst the worst. You can see that manufacturing widgets is capital and labor intensive – but in many instances, much lower risk. High end Wall street firms may crank out 100% months at times, but they also have a stupid high rate of loss at times too.
Translation – investing in different types of industries can grow your financial jewel collection to different degrees with different sets of risks.
To me, financial energy is the capture of the ROI of a business process and lock that up into a good or service.
So whether gold is $35 an ounce or $10,000 per ounce, you are not creating new gold unless it hits a certain ROI. That return is GROWTH. So when you look at a bar of gold from 400 years ago, 20 years ago, or last year – all of them were made with capturing perhaps 20% ROI.
At times, fuel costs, labor costs, equipment costs, or land costs can all vary when determining the composite price of gold. To make gold, you are not capturing physical energy. You are capturing the ROI on that business process. And that is relatively consistent through millennia. If it costs $2200 to mine gold and it is worth $1800, you shut down the mines until 1 of 2 things happen:
- You figure out more efficient ways to produce gold and get the ROI, then do it.
- Wait for demand to increase over time with the deflationary event of producing less.
Why is this a big deal to me? Because I saw how gold had relative values to just about everything going back hundreds of years. They say, “one ounce of gold is worth a fine man’s tailored suit”. This is because the RELATIVE ROI to produce gold then is the same as the labor and effort put into making that suit. The ROI for gold may need to be 20% to mine it, but for those types of suits they might be 36%. This pin of relativity can be seen with oil. I have shown in this how one barrel of oil is about worth 1.93g of gold over time.
Last year, when oil demand fell off the face of the earth with Covid, gold had a hear play and gold went way up relative to oil.
Now, I hear next summer oil might be $120 per barrel and gold may be back up over $2000. That is $64.30 per gram of gold. This then means the price of oil, in grams of gold, is 1.87. Pretty damn close to the 1.93 historical average.
So at times, you may see the USD in something go down relative to something else – this affects the ROI and either creates abundant supply or shortages. This then creates the oscillation you see. The ROI is an AVERAGE over a lot of time.
The idea here is to play the arbitrage. If you look on this chart, wouldn’t it have been nice to turn all of that gold you own to cash last August, and buy barrels of oil? Yeah. This is how the free market works. You find value relative to gold. If ALL things you make things with, commodities, are ALL getting more and more efficient means of making them – it means that all of them have needed less and less PHYSICAL energy over hundreds of years.
However, all of them have the value of the process locked up into them. And these are then input costs into other things.
If I can go back to Bitcoin for a second. BTC uses a PoW concept to make BTC. This uses a lot of energy per bitcoin, or about the power my house uses in a month an a half to make one. But as you can see, the PHYSICAL energy is only a fraction of its input cost. So when you are buying a BTC for $64,000, are you buying that energy equivalent? No. The physical energy that went into that was $200.
What you are paying for is the SPECULATION on a business process. You see, someone went into business to mine BTC. They took cash and then wanted to grow it using a business process.
They buy these mining rigs for million and rent space for lots of loot. At a cost to them averaging $11,000, their job is to crank out BTC. If the market price for BTC were to drop to $5,000, no one would buy new rigs to mine BTC. With the halving coming up in 2023 or so, this could then double the cost to $22,000 because you need twice the processor power. Energy costs would then go to $400 per BTC, or about 3 months of powering my house.
By then, people think BTC will be $250,000 or $1m. Is this PoW storing that $200 energy, or the BTC storing financial energy as a return on the business of mining BTC?
Is there risk in mining BTC? YES. BTC has dropped 90% three times already in its 10 year history. You might then think that you might need a higher IRR and discount rate you’d think? Meaning – this is a HIGH RISK BUSINESS – and with that, it may have a higher amount of financial energy stored with it as a reward.
However, with gold you are essentially taking 1/3 of the cost of this in fuel and then turning it into a bar – so you can perhaps see the relation between physical energy and the money that is produced – as this PROCESS has a RELATIVE VALUE to all other processes for HUNDREDS OF YEARS. Where this fails with BTC is that this process is extremely new and has no relativity to gold. It is perhaps mining something, but it’s mining something with no intrinsic value. Gold is a proven store of wealth that is used in jewelry and money. At this point, BTC has no utility other than store of wealth, and since it has not ever seen a recession and has lost 90% 3 times in 10 years – and many other like products have the same utility, it is classified as speculative property like art – and not a store of wealth like money.
This is not to degrade BTC, but to properly classify it so those in the crypto space can understand it better. It is not storing energy, as you think it is, as only .3% of its value right now relates to the energy costs used to make it. Energy costs are likely in the nodes running and trying to update the blockchain – with very few transactions per second that can be done. Which is why I think the PoW concept is stupid and they’d better be served with a form of lottery to reward participants who run nodes. One best use case I thought for a BTC was fleeing a country with hyper inflation, you can sell your gold for cash, convert to BTC, get on a plane, and take your wealth to the country you want to go to. Well, Kinesis now does that, and you can keep your gold in the vaults and when you get to the new country, if you want, you can get your gold shipped to you. So I think BTC eventually will fail due to other things doing everything BTC was supposed to do, but better.
Not trying to dig on it here, but explain how the physical energy with BTC is not necessary and eventually will fail as energy costs go up and use case goes down. IF it had utility, then the financial energy “captured” would endure. Instead, this will be a lot of financial energy that is lost in a high risk business process. That energy wasn’t entirely lost – remember the people selling the mining rigs locked in their profits. Energy companies locked in their profits. Miners mostly locked in their profits. Where the loss is, is the speculation at the back end of this.
(ii) gold equities with higher all-in costs of extraction
So I have heard that to mine gold, you are looking at 1/3 fuel costs. At times, you will see the profit for miners increase when energy costs go down, and thus you may see the profits decrease as prices go up. Remember the oscillation in oil and gold prices above?
From what I also heard, the futures costs are generally just over the price of producing. This is how the market efficiency TRIES to work with the paper market. The paper market sells at a price, and as buyers come in to lock it in, this sets the market price. If the sellers gin up contracts from the heavens, price falls. When buyers are hitting the bid price goes up. But the invisible hand here is the market perception of cost to produce. IF you think it costs silver producers $15 to produce, you could see them selling legit silver into the BB at $22 or so and then the BB would hedge that at $22 (paper shorting) to preserve the value.
IF BB are seeing a slow down in supply coming in, they probably are going to slow down papering from the rafters. What most don’t realize is that most silver supply is a byproduct of other metals, like zinc. If you have a First Majestic who mines 15m oz per year of silver (not SEOs) and they are among the largest – you are looking at 800m of mine production a year. That is, First Majestic as one of the largest producers makes 1.9% of silver per year.
That tells me that BB do not give a shit about First Majestic’s feelings, and if they can drive the primary silver producers out of business, then all they have is silver as a byproduct to everything else. In theory, so what if you lose 80m oz of mine production from primary silver producers? Well, the problem is the demand is far outstripping mine supply these days. With that, you may have to entice supply on the sidelines to come in for recycling. The big issue there is there’s only about 200m oz silver recycling capacity per year. So unless you plan on building a lot more refineries, you still need those 80m oz out of the ground. And Neumeyer knows this.
When the costs of energy go up, well, margins are hurt. If your AISC for a mine starts to go above the spot value, you will put the mine on care and maintenance, like First Majestic did for a bunch of their mines. Why would you mine oz in the ground now if the cost to mine them were $32? You don’t. But you have reserves there you can count on as price goes up. What happens is when these energy prices go up, the BB also know they need x amount of metal the next year for contracts, and if price doesn’t gp up to reflect these increase costs, then they will mine less. Price would have to go up to shake out grandma’s silver OR entice more mining. Meaning – when energy prices go up, margins are less and BB know they need to have prices go higher to support the manufacturing needs. There may be some lag on this, but the concept is that margins will hurt at first, but should correct.
Where you get sneaky is a First Majestic who runs a hydro dam at San Dimas. I haven’t looked at all of their costs and the like, but if you are generating plant power through hydroelectric rather than by diesel fuel in the middle of nowhere – when fuel prices go up, you hydroelectric costs are stable. Prices of metals may go up – and your margins INCREASE. So those miners who use hydro for power may reap benefits when fuel prices skyrocket.
I can tell you that projects like Discovery are “a home run at $20 silver”. I first invested with them back when silver was $18 before everything went vertical with silver last June. They have about 1.5b oz. Taj singh was re-working the project to sell 600m oz of higher grade to make the $20 silver work. If Discovery does start mining in 2023 or 2024, and they can crank out 20-40m oz per year for 20-30 years, dear God. The concept COULD be that energy and metals prices are much higher then, due to a lot of things. Inflation, currency issues, you name it. IF silver is $50-$75 then? You are looking at 1.5b oz in the ground. That about $100b in silver that could be extracted over those 20-30 years.
If you think silver might be $100+ in 2030 and beyond, just think about the value of this company.
Do we think this company could be a 10x in the next few years? Possibly.
But let’s look at those higher costs of extraction? If oil hits $120 next summer, it’s going to its mean reversion of about 1.9g per gold per barrel. All of this is within a standard ROI/profit model.
What about $150 – $200 per barrel? $300? In these situations, I would think you have small producers like Impact Silver hurt the most. While we most certainly would get higher silver prices, there may be a lag with this that they cannot catch up to. IF silver price is $50 by next summer, Impact will probably be one of my best performers. But if we see $22 silver with $150 fuel costs, we may see them stop producing or sell, as they would not really be able to keep the lights on for months until higher prices came through. I’m exaggerating this a bit, as I think they have some high grade they mine at times when things get tough, but the idea is that a junior producer may get squeezed the most, most quickly. The majors can absorb higher fuel costs for a time until price moves higher.
However, you have the major producers of silver that make this as a byproduct that don’t care about the price of silver. It might be 2% of what they mine. Meaning if you have sustained higher fuel costs, all of this is lost at the margins. The Impact Silvers of the world add up, and your mine production might fall to a rate of 730m oz in a year – prorated by month – you will start to see less coming in. This then needs price to go higher to shake out grandma’s candle sticks.
While we all bitch about the drive by shootings with gold and silver, over a LONG period of time, these prices move to physical supply and demand homeostasis. Right now, with solar, EVs, and investment demand shooting up the value of silver last year and getting more juniors producing more – structurally silver is in a massive deficit which requires higher prices…NOW. On top of that, you have escalating inflation fears and an administration who will probably put in a dove at the Fed to print more and have the dollar go down. Add to this supply chain issues, and how silver might be in 50 different parts in a car, and if one of those parts in the supply chain doesn’t have silver, you cannot roll out the car. Now, add to this higher energy prices predicted which may hurt supply more – and you have some massive lags that will snap the rubber band back to reality quickly over the next 6 months.
While input costs to mining can rise, the Newmonts of the world right now have a PROFIT of $800 per ounce and are printing Free Cash Flow by the billions. It is more likely that producers with higher input costs could be hurt first – and if there’s no steep correction to price, the company may fold or sell to a major at a discount.
Other miners like First Majestic are using power from hydro dams which may mitigate higher power costs – but projects like Chesapeake in the middle of nowhere in the desert might have high costs of fuel and power generation which increase AISC for their gold at $1700 on the PEA. These projects may not get construction decision until and if we see $2500 gold for a long period of time, sustained. While $1050 became the new floor in 2015, it’s quite possible that we see the 2020s have $2500 gold as the new floor IF they ever can unlock more supply at increasingly higher costs and lower grades.
Finally, we see the oscillation of oil to gold. At some point, oil may hit $180, then gold hits $3000, then oil comes back down to $120 as a floor. Over the next 100 years we will see that oscillation.