If I’d bought gold mining stocks a year and a half ago, I’d have lost my shirt. But that’s not stopping me from buying them now.
Things just seem to be so beat-up that the contrarian investor in me is coming out. The gold mining industry has had 15 years of pretty much getting everything wrong. And now it’s high time the industry started to get things right.
I won’t lie, It’s a risky move. But if this plays out, then gold miners could be set for a great few years. And more importantly, we could see some great returns.
Gold mining’s 15-year journey
As the millennium kicked off, the gold mining industry did pretty well. But really, they didn’t do as well as they should. Gold pushed up from below the $300 level and topped out just under $2,000.
Just think about that. Back in the ’90s, miners were, on average, paying something like $150 to $400 an ounce to get the stuff out of the ground. Productions costs vary wildly, but based on these sorts of figures, you’ll see that some of the industry was profitable, while other players were mining at a loss, hoping for an upturn in the gold price.
Say you were one of the lucky producers. Maybe your costs were $200 and the stuff was selling for $300 at the time. Based on an annual production of a million ounces, you were making shareholders $100m.
Of course, as the gold price started to rise and hit something like $600 – suddenly a producer like this should have been making serious money. Remember, if production remained flat (a million ounces) and costs were still $200, then suddenly the business was generating $400m. Note that the gold price doubled, yet profits quadrupled (or at least, they should have). This is known as operational gearing.
Extend that example out towards $1,900 and you might see how operational gearing can get shareholders very excited. The only problem was the mining industry found a way of cocking things up.
For starters, the industry had grown paranoid and petrified. The guys that had previously been mining at a loss were scared stiff that the gold price would fall again. I mean, there’s only so long that you can run a business operating at a loss. Therefore, as soon as prices bounced off the bottom, they were selling forward production (what’s known as hedging) at prices of say $400. So when the price recovered to $600 – or more, the producers weren’t feeling the benefit.
The other problem with running a business at a loss is that you have to pare the whole operation down. Essentially, production fell as the businesses were scaled back to the bare bones. Again, shutting mines and reducing staff costs money. There were a lot of ‘extraordinary costs’ to factor in, and those costs were incurred even as the gold price recovered.
The industry has been lambasted for what, with hindsight, look like awful hedging strategies.
And yes, it’s true. They were! But the fact is, the industry was in a tight spot. They were survival strategies. The problem was, hedging ruined their profits when the price started to rise.
The mining industry’s many mistakes
OK, now let’s travel a little further down the track. As the gold price rose through the $1,000 level, the guys in the boardroom started to forget all about hedging. I mean, it hadn’t been popular with shareholders, anyway.
But now shareholders had something else to criticise: poor production figures. Remember, production had been pared right back. So now suddenly it needed to be brought back up to par. Only problem was, with everyone ramping up production at the same time, it came at a hell of a price.
Diggers, crushers, scrubbers, centrifuges and screeners – these are the bits of kit that the miners use. And they were all getting rather expensive.
Fuel costs are a significant part of mining costs. And the oil price was no longer back at 1990s levels. And that’s why the days of $200 production costs are long gone. Recent figures suggest that the ‘all-in sustaining costs of production’ are $1,200 or more. An unlucky few have even reported costs of over $1,400.
Clearly, the mining industry has scored yet another own goal. Gee’d up by gold’s price action a couple of years back, the industry allowed costs to escalate out of control. As well as the cost of ‘picks and shovels’ and energy prices, the industry was also implementing new and expensive extraction methods to try to get hold of every last ounce of gold in the rock.
And remember, many had now done away with hedging production. So more recently, when the gold price tumbled, many producers faced exactly the same predicament as they did ten or 15 years ago. A very sad state of affairs.
What comes next?
Once again, the industry is battening down the hatches.
And that’s a good thing. It means the costs of production are likely to fall this year. Some producers were hedging gold production as the price fell from its 2010/2011 peaks too. Again, with gold now trading around its five-year low, that looks like a good move.
And perhaps… just perhaps… the gold price has now found a bottom. Having suffered a near 40% retracement from its high a couple of years back, any improvement will be sure to jolly up the miners.
But even with what could be construed as a better outlook for the miners, many share prices continue to reflect despair.
Source: Van Eck
It strikes me that the bad news is pretty much priced into the industry’s shares now. It’s a contrarian move. But the gold miners could really be poised for much better things.
Of course, any investment comes with significant risk. And that risk comes from the gold price itself. Remember, operational gearing works in reverse too. A falling gold price could send many miners to an early grave.
One way of mitigating risk could be to buy in to a pooled gold fund. London-listed investment trust, Blackrock Gold and General Trust run by Evy Hambro is one popular fund, and its stock is certainly bouncing around its recent bottom right now.[xyz_lbx_custom_shortcode id=10]