Merrill on Base Metals' Contribution to Gold/Silver Miners

This Merrill Lynch research report examines the cash flow contribution of copper and zinc/lead base metals to the gold and silver miners. As long as base metal prices remain high, the exposure is welcomed by investors. Download Nov 6 ML report on Precious Metals (.pdf).

As zinc traded at an all time high price of $1.94/lb this past week, the precious metal miners with exposures to the base metals (copper, zinc and lead) have reported increased cash flows in recent quarters. As gold and silver prices plummeted during May and June, it was the PM miners with base metal exposure whose stock prices held up most.

Of course, that coin has two sides. Last week, copper futures ($COPPER) dropped -2.42 pct while $GOLD and $SILVER were up +4.69 pct and +4.59 pct respectively. That meant that detailed pricing models of the larger capital managers effected a price divergence in the share prices of these miners who have a mix of precious and base metals.

The precious metals company with the greatest exposure to base metals is Pan American Silver (PAAS), where ML estimates some 40 pct of Net Asset Value [NAV] is derived 38 pct from zinc/lead (mostly zinc) and 2 pct from copper.

ML also points to Hecla Mining (HL) (25 pct of NAV) and Agnico-Eagle (AEM) (10 pct) as having significant zinc/lead exposure.

Of the copper-rich precious metals companies, Northgate (NXG) (38 pct of NAV), Yamana Gold (AUY) (36 pct), Barrick Gold (ABX) (13 pct) and Newmont Mining (NEM) (10 pct) are the producers with the greatest NAV contribution from copper. Agnico-Eagle (5 pct) is another.

This report also discusses the problem of the senior precious metal miners like Barrick and Newmont with respect to their rising costs and production of lower-grade ores. This is usually the time in the cycle (actually it started early this year) when the sharpest trading minds switch to the small and mid cap miners that control new large scale projects coming onstream.

In addition to falling ore grades and reserves, and hence rising cash costs of production, the top tier miners usually trade at the highest Price to NAV, which means that the smaller companies are subject to take-overs by larger companies trying to resolve long-term issues.

Over the years, experienced traders have watched the smaller and healthier companies like Goldcorp become larger ones while some of the other ones with issues, like Placer Dome and Echo Bay, have been taken over. This cycle repeats over and over, and traders always need to have an eye on the companies that are on the upswing and the downswing.

With the miners, the value is largely in the quality and size of the asset(s) as well as the ability of the promoter to raise capital to meet capex spending needs, which is a quite separate and distinct attribute.

With respect to the latter, I like the business model approach taken by Xstrata, a diversified producer of metals who have come from nowhere to become one of the top five miners in the world. Their mining operations are run by local operators, while CEO Mick Davis works between a financial office in London and a trading center in Switzerland.