Drilling for $1300/Oz Gold: A Look At Nevada's Investment Conundrum

When the average all-in cost for mining gold in the U.S. is $1,200/oz and gold is selling for $1,300/oz, it is time to ask a very simple question. What is the point?

One question sums it up for most investors. Most drilling programs came to an abrupt halt in 2012. The $1,300/oz price of gold fell below the profitability threshold for most projects, not to mention tightening credit conditions and deteriorating investor support. Newmont Mining (NEM) laid off workers last year and several exploration companies suspended drilling projects throughout the state. Barrick Gold (ABX) lost over $17 billion of market capitalization after its high-cost Pascua Lama project was suspended (causing a $5.1 billion writedown by itself), creating panic throughout the rest of the company. Allied Nevada (ANV) laid off workers in Nevada, and Couer Mining (CDE) raised its cost estimates for mining from all mines, including its flagship Rochester mine in the northwest corner of the state, from $8 to $10.50 per ounce of silver: a drastic 31% increase.

Gold mining companies in Nevada, the state that controls 73% of domestic gold production, were soaring to 52-week highs when gold was selling for $1,900/oz. Today, trying to squeeze out a maximum profit of $100/oz ($1,300 minus $1,200 in costs) is difficult at best and impossible at many mines. Many investors have already fled, with all major gold companies in Nevada losing an average half of their value during the past two years. Treatment of smaller gold companies has been even worse, with 2012 being among their worst years in history.

Nevertheless, some companies are still drilling for gold in Nevada, flying in the face of traditional business wisdom. For example, Pershing Gold (PGLC) announced a 20-hole expansion of its drilling program in July. Analysts expect its all-in costs for gold mining to be as low as $700/oz (significantly below the industry average of $1,200/oz). This counterintuitive move by Pershing Gold becomes even more unusual after Monday's announcement of a $9 million financing priced at market (without a customary share price discount), which is enough cash to fund its drilling objectives well into 2014.

It is worth underscoring the peculiarity of this company amid Nevada's floundering mining economy. Pershing Gold's mine is located less than two miles from the Rochester mine: the most productive silver mine of all time that is still expanding after 25 operating years. Pershing Gold's private placement of $9 million represents 10% of the company's market capitalization and 27% of its float (29.229M/107.78M), proving that very wealthy individuals believe that it will be able to extract gold for significantly less than $1,300/oz, even when they know that the industry average is $1,200/oz. Indeed, if Pershing Gold keeps costs at $700/oz, its 564,000 ounces of gold translate to $300 million of profit potential at current gold prices.

However, outliers like this are anything but common. A managing director at Headwaters MB explained, "$1,300 is not a sustainable gold price." Fidelity Investments' Joseph Wickwire agreed, "Below $1,300 gold, about 30 to 40 percent of mine production is probably not cash-flow positive."

This inescapable problem of $1,300/oz gold contrasts with one of the greatest displays of corporate strength throughout the rest of the stock market. U.S. stocks have rallied 18% this year. Companies hitting all-time highs outnumber companies at lows by a four-fold factor. Corporate profits are at the highest level in history. Yet Nevada gold stocks have suffered one of their worst years ever.

Even at a 50% discount versus prices two years ago, many major gold stocks are still expensive. "I still see more pain ahead," said Frank Curzio. Indeed, with average profit margins down from $800/oz at their peak to $100/oz today -- a decline of 87% -- many investors understand the conundrum. For now, it seems as though Nevada investors will be looking for outliers like Pershing Gold while anxiously awaiting guidance from management teams at Newmont Mining, Barrick Gold and Allied Nevada about their long-term plans for success at $1,300/oz gold.