The gold miners’ season is upon us.  Out of the summer doldrums and through the usually disappointing (for most) margin squeeze reported after the second quarter.  As we are eagerly awaiting the annual gold stock party (and, at the same time, the annual Denver Gold Group’s show), it may be helpful for the readers to understand in what way investment in gold mining companies differs from investment in physical gold.

It is well-known that gold prices are fairly stationary.  Over long time, they represent a form of insurance, whose price is the non-existing yield (if we forget for the moment the return that could in theory be earned by lending bullion at rock-bottom lease rates).  Gold mining companies are not like that.  They do not “hold” gold – they sell it.  They currently dig out gold at an average cash cost of $490/oz and, depending on the total cost, pocket the difference with the spot price or some combination of spot and forward sales.

A self-respecting gold investor should hold a portfolio combining the insurance value of gold or gold-backed instrument, a position in companies that sell gold for a good profit and a sub-portfolio for derivative trades enabling her/him to benefit from changes to the volatility of the metal.  The problem is that the three subportfolios require very different skills and time horizons.  Physical gold requires a long-term macro vision (and wealth to preserve in the first place).  Investment in gold mining equities – long or short – requires a level of knowledge of the complex industry which can only be gained by actually working there; a privilege few of us mortals will have.  Finally, dynamic option trading requires both experience and a fairly good orientation in what other large derivative desks are doing.

We shall focus here on the second element of such an ideal portfolio – investment in gold mining companies.  Four years ago, during the height of private equity activity, someone made an interesting observation that unlike oil and gas industry, mining attracted very little in way of leveraged long-term investment.  In many scarce commodities – from lithium to uranium – it is theoretically possible to take a controlling position in an early stage company against the future offtake of the product (assuming that the private equity firm is appropriately positioned further down the value chain).  But in gold, the intermediary bullion banks have been in the business for decades and the product is never “scarce” by any conventional measure.  In addition, the complex knowledge necessary to analyze a mining investment is a hurdle that few non-operating companies undertake.  Those who can do this, are successful royalty businesses.

Why is it so difficult to switch from analyzing, say, retail or machinery sectors to analyzing mining?  There is one underlying conceptual difference.  Your clothing stores and your factories will be differentiated by the product they churn out.  But the process of a factory based in Mexico or in China may be exactly the same.  In mining, the opposite is true.  The product is essentially an undifferentiated commodity, with specific qualities and standards determined by decade-long interaction between producers and users.  But it is the process of obtaining this commodity that differs in every single operation.  The combination of geology, metallurgy and engineering makes each and every one mine a unique operation.  In order to understand the process fully, nothing replaces the actual visit to the site.  And the sites tend to be off-the-beaten track.  As my former boss would quip – “God had a sense of humor when he decided where to put gold”.  From the Arctic Circle to breath-taking heights of 12000 ft and equally suffocating depths underground, from deep jungles to parched deserts, gold just does not happen to be easily accessible.

The 19^th and early 20^th century gold rushes in California, Alaska, Australia, Brazil and South Africa show that God’s sense of humor was somewhat less acerbic at that time.  But much of the easily accessible land has now been scoured for prospectivity, a process that accelerated in the 1980s.  Parts of Australia and Nevada are now drilled out like Swiss cheese.  No wonder that the most prospective gold and copper porphyry-rich Tethyan belt snakes through Burma, Tibet, parts of Afghanistan and Iran, and into Pakistan, where Barrick & Antofagasta’s Reko Diq project is located.  In addition to the challenges posed by the difficult terrain, it is the above-ground factors in these countries that have considerably raised the operating risk.  Such an adverse environment requires the deposit be highly prospective – either rich in grades (which is preferable), or very large.  In the latter case, the operation may incur high development cost or extend way into the future, making the value of the project highly vulnerable to discount rates used to value the cash flows.  The question how to reflect the risk of low-frequency but high-impact events is a huge topic with bankers insisting on somewhat arbitrary adjustments to the discount rate, and operators seeking to reflect the hazards directly in the cash flow profile.  Either way, the shareholders purchase the associated risk, most often with little knowledge of the applicable probability distribution for the potentially damaging events.

This is just one example of the complexity involved in the decision to invest in a mining venture.  Even though the rewards can be considerably higher than in the case of defensive holding of physical gold, the homework concerning the intangible notions of risk takes a bullion-hoarding investor way out of his comfort zone in the Swiss vault.

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Tags: gold vs gold miners, ideal gold portfolio, risk assessment, unerexplored ground