The disconnect between gold prices and gold equities

One of the curious aspects of the surge in gold prices over the past few years has been the relative lack of performance by the companies that actually dig, produce and make the stuff – gold producers.

And it’s not just Australian gold companies either; this has essentially been a worldwide phenomenon. Unfortunate and bewildered gold equity investors have been left scratching their heads, wondering where they’ve gone wrong with their investments.

It’s a good question too, because in the old days the accepted theory was that to best maximize leverage to a particular commodity you had to buy shares in the companies that dug the stuff up (or in the case of oil, the companies that pump the stuff out of the ground).

In Australia, the disconnect between the price of gold and the share price performances of gold companies has been particularly pronounced. In fact over the past three years, half of the gold stocks in Australia’s gold mining index have returned less than investing directly in the gold price itself.

According to EIM Capital Managers’ John Robertson, among the 47 stocks within the S&P/ASX All Ordinaries gold index, just 25 rose outperformed the Australian dollar gold price and just 22 outperformed the US dollar gold price over the last three years. During this period the gold index increased by 55% to the end of July 2011, the US dollar gold price rose by 78% and the Australian dollar price rose by 53%.

One of the major explanations for the relatively lackluster returns from gold equities has been the rampant performance of our currency versus the US dollar.

The Hawke-Keating economic team floated the Aussie dollar way back in December 1983 and for at least the first couple of the almost three decades that have since passed, the currency was commonly and affectionately referred to as the “the battling Aussie dollar.”

Even just a few years ago the consensus from experts and traders around the marketplace was that the Aussie’s rise in value wouldn’t be sustainable; opinion dictated it would return quickly to its long-term average level versus the US currency of around $0.75.

But rather than follow the experts’ predicted path, the Aussie currency has instead surged to record levels on the back of escalating commodity prices as a result of the Chinese economic boom.

From my perspective however, you didn’t really need a degree in rocket science to figure out that this was going to happen.

Fundamentally, Australia’s dollar has always been a commodity-driven currency, dating back to the days of sheep and wool as our primary exports. These have now been replaced by iron ore, coal and gold; but the analogy is still the same.
What seems to have caught many of the experts napping was the rise of China.

From the wreckage of the train-crash that was the dot-com sharemarket meltdown more than a decade ago, came the lesson that it was ok to run an ‘old-fashioned’ economy.

The concept of the ‘new economy’ was all well and good. Except most of the internet promoters in the marketplace hadn’t the foggiest idea of what their businesses were, or how they’d ever make money from them. Unsuspecting stockbrokers and investors had even less idea, but went along for the ride anyway.

The dot-com boom began in 1995 and died a merciful death in 2000. At the same time, China was emerging with its economic miracle and caught many market-watchers napping.

Most of the resource companies that had been dabbling in IT quickly jumped shipped back to being miners and explorers once again. As China swamped the world with its demand for raw materials, Australia realized that low-tech was ok and that digging stuff out of the ground was once again cool and hugely profitable.

And it was a business that investors here at least understand. And it wasn’t long before the Aussie dollar began its inexorable climb just a year later. The chart above shows the almost decade-long rise in the value of the A$ since 2001.
This is a very roundabout way of bringing me back to our original discussion with respect to gold and the apparent disconnect between gold prices and gold equities. Our currency has always been a rather valuable hedge for our commodity exporters.

Being essentially a commodity currency the A$ tends to decline when commodity prices fall, helping insulate companies from the worst of the market. Likewise it tends to rise when commodity prices increase.

This however tends to take the edge of commodity price gains, meaning company earnings aren’t as substantial as they otherwise would have been had the currency remained stable.

It’s essentially swings and roundabouts. But the currency does provide a somewhat natural hedge for our exporters. I view it as a sort of insurance policy that helps protect miners during tough times.

The problem for Aussie gold companies is that it hasn’t just been the currency that’s flattened their earnings. They’ve been hit by a bunch of other factors like rising fuel costs, labour charges, capital costs and funding charges, which have all eaten into operating margins. And at the end of the day, maximizing operating margins is what making money is all about.

The chart above clearly shows the rising cost of mining and producing gold in all of the world’s key jurisdictions. What’s significant is where Australia sits. Australia ranks second in terms of cash operating costs, behind only South Africa. And South Africa these days is a virtual gold mining basket-case in terms of the problems afflicting its aging, deep, high-cost gold mines, with falling production levels.

So operating margins in Australia are being impacted by the strong A$ and other rising input costs.

Interestingly, over the course of the past week heightened volatility and risk aversion in international markets have led to a plunge in the value of the A$ and a corresponding rally in the gold price. This has propelled the A$ gold price to a new high of around A$1,739/oz.

The A$ gold price has it must be said been relatively muted for much of the past three years, with the last record A$ gold price reached during the GFC in early February 2009. At that time the A$ gold price peaked at A$1,545/oz. The red trend-line below (A$ gold) is much flatter than the black one (US$ gold).

So it’s possible that the latest break-out in the A$ gold price could be just what long-suffering Australian gold investors have been waiting for. That is, an opportunity to start realizing the full value of their investments.

It might also provide an opportunity for those investors who have watched bemused from the sidelines, with an opportunity to jump in and start enjoying the fun.

Gavin Wendt is the founder of MineLife, publisher of the MineLife Weekly Resource Report