The benefits of investing in the mining sector

Historically, gold miners traded at a premium to most other equity sectors including the broader mining sector, but this is no longer the case. In addition, in the past two years, the performance of gold miners’ share prices has substantially diverged from the performance of gold.

While there should be a strong relationship between gold miners and the physical commodity, macroeconomic factors have been partially to blame for driving a wedge between company valuations and their main revenue source.

As the gold price has been driven by concerns about currency debasement and European sovereign risks, these same concerns adversely affected broader equity markets, in turn weighing on gold miners’ share prices.

The sluggish performance of gold mining stocks in recent years contrasts to the broader materials sector performance. Historically, gold miners have tended to outperform gold during periods of rising global business activity, as measured by the US Manufacturing ISM index.

Conversely, gold generally outperforms gold miners when growth is slowing and the global economy is in a downturn.

However, recently this relationship appears to have broken down. With growth in the US and China now starting to pick up again and most stockmarkets hitting multi-year highs, gold miners are trading at a 53 per cent discount to gold and 114 per cent below their 10-year average against gold, causing many investors to wonder whether their undervaluation may be explained by their underlying business fundamentals and management choices and how long this de-rating is going to persist.

The cost of producing an ounce of gold has soared at an annual compounded growth rate of 16 per cent in the past 10 years. The average cash cost of extracting an ounce of gold from the ground is estimated to have been roughly $671 in December 2012 compared with $151 in 2000.

As the amount of gold in a mine nears exhaustion, mining becomes more difficult and costlier. Higher prices for mining inputs such as energy, labour and equipment have put mining bottom lines under increasing pressure.

However, producers’ progressive de-hedging and the rising gold price have allowed gold miners’ margins to expand, outpacing the rise in cash costs in the past 10 years.

With the average realised price increasing at an annual compounded rate of more than 20 per cent, gold miners should have been able to secure substantial profits over the years. However, company valuations have continued to languish even as reported margin expansion has occurred.

Reserve replacement is probably the biggest challenge gold miners are faced with and the very high cost of exploration is eroding their profits.

According to the Metals Economics Group, only 99 new deposits containing over 2m ounces of gold were found between 1997 and 2011, for a total of 743m ounces of new gold reserves.

Those discoveries have replaced only 54 per cent of the gold mined during the 14-year span to 2011, leaving a production gap that has undermined gold miners’ performance in the past years.

The challenge for gold companies is that not only are new deposits increasingly difficult to find, but it appears all the easily extractable gold has already been found, as evidenced by the declining trend in miners’ reserves.

Once exploration and project development costs are taken into account, the total cost miners are faced with increases substantially.

As most of those costs are capitalised and treated as an asset from an accounting perspective, the impact on miners’ financials can be distorted, as capitalised costs would not be immediately recognised in the profit and loss account, unlike cash costs. The impact of these costs on miners’ profitability is substantial when one considers that exploration expenditure has grown at an annual compounded rate of more than 28 per cent year-on-year since 2001 vs an annual increase in cash costs of 16 per cent in the same period.

However, they are not the only cost component to consider. In order to convert exploration into mining and mining into production, miners are faced with new investment and sustaining capital expenditure.

Once these outlays are taken into account, the cost of producing an ounce of gold almost triples to more than $1,500oz, making mining unprofitable for many companies. Skyrocketing exploration costs are likely one of the key reasons for the underperformance of the gold mining sector on the stock market.

However, mining companies have become increasingly aware that lack of transparency and over-budget projects are an issue for the sustainability of the industry. Some of the biggest miners, from Barrick Gold to Newmont, have undertaken drastic changes at management level and embraced a high-margin, low-cost, strategy. This could bring miners back in favour, reversing the current de-rating process.

In spite of the poor performance of gold miners’ shares in the past couple of years, investors should not disregard the potential benefits of investing in the mining sector. In the past 10 years, gold miners have tended to outperform the gold price during periods of rising global business activity, as measured by the US ISM Manufacturing index.

In addition, with China and the US showing signs of economic recovery and equities back in favour, there may be scope for miners to begin to claw back some of their performance gap to gold.

Simona Gambarini is associate director of research at ETF Securities