China's Gold Farmers

Most investors think that China is just another market. After all, according to that science teacher on the E-TRADE ad, all you have to do is click, and you're buying shares in Hong Kong. Well, that part's true of course, but it's a lot more complicated than that in China.

Gold and China

China outshone South Africa last year as the world's largest gold producer. As with most things behind the big wall, getting real numbers is a challenge, but smart people say somewhere between 9.7 and 9.9 million ounces (or 276 to 280.5 metric tons, depending on how you like your measurements) came out of Chinese soil last year. Either way, it comes to an increase of more than 12% over the previous year. In China, this production is achieved by dozens of junior mining companies, often with complex ownership, and with only a handful of them publicly listed on exchanges.

One company, Zijin, already listed on the Hong Kong Stock Exchange (HKG:2899), recently offered an IPO on the Shanghai exchange (SHA:601899). The IPO was so popular, at one point it traded up 208%. Worried that speculation was out of control, the exchange took the unprecedented step of suspending trading for 30 minutes in an attempt to cool the IPO fever. By close, the shares had settled to a paltry 95% gain on its first day of trading.

Welcome to China

Chinese Gold Mining Companies vs. Gold 1/1/07 to 4/18/08

By listing on the Shanghai Exchange, Zijin joins some of its smaller competitors in the gold mining sector.

On the chart, the companies break into two groups.

Let's take the top group first. Jiangxi (SHA:600362), Zhongjin (SHA:600489) and Shandong Gold (SHA:600547) are traded on the Shanghai stock exchange. Yunnan Copper (SHE:000878), though mainly a copper miner, does produce gold and trades on the Shenzhen exchange.

All four companies outperformed gold to an amazing degree. In October, Shandong's stock price had grown over 500% since the beginning of 2007. This occurred at a time when gold was "only" up 10 to 20% for the year. Towards the end of the year, the stock went even higher, though never for long.

The mainland Chinese market for gold miners has been on a downslope since March. That may be changing as company earnings reports for Q1 start trickling out. Shandong's report is a standout, with first-quarter net profit expected to be over 300%. Early reports put it well over that number to 389.69%.

Hong Kong Is Not China

Then there's poor Zijin. Zijin is China's largest publicly traded gold mining company and responsible for a reported 20% of China's gold production. But Zijin's performance in the beginning of 2007 looks positively anemic compared with the other companies. Of course, since Zijin has only been listed on Shanghai for a few days, we're looking at stodgy old Hong Kong stock performance. The juxtaposition highlights a big difference between the markets. While Hong Kong investors did bid Zijin up in the Chinese Gold Farmer Boom of Fall 2007, it was vastly muted.

So what's with the premium? Well, to start with, stocks traded on Shanghai and Shenzhen trade at a premium to Hong Kong stocks, even with all else being equal. As this Reuters article explains:

The average premium of dual-listed companies' A shares over their H shares is now 39 percent, having dropped from a peak of above 100% in January.

The reason for the premium is attributed to China's closed capital markets and the yuan's recent appreciation. (Brad covers the gold/currency link - and lack thereof.) There is also a compelling argument that there are simply so many Chinese playing the stock market, many times with little or no trading education, that prices are driven up in frenzy. It's the same simple supply/demand economics applied to shares of stock that have made rational investors pull their hair out since tulips were the next sure thing.

Is there a right premium? Analysts say yes, but that 100% is too high. Someone should have told that to the people who bought Zijin in Shanghai on Friday - the closing price put the premium at 103%. (The percentage calculation, courtesy of the above Reuters article: Stock prices were Y13.92 on Shanghai and HK$7.61.) That premium has gone down as the gap between exchange stock prices narrowed as the IPO fervor began to wear off with Zijin closing in Shanghai at Y11.28 and on Hong Kong at HK$7.23 on April 29.

A Little Closer To Home

Meanwhile, back in rational investor land, the more mainstream gold miners (here proxied by the Van Eck Gold Miners ETF (GDX)) were experiencing a nice rally that would put them well in the lead of the price of gold over the same period, but nothing like the wild speculation of mainland Chinese companies.

Quick refresher. GDX is Van Eck's Gold Miners ETF that is based on the Amex Gold Miners Index (GDM). It currently includes 34 companies, with Barrick Gold (ABX), Goldcorp (GG), Newmont Mining (NEM) and AngloGold Ashanti (AU) making up the top 30% of assets. The companies are spread all across the globe, and include large-, medium- and small-cap firms, but all have to be listed or at least quoted on an American exchange to be included.

The relationship between gold and gold miners is like every other company and the commodity it produces. The stock price won't track the commodity exactly because of the multitude of factors that go into running a company (strategy, assets, efficiency, etc.), but the company will generally benefit from rising prices (or lose from falling prices). Gold mining stocks continue their ups and downs but have been pulled up to a new level by high gold prices.

In these times of high gold prices, mining companies have an interesting decision to make. Do they mine the high-quality, relatively easy-to-get ore when prices are high so as to cash in on the difference between cost of production and sale price? Or do they mine the harder-to-get-at ore since higher gold prices can cover higher production costs? Short-term gains or extending the life of a mine?

Our guess is that the more established companies - those in the GDX, not the minor miners in China - will make the long-term decisions, but only annual reports will tell. But with companies such as Shandong reporting huge net profit increases, it may be that they are grabbing the low-lying fruit to cash in on the gold.

In the end, the nuttiness of the Shanghai mining group is just that: nuts. Speculation is a large part of how the market functions. Wild swings are part of life. This article sums it up nicely:

Just how painful is China's volatility? Single-day moves of 2% or more-the kind of loss seen on April 17, when stocks hit their lowest level in nearly a year-are perceived as normal. On one memorable day in February 2007, the Chinese market slumped nearly 10%. Last week, the tax cut pushed Shanghai stocks up 15%.

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