Are Gold Mining Equities a good bet on the price of gold?
By: Angus Macheath
Tags: Blockchain, Ling3c, Gold, Investing, Mining

On face value, the logical answer should be yes but as I hope to show, the true answer is probably NO!

This is the first in a number of pieces I’m intending to publish on various areas of the gold market. The purpose of this article and subsequent ones is not to provide advice on what is the best route to invest in gold or even that gold is an attractive investment. These articles are simply intended to provide some insight into a number of issues that various areas of the market face.

A “Gold” mining company derives most, or in some cases 100% of its revenue from gold and therefore should be a good proxy for investing directly in gold. Mining companies also offer potential upside benefits through new discoveries or simply proving up additional reserves which both provide additional gearing to future gold prices. Most of the larger gold producers also pay dividends. Lastly, as the total gold production costs average something like ~$1000/oz (1) gold mining equities should offer significant gearing to a rise in the price of gold as profits grow significantly. By contrast, investing in physical gold would incur storage, insurance and other costs of $60/oz p.a. (Bullionvault.com estimate) while a Gold exchange-traded funds (“ETF’s”) comes with associated fees and, in most cases, gives the investor paper rather than physical gold. Gold mining equities should theoretically be the perfect bet for anyone who is bullish for gold and due to their gearing outperform gold bullion in a rising gold price environment. This is not entirely true as gold equities have significantly underperformed the price of gold in recent years and in US$ terms are actually fairly poorly correlated with the price of gold over the long term.

To highlight the performance of gold mining companies, share price relative to gold we have used the NYSE Arca Gold BUGS Index (ticker symbol HUI) rather than individual gold mining stocks or other gold mining indexes. We have used this index as a proxy for gold producers for a number of reasons: It is a long-dated series going back to 1996. It only includes unhedged companies (BUGS = ‘Basket of Unhedged Gold Stocks’), it doesn’t have a material exposure to royalty and streaming companies or silver production unlike some other “gold mining” indexes and it is probably the most followed index. However, like the majority of gold mining indexes, it is heavily exposed to Newmont, Barrick and Goldcorp which collectively account for ~40% of the HUI index by weight and there is a dominance of North American producers in the current 23 companies included in the index. That said, the HUI should provide a good proxy for gold mining equity performance in general. Additionally, when we compared the performance of HUI to other gold mining indexes or individual stocks they are all highly correlated.

The Relative Performance chart below (fig. 1) shows that prior to 2011 there was a reasonably strong relationship between gold equities and spot gold. They tended to move broadly in parallel. Rising gold prices actually translated into larger percentage rises in gold equities. Effectively gold mining companies’ outperformed spot gold. From 2000 to 2010 spot gold increased from $290/oz to $1400/oz (4.8x increase) while the HUI increased from 74 to ~570 (7.7 x increase). However, since 2011 gold equities have materially underperformed the spot gold price. For example: in 2012 gold was up 4% while HUI was down 19%, in 2015 gold was down 11% and the HUI was down 46% and in 2018 gold was down ~2% and HUI the down is ~23%.

The ratio chart (fig. 2) shows the effective buying power of gold in terms of the number of HUI units per Troy Ounce of gold that can be purchased. The more units of HUI that can be purchased for an ounce of gold then the weaker or cheaper gold mining equity prices are relative to spot gold. Given the gearing of gold producers to moves in the price of gold due to their cost of production, you would expect a fall in gold to trigger a bigger fall in HUI. Conversely, a material rise in the price of gold should result in a much larger rise in HUI. The data seems to indicate that in recent years the ratio only shows noticeable moves when gold falls sharply. Therefore, Gold equities only seem to “outperform” spot gold on a downward movement in the price of gold. There are no discernible large moves in gold mining equity when gold rallies. Between January 2009 and September 2011 the gold price increased >$1000/oz and therefore, all other things being equal gold producers profits should have increased significantly. However, over this period the HUI vs. Gold ratio stayed almost unchanged at ~3 units of HUI per troy ounce of gold. The jump in gold equity prices that you would expect to see on a large rise in spot gold due to the gearing of gold producers doesn’t appear to exist. For a gold producer, this is clearly far from ideal.

We also looked at the recent relative performance of gold mining and base metal mining equities. We selected the S&P/TSX Global Base Metals Index as a proxy for base metals mining equities. While the data series isn’t as long-dated as NYSE Arca Gold BUGS Index (HUI) it is a better proxy for base metals than some of the other Global Mining Indexes as these also include precious metals producers. For the period we could source reliable data for, (back to Q4 2008) the base metals mining equities outperformed gold mining equities. As the chart below (Fig. 3) shows, base metals equities ended up >25% and gold mining equities ended down >35%.

This doesn’t seem to be a function of the underlying prices for gold and base metals as over the same period gold actually outperformed both copper and aluminium as the chart below (fig. 4) shows.

There are multiple reasons given for the underperformance of gold equities in recent years. Some are more feasible than others.

Rising operating costs or more exactly, the perception of rising operating costs eroding profit margins and leaving producers more exposed to falling gold prices. Most producers would contest this point and production cost data from Barrick, Goldcorp and Newmont show that their all-in sustaining cost (AISC’s) of production has fallen since 2011/2012 as the table below shows.

In 2013, the World Gold Council and senior gold companies introduced a new reporting measure called “all-in sustaining costs” (AISC’s) to try and provide a standardised reporting measure that gave more clarity on true costs of production and moved away from the often abused and misused cash cost (C1). Importantly, AISC’s is still a non-GAAP standard and there is a degree of flexibility in what is included in AISC’s. The costs are further complicated by how bi-product credits (silver, copper etc) are valued and how bi-product mining and processing costs are treated and included in all-in sustaining cost. In simple terms, while this methodology is better than the C1 costs it is not perfect.

Some commentators highlight that Free Cashflow is a better indicator of total costs than AISC’s and on this basis profitability seems to have fallen in some instances. While AISC’s may not be the perfect measure of costs it is the industry norm and basis data produced by the World Gold Council these costs have fallen since the highs seen in 2012/2013. (See Fig. 5). The average AISC data from WGC supports the costs taken from the “big three’s” websites.

Declining production and reserves. The general view, in simple terms is, you can only mine an ounce of gold once and all the easy gold has already been found and mined and therefore global mine production must fall. To some extent this is true, however, continued improvements in mining technology and exploration techniques mean that deposits that were once uneconomic are now viable and new discoveries continue to be made. Basis World Gold Council data (see Fig. 6), global gold production has actually increased year on year for the last 8 years rather than declined, although the rate of increase has slowed dramatically in the last few years. While global gold mine production increased ~19% between 2010 and 2017, the increase is not seen across the entire industry. The top 10 gold mining companies have actually seen their production decrease by ~6% over this period.

Many are now predicting that we have reached peak global gold production. This is supported by strong evidence that average head grade and global mine reserves are both declining, as shown by Fig. 7 & 8 below. If grades are lower the “rock” contains less gold and therefore more tonnes need to be mined to produce the same volume of gold.

The long term consequences of falling gold grades and reserves are that production should start to fall and most likely costs will rise. Therefore miner’s revenues will also fall if they are producing less in the future at a higher cost. An additional consequence is that additional reserves that are acquired will become increasingly expensive as miners all fight to maintain their production base going forward. Whilst there are justifiable reasons why production going forward may fall in volume and increase in cost, this doesn’t explain the historic share price underperformance since 2010–2011 when production was actually rising and stated operating costs were falling.

For most commodities, falling production and falling reserves would be very supportive for prices. This is less true for gold due to the vast amount of above-ground stocks. The World Gold Council estimate that total above-ground gold stocks at ~190k/tonnes (6,100m/ozs) or at current rates of production ~59-years global mine supply. Therefore, falling global gold mine production in the future may not have a meaningful positive impact on the price of gold that could have helped support gold mining companies profits.

Management Some commentators also cite the management of companies as being a major issue to the performance of mining stocks and particularly the level of remuneration received by senior management. Personally, I feel this is largely an unfair criticism raised by people championing bullion as the only “sensible” investment and my dealings with senior management, with a few exceptions, has always left me impressed with them and their focus on maximising returns for shareholders.

The rise of the Royalty and Steaming companies may be another contributing factor to the underperformance on mining equity. Royalty and Streaming companies provide a significant upfront payment to a mining company in exchange for the right to purchase all or a portion of one or more metals produced from a mine, at a price determined upfront for the life of the transaction. In a gold Streaming transaction this is commonly ~US$400/oz and in most Royalties, it is effectively zero after certain pre-agreed costs such as transportation, insurance, refining and smelting costs have been deducted. Additionally, these transactions are normally for the Life of Mine (LoM).

While gold mining companies have underperformed gold since 2011, some royalty companies have outperformed gold. This outperformance would likely attract gold mining company investors to switch from holding gold mining equities to streaming/royalty companies and hence contribute to the mining company’s underperformance.

For those promoting royalty companies, the reasons given for them outperforming gold are: Royalty companies tend to have relatively high profit margins and very low overhead costs. They have very predictable expenses and they are not exposed to the volatility in operating costs that the mining companies face. Through buying royalties and streams from multiple assets they are diversified and less exposed to the failure of an individual mine to the extent that the mining company would be. Additionally, the royalty companies have tended to pay reasonably generous dividends.

All the above is true but probably the biggest contributing factor to their share price performance is probably down to the very limited number of Royalty companies. To put this into perspective, the market cap of the top 15 gold mining companies which account for only 1/3rd of global gold production is 4.2 x the entire market cap of all precious metals Royalty and Streaming companies. By market cap Franco-Nevada, Wheaton Precious Metals and Royal Gold account for ~90% of the combined market cap of gold Royalty and Streaming companies so the investment opportunities in this sector are very limited. A relatively modest shift in shareholders from gold mining companies to Royalty companies would have a disproportionate impact on the share price performance of the Royalty companies. Hence, they have outperformed simply because there are so few large royalty companies to invest in. Fig. 9 shows the relative performance of the three largest Royalty companies relative to gold. Wheaton Precious Metals marginally underperformed gold but still outperformed the HUI. The main reason for Wheaton’s underperformance to gold was the long running dispute they had with the Canada Revenue Agency. This has recently been resolved in Wheaton’s favour.

The rise of Gold ETF’s. Possibly the biggest factor contributing to the underperformance of gold mining equities in recent years is the rise of the gold ETF. The first gold Exchange-Traded Fund (“ETF” or paper gold) was launched in March 2003. By 2005 the size of this sector was ~7million Troy Ounces. While current holdings at ~78.5million Troy Ounces are below the highs seen in 2012 (~85m/ozs) this still represents a significant amount of gold. The current value (Market cap) of total gold assets under management according to the World Gold Council data is equivalent to the combined market cap of the top 10 publicly traded gold mining companies ranked by production. These companies account for ~30% of the global annual gold production. If you make a reasonable assumption that there would be an overlap between the likely investor base for Gold Mining Equity and Gold ETF’s then it is reasonable to assume that there has been some investor migration from gold mining equities to gold ETF’s. The result of this would likely be an underperformance of gold mining equity prices since 2011. The chart below (fig. 10) shows the rapid rise in Gold ETF holdings since 2003 and the gold price over the same period.

As the chart below (fig. 11) shows, there is a very strong correlation between the price of gold and the volume of gold held in all Gold backed ETF’s.

While it is hard to prove that the ETF volumes are driving the gold price or if the gold price is driving the ETF volume it would appear that the Gold ETF’s have contributed materially to the rise in gold prices since ~2008. This rise in gold prices has to some extent reduced the impact on gold producers of investors switching from mining equities to ETF’s. The high gold price and therefore higher mining profits/smaller losses have partly reduced the fall in gold mining equity prices.

Summary

While logic would suggest that gold mining equity should be a good proxy for investing in gold this would no longer seem to be the case. There are multiple possible reasons for the gold mining equity under performance in recent years and the majority of these look to be here for the long term. We would, therefore, conclude that gold mining equities are likely to continue to underperform the price of gold. This underperformance will not impact all stocks equally. Those companies that reduce costs, increase production or make significant new discoveries will outperform their peers. Additionally, there will likely be periods when gold equities outperform gold but overall, we would conclude that gold mining companies represent a sub-optimal investment for those looking for exposure to any rise in gold prices.

There is another material consequence for gold miners due to their recent share price underperformance. The cost of raising additional funds through issuing equity has become prohibitively high. Any large fund-raising through equity issuance would result in significant dilution for existing shareholders and consequently depress the share price even further. One of the main sources of fund-raising is effectively no longer available to gold miners or not available at a price that would prove attractive. This leaves gold miners with granting some form of Royalty or Stream or raising debt as the only viable sources of fund raising.

As a follow up to this article I am looking to cover how Royalty and Streaming companies perform as a proxy for investing in gold as well as looking at physical gold and Gold ETF’s. Finally, we will look at what Granatum Finance are looking to offer in this space.