Bumper gold margins

Gold miners are leveraged plays on the price of gold with this illustrated by the strong increase in Barrick Gold's second quarter profits. The realized gold price for the group rose by 29% on a year ago but net income jumped by 59%. As we continue to be bullish on the gold price we expect Barrick Gold to see further strong profits growth and therefore rate the group a hold.

With Barrick Gold the world's biggest gold producer it has been a prime beneficiary from the break out of the gold price to new highs. It is also a company which has the only "A" rated balance sheet in the gold industry illustrating that it is a mature and relatively low risk way to obtain exposure to the gold price. Strong diversification with 26 operating mines in a range of different regions also serves to lower operational risk.

As a relatively mature company the chief attraction is not production growth but the changes to the group's margins. In the second quarter the cash margin jumped to $748, or 62% of the gold price, an ounce versus $479 a year ago which is a rise of 56%. The driver for this rise that the average realized gold price came in at $1,205 versus $931 - an increase of $274 - while total cash costs were almost unchanged.

Gold production rose slightly by 4% to 1.944m ounces but the amount of gold actually sold only increased by 1.6%. Clearly then the driver of profits for the group is the gold price first and foremost. For relatively mature gold miners this is generally the case as it is not easy to increase production meaningfully from already very high absolute levels.

The main issue then for Barrick Gold investors is how the gold price will move in the years ahead. On the demand side gold is benefiting from emerging market growth as Jewellery consumption increases and the demand for gold as an investment vehicle rises. Central banks in China and India are increasing their gold holdings while they newly wealthy in these countries see gold as a way to protect wealth.

Developed market investment demand also looks set to be strong with investors like John Paulson investing heavily in gold. With the US economy still weak it is also likely that the Federal Reserve will go on another money printing escapade in the near future.

Supply of gold has been fairly moribund since starting to decline in 2001. This is despite the higher gold price providing a strong incentive to mine more gold. The main problem has been declining output from mature mines in South Africa. Going forward it is possible that new supply could start to put output on a rising trend especially with China becoming a leading gold producer. In the medium term, though, the evidence is that the industry is not able to increase production significantly.

Looking at the weekly chart of Barrick Gold we can see that the stock has been in an impressive uptrend since the October 2008 low. This move has taken the share price from a low of $17.27 to a high of $48.02 on the 4th of December 2009. The share price has tried to break above this high on several occasions but has met selling pressure on each occasion. The weekly MACD is seeing frequent crossovers which are to be expected given the sideways consolidation that we have seen in the price action.

Looking more closely at the daily chart of Barrick we can see that the share price has broken the near term uptrend (red line) support line but still remains well above the long term uptrend  support (green line). Since failing to breakout above the $48 resistance once again in June the price action pulled back to the 200 day moving average but found support at this level. The bounce from this July low of $39.67 has met resistance at the 50 day moving average. We would like to see a break through this MA followed by a successful move through the $48 resistance.

Turning to Barrick's own production and expectations for 2010 are for output of between 7.6m and 8m ounces. With production of 4m ounces in the first half this should be easily achievable. This compares to production of 7.4m ounces in 2009 which and 8m in 2007. Thus production is set to rise on a year-on-year basis and could be set to rise above the levels of three years ago.

New mines are in the works at no small cost and so Barrick Gold does look set to see some modest production growth in the years ahead. A new mine now in production is Cortez hills which following a Q1 ramp-up achieved 0.29m ounces at a cash cost of $308 per ounce in the second quarter. This compares to totally quarterly production of 1.94m ounces in Q2 so Cortez hills is making a meaningful contribution.

Other new mines due to come onto production are Pueblo Viejo, in the Dominican Republic, which is due to come into production in Q4 2011. The capital costs for this are $3bn and at the end of the second quarter construction was 25% complete.

A second key project is Pascua-Lama, on the border of Chile and Argentina, and this remains on track or production in Q1 2013. The pre-production capital budget is $2.8-$3bn with over one-third of the capital already committed.

Taking these three mines together - Cortez hills, Pueblo Viejo and Pascua-Lama - and the group has the 2.4m ounces to annual production when they are all at full capacity. A significant contribution compared to the expected production this year of between 7.6m and 8m ounces. Whether this grows output or sees it falling in the medium term depends on whether existing mines see falling output or not.

Barrick is able to afford such huge projects due to its solid balance sheet and significant cashflow. In the second quarter alone operating cashflow rose 42% to $1.02bn and exceeded $2bn in the first half of the year. The group's cash balance as a whole is $3.9bn and there is a $1.5bn undrawn credit facility. As such it is no surprise that Barrick felt able to increase its dividend by 20% while the group is also moving towards a quarterly dividend payment structure.

Accordingly, Barrick Gold will remain firmly held in the Fat Prophets portfolio.