Gold miners no longer leveraged play on the metal

August 31, 2011

By Martin Hutchinson
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Gold miners’ shares are a damped rather than leveraged play on gold — at least from evidence this year. The yellow metal’s price is up more than a quarter since December 31, but mining shares are roughly flat. Australia and Peru recently showed how governments grab more when commodity prices rise, while operating costs go up with prices, too. Moreover, mining investors tend to discount spikes in the price of gold as merely temporary, offering little uplift to the miners’ value.

Royalties or equivalent charges paid to governments can severely crimp a miner’s upside. Australia, for instance, is mulling a tax that would take 30 percent of operating profit exceeding a return equal to the government bond yield plus 7 percentage points. That will not deter investment in high-cost mines, where profitability is modest, but it caps the leverage of mining profit to 70 percent of the change in the gold price once profits are high. In Peru, miners feared that new president Ollanta Humala might expropriate assets; in comparison, the royalty he has proposed seems a fair deal. Nevertheless, the government’s levy will be linked to operating profit, again limiting miners’ upside.

There is slippage on the cost side also. Oil prices often rise along with other commodities and precious metals, and fuel typically represents 25 percent of mining operating costs. Naturally miners’ wages, especially for skilled labor, also tend to increase when prices are high and activity intense. The same applies to the cost of mining equipment.

Finally, rocketing gold prices make increasing numbers of higher-cost mines viable and attract new capital into the industry. That adds competitive pressures. Meanwhile, investors doubt the long-term sustainability of high prices. Both these effects tend to mean mining companies decline in value relative to gold itself.

In 2010, an earlier phase of the upward trajectory for gold, the Market Vectors Gold Miners exchange-traded fund rose 33 percent, more than the 29 percent rise in the price of the metal. In 2011, by contrast, the ETF has gained only 2.5 percent compared with gold’s rise of 29 percent. This year at least, mining shares just aren’t shining for gold bugs.

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The ETFs – most veterans of the sector consider them Dastardly ETFs! – have been pumped hard by the Anti-Gold crew BECAUSE they tend to attract Speculators, who are by nature “Weak,” both on the Short side and the Long side.

Veterans of the sector tend to prefer the better Gold and Silver STOCKS, which are much less attractive to Speculators. In fact, the volatility which occasionally plagues the stocks comes via their major Market Makers, who often play games to purge what they consider THEIR private province from all “Weak” hands, again on both the Short and the Long sides.

At the moment, the XAU to POG ratio and TSX Gold to POG ratio are at multidecade lows – Yes, multidecade! This makes the premier Gold Stocks extraordinarily valuable to those who know the sector and know what they are doing. Of course, it also means we’ll have further bouts of excessive volatility as the major players jockey for position.

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