Technical Take: Gold Miners Undervalued For Now Without The Leverage Effect

Thursday, October 27th, 2011

Technical Take: Gold Miners Undervalued For Now Without The Leverage Effect

By Willem Weytjens

In this article, we will have a look at the so called “leverage” effect that mining companies are supposed to have to the underlying metal prices.

To explain briefly why mining companies SHOULD have a leverage effect to increasing metal prices, I will illustrate this with a simple example.

Suppose you have a mining company X.

X is mining gold, which is trading at $300 at the moment. However, the company has to pay its employees, has to pay for exploration of the mines, it takes a lot of money to build the mine, and so on. Assume it costs $500 to mine one ounce of gold. Initially, the company will make a loss of $200 for each ounce of gold mined. However, when the gold price rises to $500, the company will break even.

With a gold price of $600, the company will make $100 profit for each ounce of gold mined.

Now here is the key: if gold rises now from $600 to $700 (16.66%), the profits will rise from roughly $100 to $200, which is +100%!

So even though the price of gold rose only 16.66%, profits doubled. So each $ increase in the price of gold, will lead to more profits for the company. When profits soar, the stocks are also expected to soar.

However, of what we have seen in recent years, it looks like this is definitely not always the case.

Some examples of gold stocks that have risen substantially more than the price of gold are ANV (Allied Nevada Gold) and GOLD

(Randgold Resources), as we can see in the following charts:

Chart: Freestockcharts.com

Chart: Freestockcharts.com

The kind of companies shown above, seem to be rather an exception.

Some other gold mining companies have performed equally to GLD, such as RGLD (Royal Gold) and GG (Gold Corp.).

Chart: Freestockcharts.com

Chart: Freestockcharts.com

However, as a result of the financial crisis in 2008, most gold stocks got beaten down so much that sentiment is so bearish, that it looks like these companies will never be able to increase profits or cash flows from their operations.

Some examples are AU (AngloGold Ashanti) and NEM (Newmont Mining). However, please notice that both these stocks are currently near their long term red resistance line. If price would manage to break above these lines, these stocks could be in for one of the biggest rallies you will ever experience in your life, as money will flow into the most undervalued stocks, and when suddenly everybody starts to chase after them, they could rise at the speed of light:

Chart: Freestockcharts.com

Chart: Freestockcharts.com

When we look at the HUI index, we can see that from 2005 until 2008 (right before the financial crisis), the price of the HUI index was highly correlated with the price of Gold. However, recently, the HUI index has been lagging the price of Gold in a way that asks for a huge rally of mining stocks, or a huge drop of the Gold price, or a mixture of both. This can’t sustain in the long term, and with gold now being in a favorable position, we think the HUI index will play catch up with Gold.

Chart: Freestockcharts.com

When we measure Gold stocks in Gold, we can see that many stocks are now at or near historical low prices:

Chart courtesy stockcharts.com

To give you one particular example of a stock we mentioned above, we take NEM (Newmont Mining). NEM is now trading at about 3.8% of the price of gold. In order for the ratio to go back to its historical average of about 8%, NEM could more than double, even if Gold would stay flat.

Chart courtesy stockcharts.com

Another nice example of a stock that is trading near its lows when measured in gold is Tanzanian Royalty Exploration:

Chart courtesy stockcharts.com

Conclusion: Although the mining stocks should have a leverage effect to a rising price of the metals they have in the ground, we can see that because of the financial crisis this leverage effect has often disappeared.

However, with the crisis in Europe only worsening, and the US on the brink of financial disaster, we think it’s just a matter of time before the rating of the perceived “safe haven US Government bonds” will be lowered again.

When this happens, investors have nowhere to go but GOLD. When the mass finally realizes that the mining stocks are severely undervalued, the mining companies could start a rally like you will only see once (or maybe twice if you’re lucky enough to become old) in your life.

Courtesy Willem Weytjens at Profitimes.com (EconMatters author archive here)

The views and opinions expressed herein are the author’s own, and do not necessarily reflect those of EconMatters.

© EconMatters

Tags: Anv, Bonds, Financial Crisis, Gg, Gold, Gold Corp, Gold Miners, Gold Mining Companies, Gold Price, Gold Rose, gold stocks, Gold Trading, Leverage Effect, Mining Company, Mining Gold, Nevada Gold, Ounce Of Gold, Price Of Gold, Profits, Royal Gold, Sentiment, Willem
Posted in Bonds, Brazil, Gold, Markets | Comments Off

Gold Market Diary (September 27, 2010)

Saturday, September 25th, 2010

Gold Market Diary (Sepetember 26, 2010)

Spot gold closed at $1,295.95 per ounce, up $21.65, or 1.70 percent for the week. Gold equities, as measured by the Philadelphia Gold & Silver Index, rose 2.82 percent. The U.S. Trade-Weighted Dollar Index fell 2.60 percent for the week.

Strengths

• The gold price climbed to an all-time high of $1,295.95 this week following the Fed’s statement to keep interest rates significantly low as the economy continues to struggle.
• Nevada gold producers are seeing higher-than-expected profit margins in 2010. The average price of gold received by gold producers in Nevada is $100 dollars higher than a year earlier. At the same time, the average cost of gold production in the state declined about $20 for the first time in a decade.
• David Rosenberg, chief economist and strategist at Gluskin Sheff, said recently “the reality is that no country wants a strong currency right now, which is why gold has so much allure as it makes its transition from commodity to monetary metal.”

Weaknesses

• A survey released by the Nevada Division of Minerals found that exploration investments in the state totaled $110 million during 2009, compared with $158 million in 2008.
• A ministerial panel in India has approved a mining bill that will see mining companies share 26 percent of their profits with the local population of communities affected by mining projects. The bill also states that, if a mining project is not successful, the company has to pay to the locals an amount equal to the royalty paid to the government.
• Of the 450 audience members attending the annual Denver Gold Forum, when asked who among them was bearish on gold, only two attendees raised their hands leaving 448 bulls to the two bears.

Opportunities

• MF Global is looking for the gold market to maintain its upward momentum, with gold prices perhaps advancing toward $1,350 an ounce over the next few weeks.
• David Rosenberg also mentioned that gold is likely to remain in its secular uptrend for years to come with gold prices reaching $3,000 per ounce.
• Barclays Capital said “we maintain our view for the fourth quarter of this year to be the strongest quarter on record yet for gold prices, with downside corrections finding support from the seasonally strong period of fabrication demand with the forthcoming wedding and festival season in key gold-consuming countries.”

Threats

• A recent headline for a gold company with a property in Panama, noted it had completed a $45 million prepaid forward gold purchase.
• Jeff Christian, managing director at the CPM group, believes the price of gold is booming and expectations will remain strong into the second quarter of 2011. However, he does not believe the gold price will have a repeat of the 1980’s uptrend.

Tags: BRIC, BRICs, Chief Economist, David Rosenberg, Denver Gold, Gold Equities, Gold Forum, Gold Market, Gold Prices, Gold Producers, Gold Production, India, Market Diary, Mf Global, Ministerial Panel, Nevada Division Of Minerals, Nevada Gold, Philadelphia Gold, Profit Margins, Silver, Silver Index, Spot Gold, Two Bears, Upward Momentum
Posted in Emerging Markets, Gold, India, Markets, Silver | Comments Off

China: Investing In The US After Unocal

Monday, August 23rd, 2010

After state-owned CNOOC was blocked from the Unocal acquisition in 2005, China has instead turned toward other countries such as Australia, Canada and Brazil for its natural resource strategic investments.

While China is the top U.S. debt holder in the world, percentage-of-GDP-wise, the U.S. receives relatively very little non-bond investment from China, based on data tracked by The Heritage Foundation. (See chart) Part of this “allocation difference” could be attributed to the long existing tensions over various issues including, but not limited to—trade imbalance and currency–between the world’s top two economies.

The increasing frictions have prompted the U.S. to scrutinize China-related domestic acquisitions with an extra pair of magnifying glasses.  And the resource and infrastructure sectors appear to be the most politically sensitive.  Even as recent as last December, a Chinese mining company had to back out of a deal to invest in Nevada gold mine after security concerns cited by the U.S. government. (The mine is about 60 miles from a U.S. naval base.)

China – Investing Strategy Shift

However, Chinese companies have become much more aggressive and savvy in their approach to deal making, and have adapted to the political environment through joint ventures with local companies and small stakes instead of ambitious, high-profile large acquisitions.

Based on the data from the Heritage Foundation, the bulk of Chinese investment in the U.S. since 2005 has been in the financial and real estate sectors. (see graph)  Nevertheless, the shift in approach has helped the Chinese enter into the U.S. energy and power market through the following major deals:

• In Feb. 2007, Sinopec agreed to provide Syntroleum with $100 million to support a Joint Gas-To-Liquid (GTL) technology development.
• Last October, Norwegian energy group Statoil sold some of its US Gulf offshore oil assets to CNOOC for an undisclosed amount.
• Last November, China Investment Corp. (CIC) agreed to buy a 15% equity stake in Virginia-based power company AES Corp. for $1.58 billion
• In May of this year, Hopu Investment Management Co., a Chinese private equity firm, invested about $100 million for around 1% stake in Chesapeake Energy

U.S. – Jobs, Jobs, Jobs…Or Not?

Meanwhile, a subtle change is also taking place on the U.S. side.

Reuters reported that China state-owned Anshan Iron & Steel Group, the parent of Angang Steel Co. has agreed to pay $175 million for about 14% stake in a rebar plant that Steel Development Co.–a U.S. private startup– is building in Mississippi.

Despite a previous report of shelving the project due to congressional opposition citing national security concern (we are talking about a relatively small base-metal rebar plant here), Anshan now says it is still planning to invest in the U.S. And according to Steelorbis.com,

“The Angang official recalled that the US Department of the Treasury had affirmed that the US Overseas Investment Office would deal with any national security concerns in relation to the issue and would seek to maintain an open investment environment.”

This investment reportedly would create about 1,000 construction jobs and more than 200 permanent manufacturing jobs in the U.S. once the facility is complete.

Union’s Also Warming Up to China…Sort of?

Separately, the United Steelworkers (USW), which has backed a myriad of trade cases against China, announced in early August that it had signed agreements with Chinese power generation companies A-Power Energy Generation Systems Ltd., (AAPWR) and Shenyang Power Group (SPG) to supply wind turbines to the SPG-owned 600-MW Texas wind farm set to begin construction soon.

Apparently, the initial criticism that U.S. stimulus money will be funding jobs in China was quelled by A-Power’s plan to purchase up to 50,000 tons of steel from American mills and set up a facility in Nevada, thus creating perhaps 1,000 American jobs.

The USW is calling this “vision for win-win relationships between manufacturers and workers,” but indicates it will not back off its trade cases against China.

A Japanese Evolution

These two deals in the metals sector took place in the context of high unemployment and job losses caused by the global financial crisis, which most likely has somewhat softened the opposition to Chinese investment.

On the other hand, Chinese firms seem to have embarked on an evolution similar to that of the Japanese firms. Back in the 1980s when Japanese companies burst onto the world market, there was a global widespread defensive reaction, particularly in the United States. Then, Japanese firms began to change their investing approach by setting up assembly and full production facilities in the U.S. and eventually found acceptance.

Foreign Investments Contribute To U.S. Growth

The U.S. has the advantage of being one of the most politically stable and attractive regions with rich intellectual and natural resources. Meanwhile, with good cash-flow, strong balance sheets and the implicit support from Beijing, the Chinese state-run as well as private enterprises will continue their overseas expansion.

Most importantly, foreign investment inflows– including China’s—contribute to the economic growth and development of the United States, and could potentially help the trade imbalance.

Politics aside, given the size and relative competiveness of its economy, the U.S. should be able to handle a few more billions from China or other trading partners without raising the risk to national security. Otherwise, by alienating allies, the United States could find itself isolated in an increasingly interconnected world, while potentially putting employment, competitiveness, and innovation at a disadvantage.

On the other hand, although the increasingly multi-faceted approach by the Chinese is expected to continue evolving, managing PR, host country perception, political environment and developing relationship could prove to be a greater challenge than anything for Beijing, partly because much of China’s overseas investments are still going through state-owned companies. From that perspective, it would be to China’s benefit to speed up its privatization process in order to truly transform its economy.

A Crash or Collision Course?

Foreign investment in US companies and assets has long been controversial since World War I, but this financial crisis has pushed both China and the U.S. on an accelerated learning curve of cross-border investments. However, taking a crash course–instead of a collision course–will require some give and take from both of the world’s top countries.

So, which course would it be?  Only time will tell.

Disclosure: No Positions
Dian L. Chu, Aug. 21, 2010

Tags: Bond Investment, Brazil, Canadian Market, China, China Investment, Chinese Companies, Chinese Investment, Cnooc, Commodities, energy, Energy Group, Frictions, Gold, Gold Mine, Gtl Technology, Heritage Foundation, Infrastructure Sectors, Magnifying Glasses, Natural Gas, Natural Resources, Nevada Gold, Norwegian Energy, oil, Oil Assets, Real Estate Sectors, Sinopec, Strategic Investments, Strategy Shift, U S Energy
Posted in Brazil, Energy & Natural Resources, Gold, Infrastructure, Markets, Oil and Gas | Comments Off