Precious Metals & Oil: When Bull Markets Collide (NEM, PD; ETFs: GLD, IAU, USO)

Includes: GLD, IAU, NEM, PD, USO
by: The Silver Analyst

Roland Watson (The New Era Investor) submits: Back in the 1950s when gold, silver and oil were far less interesting subjects, Hollywood produced one of its better science fiction B-movies called When Worlds Collide. The basic story involved a star on a collision course with the Earth. The lucky few rocketed off to its companion planet before the star incinerated the Earth to a cinder.

Sadly, important questions were not answered by the filmmakers such as whether this event led to the mother of all gold bear markets and whether Greenspan or Bernanke managed to convince anyone they should be on that rocket. After all, central bankers are indispensable, right?

I don't know, but that led me to think of when bull markets collide. There are two bull markets currently locking horns on this planet -- metals and energy -- and they are not unconnected. They are colliding, but we are not sure who is staying on the Earth and who will be on the rocket from an investors point of view.

Consider this recent statement from OPEC:

OPEC Warns High Commodity Prices May Kill Oil Projects

Soaring commodity and raw material prices are increasing the cost of oil and gas projects by up to three times, Organization of Petroleum Exporting Countries ministers said Friday.

Although current high oil prices may be helping to drive much-needed crude investment, the rising cost of construction projects could curtail new energy production development, they warn.

Addressing delegates at Petrostrategies annual oil summit in Paris, Qatari Oil Minister Abdullah al Attiyah said: "Our costs have tripled from two years ago, due to high (commodity) prices. And it's not just that, it is also contractors who have tripled their prices."

So we have a 200% rise in the material costs of exploration and development of gas-oil projects. This is partly due to the raw material costs (e.g. thousand of meters of drilling shaft) but also higher costs for renting and buying machinery made from such materials. What the article does not state is how much these costs compared to other capital costs such as wages in a project budget.

Meanwhile, on the other side of the bull market planet, metal producers are feeling the pinch from higher energy prices (from Bloomberg):

Newmont, Barrick Use Power Plants, Big Trucks to Cut Fuel Costs

Aug. 23 (Bloomberg) -- Newmont Mining Corp., Phelps Dodge Corp. and Barrick Gold Corp., faced with surging energy costs, are building their own power plants, locking in fuel prices and using bigger trucks to reduce expenses.

Oil reached a record $67.10 a barrel on Aug. 12. Retail diesel prices in the U.S. averaged $2.255 a gallon in the second quarter, up 32 percent from a year earlier, according to the U.S. Department of Energy. Newmont's energy costs have climbed 44 percent in the past year to $130 million, or 25 percent of all expenses, Hansen said.

Vancouver-based Placer Dome Inc., Canada's second-biggest gold producer, had a $7 million loss in the second quarter as higher fuel prices contributed to a 23 percent jump in the cost of producing gold. Newmont's production costs rose 8.4 percent.

Production costs up 8.4% at Newmont (NYSE:NEM) and 23% at Placer Dome Inc. All other things being equal, gold had to rise at least 23% just to keep Placer Dome running on the same spot. In the future, if a company cannot offset its energy costs adequately, they will be ripe for bankruptcy or takeover.

Unless such costs can be unobtrusively passed onto consumers, one would assume that rising energy costs are good for gold but not for gold producers. Is this reflected in the recent price action of gold equities? From the big move up in mid-May 2005, the HUI has leveraged the price of gold by a factor of 1.5. This is actually not a good number over the last five years (3 or 4 is a sign of a more healthy leverage) and so one must wonder how much the price of energy is beginning to influence investors’ perception of large and middle gold producers. For now, the jury is out on that one.

So, many investors may be looking at the price of gold and the potential profits this may generate for companies. I say "potential" profits, because in the peak oil era, they will have to increasingly consider the price of energy as well.

Mining companies can currently get round these problems in various ways. They can seek alternate supplies of energy such as Newmont's coal-fired power plant in Nevada. They can use more efficient strategies such as moving to higher-haulage trucks or using off-peak electricity rates on night shifts. They can also hedge against rising energy prices by going into the futures markets to buy oil and gas or take the investor route by going long in the energy market.

But we can see in the Newmont and Placer Dome numbers that high-energy costs are still the order of the day. You can only make so many efficiency gains and hedging only puts off the evil day if energy costs keep on rising. Indeed, I suggest that increasing energy costs will be the main preoccupation of the decade and onwards as Peak Oil begins to have its way. How does this nominally affect companies? I quote from the same article:

Energy is a mining company's second-biggest expense after labor and makes up about 10 percent of operating costs, said Brian O'Shaughnessy, chief executive of Rome, New York-based Revere Copper Products Inc.

Mr. O'Shaughnessy in another quote on electricity costs affirms this pessimistic view for mining profitability and energy costs:

Revere Copper Products, of Rome, spends about $500,000 more on power each year than similar-sized competitors in low-cost states, said M. Brian O'Shaughnessy, president and chief executive officer.

"At some point, energy costs will have the potential to be a major factor in our survival," O'Shaughnessy said.

What I could not establish was whether the quoted 10% cost was based on the equivalent of $40, $50 or $60 oil. If it was $50 and oil proceeded to hit $100 and stay there, then 10% becomes 20% of operating costs. Gold that cost $350 to produce would then cost $385 to produce. That of course does not take into account the impact higher oil costs would have indirectly in other areas such as wage demands. So, if gold is at $550 then the potential profits drop 17% from $200 to $165 per ounce. Therefore mines considered uneconomic at lower gold prices remain uneconomic at higher gold prices and the primary supply of gold to the markets suffers.

When bull markets collide, something gets destroyed. In this case, it is high energy cost producers. But for the metals and energy investor, bull markets may merge rather than destroy each other. Going back to our OPEC article:

Hamli said as a result of soaring commodity costs, it is difficult to forecast how much it will cost the UAE to raise its crude production to 3.5 million barrels a day from 2.5 million b/d by 2010.

What can we say but higher E&P costs pushes up the price of the final product. Higher costs means delayed and cancelled projects. To get them back online requires the price of oil and gas extracted to outpace the cost of the materials (including energy) used to find them. That doesn’t imply that a 10% rise in the price of rolled steel or drill pipe means that crude oil has to go up by 10% since the materials only form part of the overall budget. What it does mean is that in a time of increasing labour costs and governments wanting a bigger slice of the oil pie, price increases at the margin carry more leverage.

Thus, the virtuous investment circle is complete. Higher energy prices keep lower-grade gold underground and higher metal prices keep lower-grade oil underground. Something has to give and as the investment landscape changes in a world of increasingly expensive production, investors will have to change their physical and equity allocation accordingly.

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