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Mining Stocks: Fool’s Gold or Diamonds in the Rough?

by Douglas Davenport on July 9, 2013

in Commodities, Stocks, Technical Analysis

Douglas Davenport

Gold is considered to be a safe-haven investment during times of economic uncertainty. But as we’ve seen during the past nine months, nothing has been more volatile.

The yellow metal closed at an all-time high above $1,800 an ounce on October 4. When Federal Reserve Chairman Ben Bernanke indicated in May that the central bank may start winding down its quantitative-easing program, the rout was on.

Since that record close, gold has lost more than a third of its value, dropping to below $1,180 an ounce last week. It’s fallen by about $200 an ounce, or nearly 14 percent, in the past two weeks alone. And it recorded its worst quarterly performance ever last quarter.

The sell-off has been a disaster for gold bugs, who extolled the metal’s virtues as a hard asset that was safer and more stable than fiat currencies. But gold’s decline has also had a deleterious effect on another group — gold-mining companies.

Many junior gold-mining companies are struggling to remain profitable.
Many junior gold-mining companies are struggling to remain profitable.

High Cost of Mining

Gold miners rely on high gold prices to offset their exploration and production costs. If you research miners’ cost per ounce of gold produced, the numbers are all over the map. That’s because there isn’t a standard metric to measure the true costs of mining operations.

One figure that’s often cited is a miner’s “cash cost.” But this measure only covers the cost of physically extracting the metal from the ground. “All-in cost” is a much more comprehensive metric, and includes not only cash costs, but general and administrative costs, rehabilitation, exploration, mine-development expenditures, capital expenditures, and royalty fees paid to foreign governments.

According to Dundee Capital Markets, the average all-in cost of the top 20 global gold miners was $1,306 per ounce in the fourth quarter of 2012. With gold currently trading at around $1,250 an ounce, many mining companies might now be operating at a loss.

Mining Shares Tend to Lag

Gold-mining stocks and exchange-traded funds holding a basket of gold miners tend to track the price of gold. But during the huge bull market in gold prices, these stocks and funds didn’t quite keep pace. The companies’ high operating costs and leverage, as well as political risks such as royalty tax hikes and labor strikes, cut into their share prices. So investors who held these issues didn’t enjoy the same level of returns as those who opted for physical gold or gold exchange-traded funds, such as SPDR Gold Trust ETF (GLD).

But as gold peaked and began to fall, the discrepancy became even worse. Over the past two years, gold-mining stocks have tumbled even more than the precious metal, dropping to multi-year lows. Shares of Australia’s Newcrest Mining (NCMGY) and Canada’s Barrick Gold (ABX) have lost half of their stock-market value since April.

These stocks have become unattractive to investors for several reasons. Gold-mining companies typically haven’t been good at managing capital. In addition, they’ve kept dividend payments to a minimum, underestimated the cost of building new projects, and issued new equity to finance acquisitions.

Traders recognize that Barrick is a particularly risky investment. At $15.5 billion, it has the most debt in the industry, heavy capital expenditures, and its new Pascua Lama project is facing delays.

The Pascua-Lama site, on the border between Chile and Argentina, has proven reserves of 18 million ounces of gold, 676 million ounces of silver, and a mine life of 25 years. Once it’s operational, Pascua-Lama is expected to be one of the world’s largest low-cost mines, and contribute significantly to Barrick’s bottom line.

But until then, Barrick isn’t generating any free cash flow. It has already spent $4.8 billion on the project, and investors are becoming increasingly concerned about the delays getting the mine up and running. Meanwhile, the falling price of gold only exacerbates Barrick’s problems.

Changing Landscape of the Mining Sector

Barrick’s situation may be one of the most extreme among the large miners, but it’s far from unique. The cost of mining a single ounce of gold has surged by as much as 40 percent since 2010. That may have been acceptable when the price of gold was rising as well, but in this bear market, it puts many miners’ very existence at risk.

In fact, many junior miners are already struggling to remain profitable. We may soon see them begin to close down some of their more costly mines, spend less on exploration and invest less in general. However, as miners are forced to cut output, prices should begin to stabilize.

If your appetite for risk is relatively high, you may want to consider bargain hunting in this sector. If you do decide to look more closely at mining stocks, you must remain nimble, and try to find large, relatively stable companies that pay a healthy dividend. One company that fits the bill is Newmont Mining (NEM), which has a dividend yield of 4.7 percent.

Best wishes,

Douglas

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