Thursday, March 27, 2008

How cheap are gold stocks relative to bullion?

My recent post entitled “A short term warning for US Dollar bears and commodity bulls” must have struck a nerve. I received a torrent of responses regarding gold, gold stocks and how the US economy was going down the tank.

In response, I analyzed the question of the relative value of gold stocks compared to gold bullion. The above chart shows the ratio of the PHLX Gold & Silver Index (XAU), which has a longer history than the popular Amex Gold Bugs Index (HUI), to gold bullion. Since the line is near the bottom of its historical range, it suggests that gold stocks are a bargain compared to gold.

A synthetic gold stock tells a different story: Rising production costs
Back in 2006 I wrote a research report (How to Watch for Signs that the Gold Correction is Ending, 15 March 2006; if you are interested in the full details email me and I will send it to you) detailing how to make a synthetic gold stock.

Conceptually a mine can be thought of as a series of call options on the underlying commodity, with the exercise price as the cost of production. If the commodity price falls below the cost of production, the mine operator has the option to either close or mothball the mine until prices improve. I created a synthetic gold stock by building a model based on these principles. Key features of the model are:

  • A series of eight deep-in-the-money call options on the price of gold, with terms of 1, 2, 3 … 8 years, which models a mine with an eight year life, a common estimate of long-lived gold mines;
  • An exercise price equal to cash production cost of $250, rising each year by the current inflation rate. ($250 appeared to be a common estimate of cash costs for existing gold stocks in 2006);
  • Equal amount of gold mined each year; and
  • The position is rolled forward once a year at a cost of 1.5%.

Of course, there are some important differences between the synthetic gold stock and the actual gold stocks themselves:

  • Gold miners have exploration upside and operational risk, which the synthetic gold stock does not;
  • Gold mining companies may hedge the gold price with forward sales and other derivatives;
  • Actual gold mines can somewhat manage the cost of production by high-grading when gold prices are low and mining a lower grade of ore when prices are high. The synthetic gold stock’s assumed cost is inflexible.

Production costs are rising
The synthetic tracked the actual index reasonably well until 2006 (which was, of course, the out of sample period) when the synthetic began vastly outperforming the actual index. Delving further into the model, I found that the price divergence was explained by rising production costs of shown by the actual gold miners. Recent analysis by David Galland of Casey Research confirms this trend of rising costs at major producers Barrick and Newmont.

So what’s the answer? Are gold stocks cheap or not?
Gold miners are experiencing higher costs than historical experience, which deflates the case that gold stocks are cheap compared to bullion because their margins are lower. However, higher costs can be explained either by companies mining a lower grade of ore in the current high price environment in order to preserve their reserves and asset value (which is bullish), or costs escalating out of control and squeezing bottom lines (which is bearish).

The truth probably lies somewhere in between the two explanations. Given the recent experience of NovaGold at Galore Creek, I would lean towards the latter as a more likely explanation of higher costs.

Here is a stupid question: rather than agonizing which is the correct explanation for rising production costs, why not just buy the synthetic? That way an investor can customize and control his desired risk profile and exposure to gold.

(Warning for individual investors - don't try this at home. The synthetic is a highly sophisticated instrument that even professionals can get wrong if implemented incorrectly.)


Priya said...

Nice article (and blog!). However, with regards to the XAU/GOLD ratio measure, doesn't the ratio automatically take into account cost escalation? In other words, if costs were static, a valuation model would be of the form GOLD-XAU=constant. The XAU/GOLD ratio model assumes that costs increase at the same rate as GOLD. Of course, costs may increase faster than the rate of the gold in the short term (which could explain a temporary lower ratio) but the value-preserving nature of gold will usually result in gold catching up to costs over the long term. Thus, I argue, over the long term, the XAU/GOLD ratio is a good predictor of value of gold stocks.

Cam Hui, CFA said...

I think of gold stocks as a levered play on gold.

Suppose a gold miner's cost of production is $400/oz and gold went from $800 to $1000. An investor in bullion would gain $200 on $800 = 25%. The gold stock investor would gain $200 on a smaller base (in the money amount = $800-$400) or 50%.

Otherwise, why would you have a preference of the gold equity over bullion or vice versa?

Priya said...

Sure, leverage of gold stocks works when mining costs increases less than the cost increase of gold. But over the really long term, the fact that gold price is value-preserving (but not more!), implies that gold price increase and cost increase will be matched. Thus, I was arguing that the XAU/GOLD ratio is a meaningful measure over long periods of time.

As far as choosing between gold stocks and gold, a number of factors come into play. Apart from the difference between the rate of cost increase versus rate of increase in gold price (GOLD/CRB ratio is a good proxy for this) which determines upside or downside leverage of gold stocks, there is under-valuation, discovery, politics, etc. that can favor individual gold stock names over gold.

In summary, I like your analysis which shows that gold stocks are not as severely under-valued today as the XAU/GOLD ratio indicates but if gold maintains its value-preserving function, either cost increases will come down or gold price will increase enough, so that XAU/GOLD ratio will become meaningful again as a valuation measure.

Unknown said...

Easing input and production costs should allow small mining companies like Novagold to bring mines online, capitalizing on their huge unhedged gold reserves. When gold prices rise proportionately faster than input and production costs margins improve. This process can turn a mine deemed uneconomical into a prized asset - as is currently the case.

For more information read here:


Michael said...

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US Gold Bureau