Why Are Gold Stocks Underperforming Gold?

Written By Luke Burgess

Posted July 1, 2011

Gold mining companies have always outperformed the physical bullion in the market. By some estimates, gold stock investors beat spot prices by a 3-to-1 ratio.

The price of gold has rallied over in the past twelve months. But despite a solid increase, gold stocks have had difficulty keeping up.

Now, the question is: Can gold mining companies regain their footing in the market to return for a rally?

In the past 18 months, the spot price of gold has increased over 35%, as measured by the SPDR Gold Shares ETF (NYSE: GLD).

Yet the Market Vectors Gold Miners ETF (NYSE: GDX), a composite of 31 senior gold mining companies, has underperformed, gaining only 25% in that time.

This is hardly the 3-to-1 payout ratio suggested by analysts…

Meanwhile, the Market Vectors Gold Junior Miners ETF (NYSE: GDXJ) — a similar ETF to GDX consisting of 73 small-cap mining companies — is also performing just below GLD. Take a look for yourself:

july 2011 gld gdx
click to enlarge
july 2011 gld gdxj
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Other precious metal stock indexes are underperforming gold as well. The Amex Gold BUGS Index (AMEX: HUI) and Philadelphia Gold and Silver Index (PHLX: XAU), which both track many of the same companies listed in GLD, are only up 30% in 18 months.

As you can see in the charts above, the underperformance has been concentrated in the last few weeks, beginning with a significant sell-off at the beginning of May.

John Bridges of J.P. Morgan’s North America Equity Research wrote earlier this week:

After climbing 1,400% since their 2000 lows compared with the S&P500’s 11% fall, gold equities are now failing in investors’ “what have you done for me recently” category.

Part of the reason gold stocks have been underperforming bullion this year is the same troubling issue that’s been facing the mining industry for years: rising production costs.

Rising Production Costs Weigh Down Gold Miners

july 2011 open pit mining

Mining for gold is often romanticized as an adventurous way to profit a little extra. But as a business, it’s very difficult to make a profit.

Gold production is incredibly energy- and labor-intensive. Over the past few years, rising crude oil prices and increasing demand for higher wages have forced global gold production costs to increase quite dramatically.

Rising production costs have narrowed profit margins for gold mining companies. And recently, many large investors have exited their gold equities (in the green) over fears continued increases in gold production costs could further thin revenue. They may have good reason for concern…

A new report from ABN Amro Bank, VM Group, and Haliburton Mineral Services reveals a +50% spike in global gold production costs over just the past three years.

*Cash costs include direct mining and processing expenses, other onsite charges, third-party smelting and refining charges, and royalties and taxes net of by-product credits.

The report is based on cash costs* per ounce of production from 111 gold mining companies operating a total of 274 mines around the world.

During the first quarter of 2011, the worldwide average cash cost of gold production increased to $620 an ounce, an increase of 12.5% year-on-year.

Rising production costs has been a trend in the gold mining industry over the past few years. Since 2007, the cash cost to produce gold has increased a whopping 57.4%, according to data from VM Group/Haliburton Mineral Services.

Global Gold Production Cash Costs
july 2011 gold production cash costs 2007-2011

The key factor in rising cash costs has been the weakness of the U.S. dollar (in which gold is priced), due to the vast amounts of excess liquidity generated by QE1 and QE2.

ABN Amro Bank, VM Group, and Haliburton Mineral Services report increasing cash costs in connection with a weakening dollar is “evident in regional cost breakdowns, where U.S. production costs have significantly lagged increases elsewhere.”

Another key instrument in bringing up production costs has been the rising price for labor and raw materials. Inflationary pressure from the recent flood of various government stimulus packages has sent worldwide wages and energy prices skyward.

Even in South Africa — where gold production costs are highest — it seems likely that cash costs will rise even more. Power supply shortages, labor disputes, and geological issues in the region have contributed additionally to rising gold production costs.

Wage negotiations in South Africa have begun between the miners’ union and three producers: AngloGold Ashanti (NYSE: AU), Gold Fields (NYSE: GFI), and Harmony Gold Mining (NYSE: HMY). But South Africa’s mining union is seeking a pay hike of more than 14%, and has already turned down a counter offer of 4%.

 Gold Production Cash Costs Around the World
Highest Lowest

Average cash costs of gold production by region
(U.S. dollars per ounce)

july 2011 gold production cash costs by region
Source: VM Group/Haliburton Mineral Services

Click here to learn more about mining in Latin America

 South Africa
 Avg: $869/oz
july 2011 south africa mapSouth Africa is the most expensive place to mine gold. The average cash cost for miners rose to $869/oz during 1Q 2011. Many miners pay more. About 10% of South Africa’s gold was produced above $1,200/oz. The highest cost operation in the region was $2,134/oz at Newcrest Mining’s (ASX: NCM) Bonikro mine in the Ivory Coast.
 Latin America
 Avg: $496/oz
july 2011 latin america mapLatin America remains the most competitive region in terms of gold production costs. Gold miners in the region paid an average $496/oz in cash costs. The lowest cost producer in Latin America was Barrick Gold’s (NYSE: ABX) Lagunas Norte mine in Peru, which produced 192,000 oz of gold in 1Q 2011 at total cash costs of $282/oz.

Despite rising production costs, I remain bullish on gold stocks in general, and I consider this year’s underperformance a substantial opportunity to buy quality, gold mining stocks for many reasons.

Among these reasons: Rising gold production cash costs will be offset by rising metal prices.

Despite rising cash costs, gold producer margins increased approximately 1.2% during the first quarter of 2011 compared to the previous quarter, and rose by 37.5% year-on-year. Data from ABN Amro Bank, VM Group, and Haliburton Mineral Services shows this is part of a continuing trend.

Average Gold Miner Producer Profit Margin
july 2011 gold producer profit margin

Comparing production of 250,000 ounces of gold in the first quarter of 2009 and the first quarter of 2011, miners’ margins are $79 million better. And I’m confident higher bullion prices will bring bigger profits.

We’ve seen these types of setbacks from gold stocks in the past. The fact is these pullbacks are common, but temporary.

J.P. Morgan equity research analyst John Bridges states:

A review of the data shows that gold equities have underperformed gold in previous periods of market weakness in 2000 and 2008. We are encouraged by gold’s recent strength at a time in the year when it’s common for the metal to lag, and we feel this is encouraging for further strength in H2. Once investors feel that the risk of another leg down in general markets passes, or after a downswing in the markets, we feel the gold equities will do some catching up.

As for specific gold stocks, Bridges noted that his firm is targeting “growth gold equities where increasing production helps balance cost increases.” He highlighted Goldcorp (NYSE: GG), Kinross Gold (NYSE: KGC), and Newmont Mining (NYSE: NEM) — all components of the GDX.

The lag in gold stocks has carved out a perfect buying opportunity for investors to take a position at historically low prices compared to bullion.

Gold shares are very cheap. Regardless of the volatility we may see in the short term, I expected a sustained recovery in the performance of gold stocks relative to the physical bullion.

Good investing,

Luke Burgess
Analyst, Wealth Daily

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