The Gold Miner Paradox

 | Sep 19, 2011 | 3:30 PM EDT  | Comments
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Stock quotes in this article:

abx

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xom

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gld

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au

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gg

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auy

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kgc

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aem

By all accounts, the past decade has been a bull market for gold.

In 2000, gold was trading for approximately $250 an ounce, while oil was around $25 a barrel. Today, oil sits near $85, up more than three-fold, while gold sits over $1,800, up more than 7-fold. During this nearly-12-year stretch, shares in ExxonMobil (XOM) are up over 73% while shares in Barrick Gold (ABX) are up about 120%.

But those returns don't account for the dividend payments that Exxon has been paying out over that time. In 2000, the annual dividend was $0.88 a share. In 2010 it was $1.74 a share, or a yield that averages 2% to 3% a year. Over the same stretch, Barrick's yield has been below 1%.

Despite the surge in gold over the past couple of years, shares in gold miner stocks have not been as impressive as many would have hoped. To be sure, anyone invested in gold miners in 2008 ended the year on much more pleasant note than the S&P 500. And with gold sitting at $1,800 an ounce today, the coffers of gold miners should be swelling exponentially. But they aren't, or at least the market doesn't seem to think so.

In the past year the price of gold, as measured by the SPDR Gold Trust (GLD) is up 39%. Barrick is up 17% while rivals Newmont Mining (NEM) is up 5.1% and Anglo Gold Ashanti (AU) is up 7.5%. Goldcorp (GG) leads the pack up 20% over the past 12 months, but still below the appreciation in the physical metal.

Those price signals suggest a couple of different scenarios. First, the movement in the price of gold has nothing to do with demand. That's a viable scenario and one that can exist with various other commodities, but more so with gold. Unlike oil, gold has no significant utility. Its main value is psychological. Gold is a safe haven against any and all monetary disorder.

Another scenario is that the market doesn't believe that the price of gold can continue to climb higher. For what it's worth, it doesn't appear that monetary stability is in the cards for the global economy anytime soon. Europe is a mess that will take a while to clean and the US has printed so many dollars over the years and may continue to do so to keep the economy stable. That's an environment that bodes well for the price of gold.

So, if the price of gold remains strong, then another scenario is that gold miners are incredibly cheap and the market simply hasn't realized it yet. Yet as much as gold is making headlines these days, the market is clearly aware of the type of profits that gold miners can earn when gold is at $1,800 an ounce and miners are expending $400 to $500 an ounce to bring it to market. The profit curve slopes upward exponentially with each rise in the gold price. The issue is what I dub the paradox of gold miners.

Like other miners, gold miners are dealing with higher input costs. In addition, gold is incredibly rare and hard to find. And on top of that gold miners deal with an immense amount of political risk. Moreso, the future possibility of higher interest suggest that investors could abandon gold in favor of higher yielding assets. When central banks dramatically raised interest rates to fight high inflation in the late 1970s, many gold investors chose to sell their gold and invest in government bonds with yields of more than 12 percent. But with those caveats is the reality that gold miners are likely to make more money when gold is at $1,800 vs. $1,700 or $,2000 vs. $1,800.

Names like Yamana Gold (AUY), Kinross Gold (KGC), and Agnico-Eagle Mines (AEM) are interesting plays. They are boosting production and maintain low costs of production.

Understanding the realities and potential paradox between the price of gold and the gold miners will help alleviate a lot of disappointment for investors who are scratching their heads as to why gold mining shares haven't appreciated (yet) as much as the underlying commodity

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