Despite Sell-Off, Gold Miners Still Risky

Includes: ABX, GDX, GDXJ, PVG
by: Prudent Finances

Gold mining stocks (NYSEARCA:GDX) are down 36% this year and gold junior mining stocks (NYSEARCA:GDXJ) have performed even worse. Despite the pummeling gold mining stocks have taken this year, I believe they are still risky to buy even at these depressed levels. Last week, Dennis Gartman on CNBC said that he hates gold mining stocks. While I do not agree with him, I do understand his arguments against gold miners.

The argument for buying gold stocks is that they provide leverage on an increasing price of gold. Here is an example. Let's say gold is at $1,500 an ounce and mining company XYZ's all-in production cost is $1,300 per ounce. Therefore, XYZ is earning about $200 per mined ounce. Let's fantasize and say the price of gold rises to $1,900. If you own gold bullion, your assets increased by $400 per ounce (or about 27%). However, if you own XYZ, the company's earnings would have tripled from $200 per mined ounce to $600 an ounce. That would be a 200% increase in earnings. That's the kind of leverage a gold or silver mining company has.

However, while I believe that it is almost a certainty that gold will increase in price in the long-run due to negative real interest rates, monetary debasement, and physical demand especially in Asia, I do not believe gold mining stocks offer the same guarantee. There are many risks that you have to consider when buying into the mining sector. And I'm talking about all kinds of mining, not just gold miners. Let's take a look at some recent news that illustrate two of these risks: dilution and government interference.

Share Dilution

This is a problem particularly with junior mining stocks. Developing a mine is extremely capital intensive and most of these smaller miners need to raise money in order to complete development. So one way to raise money is to sell stock and dilute the shares. Take a look at what Pretium (NYSE:PVG) did recently. PVG was trading near a 52-week low and they decided that it was the time to sell shares and dilute the existing shareholders. What brilliant timing! The last time they diluted was February when the share price was nearly double what it is now. Since PVG has no operating mines and hence no revenue besides the .000000001% interest they are probably receiving on bank deposits, they are forced to seek funding until early 2016, which is the earliest their Brucejack mine will be operational. So we are looking at more dilution for almost three more years whether the stock price recovers or not. Basically, they are now at the mercy of the market. If the stock price does not recover then PVG could be forced to sell more shares at low prices. Sometimes when a mining company gets funding, they need to issue warrants as well. Warrants are essentially free call options that are given to the financer. If the warrants are exercised, then you have more share dilution.

Government Intervention

Most or all mining stock investors would agree that the U.S, Canada, and Mexico are considered to be safe mining areas. But many of the earth's resources are located in places like South America and Africa where government intervention occurs more frequently. The best example of this was probably when Venezuela under Hugo Chavez seized the Las Cristinas project of Crystallex (OTC:CRYFQ) and the Brisas project of Gold Reserve (GDRZ). Crystallex is now a penny stock and Gold Reserve is in a never-ending arbitration battle with Venezuela that will determine whether the company will survive. Recently, Barrick Gold (NYSE:ABX) encountered a problem of their own in Chile. Due to environmental concerns, a court ordered construction on the Pascua-Lama project to be stopped. The $8.5 billion Pascua-Lama project straddles the border of Chile and Argentina, so the court order applied only to the Chilean part. Construction will continue on the Argentinian side. Unfortunately for ABX, most of the mineral reserves are on the Chilean side. Considering that ABX's market cap is $20 billion, potentially losing a big chunk of an $8.5 billion project is disastrous.

Final Thoughts

Share dilution and government intervention are just two risks that mining investors need to consider. For those who want to learn more about the mining industry and get some investing ideas, you can check out the Cambridge House Investment Conference in Vancouver, Canada on May 26-27.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.