Gold / Oil Price Ratio Favors Precious Metal Miners

Includes: GDX, GLD, OIL
by: Jeff Nielson

Investors in precious metals miners (like myself) were greatly disappointed by the performance of those stocks in 2008. There is no big surprise there. However, where precious metals investors differed from investors in most other sectors is that we were greatly disappointed by returns prior to the meltdown in markets which took place beginning in the summer of 2008.

In March of 2008, gold broke $1000US/oz, yet the share prices of most of the mining companies went nowhere. Some of the reasons for under-performance have been discussed here previously – with perhaps the most important factor being how the (so-called) bullion-ETFs soaked up billions of dollars of investor-capital which would have otherwise flowed into the precious metals miners, had those dubious funds not existed (see “Your ETF-Silver is For Sale”).

However, there was one factor cited by some analysts for this poor performance which had nothing to do with the chicanery of the anti-gold cabal: high oil prices.

The problem for gold bulls in March 2008 was that as gold was briefly pushing above $1000US/oz, oil was surpassing the $100US/barrel for the first time, with the crude oil price for the month of March averaging over $96/barrel. In other words, at what was otherwise a bullish period for the precious metals sector, with a gold/oil price ratio of 10:1, the mining companies were unable to capitalize on bullish sentiment in the sector.

Conversely, when gold shot past the $1000-mark in September this year, the price of crude was averaging only $60/barrel. Instead of a gold/oil price ratio of 10:1, investors were presented with a ratio much closer to 20:1. In this environment, the mining companies have been thriving – although the gold derivatives used by many of the larger miners have greatly detracted from their profitability.


January $84.70 July $126.16
February $86.64 August $108.46
March $96.87 September $96.13
April $104.31 October $68.50
May $117.40 November $49.29
June $126.33 December $32.94
2008 Average $91.48


January $33.07 July $56.16
February $31.04 August $62.80
March $40.13/$39.88 September $60.98
April $42.45/$42.20 October $67.43
May $51.27/$51.02 November $69.43
June $61.71/$61.46 December
2009 Average $52.40/$52.31

It would be nice if investors could use this ratio as some sort of formula to value the miners, unfortunately the price relationship between gold and oil is not simple enough to lend itself to such a simplistic analysis.

To begin with, there is enormous variation between the level of profitability among the miners, with bullion at any given price (and oil held constant). For instance, one miner might have cash costs of $400/oz – and thus make $600/oz profit with gold at $1000/oz. A second miner might have cash costs of $700/oz, and thus a profit margin of half that amount with gold at $1000.

Now let's factor the price of oil into this. Assume that the profit margins above are based upon crude oil at $50/oz. This would mean we would start with a gold/oil ratio of 20:1. If we leave the price of gold at $1000/oz, but increase oil to $100/barrel, then our gold/oil price ration moves to 10:1. How does this affect the profit margins for the two, hypothetical miners in our example?

The answer is: we don't know. Along with variations in the profitability of miners, these gold producers also use the “inputs” of their production in varying levels. For some miners, energy costs (which vary either directly or indirectly with the price of crude) may be 25% of their incremental production costs, while for another miner it could be 50%. Thus, some miners are extremely price-sensitive to energy costs, while other miners are more resilient.

Again, it is impossible to generalize here. One big variable in this equation is whether the miner in question is extracting ore through an “open pit” mine, or a traditional underground operation. While underground mines generally require significantly greater capital costs to bring them into production, underground mining is much less energy-intensive than open-pit operations.

The next variable in this equation is jurisdiction. Energy-rich countries, or those with very mining-friendly governments will generally give miners access to energy on much more favorable terms. As a result, miners in those jurisdictions will again be less price-sensitive to energy costs than miners operating in less “mining friendly” environments.

The third most-important variable here is whether the mine is able to be patched-into the energy grid of the jurisdiction in question, or whether it must rely wholly or partially upon oil-powered generators. Those with no access or poor access to energy grids will be more vulnerable to energy price increases.

Finally, even miners who operate in mining-friendly jurisdictions, who traditionally have cheap, reliable energy supplies can always be ambushed by Mother Nature. Chile, which is one of the most mining-friendly nations on the planet, has always made abundant amounts of hydroelectric power available to supply the needs of its large mining community. However, last year, drought in Chile dramatically lowered water reservoir levels, which in turn significantly reduced its total amount of available power.

Miners in Chile narrowly avoided significant power problems, but had the drought situation deteriorated any further, it would have had a very negative impact on both mining production and profitability.

Thus, while energy costs are a tremendously important factor in determining the profitability of any particular mine/miner, analyzing this dynamic is not as simple as we might believe at first glance. For those investors who do their homework, this should provide them with an advantage over many less-diligent buyers and sellers.

After classifying miners into those with open-pit operations and those with underground mines, investors must become familiar with how a miner's power needs are being met. Is it from the national energy-grid, or private generators? If from a national grid, is it hydro-power, oil-power, or perhaps even nuclear power (in more advanced jurisdictions)?

Obviously there are many more nuances here for investors with the time and desire to research this issue in even greater detail. Overlaid upon this dynamic is the fact that unless one does not believe in “peak oil” we know that rising oil prices will be a way of life in the future. While gold bulls can remain confident about bullion prices, we can not afford to become complacent with respect to production costs.

Again, I would recommend to readers that you familiarize yourself with Chris Martenson's “Crash Course” (broken up into twenty, very organized and understandable clips) – most particularly his analysis of the current and future energy market, and availability of supplies.

Those investors who do so will gain a new perspective on the importance of the “energy issue” to mining companies. Of course, many sectors of our economies are extremely sensitive to changes in energy costs/prices, so I don't want to scare people away from the miners through creating the impression that this energy issue is in any way unique to this industry.

Dealing with rising energy costs will be a way of life for our species unless/until some superior, abundant energy source is made available. Understanding the dynamics of the impact of changing energy prices will be a significant factor in the success of investors in investing in precious metals miners.

Do not allow yourself to be mesmerized by bullion prices alone. Remain cognizant of the gold/oil price ratio, and the energy status of the miners you hold, and this will be one less potential “surprise” to deal with in your investment portfolio.

Disclosure: none