The Ormetal Report

Gold stocks: the real leverage!

For years you have been told that the gold stocks offer more leverage than the yellow metal itself. And it is true, of course. When a miner can produce gold at an operating cost of $200 and gold stands at $250, its gross profit per ounce is $50. If gold makes a move of 20% and jump to $300, the miner now makes a gross profit of $100 which is a 100% increase on its previous profit. It is easy to conclude that gold stocks offer an additional leverage to the metal. Of course, because of the taxes and other non-operating expenses, the leverage is not exactly 5:1 (100% to 20%), but it is usually agreed that the net leverage is in the order of 3:1 for stocks versus gold. This is one reason why gold is purchased for insurance but gold stocks are purchased for profits.

It works the same way in bear markets. When gold goes down, profits tumble mush faster and so do gold stocks. This leverage explain why many gold mining stocks are down 90% and more in the current bear market.

But what I call the real leverage is somewhat a more complex issue than just the profit leverage described above. I will call it the resource leverage. Basically, I am talking of the leverage offered by the quality and quantity of the “in the ground” resources a gold miner has in contrast with the profit it gains from its annual production. This kind of leverage is present with both producers and explorers but works best for smaller explorers.

Before we examine how this resource leverage may impact on the prices of the mining stocks we invest in and therefore influence our stock selection, here are the two main principles we must understand:

• 1) an ounce of gold in the ground may have some value
  only if it can be recovered by a known mining process.
   
• 2) the value of this same ounce of gold depends on the
  current price of gold and the cost of the mining process.

Is there a need to say that a deposit with refractory ore for which there are no available process that can recover the metal, will have no value. Similarly, if one company has a deposit that needs a price of $500 gold in order to break even, you can bet that nobody will be interested by this deposit and therefore it will have no value.

From there we can understand that gold analysts have always mentioned the concept of an average operating cost which should represent the average cost of producing an ounce of gold given all known technologies. Again we are talking here about operating costs which are the costs to produce on a daily basis. These do not include the one time capital costs which are the costs to build the infrastructures needed to produce the metal. Today in 1999, the average operating cost (also called cash cost) among all producing companies, is estimated at US$200 per ounce. Of course, you will find producers with cash costs exceeding US$300 and some with cash costs lower than US$100. It is therefore reasonable to expect that current explorers who will be tomorrow’s new producers will have cash costs in the same range.

When gold stood near the $370-$390 level in 1994-1996, I remember that average cash costs were some 20% above current levels or near US$230-US$240. They came down since then because of some actions by the miners that include the mining of higher grade ore and the introduction of some improvements in their operations. In those days, an ounce of gold in the ground was valued at US$140-$150 on average or more or less the differential between the price of gold and the average cash costs. Today, unless you are a senior producer with a very strong hedge book, market valuation have tumble way below $US75 per ounce. As an example, in the fall of 1998, Glamis Gold (GLG.T, $2.80) took over Mar-West Exploration at roughly US$35 per ounce. Last spring, Sutton Resources went to Barrick Gold for US$40 per ounce or so. Both Mar-West and Sutton were explorers.

In short, the drop in the price of gold has cause a similar drop in the value of gold resources in the ground. But this is now about to reverse its course. Once a bottom in gold is achieved, a new uptrend will start and valuation will be on the rise again. This is why it is important to understand this kind of leverage.

Lets examine the case of Company A, a junior explorer well-known to our subscribers. Company A is trading at $1.75 and has 26.2 millions shares outstanding for a market capitalization of C$46 or US$30.5. Company A and partners have developed over the years a large gold resource on their properties located in the Nunavut territory, Canada. Company A share of this huge resource is, as of today, 3.3 million ounces.

Company A has other valuable non-gold assets that are worth US$8.3M at current rates. This would leave a market valuation of some US$22.2M for the ounces of gold in the ground on their properties. Divide this amount into the 3.3M ounces already indicated and you get a theoretical market value of US$6.67 per ounce. This is indeed very cheap for an ounce of gold now selling near US$260. But that is the kind of market we are in. Nobody wants gold stocks, so the valuations are way down.

We are convinced that gold will return before long to the prices seen just 3 years ago and we also think that gold will eventually make a new high. Lets say that gold move by only 50% from here and reach $380 or so. The profit leverage would implied a 3:1 (in this case 150%) gain for many producers like Placer and Barrick which would probably move back to the $50-$60 level against their current $20-$30 range.

But the average junior exploration company like Company A would probably enjoy much greater leverage. The chart above shows some of the past valuations of Company A on a per ounce basis. The variations in the different valuations reflect both the evolution in the number of shares outstanding and stock prices, as well as the number of ounces drill indicated by the company at the time. Back in early 1996 when gold peaked just above $400, Company A was valued at US$164.95 per ounce in the ground base on some 675,000 ounces or so in the ground and 17 millions shares outstanding (plus or minus a few hundred thousands). In terms of US$ per ounce, Company A is now 24.7 (164.95/6.67) cheaper than it was in early 1996. In other words, if gold goes back to those levels, bet on this company stock reaching prices much higher than the $10 level reached in 1996. Theorically, a leverage factor of 24:1 or so would bring the stock in the $40. Of course, there are numerous other factors that will affect the price and we probably should be conservative and use 10: 1 or 15:1 leverage. But I guess you get the idea. In the next bull market, the small juniors with good balance sheet and strong reserves will have the best performance. That is the kind of leverage we like and leverage much higher than the one above is currently available on the market. It is time to make your selections.