Before you invest in gold stocks, read this

With the price of gold heading for $2,000/oz, you might think gold mining shares would be racing up just as fast. In fact, shareholders in the sector have had mixed fortunes.

The gold mining sector of the Australian stock market, a reasonable proxy for the industry worldwide, has gone sideways this quarter. Indeed, it is at pretty much the same level as it was a year ago.

We have seen the gold price rise by 50% since then. This should have spelled a bonanza for gold miners. After all, the cost of producing gold should not change whatever its price. The extra revenue from the higher gold price should feed straight through to the line that matters most for investors: profit.

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But somewhere along this line the link in this profit chain has evidently broken. Why?

This is what's holding the gold sector back

The first reason is currency. While the gold price is quoted in US dollars, mining costs are mainly denominated in local currencies and these have tended to appreciate against the weak US currency. The Australian dollar, for example, is up 10% against the US dollar over the last 12 months.

The second reason is cost inflation. Supply pressures in the industry have led to rising costs. According to GFMS Research, costs increased in 2010 for the ninth successive year. And analysts believe cost inflation is returning to the 15-25% levels that prevailed in the period from 2003-2008.

On top of this, the deterioration in grades and a rising strip ratio has also affected the cost of producing gold. Miners have been digging ever deeper to extract gold of increasingly poor quality. This is a prolonged trend that has led to a decline in average grades of up to 30% in the last decade.

All told, GFMS calculates that the average cash cost of producing an ounce of gold shot up last year from $478/oz to $557/oz. Taking all capital and project development costs into account, the total rose 20% to $857/oz.

Fortunately, the price of gold has been heading up at an even faster rate than the cost of production. That allows plenty of profit margin, even at these higher mining costs. But not all miners are able to sell gold at $1,850/oz. Only those that are actually producing today can do so.

This is why the best performers have been established producers miners such as KIRKLAND LAKE (KGI) and HIGHLAND GOLD (HGM). Gold miners at the exploration and development stage, on the other hand, can only cross their fingers that such high prices prevail when they finally pour their first gold.

Few mining executives or analysts are taking this on trust. Executives in the oil industry routinely use a conservative price as the basis for forward planning, and the mining industry is no different. I should be surprised if any gold mining executive is using a gold price above $1,200/oz as a working long-term assumption. And most analysts are basing their forecasts on prices well below today's arguably spiky price.

The fact remains, however, that most of today's new gold projects were initiated prior to 2009, when the gold price was much lower than it is now. If the price stays anywhere over of $1,500/oz, many of these projects should be very profitable. But there is another factor that may prove an obstacle to bumper margins for investors.

Why the climate is changing for gold juniors

The potential for huge profits from post-2009 gold projects has not been lost upon host governments. In the search for rich deposits, gold miners have had no choice but to venture into countries where political risk is higher than they would like, and one government after another has been retrospectively changing the rules to prevent foreigners from walking off with prized assets. On top of this, China has muscled in, offering to fund infrastructure projects in return for mining assets and it has not been shy of elbowing others out of the way.

Analysts, though, remain bullish and my inbox is full of recommendations for gold juniors. ANGLO ASIAN MINING (AAZ) and NORSEMAN GOLD (NGL) are both producing miners trading on forecast price/earnings ratios of around four. SHANTA GOLD (SHG), STRATEX (STI) and ARIANA RESOURCES (AAU) are all close to the transition from exploration and development into production. And SOLOMON GOLD (SOLG) is another favoured for its proven management and potentially massive resources in the Solomon Islands.

I've not done thorough research into any of these stocks. They're on my to do' list for now to look at another time..

This article is taken from Tom Bulford's free twice-weekly small-cap investment email The Penny Sleuth. Sign up to The Penny Sleuth here.

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