Declining gold stocks
May 2, 2005
If you own gold stocks and follow the gold market at all,
then you are aware that the stocks declined by almost twenty percent since
the middle of March, while the gold price itself has remained relatively
One possibility is that investors anticipate a decline in
the gold price. Gold stocks don’t always correctly indicate coming
changes in the gold price, but they are right more often than they are
Another possibility is that gold stocks have simply declined
along with all the other stocks: the Dow Jones Industrial Average is down
nine percent since the beginning of March.
Yet another possibility is that gold stocks are down because
investors are disillusioned by the earnings from the sector. Take Newmont,
the largest gold mining company in the world, as an example: it had marginally
lower first quarter earnings than last year, despite a ten percent rise
in the dollar gold price. Why own gold stocks if a ten percent increase
in the gold price does nothing to their earnings? Given the leverage that
gold mining stocks should have to the gold price, a ten percent increase
should result in a substantial increase in earnings.
The reason why many gold mining companies are hardly making
any more money now than they were a year ago is that the gold price has
been rising in US dollars because the US dollar has been falling on foreign
currency markets. That means if a company is mining gold outside the United
States (and not in any area where the US dollar is the de facto currency),
it may not have had any benefit from the rise in the US dollar gold price.
The gold price in many other currencies has not risen at all.
Having said that, let me add that I don’t know of
any gold mining companies with projects exclusively in the US that are
worth owning. I own a few gold exploration companies working in Alaska
and Nevada, but no gold producers. The problem is that the big names,
like Newmont, Barrick and Placer Dome, are so geographically diversified
that they cannot be called US gold mining companies. They may be listed
on US stock exchanges, but because their operations are scattered all
over the world, the increase in the US dollar gold price has had a marginal,
if any, impact on their bottom line earnings.
Does this mean that gold stocks will continue to under-whelm
us when the US dollar gold price strengthens?
If the market were rational the answer would be yes. Only
the stock of those gold mining companies that have direct leverage to
the falling US dollar (in other words, gold mines in the US) should see
their share prices increase as the dollar falls.
However, a falling dollar not only means more dollar revenue
for gold production, it will ultimately also lead to higher production
costs. But the operating margins of gold mining companies with direct
leverage to the falling US dollar should continue to expand for two reasons.
Firstly, assuming the mine is cash flow positive, the increase in cost
is on a lower base than the increase in revenues. Say the production cost
is $300 an ounce and the gold price is $400 an ounce. The operating margin
is therefore $100 an ounce. A ten percent increase in both revenue and
cost would also result in a ten percent increase in operating margin:
440 – 330 = 110. Secondly, the increase in revenue from a decline
in the dollar is instantaneous while the increase in costs will come more
gradually. Therefore, as long as the dollar falls faster than the rate
of inflation (the most likely scenario) the operating margins of a US
based gold mining company should increase much more rapidly than the example
But the market is not rational. Most investors still look
at the US dollar gold price as “the” gold price and when gold
increases in US dollars they buy gold stocks almost indiscriminately.
Once enough investors figure out that an increase in the US dollar gold
price does not necessarily benefit all gold mining companies, then the
gold stocks as a sector could very well under-perform the US dollar gold
Is this already happening? I do not think enough investors
are paying attention to the geographical location of mining operations
and the impact of currency exchange rates yet. So I suspect that the lackluster
performance of gold stocks at the moment has more to do with the general
malaise in the market.
We are at a precarious point in the economy and the financial
markets. I have written much about where I think the dollar, the gold
price and the economy is going. I don’t see anything to change that
view. Rather, I see current events as confirming that we are on track
to see a major decline in US economic growth, further weakening of the
dollar and, as a result, much higher US dollar gold prices.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
own portfolio and shares his investment ideas with subscribers to his weekly
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