By doing so, the gold miners hope for better results after abysmal performance recently, as gold prices have fallen. And, as always, gold miners’ profits rise and fall much faster than the yellow metal’s price.
The underperformance of the Market Vectors Gold Miners ETF (NYSEARCA:GDX) compared with that of the SPDR Gold Trust (NYSEARCA:GLD) bears this out. GDX is down 20.5% since the end of last year, while GLD is down 4.8%.
Investors are starting to get really impatient with the gold miners – so much so that billionaire hedge fund manager John Paulson is arguing some of the world’s biggest gold mining companies, including AngloGold Ashanti Limited (NYSE:AU), spin off some of the mines that they have acquired through M&A over the past 10 years.
Paulson, the largest shareholder of GLD and AU, thinks the sum of the parts is greater than the value of the whole mining company. Paulson certainly can’t be pleased with AU’s 23.5% decline so far in 2013.
Other gold majors, including Gold Fields Limited (NYSE:GFI) and Barrick Gold Corp. (NYSE:ABX), have already spun off some of their mines or are in the process of doing so.
Why Growth of ETFs is Bad News for Gold Miners
Mining shares have generally underperformed the shares of ETFs that allow investors to buy gold, silver or other metals directly.
There are so many different factors to consider when considering an investment in a gold mining company – the quality of the mine, the cost of getting the gold out of the ground and refining it, the stability of the country the mine is located in, whether the company has enough cash on its books to actually get its mine into production, to name just a few.
Isn’t it easier to just short-circuit the whole process and buy GLD instead?
Clearly, that is what many investors are doing.
This has made life extremely difficult for junior miners that are developing new mines and may not be producing anything yet. If you can buy a mine before it goes into production and it turns out to be a winner, then you can make a killing.
But until a mine goes into production, you’re investing at a high risk.
Gold Prices and Miners’ Performance
But even the majors lately, with producing mines all over the world, have been disappointing. Part of this is due to weak gold prices.
If it costs a mine $1,200 to produce an ounce of gold and the price of gold falls from $1,700 per ounce to $1,600 per ounce, the miner’s profit per ounce falls by 20% when the price of gold has fallen by only 6%.
Of course, when the gold price is rising, this works the other way around. If the price of gold rises from $1,600 per ounce to $1,800 per ounce and it still costs a mine $1,200 to produce an ounce of gold, the 12.5% increase in the gold price results in a 50% rise in the miner’s profit.
This assumes that the cost of producing an ounce of gold remains stable at $1,200 per ounce. In the real world, that has not been the case.
Goldcorp Inc. (NYSE:GC) CEO Chuck Jeannes, speaking at the Mines and Money Conference now being held in Hong Kong, told the audience gold mining costs have been rising by about 15% a year.
Most of that is because the mines have already extracted the richest ore and that leaves only lower-grade ore, which produces less gold per ton. But, Jeannes suggests, some miners have done a poor job controlling the costs that are within their power to control.
Investing in Gold Miners
So what should an investor do?
If you believe in the underlying value of gold, as we here at Money Morning surely do, then investing in physical gold – bars and coins – or in GLD, which is backed by physical gold, makes the most sense for a long-term investment.
But if the gold price begins to rally sharply, some of the major gold miners or GDX could make a very profitable trade because of the way the miners’ profits jump as the price of gold rises.
You could also consider investing in companies the major gold miners spin off into attractive assets as new, listed companies.
There are many reasons for a gold mining major to spin off a particular mine or group of mines.
For example, labor unrest, power shortages and declining ore grades prompted Gold Fields to spin off most of its South African assets last month.
Another major might decide to group together some early-stage mines that require a lot of capital spending to ramp up production into a spin-off. That would boost the profitability of the major’s remaining assets but still give investors in the spin-off the opportunity to make a good profit on a riskier bet.
A major also might decide to spin-off some attractive mines in a politically unstable region, such as Africa, to reduce the political risk in its remaining mine portfolio.
Depending upon what is included in spin-offs and how they’re priced, they could be very attractive short-term investments, so keep a close eye on them.
For more on investing in gold, our Global Resources Specialist Peter Krauth just told us one of his favorite gold-related investments right now. Go here to learn which company it is, and see his complete interview on investing in gold stocks.
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