A Different Way To Own Gold?

With gold dominating headlines today, you might be wondering how to own the mysterious yellow metal.  After 11 years of gains, many investors are beginning to understand the logic professed by gold bugs throughout this bull market.  Once a decision to participate has been made, investors often face an even more confusing set of choices.

Gold can be held in many forms.  Physical possession is one option.  Holding gold physically creates the certainty that can only come with possession.  Some physical ETFs have been accused of not possessing gold as they only hold paper futures contracts representing the right to purchase metal which might or might not exist.  Holding physical gold is not risk free though as theft becomes a peril that must be avoided.  This often creates storage costs in addition to the most common complaint, lack of utility.

As this bull market persists, gold mining stocks will become more popular.  Savvy investors will begin to profess that controlling wealth in the ground is the most profitable approach to gold ownership.  Considering that the sector’s share prices have been mired in a persistent bear market, there are certainly an abundance of attractive gold producers to choose from.  Often times these companies began developing their mines several years ago when gold was half of its current price.  The mines were economically attractive then and a rising gold price only adds to profitability.

Gold mining somehow triggers a greed instinct in humans.  Pure panics have at times caused geographic shifts that affect areas many years later.  The gold rush of the late 1840’s changed California forever.  Canada’s Yukon Territory is currently experiencing a modern gold rush.  While the lure of excessive profits is powerful, we must remain objective when analyzing this sector if profits are desired.

As previously mentioned, the rising price of gold has made miners more attractive.  Although the price of their output has doubled, the operating earnings per share have not necessarily followed suit.  Fuel, labor and equipment costs have also risen.  Add those costs to a volatile financing market and you begin to see the growing pains felt by many mining firms.

Another factor hurting mining equity valuations is countries that have failed to maintain consistent tax policy.  As tax policy changes, manufacturing companies often relocate in search of a friendlier jurisdiction.  Companies traditionally negotiate long term tax abatements in exchange for creating job growth through investment in a new facility.  Mining firms do not have this option.  If the gold is in the ground in Argentina, that is where you will have to build the mine.  Argentina recently announced changes to the tax and regulatory structure that governs mining firms.  There was uncertainty associated with the announcement which caused stock prices of companies with projects in the country to plummet.

While the potential for success in mining shares is great, the risks can be daunting.  Most part time investors find it difficult to track 10 or more companies engaged in mining activities spread around the world.  Some end up settling for a mutual fund approach as they attempt to leave it to the experts.  Our experience has been that this approach does not accurately compensate you for the risks taken by participating in the sector.  Returns are often mediocre as fund managers possess a surprisingly poor understanding of how to allocate capital.

What if you could own a portion of mine output without the risks associated with operating the mine?  This could sound too good to be true but it is an option.  The typical gold mine takes 7-10 years to achieve production.  The entire process looks something like this:

  • Exploration
  • Discovery
  • Shallow drilling
  • Deep drilling
  • Mapping & analysis
  • Feasibility study
  • Bankable feasibility study
  • Mine construction

Companies can spend hundreds of millions of dollars just reaching the first feasibility study phase.  This study outlines the exact economics that will be in place once the mine is operating.  The geologists confirm the costs of the extraction techniques, the proven size of the deposit and the final extraction method.  Once this study is considered bankable, construction financing is more readily available.  Lenders feel certainty in the accepted methods used to construct the study.

During the journey that leads to the bankable phase the company is constantly trying not to run out of capital.  If the project is becoming more and more attractive, constant capital needs can make it a sitting duck for unfavorably priced takeovers.  Equity is often issued several times in order to keep this process moving.  As a shareholder, each equity issuance narrows your slice of the pie.

In the company’s approach to financing, management might consider an investment from a gold royalty company.  These firms are led by executives with a deep knowledge of the mining industry.  They are able to fully understand the project and make a good assessment of potential success.  During the development phase, the royalty company will make a large capital infusion in exchange for a percentage of net mine revenue once operating.  This arrangement is attractive in that the company is able to minimize its exposure to the public markets.  Meanwhile, the royalty company is confident that the project will be economic and their ongoing payments from the mine will be significant.

Payments to a gold royalty company are often structured in the form of a Net Smelter Royalty.  The royalty company evaluates and makes a decision about the risks associated with the project before making an investment.  After the investment is made, they may keep tabs on the mining company’s progress but are not involved in any part of operating the mine.  They also bear no costs associated with development as the company spends the invested capital as they see fit or according to the terms of the investment.  The royalty company does however maintain exposure to variable operating expenses associated with running the mine.  Since their royalty is calculated on a net basis, rising costs will have to be offset by rising gold prices or increased output.  At the end of each quarter a payment is made to the royalty company based on net operating profits.

As an investor seeking to participate in the gold bull market this can be an attractive arrangement.  Many royalty companies are publicly traded and offer exposure to a rising gold price without some of the incredible risks associated with operating a mine.  While this is an attractive investment in our view, there is a more direct and innovative approach that should at least be considered.

Gold streaming companies offer a similar appeal to that of the royalty firms but there is one key difference.  The streaming company makes a similar investment, often during the same phase of development as a royalty company.  Whereas the royalty firm seeks a portion of net revenues, the streaming firm enters into a Gold Purchase Agreement.  In exchange for its investment, this agreement entitles the streaming company to purchase a certain percentage of production at a fixed price over the entire life of the mine.  It is not uncommon for these firms to hold rights to 15-20% of mine output at $350-500 per ounce.  The contract entitles them to actual gold ounces, not cash.  This arrangement fully mitigates the risk of rising operating costs.

Streaming companies are still misunderstood by the investing public.  At this time, the gold bull market is not even acknowledged by the mass investor.  As currency debasement created by sovereign nations unable to pay their bills continues to persists, the price of gold will continue to rise.  Streaming companies capitalizing on well negotiated gold purchase agreements offer perhaps the most innovative and sensible approach to participating in this trend.

By Edwin B. Tucker

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