Gold Prices vs Gold Stocks: Will The Gap Close?

Gold prices have rallied, resulting in higher revenues and cash flows for miners, yet these increases have not been accompanied by comparable rises in gold mining equities.  Gold stocks are trading at historically low levels when compared to gold prices, to which some analysts insist that this type of spread cannot and will not last forever.

Putting the disparity between gold stocks and metal prices into perspective, a PricewaterhouseCoopers (PwC) report says through December 15, 2011 gold had risen 11 percent, but gold stocks within the S&P/TSX Global Gold Index declined 10.6 percent.

In 2012, this disparate relationship between gold prices and gold mining shares has continued along with the desires for an explanation.

“Gold stocks are put into periods where they lag bullion for one of two reasons,” Joseph Wickwire, manager of the Fidelity Advisor Global Commodity Stock Fund told Bloomberg.

“One, the market doesn’t believe the gold price is going to go up. Therefore why would you want something levered to the gold price? Or, two, the markets are skeptical about whether the gold companies are going to be able to deliver a margin expansion against the rising backdrop of the gold price,” he said.

Most investors looking to play gold want the best possible access to the metal price. And that poses the question of whether miners are indeed the best choice.

To invest in gold mining stocks involves much more than playing the metal. It is a move that also involves taking on the risks that the underlying companies face. The risks for gold miners are often already quite substantial and their challenges continue to grow.

One of the those challenges is the management of costs. Though gold prices have rallied in recent years, for many miners, costs are rising above the rate of inflation.

Nick Holland, CEO of Gold Fields (NYSE:GFI) said we should expect cost inflation of about 10 percent per annum, not just for gold miners but for the mining industry at large.

“Our business is structured around the long term gold price of $1500. And we’ve been conservative as a consequence,” Holland said. But he also noted that if you consider the all-in costs, you are already looking at somewhere around $1400/oz, leaving little room for error.

Wickwire, though believing that mining equities will rise, admits that these companies haven’t been their own best friend because they have had challenges executing.

Some argue that there just is no reason for investors to get tangled up in these mining stocks. Among them is Kevin O’Leary, Chairman of O’Leary Funds, who believes that gold companies tend to be poorly managed.

While he owns gold and likes the metal because it is a “stabilizer” or “insurance policy,” O’Leary says there is no reason to own the miners.

“If your cost to actually mine an actual ounce keeps going up, why would I ever buy the stock,” he said in an interview with Daniela Cambone of Kitco.

Attitudes such as this highlight another of the causes commonly put forth for the under-performance of gold mining stocks.

This is not the first time such a disconnect has between the metal and share prices has occurred, according Wickwire. “From 2004 to 2005, for 17 months we saw the exact same behavior only to see the gold stocks come in and outperform the bullion for the next two and half years.”

There is, however, a major difference between the market then and the one we are in now.

ETFs change the market

In addition to bullion, miners also have especially fierce competition in the form of ETFs. These are investment products that have become game changers for the industry.

With ETFs, investors are able to conveniently enter and exit the gold space while avoiding the business risks associated with mining stocks and also the requirements associated with bullion, such as transporting and storing it.

This is the first bull move where those interested in betting on gold can purchase bullion through an ETF, says PwC.

Gold mining stocks undervalued

Still, while gold mining stocks have been unloved for some time, they still have supporters. And, many of those supporters insist that stocks are extremely undervalued, are at or near their bottom, and those who are in should stay and those who aren’t should buy.

Recently, economic turmoil has been driving safety seekers to the dollar in droves. Some gold equity supporters believe this will change as investors start focusing again on the reality that the US has its own list of problems. When this happens, sentiment toward gold is expected to also change and investment demand to improve. As prices rise, market sentiment about the outlook for gold prices is likewise expected to improve.

Some also foresee the looming economic slowdown easing gold miners’ costs.

Gold miners gaining popularity

JJ Abodeely, Director and Portfolio Manager of Sitka Pacific Capital Management says there is strong evidence that China, the marginal consumer of oil and other industrial commodities is slowing dramatically. What happens to these input prices if the global economy rolls over? Miners costs will fall or at least stop growing.

Of late, gold miners popularity is reportedly growing.

In a  number of his recent market notes, Ed Steer, director of  Gold Anti-Trust Action committee and Casey Research correspondent, reported buyers in the market snapping up gold and silver stocks with both hands.

“Until recently, miners lagged gold,” says Dennis Gartman, investor and publisher of the Gartman Letter. “Now the miners lead the way higher as Barrick (NYSE:ABX,TSX:ABX) or Newmont (NYSE:NEM) or ASA Ltd (NYSE:ASA) gain upon GLD (SPDR Gold Shares) on up days and down. This we find impressive and this we find important.”

Securities Disclosure: I, Michelle Smith, do not hold equity interest in any of the companies mentioned in this article.