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Gold prices soared last week when market pricing went to extremes, with
bond prices indicating that there was next to no chance of a rate hike in the
next twelve months. We have covered the cause of this irregular pricing,
which was the stopping out of 2016 consensus macro trades, in a previous article, so we will not repeat ourselves here.
For the purpose of this analysis it suffices to say that gold prices were
heavily overbought when they challenged $1250 and that the currently high
levels are unsustainable.
As gold spiked to one year highs the precious metals mining sector
followed suit and tore ahead. The HUI increased more than 60% in value from
its January lows to triple the performance of gold. With this strength many
have been calling to load up on precious metals miners while they are
"cheap".
However, we are not so hasty to jump on the band wagon due to the historic
underperformance of the gold mining sector and the underlying fundamentals
for gold, which remain bearish over the long term. Therefore in this article
we analyse the risk reward dynamics involved with the precious metals mining
sector.
The mining sector faces increasing costs
The significant decline in oil prices have led some to believe that the
costs of production for mining companies will also fall. While energy costs
are likely to be lower, these are far from the only cost facing mining companies.
One of the most significant and threatening to the mining industry is the
increase in debt costs.
In 2013 Hecla Mining raised capital to fund the takeover of Aurizon Mines,
selling bonds with a coupon rate of 6.875%. In 2015 the yield on these bonds had
risen to around 9%. Today these bonds offer a yield of over 17%.
Hecla Mining is not the only company facing extremely high borrowing costs,
Coeur d'Alene is another miner whose debt offers close to a 20% yield. While
the bonds for much larger miners, such as Barrick, offer lower yields, the
fact remains that borrowing costs are high and increasing for the mining
industry.
Of course, these companies may not need to borrow and the high yield on
their current debt may not be an issue as the pay the lower coupon rate.
However, any miner looks to borrow in the next five years will almost
certainly be subjected to higher costs. This means that miners will struggle
to expand into new projects, as the increased cost of borrowing will makes
these financially inviable. This means that any undeveloped assets in the
ground are unlikely to be greenlit, and therefore any expected increase in
earnings from those projects are unlikely to eventuate.
Perhaps more importantly is the cost of rolling over debt. If Hecla Mining
needs to roll over their current debts, then they would have to do so at
almost three times their current borrowing rate. This means if Hecla Mining
wishes to refinance any of their debt in the next five years, it will almost
certainly be at a higher rate. This means that they are locked in to their
current rate, as are many of the mining companies.
Borrowing is just one of the many costs that face the mining industry. One
can make the argument that these are unlikely to flow over to some of the
larger miners, but this holds little water. Newmont Mining, one of the
largest and best performing mining stocks in 2015, had an all-in sustaining
cost (AISC) of $999 per gold ounce in Q4 2015, compared to $927 the previous
quarter. The numbers do not lie. Oil and commodity prices may be in a rout,
but the miners costs are still going up.
Take a look at the earnings
In terms of earnings per share, last year Newmont Mining Corp was one of
the best performers in the gold mining sector. In fact, of the top 10 largest
holdings in the GDX fund, Newmont was the best performer with earnings per
share of 3.83% its current stock price. By taking a closer look at the
figures, we can paint a rough picture of how the company will be likely to
perform going forward.
The first figure that stands out here is that of their 2015 gold reserves,
which were calculated at a gold price of $1,200. However, the average
realised gold price was $1084, which means that the estimation for the value
of reserves is based on figure more than 10% over the price achieved. Of
course, the price of gold fluctuates and the metal has been off to a roaring
start in 2016, so it is not impossible that the average realised gold price
could be $1200 in the first quarter this year.
However, it is highly unlikely that such a level can be sustained in 2016,
and over the next five years it would be close to impossible to secure an
average realised gold price of $1200. Gold has only closed above $1200 four
times this year and is likely to continue falling back as market pricing
returns to more normal levels. This means that going forward the value of
reserves is likely to fall, which means that earnings over the long term will
be lesser.
There is also the matter of production costs to consider here as well. As
mentioned above, Newmont had an AISC of $999 per gold ounce last quarter,
which means they made a profit of $85 per ounce. A crude deduction from this
means that if the average gold price, not the spot, for this quarter drops
$86, then Newmont will be lose money.
Admittedly, the currently high gold price means that this is unlikely to
happen this quarter, perhaps not even this year. However, it is likely that
over the second half of 2016 and beyond we will see the Fed hiking rates and
this will almost certainly drive gold into the triple figures, which means
that unless costs somehow fall Newmont Mining could be facing losses.
Now, recall that Newmont Mining was the best EPS performer in 2015 out of
the top 10 GDX holdings. If a titan of the gold mining industry, that faces
much lower borrowing costs than many, will be near certain to lose money if
gold falls into the triple figures, then how vulnerable is the rest
of the sector?
With long term gold prices likely to be lower than expected and costs
rising across the industry, we believe that the gold miners are heavily
overbought at current levels. Further to this, it is likely that they were in
fact overvalued before gold prices rallied. This means that once the short
term spike in gold passes, the gold miners are likely to fall to new lows.
Trading arguments against holding gold stocks
The recent spike in gold and its miners, along with the calls from the
bulls to back up the truck on "cheap" gold stocks, may tempt some
into getting long the mining sector. We are not so easily convinced. These
companies face increasing costs against falling revenue and downward
revisions in the value of their assets. This means that the trade is not
buying gold miners.
Even if one were bullish on gold, the trade would not be to buy gold
mining companies. There exist a number of varied ETFs that offer direct long
positions on gold that can be easily traded. GLD is single long gold, DGP is
double long, and UGLD is triple long. This means that if one wanted a
position that outperformed a gold long by triple, as miners did in the recent
spike, then one could easily get that by buying UGLD. This trade would
achieve the desired returns if the bullish view is correct without any of the
risks involved with gold mining companies.
Suppose that one insisted on having long exposure to the gold mining
sector. Buying gold stocks would still not be the best way to go in terms or
risk reward dynamics. Consider Hecla Mining, whose debt yields over 17% a
year. For a long position on the company's shares to outperform their bonds
over a 5 year period, HL would have to more than double in value.
Even in one of the best 5 year periods for gold, 2007 - 2011, gold mining
stocks did little more than double. How can one reasonably expect them to
perform better than this in an environment where gold is a third lower and
more likely to fall than rally?
This is not to mention that in the case that one's bullish view on gold
stocks is wrong and the company starts to lose money. In this situation, the
debt has first call on the company's assets. This means that your downside
risks are much higher when holding the stock versus holding that same
company's debt. Given that long debt exposure offers a considerably higher
expected return and much lower potential losses, holding gold stocks has poor
risk reward dynamics even if one insists on having long exposure.
Therefore, we recommend not holding any long exposure to shares of gold
mining companies. It is our view that there is no reasonable situation in
which long trades on these companies can offer positive risk reward dynamics.
Long trades are simply not compensated well enough for the risks being taken.
What is the trade?
If not long, is the trade to get short? We believe the answer is yes, and
that one can do so in an exceptionally attractive way. Double or triple short
ETFs, such as DUST, are not our favoured vehicle here. The way these inverse
vehicles move does not make them suitable for longer term investment in our
view.
We also do not believe the right trade is to short the miners, or a long
gold miners ETF such as GDX, outright. This type of trade involves unlimited
potential risks, and although we believe the probability of these risks being
realised is low, we would not be achieving our top goal of prudent risk
management if we took on such a position.
It is our view that the best risk reward dynamics for any trade on the
gold mining sector come via options. The versatility of options allow one to
take a low and limited risk position with significant upside potential. We
have used options to tailor positions to exactly fit our views on gold mining
stocks and have issued these trades to our subscribers. If you wish to find
out the exact details of these trades, please subscribe via either of the
buttons below.
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