Leveraging Up on Precious Metals Ahead of Fed Meeting

The Fed will meet once again today. No one knows for sure what the outcome will be, but considering the current state of the markets, they’re not likely to make any drastic moves.

If the Fed stays in line and it does as expected, their actions (“inaction” would probably be more appropriate) could propel one sector 30% to 40% higher in a matter of days. In this case, it has happened before.

Precious Profits

After the last Fed meeting, precious metals prices and shares of gold and silver miners stocks soared.

iShares Silver Trust (SLV), which moves in lockstep with silver prices, climbed from $16.60 to $18.20. A move of 9.6% in a week. The gold price tracking SPDR Gold Shares (GLD), formerly StreetTRACKS Gold Shares, climbed  a more modest 6% in a week.

When the Fed signaled inflation is not the top priority…the world ran for protection. At the time, that protection was in silver and gold. On Tuesday, when the Fed stands on the sidelines as they did last time, the protection seeking herd will move once again to silver and gold.

Whether that’s what the Fed should do or not isn’t really important here. The key is they won’t don’t anything. And that’s going to get the gold bugs howling again.

Leveraging Up

To be honest, 6% and 9% are not much to get me excited. The small potential upside isn’t enough to offset the downside risk in this type of situation. However, if we add a bit of leverage we can get the much larger upside.

After the last Fed meeting, silver and gold made strong moves. The bigs moves, however, were in the leveraged plays.

For instance, Silver Wheaton (SLW), a highly leveraged silver company, and Goldcorp (GG), gold mining company, both scored gains of around 18% in the week that followed the lat Fed meeting. Other major gold miners like Barrick Gold (ABX), Newmont Mining (NEM), and AngloGold Ashanti (AU) followed sit. On average, the group more than doubled the returns of silver and gold bullion.

These two offer the leverage to make some decent gains on the Fed’s inaction. In this case, Silver Wheaton offers a lot more potential over the medium term. Here’s why.

Mining’s Dirty Little Secret

One of the biggest problems facing mining companies now is costs. The early stages of commodity eurphoria have disappeared. Mining companies now have to deliver on their numbers to get some recognition from the street. Merely being a mining company in a commodity bull market is not enough anymore.

The perfect example is in the copper sector. When oil was at $20 a barrel and a pound of copper was trading for 80 cents, mining companies were profitable. The cost of producing  copper ranged from 50 to 60 cents per pound. As long as mining companies were selling it for 80 cents per pound, they were making money.

When copper surged to $4 a pound, copper miners like Freeport McMoRan (FCX) and Rio Tinto (RTP) watched their stock prices and profits soar. After all, if they would be able to sell copper at higher prices all of the extra revenue should go to the bottom line, right?

Not exactly. The whole time copper prices were rising, so was the cost of everthing else. Mining takes a lot of diesel fuel, sulphuric acid, oil, natural gas a host of other resources depending on the type of mine. As those commodities rose in value, so did costs of producing copper.

In most cases, it now takes between $1 and $1.50 to mine a pound of copper. That’s about double what it was a few years ago and the costs are only going up. That’s why mining stocks have been hit hard in the recent downturn. The euphoria is over, now they have to deliver with profits, which they haven’t all been doing.

That’s why I think Silver Wheaton, and it’s unique business model, has a lot more upside than GoldCorp.

Turn One Man’s Trash into $2 Billion

Silver Wheaton isn’t your typical mining company. The company takes the extra silver from mines that were built primarily to produce copper, lead, and other base metals around the world. Silver Wheaton fronts a big portion of the cash needed for these mines to go into production in exchange for the silver byproduct at a predetermined price of $3.90.

The miners needed the cash and weren’t too worried about the silver. Silver Wheaton had the cash and was willing to buy all the silver. It’s a one-sided win for Silver Wheaton as long as silver prices keep going up.

The Silver Wheaton model has been extremely successful so far. And it’s only going to be more successful as mining costs continue to rise and Silver Wheaton just buys silver for less than $4 an ounce and flips it for market price. (On a side note, the same people that created Silver Wheaton are doing it again. This time they’re focused on gold. Gold Wheaton (GLWGF.PK)  is currently traded in Canada with ticker symbol GLW and also on the U.S. OTC under GLWGF. Gold Wheaton is already sports a market value of about $1 billion)

But it’s not just a great business model, rising prices, and steady costs that will help Silver Wheaton shares from here. The biggest driver ahead is growth.

Silver Wheaton expects to flip 13 million ounces of silver in 2008, 19 million ounces in 2009, and 25 million in 2010. If silver prices hang around the current $17 level, that would work out to about $325 million in operating profit. That’s not bad for a $2.8 billion company with drastically low costs. But if silver goes to $25, $30, or higher, Silver Wheaton’s profits will increase exponentially. And the next big run for silver could start sooner than later.

Here We Go Again

The last Fed meeting the world realized the Bernanke’s bind. The Fed has only two choices. Both aren’t good for the economy. The U.S. central bank had to choose between raising rates to curb inflation and stunt any economic recovery that may have already started or hold steady and let inflation start to run.

The Fed made its intentions known when  it held rates steady. The Fed pretty much told investors near-term economic growth is more important than inflation. That is a good sign for precious metals in the short-term. And it’s only getting better.

Seventh Time is the Charm for Silver

Currently the futures market is showing 51% odds of a Fed rate hike at the September meeting and a 40% likelihood of another raise in November. For now, that means no cuts. And if the Fed language is just right, we could see another big run in precious metals stocks.

The U.S. economy shed another 51,000 jobs last month. That marked the seventh consecutive month of job losses in the United States. Unemployment now sits at 5.7% and is on it’s way to 6% and beyond. The whole time inflation pressures are as strong as ever. That’s including the recent correction in commodity prices.

Bernanke’s in a bind and precious medals could be set for another quick run. If so, Silver Wheaton is going to be one of the biggest winners of them all.

The best way to play precious metals isn’t with an ETF though…it’s with leverage. The biggest moves are in the highest leverage precious metals plays. Mining stocks don’t provide the leverage they once did. It’s all about costs now. That means next week could likely prove very exciting for Silver Wheaton shareholders.

If not, at least there’s not much downside from its current prices. Silver Wheaton shares have dropped about 20% in the past two weeks in anticipation of lower than expected earnings report. Silver prices have held steady and are set to climb again. Silver Wheaton is on the verge on some torrid growth over the next three years. Keep in mind those, this is still the mining sector and delays have to be anticipated.

At Q1 Publishing, we’re looking for a big run in silver prices over the near and long-terms. Any move in silver will likely make Silver Wheaton the biggest winner in the “mining” sector even though it doesn’t mine anything.

Disclosure: I am currently long SLW call options.

Comments

[silveraxis]

If the market does not expect the Fed to do anything at Tuesday's meeting, why would confirmation of that put any sort of fire under gold and silver prices, which are at the moment in free fall mode?

The example of copper mining is not quite correct. At 80 cents copper the miners were basically breaking even. Now at $3.00 plus copper they make a margin around $1.50 to $2.00 or more per pound. That is huge and has already propelled many copper miners to multi-bagger gains. It could be the same in reverse on the way down, assuming copper prices collapse as have already lead, zinc, nickel, etc.

We don't see this as much in gold and silver mining because the mentality is somewhat different--the gold miner wants to extend the life of his/her mine as long as possible and therefore will go after lower, previously uneconomic, grades that are now profitable to extract thanks to the higher gold price. This, too, works in reverse, allowing the gold miner to somewhat cushion profit margins. The problem here is not with the gold mine manager's attitude but rather with the gold mine investor's attitude.

Silver Wheaton is a fine company with a great business model but it has risks as well and there are also limits to its leverage to silver prices. With respect to risks, consider that the mines contracted to deliver silver streams are primarily base metal operations (with the exception of Penasquito). If base metal prices fall far enough while silver prices remain high or even rise, these mines may not be profitable and could face shutdown or decreasing production (to conserve cash), thus depriving SLW of silver production. As far as leverage, I recently wrote a comment on a Seeking Alpha piece and don't wish to repeat it here, but suffice it to say that the leverage is something like 70% (ie., if silver prices go up 100%, SLW should go up 170%). Good but certainly not legendary.

[User 52095]

I don't know how this guy got on SA's page but he doesn't know his ass from up.

[User 52095]

Here read what Ted Butler says about SLW and the naked shorts
www.investmentrarities...

[Witzy]

I beleive that this is a fair analysis, nad it may work. If you want a leveraged play on gold or silver, there is Horizon Beta Pro products. In Canada, HGU gets you a 2 times market exposure to gold. I'm in that.

[Cicero]

The Fed held steady; the stock dropped. Any thoughts? Time to buy some?

[Jason Hamlin]

User52095 - tranquilo bro. this article is one person's opinion and it is argued in a comprehensive and well-researched way. to suggest that he shouldn't be publishing on SA just because you disagree or don't like it is childish. grow up and stop attacking authors that you don't like. if you want "expert opinion," go watch jim cramer.

i believe we will see precious metals rebound in the next month, but the shorts are still holding the market back (as ted butler suggests). too bad the SEC doesn't outlaw naked shorting of all stocks (including miners) instead of just their investment bank buddies. crooks.

slw is buy at these levels, although we might see a quick dip below $10 in the coming days. it is the hardest thing to do, but investors would be wise to buy into the current correction. this is truly a fire sale and the precious metals market will prove, as it always does, to be resilient enough to bounce back strongly from these sell-offs.

[gigem77]

What are the differences between now and the week after the last fed statement? For one thing there is the slide into the seasonally weakest month for gold and silver. But there is another larger difference. What was happening to the price of oil and the CRB then and what is happening now? What was happening to tech stocks and financials then and what is happening now? It isn't the same.

Have you heard of catching a falling knife? The fed spoke and stocks rallied. The miners did not. CSCO beat estimates and took off after hours. Why will anybody buy miners this week? Financials, tech, pharma, even refiners are drawing the attention of buyers, but miners are drawing shorts along with the oil and gas companies. Every bounce has been shorted and as you point out, there is no uptick rule anymore.

SLW missed their earnings estimate. They have a bad habit of doing that and silver and gold are still breaking down. Take a look at this gold chart by Dan Norcini. www.jsmineset.com/cwsi...

This is a classic head and shoulders topping pattern that may target another 20 dollar drop in gold. Gold is following oil, as are the rest of the CRB components. Oil broke below another support level today. It might stop falling tomorrow. But why not wait and see?

Why buy something that is falling? Why not wait for a tradeable bounce? I'm waiting for the selling to be exhausted. When SLW and the E&P companies begin to move up again, they will be easy to buy. They fell so hard and so fast that there are millions of shares held by stranded longs who will sell as the prices rise just to get out even.

There is one chance for a long trade. Watch the EIA weekly petroleum report tomorrow at 9:30 ET. If it moves oil higher, gold and silver will bounce. We need to see some big draws in crude and gasoline. They need to be larger than expected. Also, it will help if the demand numbers show some recovery. Then we can snap off a daytrade on some of these miners and oil companies. But it will take time to repair the technical damage done to these stock prices, so for the next week or two, they are more likely to consolidate than take off higher. And if we get greater than expected builds in oil and gasoline, look out below.

[Mark D]

Reread your analysis before you post Andrew. In one breath you say that copper companies made money when mining costs were 60 cents/lb and they sold it for 80c/lb. OK - a profit of 20/60 or 33%.
Then you say their mining costs now are up to 1.50/lb while selling around $4.00 - that's up to $2.50/lb profit and you conclude THAT is why the miners have been hit hard. Even if they are only getting $3/lb that's a 100% gross profit/lb or 3X the old 60c/80c rate... SO what you are saying is completely illogical - makes no sense at all. I think miners are being hit hard for other numerous reasons...margins are better EVER.

[fxtrader07]

@User 52095: Ted Butler talks about the ishares-silver (SLV). Not a single word about Silver Wheaton (SLW)