Fund Selector: Should you dig gold?

Yet, at the turn of the decade, correlation of sorts fell away quite remarkably.

The price of physical gold continued to perform robustly for a period before softening, while gold-related equity prices came under significant pressure much earlier and tailed away rapidly, dragging the gold-mining index back to levels last seen at the turn of the century when bullion was $350 an ounce.

Gold is often perceived as an inflation hedge, which perversely is the environment in which gold equities struggle.

In no other industry has inflation been so problematic. Exact figures are a little hard to pin down, but estimates suggest the cost of producing gold in the past 10 years has increased by 100 per cent with an ‘all-in cost’ in the region of $1,150 an ounce.

The primary reason for lacklustre performance has been the costs of mining – labour, energy and equipment have become far more expensive. As the gold-mining frenzy kicked on even when physical prices soured, suppliers to the industry increased prices to capitalise.

And with more mines opening, the competition for skilled labour intensified and forced up labour costs greatly. This trend is likely to continue and repeat itself with future movements in the physical gold price, suggesting that at certain points in the cycle, buying into those sectors that supply to the mining industry rather than the mining companies themselves, may be a better investment.

As a result of these increasing costs, many mines have to spend more just to stand still. Coupled with this a declining ore grade, and these factors represent sizeable headwinds to profitability for gold miners.

The average ore grade of producing mines is 1.18g per ton and the grade of undeveloped deposits is 0.89g per ton. So with undeveloped mines accounting for 66 per cent of all deposits left on Earth, life is not going to get any easier. This trend, of course, could be reversed if new discoveries of low-cost, high-grade ore are made, but recent exploration results have been underwhelming, with only five discoveries since 2007, and all with ore grades far below the discoveries of the 1990s.

Even so, recent cost-cutting measures and shareholder-friendly initiatives have helped restore gold miners’ profits, but one must remain vigilant as to whether this is a cyclical shift or just a short-term shot in the arm.

Many of the cost-cutting measures have been straightforward to implement, with the pulling back from inefficient projects being the most notable.

But inflationary factors have been harder to manage. That said, with a lower global inflation rate, mine site costs (known as ‘slash costs’) fell 5 per cent in the past two years, suggesting a disinflationary environment may be just what is required.

At current levels it could be argued much of the bad news is already ‘in the price’ of gold equities, and one’s outlook for inflation may determine whether bullion or gold-related equities is the place to invest with a medium-term horizon.

James Sullivan is investment director at Coram Asset Management