The Industry Handbook: Precious Metals

The precious metals industry is very capital intensive. Constructing mines and building production facilities requires huge sums of capital. Long-term survival requires heavy expenditures to finance production and exploration. Technology has played a big role in the computer and internet industry, but it has also greatly changed the mining industry. Gold is the most popular precious metal for investors. As you may know, gold is a commodity, and, as such, the price for gold fluctuates on a daily basis in the commodity markets.

While there is a lot of overlap between the basics of mining gold and silver, the primary focus of here is on the gold market. Silver is less valuable than gold, and, as such, it is usually discovered either by accident or as a byproduct of gold/lead/copper mining.

Gold prices are influenced by numerous variables that include fabricator demand, expected inflation, return on assets and central bank demand. Gold is strongly pegged to supply-and-demand patterns. In general, low prices result in low production, and high prices result in high production. Market forces determine price. A company's attempt to control costs is critical to maintaining financial health and production levels in the face of declining gold prices. (For related reading, see Does It Still Pay To Invest In Gold?)

The metals industry is not vertically integrated like other industries such as oil and energy. In the metals industry, the companies that mine the gold typically do not refine it, and refiners rarely sell it directly to the public. The industry encompasses three types of firms:

Exploration. These companies have very little in the way of assets. They explore and prove that gold exists in a particular area. The only major assets owned by exploration firms are the rights to drill and a small amount of capital, which is needed to conduct drilling and trenching operations. Development. Once a gold deposit is discovered by exploration companies, they either try to become development firms, or they sell their gold find to development firms. Development firms are those operating on explored areas that have prove to be mines. The only real difference between development and exploration is that, for development firms, their area has proved to be a gold deposit. Production. Producer firms are full-fledged mining companies that extract and produce gold from existing mines; this production can range from a hundred thousand ounces to several million ounces of gold production per year.

Each operator in the supply chain has its own strengths and weaknesses. Some companies do well at extracting the metal from the earth, some refine, while others smelt and transform the commodity into a finished product.

Most gold that is mined today is used for jewelry, perhaps because of its beauty, or perhaps because it doesn't rust or corrode. Other uses for gold include tooth filings, electronics manufacturing and collectibles, but these make up a very small portion of overall demand.

Unlike other industries, companies in the mining industry come in all shapes and sizes. Much of the production is done by large blue chip companies, but the exploration side of the industry is full of junior companies looking to hit a home run with a large gold find. The mining industry has plenty of opportunities for speculators and others for income investors. (To learn more, read Getting Into The Gold Market.)

Key Ratios/Terms

Mine Production Rates: Serious gold investors follow the Gold Survey very closely, published by Gold Fields Mineral Services. Each year, it lists the worldwide mine production statistics. Increasing production rates means more supply, which ultimately means a lower price for gold - if demand remains stable.

Scrap Recovery: Another statistic published in the Gold Survey, scrap recovery refers to the worldwide supply of gold from sources other than mine production. This includes recovered old jewelry, industrial byproducts, etc. Throughout the 1990s, more than 15% of the world's gold supply came from scrap recovery.

Futures Sales by Producers As you probably know, gold trades in the futures markets. Gold producers are constantly monitoring the prices in the futures markets because it determines the price at which they can sell their gold. The Gold Survey lists statistics on producer sales. If producers are selling an increasing amount in the futures market, it could mean that prices will fall very soon. By purchasing futures contracts the producer "locks-in" a price. Therefore, if the price of gold falls in future months, it won't affect the producer's bottom line. Conversely, if prices continue to rise after the producer locks in, they won't be able to capitalize on the higher prices.

Bullion: This denotes gold and silver that is refined and officially recognized as high quality (at least 99.5% pure). It is usually in the form of bars rather than coins. When you hear of investors or central banks holding gold reserves, it is usually in the form of bullion.

Ore: This refers to mineralized rock that contains metal. Gold producers mine gold ore and then extract the gold from it using either chemicals, extreme heat, or some other method. There are different types of ores, of which the most common are oxide ores and sulphide ores.

Analyst Insight
The price of gold fluctuates on a minute-by-minute basis, so taking a look at the historical price range is the first place you should look. Many factors determine the price of gold, but it really all comes down to supply and demand. Demand typically does not fluctuate too much, but supply shocks can send prices either soaring or into the doldrums.

The difference between production costs and the futures price for gold equals the gross profit margins for mining companies. Therefore, the second place you want to look is the cost of production. The main factors to look at are the following:

Location - Where is the gold being mined? Political unrest in developing nations has ruined more than one mining company. Developing nations might have cheaper labor and mining costs, but the political risks are huge. If you are risk averse, then look for companies with mines in relatively stable areas of the world. The costs might be higher, but at least the company knows what it\'s getting into. Ore Quality - Ore is mineralized rock that contains metal. Higher quality ore will contain more gold, which is usually reported as ounces of gold per ton of ore. Generally speaking, oxide ores are better because the rock is more porous, making it easier to remove the gold. Mine Type - The type of mine a company uses is a big factor in production costs. Most underground mines are more expensive than open pit mines.

Cost of Production
The cost of production is probably the most widely followed measure for analyzing a gold producer. The lower the costs, the greater the operating leverage, which means that earnings are more stable and less volatile to changes in the price of gold. For example, a company that has a cash cost around $175/ounce is, for obvious reasons, in a much better position than one whose cost is $275/ounce. The low-cost producer has much more staying power than the marginal producer. In fact, if the price of gold declines below $275/ounce, the higher-cost producer would have to stop producing until the price goes back up. Producers usually publish their cost of production in their annual report; this cost includes everything from site preparation to milling and refining. It doesn't include exploration costs, financing, or any other administrative expenses the company might incur.

Aside from looking at costs, investors should carefully look over revenue growth. Revenue is output times the selling price for gold, so it may fluctuate from year to year. Well-run companies will attempt to hedge against fluctuating gold prices through the futures markets. Take a look at the revenue fluctuations over the past several years. Ideally, the revenue growth should be smooth. Companies with revenues that fluctuate widely from year to year are very hard to analyze and aren't where the smart money goes.

Debt Levels
Investors should keep an eye on debt levels, which are on the balance sheet. High debt puts a strain on credit ratings, weakening the company's ability to purchase new equipment or finance other capital expenditures. Poor credit ratings also make it difficult to acquire new businesses. (For related reading, see Debt Reckoning.)

P/E
As a final caveat (beware), never analyze a precious-metals company based on the price-to-earnings ratio. In general, a high P/E means high projected earnings in the future, but all gold stocks have high P/E ratios. The P/E ratio for a gold stock doesn't really tell us anything because precious metals companies need to be compared by assets, not earnings. Unlike buildings and machinery, gold companies have large amounts of gold in their vaults and in mines throughout the world. Gold on the balance sheet is unlike other capital assets; gold is seen as currency of last resort. Investors are therefore willing to pay more for a gold company because it is the next best thing to physically holding the gold themselves.

There are a few valuation techniques that analysts use when comparing various precious metal companies. The most popular and widely used ratio is market capitalization per ounce of reserves (market cap divided by reserves). This indicates to investors what they are paying for each ounce of reserves. Obviously, a lower price is better.

Porter's 5 Forces Analysis

1. Threat of New Entrants. Financing is a principal barrier to entry in the precious-metals industry, which is heavily capital intensive. Constructing mines, production facilities, exploration and development and mining equipment all require large sums of capital. This capital is required before the mine is in production. Therefore, favorable financing terms are extremely important. In short, long-term survival in the precious-metal market requires significant capital.
   
2. Power of Suppliers. The only supply-side issues that miners face deal with government regulations and rules. The supply of land is plentiful, but gaining approval and permits to mine the land can be difficult, especially if environmental risks are high.
   
3. Power of Buyers. Gold is a commodity-based business, so the gold from one company is not that much different from another's. This translates into buyers seeking lower prices and better contract terms.
   
4. Availability of Substitutes. Substitutes for the precious metals industry include other precious metals such as diamonds, silver, platinum, etc. These are worthy substitutes for gold, but they are not as widely accepted as gold. Gold has the advantage of being standard for a world currency, so a gold bar in the U.S. is worth the same as it is in Ecuador. As other forms of precious metals such as diamonds gain popularity, they may also become more threatening as substitutes.
   
5. Competitive Rivalry. Gold companies don't compete on price, mainly because the prices are determined by market forces. But gold companies do compete for land. The backbone of a precious metals company is its reserves, and the only way to beef up reserves is to explore for good mining areas. Companies go to great lengths to discover gold deposits, and the discovery is on a first-come-first-serve basis.

Key Links

InfoMine.com - Get the latest news and statistics on mining companies.

Mining USA - Here is more data and information on mining.

Mining Glossary - When you are analyzing a mining company you are bound to come across industry-specific terms you don't understand

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