How Cheap Are Gold Stocks Relative to Bullion?

My recent post entitled “A short term warning for US Dollar bears and commodity bulls” must have struck a nerve. I received a torrent of responses regarding gold, gold stocks and how the US economy was going down the tank.

In response, I analyzed the question of the relative value of gold stocks compared to gold bullion. The above chart shows the ratio of the PHLX Gold & Silver Index [XAU], which has a longer history than the popular Amex Gold Bugs Index [HUI], to gold bullion. Since the line is near the bottom of its historical range, it suggests that gold stocks are a bargain compared to gold.

A synthetic gold stock tells a different story: Rising production costs

Back in 2006 I wrote a research report (How to Watch for Signs that the Gold Correction is Ending, 15 March 2006; if you are interested in the full details email me and I will send it to you) detailing how to make a synthetic gold stock.

Conceptually a mine can be thought of as a series of call options on the underlying commodity, with the exercise price as the cost of production. If the commodity price falls below the cost of production, the mine operator has the option to either close or mothball the mine until prices improve. I created a synthetic gold stock by building a model based on these principles. Key features of the model are:

• A series of eight deep-in-the-money call options on the price of gold, with terms of 1, 2, 3 … 8 years, which models a mine with an eight year life, a common estimate of long-lived gold mines;
• An exercise price equal to cash production cost of $250, rising each year by the current inflation rate. ($250 appeared to be a common estimate of cash costs for existing gold stocks in 2006);
• Equal amount of gold mined each year; and
• The position is rolled forward once a year at a cost of 1.5%.

Of course, there are some important differences between the synthetic gold stock and the actual gold stocks themselves:

• Gold miners have exploration upside and operational risk, which the synthetic gold stock does not;
• Gold mining companies may hedge the gold price with forward sales and other derivatives;
• Actual gold mines can somewhat manage the cost of production by high-grading when gold prices are low and mining a lower grade of ore when prices are high. The synthetic gold stock’s assumed cost is inflexible.

Production costs are rising

The synthetic tracked the actual index reasonably well until 2006 (which was, of course, the out of sample period) when the synthetic began vastly outperforming the actual index. Delving further into the model, I found that the price divergence was explained by rising production costs of shown by the actual gold miners. Recent analysis by David Galland of Casey Research confirms this trend of rising costs at major producers Barrick and Newmont.

So what’s the answer? Are gold stocks cheap or not?

Gold miners are experiencing higher costs than historical experience, which deflates the case that gold stocks are cheap compared to bullion because their margins are lower. However, higher costs can be explained either by companies mining a lower grade of ore in the current high price environment in order to preserve their reserves and asset value (which is bullish), or costs escalating out of control and squeezing bottom lines (which is bearish).

The truth probably lies somewhere in between the two explanations. Given the recent experience of NovaGold at Galore Creek, I would lean towards the latter as a more likely explanation of higher costs.

Here is a stupid question: Rather than agonizing which is the correct explanation for rising production costs, why not just buy the synthetic? That way an investor can customize and control his desired risk profile and exposure to gold.

(Warning for individual investors - don't try this at home. The synthetic is a highly sophisticated instrument that even professionals can get wrong if implemented incorrectly.)

Comments

[Lisa]

Excellent article.

[dieuwer]

There is a much simpler way to estimate if miners will outperform the price of gold or not: look at the gold/oil ratio.
If you take the price of oil as an indicator for operating cost, a decline ratio of gold/oil implies decline profitability because it the miners' cost (oil) increases more than sales (gold).
However, if the gold/oil ratios rises, it implies that sales (gold) outperform cost (oil) which should make the miners more profitable.

It is interesting to note that from 2001 to 2002, the gold/oil ratio was rising, from 2002 until 2006 decline, from 2006 to 2007 rising, and recently declining again. So I am not surprised that miners have become less profitable lately.

[eric hart]

I won GG and notice that UBS came out with it as their top pick among the majors for precisely the reason of higher margins, and lower costs, as well as that their gold is located in politically stable countries. I would continue to add to GG at the right price.

[eric hart]

Actually, I didnt win it, rather I own it. My largest position.

[jimmy46]

"higher costs can be explained either by companies mining a lower grade of ore in the current high price environment in order to preserve their reserves and asset value ""

So does anyone provide info as to the yield management practices of the various gold miners?

[guapo]

very professional article. I enjoy it very much.
So far, it is not clear to me what happened in NovaGold at Galore Creek. It looks like that they have miscalculated production costs rather rising production costs . NG has changed management and they will produce gold in 2Q (I wish).

[kkin365]

A thought-provoking post. I read somewhere that in looking at gold stocks, one has to assess the extent to which its production had already been spoken for -- using your option analogy, the extent to which a company has covered calls. When so, any price appreciation above the call price belongs to the owern of this call option. This may explain why your synthetic value far exceeds the market value. Perhaps I am wrong.

[Georealist]

I'd like to think this article has some merit..but if it does it's marginal. There are far too many variables in mining to make such a simplistic comparison with a so called "synthetic" alternative. For instance...
1. "Synthetic" variables all rely on the presumption of ultimate delivery or physical presence...these almost never matter except..when they might really matter! In which case "synthetic" becomes synonymus with
nonexistent..as in "sorry, but there is no physical silver in storage."
2. Mining stocks have many other variables (often critical) that affect price that aren't even mentioned above..and by "price" I mean price of the equity..not just the underlying metal. For instance...higher cost miners bottom line jumps exponentially when price begins to exceed costs...their shares are quite likely to move higher, faster than low costs producers. Mining stocks benefit greatly in the final bull rush from exaggerated expectations...gold/si... ALWAYS jump furthest last..of course, you'd acually have to have been a real investor over time to know this.
Also...don't be fooled by what's NOT stated in the article...Options can move against one very quickly and require constant reinvestment. A miner with resources..like CDE for example..is a very simple game to play. You get your metal at half price (by ANY measure) and you can simply wait for the fundamentals and great towards real stuff to catch up......

[Dan Tyrant]

Interesting article... surely many factors contribute to the rising cost of pulling gold out of the ground, but one of those factors must be that the price of oil has risen far more quickly than that of gold these past few years. The Oil/Gold ratio is out of whack. Price suppression is another obvious factor, though it's one that ought not to be mentioned in polite conversation for some reason.

[metoo105]

Very interesting post/story.

My follow-up question is related to the statement above: why not then just buy low cost production, like GG, or perhaps AUY? I am not sure why or how their margins are better, perhaps it is just long term supply contracts, but they do appear to be. Finding such stocks seems infinitely easier to me than finessing the synthetic position.

[jimmy46]

"""why not then just buy low cost production, like GG, or perhaps AUY? I am not sure why or how their margins are better,""&qu...

Almost all the mining companies play a hocus pocus game,
where they pretend to be a pure miner of one metal.

In reality they dig up a ton of ore and get a bunch
of metals.
Then they sell all but one and use those profits to
offset their costs,
And then the one chosen metal is said to be
practically free.

Take FCX: they claim to be a copper mine, and
they claim their New guinea mine produces
copper for about 5 cents a pound.

BUT, they make a fortune selling gold and silver
from that mine and claim they make zero from
the those metals.

It's just an accounting/public relations game.