Thursday, April 7, 2011

Morningstar Reduces Gold Price Forecast Due To Marginal-Cost Analysis

Seeing gold as a commodity, Morningstar has reduced its forecast for gold because it estimates the marginal cost of production for the metal at $1,100/oz. The explanation behind the forecast does acknowledge that little gold is consumed, but it takes the perspective that gold's asset status means there's a large potential supply that can be dumped on the market. It also acknowledges the investment character of gold demand, which detracts from marginal-cost analysis on the high side. Despite those weak points, the forecast is based upon that margainal-cost analysis: the author does believe that gold should fall to $1,100 a ounce.
Our long-term gold price assumption of $1,100 (in today's dollars) attempts to capture both the cash costs of production and the capital costs of mine development for the marginal miner. Breaking that sum down into its constituent parts, we estimate that the highest cost miners produced gold at a cash cost of $900-$1,000 per ounce in 2010. Amortization, a decent proxy for capital costs, runs at about $100-$200 per ounce. While the industry supply curve is dynamic, we believe that, in the future, lower costs for royalties, consumables, and employee bonus schemes (all positively correlated with gold prices) will be offset by declining ore grades....

[W]e will revert to an inflation-adjusted long-term gold price forecast. In practice, this means we've cut our price forecast for 2014 to $1,200 from $1,515 and our forecast for 2015 to $1,236 from $1,579.
Mornigstar is an equity research firm, and its forecast is going to be used for discounted cash-flow analysis. Its prime use is going to be for fair-value estimates of gold producers' value, which dovetails with a conservative bias. It'll also be used as a gauge to ferret out low-cost producers.

Despite its limited use, which makes sense in Morningstar's circle of competence, the forecast itself isn't worth taking all that seriously. There's a sense that the analyst behind it is using the same old tools for an asset that doesn't quite fit the same old methodolgies. Although less crude than the analyst who scoffs at gold because equity metrics don't apply to it, Morningstar's take does have the character of a screwdriver expert using a hammer as if it were a screwdriver.

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