Gold and Gold Miners

This commentary includes views you may want to consider carefully if you participate directly or indirectly in the physical gold or gold stocks markets either as investor or trader.

Gold Companies and Gold Companies

Some commentators talk and write about ‘gold mining stocks’ as if they ‘are all the same thing’, and all fall into one broad category. That is overly simplistic. It is important when reflecting on ‘gold stocks to carefully distinguish between companies that:

are exploring for gold, which companies can properly be described as gold exploration companies, but not ‘gold mining companies’. Broadly speaking, gold exploration companies are speculative investments/trades, where the degree of speculation is based at any given point in time on whether a given company has:

• yet to find what may prove to be commercially viable deposits (at the most speculative end of the ‘speculation curve’), or
• Has found what are believe to be possible commercially viable deposits and are about to begin the ‘development phase’ (the least speculative end of the ‘speculation curve’).

Subject to prevailing and prospective financial market conditions, it is arguable that the best of the gold exploration companies represent what can turn out to be very high return investments/trades;

have found commercially viable gold deposits and have entered the ‘development stage’ with respect to their project(s), but again are not as yet ‘gold mining companies’. These companies can best be described as gold exploration/development companies. Gold exploration/development companies arguably may be somewhat less speculative than gold exploration companies. That said, investors and traders ought to be knowledgeable of at least:

• the prospects of reserve and resource quantity enhancements during the development period, and after production starts,
• increasing ‘Country Risk’ in some jurisdictions – and what may be further increased ‘Country Risk’ going forward in those and other jurisdictions,
• developer ‘timing to production’ – and what might happen to the gold and by-product (copper, nickel, silver, etc.) prices, net cash on hand, and resultant potential shareholder dilution issues that may arise from required new capital raisings through the development period,
• the escalating operating and environmental costs that may affect facilities construction costs, equipment costs, and prospective year/year operating cost increases per ounce of production – and hence may affect the ultimate economics of the project(s) under development, and
• Importantly, how ‘locked-in’ a particular company’s Board and Management is to developing their project(s) through to production, as contrasted with pursuing a ‘sell to strategic purchaser’ strategy. Arguably investors and traders face greater share price risk in a ‘develop to production’ scenario – particularly if financial markets are more than less volatile and risky during the development period; and,
• producing gold, and hence can legitimately be called ‘gold mining companies’.

Underlying Financial Market Assumptions and Issues

Commentators talking and writing about ‘gold mining stocks’ often seem to base their views on unstated underlying assumptions that:

• the financial markets are properly reading the current macro-economic climate, and
• the current financial markets at least will maintain a ‘status quo’ equilibrium going forward. That is, that world financial markets will not at some near-term or longer-term date experience a financial crisis that is in scope less than, equal to, or greater than, the one experienced in 2008.

Commentators also frequently seem to base their views with respect to ‘gold stocks’ to a greater degree than perhaps they should on historic financial market experience – this having regard to the:

• extent of economic globalization that has occurred after 1999,
• extent of trading volumes currently being executed pursuant to high-frequency algorithmic trading methodologies,
• extent of hedge fund and derivatives activity that currently exists, and
• Levels of volatility and risk related to sovereign debt leverage and other factors that ultimately must bear on the world financial markets.

For the foregoing and other reasons the current financial markets arguably are quite different in many important respects from the pre-2000 financial markets, and to some degree different from the pre-2008 financial markets. Finally, some commentators in the current financial markets environment also seem to have forgotten, or now discount, what happened in the fall of 2008 when many investors and traders had to sell out positions based on margin calls and ‘flight to investment/trading safety’ reasons. It is important to always remember that rising tides raise all boats, and falling tides drop them, often leaving some ‘high and dry’. Gold exploration, development, and mining stocks are unlikely to be exceptions to that rule. Consider carefully whether the Financial Markets ‘May Be Right’ in their Current Gold Mining Share Pricing With that background, consider that gold mining company share prices (read ‘shares of companies that actually produce gold) are not simply ‘derivatives’ of gold (as suggested by at least one commentator), nor are ‘gold’s fortune’s’ the ‘only real long-term fundamental’ of gold stocks (as recently suggested by a second commentator). That said, it is correct to say that at any given point in time the prices of gold mining stocks (and gold exploration and gold development company stocks) are influenced by the then gold price and then expected gold ‘trend price’. In turn, it currently seems that the price of physical gold is being continuously influenced by a financial markets perception that the U.S.$ is itself a safe haven in turbulent economic times. Following from the foregoing, the financial market ‘disconnect’ perceived by some may well simply be that the current prices of gold mining (producing) stocks are, aside from the physical gold price, result from strongly being influenced by important risk and operating cost issues, including:

• country specific risk issues;
• mine equipment and operating costs, which broadly seem to be escalating;
• skilled labour scarcity, where that currently is being broadly reported as an issue;
• environmental costs, which broadly speaking, seem to be escalating; and,
• the fact that, unlike non-resource businesses, gold mining (producing) companies at any point in time have a finite life – baring continued resource acquisition or deposit expansion. As a consequence, analysts have great difficulty applying conventional discounted cash flow valuation methodologies to those companies. As a result, analysts may be less comfortable with their analysis of gold producers in current markets than they are with their analysis of ‘more conventional’ companies. If that indeed is the case ‘less comfort’ implies ‘greater risk’, and hence in both theory and typically in practice ‘lower share prices’ than might otherwise be the case.

Finally, gold producer stock prices may also currently be influenced (downward from what they otherwise might be) by the proliferation of ETF’s and other paper gold instruments. Simply put, investors and traders currently have physical gold investment/trading alternatives that didn’t proliferate until after late 2004. These alternate gold investments/safe haven holdings eliminate country risk and operating cost/environmental cost risks in the context of investor/speculator/trader buy/hold decisions. It follows (or ought to follow) that for gold mining (producing) companies to be attractive going forward they will need to be able to demonstrate at least the following things:

• significant leverage on the gold price through clear and known scheduled growth in output over the course of their known mine lives; and,
• attendant internal cost controls per ounce of production, which costs are dependent on deposit type, deposit location, deposit grades, local labour costs, and a plethora of other things,

Thereby to some degree offsetting the business and operating risks implied by the foregoing. So What Does All This Mean? As a result of the foregoing, it can be argued that:

• absent a seriously increased gold price from current levels, the foregoing factors may lead to diminished world gold production, which in turn over time ought to be reflected in higher prospective physical gold prices. However, that will not be a short-term phenomenon should it transpire; and,
• Under any circumstance, this may mean that share prices of lower grade, high cost gold producers operating in higher country risk jurisdictions will suffer going forward.

Moreover, these things may, in combination with what appears to be ever more worrisome world macro-economic issues, result in;

• a positive impact on both:
• the gold price over time, and
• the share prices of high grade, comparatively lower cost gold miners that operate in the safest (least country risk) mining jurisdictions; and,
• potential increased merger & acquisition activity among gold producers, explorer/developers, and explorers where:
• gold producers are able, through either merger or acquisition, add commercially viable gold reserves or prospective reserves to their property portfolios, and/or
• business combination ‘synergies’ can be achieved to reduce total cash costs per ounce.

That said, make no mistake, generalizations with respect to gold companies and their share prices – be they explorers, explorer/developers, or miners – are very dangerous, and broadly should be viewed with skepticism. Gold companies at all levels are participants in a highly speculative, high risk industry where their revenues are driven by world prices they themselves do not control. They can, of course, hedge to protect their revenues if they elect to do that – but based on existing accounting rules, hedging itself can be harmful to earnings per share in a ‘rising gold price’ environment. Conclusions In conclusion:

• Gold mining companies arguably are the least speculative of the three types of ‘gold companies. That said, investors and traders ought to be aware of and understand all of the foregoing if they plan to own or trade gold mining company shares;
• As a generality, high potential returns ought to follow from high risk investment/trading. That said, in order to balance those things, investors and traders ought:
• to both understand and have a well founded opinion of overall financial market risk at any given point in time based on an understanding of how financial markets work and what influences them – and a clear understanding that stock, bond, and other financial instruments are priced by the financial markets at any given specific point in time, and can change (sometimes dramatically) in short order,
• to have a well founded opinion of the ‘drivers’ that impact each individual gold mining company whose shares they invest in or trade. In particular, while it is trite, investors and traders should focus at all times on the fact that all companies within any given corporate sector ‘are not created equal’, and
• to assess carefully whether the experience, the apparent common sense, apparent intelligence, apparent independence (or vested interest) of those who express opinions on specific corporate sectors or specific companies within those sectors, lend to or detract from ‘commentator credibility’ – and weight their commentaries accordingly.

We live in complex and difficult macro-economic times. Ultimately, whatever happens in the world and in country specific economies will influence the financial markets. A simple message: ‘Do not be taken in by generalities, or by opinions that fail to provide the underlying significant assumptions (and logical support for those assumptions) that back up those opinions’. There is a lot of unsupported opinion to be found on the Internet and elsewhere. Going forward, specific gold exploration companies, gold exploration and development companies, and gold mining companies may prove to provide excellent risk/reward investments or trades. That said, tread carefully, listen to and read much, be highly skeptical and cynical, and ‘think for yourself’ at all times – but particularly in the current economic and financial markets environment – before ‘jumping off the diving board into the pool’.