Are Gold Miners A Permashort?

Includes: DUST, GDX, GLD
by: Macro Investor

Gold miners have not had a good run in a long time. I tried to find a time period when the Gold Miners ETF (NYSEARCA:GDX) has been up. Over five years, one year, six months, three months, one month, and Year to Date, GDX has been down. It is, frankly, quite impressive to have a record like that. Imagine how much money one could have made by shorting the ETF?

But before I get ahead of myself, let's examine why the gold miners have been doing so poorly. There is, of course, the liquidity reason. I had earlier written an article titled Should Gold Investors Buy The ETF Or Physical Gold? This article showed that gold prices moved sideways till the Gold ETF (NYSEARCA:GLD) was launched, after which gold prices took off as the miners started to lag.

This is because before the GLD ETF was launched, people wanting to invest in gold would have to buy coins and bars from local gold dealers and store the coins and bars. That was clearly not very convenient. There was markup to pay, security risks, and storage costs. So, gold investors would often invest in the gold miners instead. Once there was an option to invest directly in gold without the trouble of paying markups to the dealers and then storing the physical gold, gold investors moved a large part of their money from the miners to the GLD ETF. This caused the GLD ETF to shoot up and with it the price of gold, while the miners essentially flat lined.

But are there more fundamental reasons why the miners have been doing poorly? This is how the ETF has done over its lifetime.

GDX Total Return Price Chart

The cornerstone of any valuation process is earnings. Earnings are the difference between revenue and costs. Let's examine the cost structure of the miners, as well as the revenue structure.

As the chart above shows, gold mining costs are rising at around 15% per year. This is completely unsustainable. In any normal industry, if the unit cost of production was rising at 15% (especially in a low-inflation environment), pretty soon the industry as a group would go bankrupt. The only saving grace for gold miners has been the corresponding steady increase in the price of gold, which has enabled them to pass on the cost increases to consumers in the form of higher prices. Not all industries are this lucky, and no one, not a single industry stays this lucky forever.

And then the inevitable happened. Over the last 18 months gold prices have stagnated. There are many reasons for that, which I am not going to go into - but suffice to say that lack of high inflation in the USA and low demand in India are the two main culprits. For more details, please read my article Short Gold in 2013.

Gold Price in US Dollars Chart

Trouble is, the cost of mining gold continued to grow at a fast clip. As reported by

Mark Cutifani, CEO of AngloGold Ashanti: "If you want to go on a total cost basis, we're running at about $1200. The industry average is probably around $1250 an ounce."

Steve Letwin, CEO of Iamgold: "It's going to be difficult for anybody to produce gold at less than $1200 an ounce."

Why is this the case? Reports the Economist magazine:

As mines age, extracting gold gets harder and costlier. Ores give up less of the metal-average grades have fallen by 30% since 1999 according to GFMS, a consultancy. And ore must be hauled up from ever greater depths. Fuel is pricier. So, too, are labour and equipment, since the global minerals boom has driven up demand for miners and drills.

This means the gross profit margins of 50%+ for gold miners are shrinking, and rather rapidly. At $1,200/oz cost of extraction, and $1,650/oz price of gold, the margins are less than 25%. If the cost increase trends continue, and gold prices continue to languish as it has in the past 18 months, in less than five years we should be seeing select gold mining companies go bankrupt.

What can gold miners do to reverse the trend? Sadly, not much. The cost of extraction will continue to go up because the easy gold has been mined already. The price of gold is dependent on a whole host of factors that the miners have no control over. They do not set the price, the market sets it.

So, what does that mean for your investment thesis, dear reader? The obvious choice would be to hold the Direxion Daily Gold Miners Bear 3x Shares ETF (NYSEARCA:DUST). This ETF is up some 60% in the past three months, and some 30% in the New Year. I believe there is another 25% left in this ETF this year, as I expect gold prices to continue to flatline, as gold extraction costs keep going up. Of course, nothing is a guarantee, but the immutable laws of geology give me comfort that I will make money on my DUST holdings.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choices.

Disclosure: I am long DUST. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.