Thursday, December 10, 2009

An embarassing question for gold bugs

Here is an embarrassing question for gold bugs. The chart below shows that price of gold decisively moved to all-time highs in early October, notwithstanding the recent pullback:

Meanwhile, the Amex Gold Bugs Index (HUI) barely challenged its old highs. What happened to the thesis that gold stocks are a levered play on the price of gold?

In case you thought I was cherry picking gold stock indices, the failure to make new highs is not exclusive to HUI, just look at XAU:

…and GDM, which is the base index for the GDX gold stock ETF:

Barry Sargent, writing at Mineweb, attributes the poor performance to the negative cash flows generated by the major gold miners:

Since the start of 2007 (and excluding the fourth quarter of 2009), eight of the world's Tier I gold stocks - AngloGold Ashanti, Barrick, Goldcorp, Newmont, Yamana, Kinross, Harmony, and Gold Fields - have generated negative free cash flow of USD 3.2bn (for the first nine months of this year, in line with rising bullion prices, generation of free cash flow has been positive to the tune of USD 1.1bn).

I believe that the story is simpler than that. I showed before that gold mines can be modeled as a series of call options on the gold price and production costs are rising at the major mining companies. Who knows, maybe the era of peak gold has arrived (see articles here and here).

I posted on this topic before and got a lot of hate mail for it. Now it’s time to revisit that issue again. For gold bulls who insist on a levered play on bullion, I would rather buy a long-dated deep in the money call option on gold than holding gold stocks.

Fool me once, shame on you. Fool me twice, shame on me.

You have been warned more than once. Gold bugs have no one else to blame if they underperform if there is another upleg in gold prices.


Daniel M. Ryan said...

Here's the embarrassing answer: the financial crisis pummeled the gold stocks along with others. Most everyone thought that gold would be killed too, so the gold stocks ended up selling at way below the values they should have. November 2008 saw the "buying opportunity of a lifetime" for gold shares.

If you compare gold with the indices from the November 2008 lows to today, you'll see the leverage.

Unknown said...

I agree with Daniel, he makes a very good point. And while we may never seen another opportunity like in Nov. 08, I still think there is a lot of upside left for gold mining stocks. I wouldn't necessarily be a strong buyer of them right now though, given their recent runup. I think we'll get a better opportunity to buy in the first half of 2010. And in terms of some specific gold miners, I'd like to draw your attention to several small and mid cap gold mining companies, all of whose stocks have done considerably better this year than the large caps because of the considerable leverage they offer to the gold price:

San Gold (ticker SGR on the TSX Venture Exchange)

Aura Minerals (ticker ORA on the TSX)

Claude Resources (ticker CGR)

Golden Star Resources (ticker GSS)

Premier Gold (ticker PG on the TSX)

Fortuna Silver (ticker FVI on the TSX Ventures Exchange) ; this one is actually a silver mining company that I particularly like as well

There is a lot of good news and analysis on these companies at too which provide details on the risks and potential rewards of each company, including projects in development, geographic and political risk, company history, description of company management and their personal experience, and a lot much.

tooearly said...

yep, a mere 300% rise off the lows is some serious underperformance!

Tom said...

Gold stocks in general may not have had leverage to the gold price from peak to peak on a buy-and-hold basis because they follow a slightly different cycle than the metals themselves. Historically you will see that leverage does exist -- for example 1979-1982, 1994-1996, 2004-2006. These are the periods when it doesn't matter what gold stock you hold, they will almost all easily outperform the metal. Indeed, the more ridiculous or unbelievable the "story", the more a particular gold stock tends to fly (ultimate example: Bre-X). When gold stocks are not in the sweet spot, it very much matters which particular stocks you pick because there will be a few cats and plenty of dogs.