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In
this article, we will have a look at the so called "leverage"
effect that mining companies are supposed to have to the underlying metal
prices.
To
explain briefly why mining companies SHOULD have a leverage effect to
increasing metal prices, I will illustrate this with a simple example.
Suppose
you have a mining company X.
X
is mining gold, which is trading at $300 at the moment. However, the company
has to pay its employees, has to pay for exploration of the mines, it takes a
lot of money to build the mine, and so on. Assume it costs $500 to mine one
ounce of gold. Initially, the company will make a loss of $200 for each ounce
of gold mined. However, when the gold price rises to $500, the company will
break even.
With
a gold price of $600, the company will make $100 profit for each ounce of
gold mined.
Now
here is the key: if gold rises now from $600 to $700 (16.66%), the profits
will rise from roughly $100 to $200, which is +100%!
So
even though the price of gold rose only 16.66%, profits doubled. So each $
increase in the price of gold, will lead to more profits for the company.
When profits soar, the stocks are also expected to soar.
However,
of what we have seen in recent years, it looks like this is definitely not
always the case.
Some
examples of gold stocks that have risen substantially more than the price of
gold are ANV (Allied Nevada Gold) and GOLD (Randgold Resources), as we can
see in the following charts:
 
Chart: Freestockcharts.com
Chart: Freestockcharts.com
The
kind of companies shown above, seem to be rather an exception.
Some
other gold mining companies have performed equally to GLD, such as RGLD
(Royal Gold) and GG (Gold Corp.).
Chart: Freestockcharts.com
Chart: Freestockcharts.com
However,
as a result of the financial crisis in 2008, most gold stocks got beaten down
so much that sentiment is so bearish, that it looks like these companies will
never be able to increase profits or cash flows from their operations.
Some
examples are AU (AngloGold Ashanti) and NEM (Newmont Mining). However, please
notice that both these stocks are currently near their long term red
resistance line. If price would manage to break above these lines, these
stocks could be in for one of the biggest rallies you will ever experience in
your life, as money will flow into the most undervalued stocks, and when
suddenly everybody starts to chase after them, they could rise at the speed
of light:
Chart: Freestockcharts.com
- Chart: Freestockcharts.com
When
we look at the HUI index, we can see that from 2005 until 2008 (right before
the financial crisis), the price of the HUI index was highly correlated with
the price of Gold. However, recently, the HUI index has been lagging the
price of Gold in a way that asks for a huge rally of mining stocks, or a huge
drop of the Gold price, or a mixture of both. This can't sustain in the long
term, and with gold now being in a favorable position, we think the HUI index
will play catch up with Gold.
- Chart: Freestockcharts.com
When
we measure Gold stocks in Gold, we can see that many stocks are now at or
near historical low prices:
- Chart courtesy stockcharts.com
To
give you one particular example of a stock we mentioned above, we take NEM
(Newmont Mining). NEM is now trading at about 3.8% of the price of gold. In
order for the ratio to go back to its historical average of about 8%, NEM
could more than double, even if Gold would stay flat.
Chart courtesy stockcharts.com
Another
nice example of a stock that is trading near its lows when measured in gold
is Tanzanian Royalty Exploration:
Chart courtesy stockcharts.com
Conclusion: Although the mining stocks should have a leverage effect to a
rising price of the metals they have in the ground, we can see that because
of the financial crisis this leverage effect has often disappeared.
However,
with the crisis in Europe only worsening, and the US on the brink of
financial disaster, we think it's just a matter of time before the rating of
the perceived "safe haven US Government bonds" will be lowered
again.
When
this happens, investors have nowhere to go but GOLD. When the mass finally
realizes that the mining stocks are severely undervalued, the mining
companies could start a rally like you will only see once (or maybe twice if
you're lucky enough to become old) in your life.
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