Posts from the ‘Gold Stocks’ Category

Sep 25

Gold Stocks: Am I Wrong?

Last week was playing out just dandy until about 7:30 am on thursday. That’s when the stock market opened and the gold stocks I owned fell along with the rest of the market.

Since the peak on Wednesday afternoon Jaguar Mining is down $1.10, or 16.4%. OceanaGold is down 0.65, or 23%. Argonaut Gold is down 14%. Lydian International is also down 14%.

Now I could write a post about how unjustified this is. How these 4 stocks, and gold stocks in general, never began to price in a gold price of $1500/oz, let alone $1800/oz. And about how in the case of OceanaGold and Jaguar Mining, the stock price is significantly lower then it was when the gold price was $1000/oz.

All of this is true, but its not necessarily helpful going forward. What is helpful is to assess the situation and determine if I am best to stick it out, or admit that maybe I am wrong about the direction of gold stocks.

I’ve spent most of the weekend pondering the reasons for gold stocks to go up and the reasons for gold stocks to go down.

I think that the basis of all the arguments for and against come down to the causation of the rise in the price of gold. Now maybe I am simplifying the situation too much, but think you can narrow it down to two contrasting views of why gold is going up. Each view leads to a drastically different opinion of what will happen to the price of gold (and the price of gold stocks) going forward.

These views are:

Gold has gone up on the expectation of Federal Reserve balance sheet expansion
Gold has gone up on fear of the disintegration of the Euro and the EU

The first argument is what is being bandied about the most over the weekend. Gold, and thus gold mining stocks, were pricing in QE3 and that didn’t happen. Operation twist is not quantitative easing. There is no expansion of the Federal Reserve balance sheet and there is none on the immediate horizon. So if the price of gold is a function of the Federal Reserve balance sheet, then gold must return to pre-QE3-anticipation levels. A good starting point would be $1400-$1500/oz. Or perhaps gold goes lower if it overshoots to the downside or if the Fed begins to gain credibility in its balance sheet management.

The second view was invoked quite often over the last month, but it seems to have fallen on deaf ears in the last couple of days. That’s because it doesn’t fit the evidence. the EU is still a mess. The price of gold is falling precipitously.

So does the move of the last two days mean that the Fed watchers are right and that the run in gold is over until there is at least some evidence of QE3 on the horizon? I’m not willing to say that yet. I’m going to re-quote what I paraphrased from Donald Coxe a couple days ago:

The investment case for gold lies in the 500 million people living within 17 different countries that have their savings, pay cheques, and pensions tied to a currency that was based on a theory and seems by the day to have less of a tie to reality.

This argument still holds a lot of water in my mind. There is still no good way to resolve the situation in Europe. As long as this is the case, gold should continue to have a bid. And I can’t see how this will stop being the case. There simply isn’t the money available to resolve the debt issues of the PIIGS. The only solution seems to be the extradition of at least some of the PIIGS from the EU. That is going to be such a messy process, with so many potential pitfalls for both the sovereigns and the banks, that I can’t see how gold would fall in such an environment.

But I remain open to the possibility that I am wrong. I will be watching the price of gold over the next few days and if the weakness continues I will have no choice but to cut my positions. In that regard, I will likely lighten up on OceanaGold first. Both Jaguar Mining and Argonaut Gold are in somewhat envious positions right now. Jaguars mines are in Brazil, while Argonaut Gold has its mines in Mexico. Both the Real and the Peso have been falling lately. This will help bring down Q3 costs and even more bring down Q4 costs.

OceanaGold operates in New Zealand, and while the currency there has began to weaken, it is still above the average levels of Q2.

Lydian I will continue to hold because the story there is really less attached to the price of gold then in the other cases. Lydian is moving forward an exploration project that will be profitable at much lower gold prices. At some point the company will be taken out. So that one I will hold as well.

We’ll just have to see how this next week plays out.

Sep 5

A Very Important Day for Gold Stocks?

I have been working on a write-up of Argonaut Gold over the weekend. I was expecting to post that write-up today, but circumstances have arisen that make other more basic questions more pertinent (by the way, the essence of my soon-to-come post on Argonaut Gold is the stock is cheaper relative to other gold stocks than I first thought).

However, first things first:

This looks a lot like the beginning of August.

Meanwhile the price of gold is up again. It is almost at $1900/oz. One of the popular gold related articles I have seen over the weekend is about how pension funds have no exposure to gold at all. A bit of a buzz appears to be beginning.

Meanwhile, on Friday gold stocks staged a breakout.

Putting all of this together, Tuesday looks like a very important day in gold stock land.

Look, I have written before about how torn I am to own gold stocks right now. I have sold down everything else in anticipation of the European mess getting worse. In my actual account I have shorted banks to hedge the market exposure of my remaining oil stocks (I cannot short in the practice account I post to this blog so this account is more exposed than I actually am). But I have held the gold stocks. This is partially because it makes sense to me that gold will go up as the Euro disintegrates. It is partially because, thus far, gold stocks have worked. But I always hold in the back of my head the recollection of 2008 when gold stocks got hit just as hard (harder?) than the rest of the market.

So what will it be this time?

Clearly, unless things change drastically over the next few hours, North American stock markets are going to be routed on Tuesday. And since Europe is the epi-center of that rout, it is reasonable to bet that the price of gold will continue to be higher on Tuesday.

Gold stocks can only do one of two things. They can follow gold and confirm their break-out from Friday, in which case I would argue that this is only the beginning (if gold stocks do decouple from the market then I suspect this will be the confirmation to many that things are different this time and that gold stocks are an inverse correlation to the evolving euro-crisis). Or they can fall back, demonstrate it was a false breakout, and show that they will fall with the market just like in 2008. In this case they will likely end up falling hard as all the momentum buyers from last week run for the exit.

Its quite a stark set of outcomes.

And that is why I suspect tomorrow is a very important day for gold stocks.

Aug 31

Oceanagold: Don’t Confuse the Headline with Cash flow

Over the last few weeks I have bought back a reasonably sized position of OceanaGold. This after having been out of the stock since the day of their Q2 update. When the Q2 update came out I took one look at the cash cost number ($900+) and one look at the production number (60,000 oz) and figured it was best to run to the sidelines and wait for the inevitable shakedown to pass.

That turned out to be a good decision.

When I read bad news, I have found it is usually better to sell first than it is to wait for the reaction to play out. It is better to “panic”. Why you would buy and hold a stock that you know is sure to go down, even if it is only in the short run? In OceanaGold’s case, it was clear that at $2.70 or even $2.50, the share price was too high given the severity of the quarter. The stock had traded to $2.20 only weeks before news of the quarter came out. Certainly one could expect it to trade to at least $2.20 once such news was public.

And it did. The stocks traded all the way down to $1.80 in fact. I was glad that I had “panicked” on the morning of the press release and gotten out at $2.58.

But one has to be careful not to confuse the reaction with the facts. The initial market reaction can be based on the inefficiencies of investors/speculators who do not read past the headline, do not know what they own, or are selling on technicals. The trick, I think, is to understand enough to both know how bad the bad news will be taken, as well as how bad the news actually is.

In OceanaGold’s case, the perception was clearly going to be a short term drag on the stock. The headline numbers were awful and that is what is most important to most investors. Equally important though, was the knowledge that the details of the quarter were not quite as disasterous as they appeared at a glance.

The majority of the miss from the quarter can be attributed to three reasons. First, the New Zealand dollar appreciated far further than I think anyone has expected. Second, the mine plan is causing the company to expense more costs. Third, they lost some of their underground workforce.

There is, of course, nothing OceanaGold can do about the New Zealand dollar.

However the latter two problems are worth expanding on.

The issue with mining costs took place at Macraes open pit. The problem, as the company explained it, had to do with a change to the mine plan and the effect it had on the accounting treatment of strip mining. When the company is pre-stripping a new orezone, the company can capitalize that strip. It will show up some time later as depreciation on the balance sheet. However once the company reaches a new orezone, all strip needs to be expensed as it is incurred.

What happened in the second quarter is that there was far less pre-strip incurred then has been the case in previous quarters. And so most of the costs of mining were expensed directly on the income statement as opposed to having some of those costs expensed.

More specifically, the original mine plan had the Company mining an area (stage 4) of the open pit that, after drilling, was determined to be uneconomic. Some of the mining fleet was supposed to be utilized prestripping stage 4 but because the area was determined uneconomic the fleet was used instead for waste mining of stage 5. Because the ore from stage 5 is already accessible, this waste mining could not be capitalized and had to be expensed.

As an aside, it’s interesting to note here how this scenario demonstrates how cash costs are not really cash costs. Cash costs are actually the expensed portion of costs for that particular period. Depending on the accounting treatment, a company could spend much more cash in a quarter than what gets attributed to cash costs.

In the case of OceanaGold, the best way to see this effect is to look at the total cash outflow that OceanaGold has been spending on producing its mines over the past few years. This cash outflow includes both expensed production costs (the costs on the income statement) and capitalized production costs (the pre-stripping that only shows up on the cashflow statement). This is shown in the chart below. Now unfortunately you can’t just look at Macraes alone. The cashflow statement gives the combined capitalized costs of all operations. But still, you get the basic idea of how costs were higher in Q2, but not as much higher as the cash costs would suggest.

The key point to be made by the graph is that while cash costs per ounce increased a whopping 25% quarter over quarter, total mining costs, as shown in the graph, increased 6%.

To get an idea of just how much money was deferred in the second quarter, when compared to previous quarters, the following chart plots total capitalized production costs on a quarterly basis. You can see how relatively little was capitalized in the recent quarter.

So really, from a cost of mining perspective, OceanaGold did not have nearly as bad of a quarter as the headline appears. Make no mistake, it also wasn’t a great quarter, but it wasn’t nearly as bad as the headline.

At Reefton, management said the problems are entirely attributable to workforce turnover. They had a bunch of their miners quit, and the new miners weren’t as efficient. So they had to mill low grade stockpiles. You can see the low grade milling in Q2 versus previous quarters below.

What is somewhat puzzling about the reason given is that when you looking at the mining output at Reefton over the last few quarters, it really doesn’t suggest that severe of a deficiency in ore. And from the figure above, mined grade for the quarter was actually quite a bit higher than milled grade (~1.8 g/t versus ~1.4 g/t).

I’m not really sure what to make of this. Either A. they’re lying about what the problems are, or B. the problems were more temporary than the company is letting on and recovered even during the quarter (they said Reefton wouldn’t fully recover until Q4)

I think the more likely explanation is that they are quietly hedging their future expectations.

Management also said they are bringing on-line the smaller Souvenir deposit at Reefton. This is somewhat interesting. Souvenir is a fairly narrow, almost vertical vein that hosts about 10,000 oz of reserves and another 30,000 oz of resource. The grade is somewhere between 3g/t and 4g/t; based on drill results it is probably closer to 4g/t but because there is sparse drilling at Souvenir the auditors decided to err cautiously.

Souvenir should help make a dent in cash costs at Reefton by bringing up the overall grade through the mill. But given the small size of the deposit, this is not really a long term solution to the labour force issues. Those need to be (and hopefully are being) addressed.

Valuation

The thing about OceanaGold is that they are just so cheap compared to their peers. Therefore, if you can’t discount the company’s value because of major operational issues (which I have tried to show is not the case) then there is just no reason for it to be trading as cheaply as it is.

BMO wrote a great report on the gold miners a week ago. OceanaGold was included in the comparisons. Below I have cut and paste a couple valuation metrics that BMO used in a recent report on precious metal miners. These comparisons show clearly just how undervalued OGC is relative to its peers.

The company trades on metrics that are only comparable to low caliber junior miners and larger miners with high cost operations that cannot generate cash flow. Heck, there are some miners that haven’t consistently generated cash flow that trade at a premium to OceanaGold. Its ridiculous. OceanaGold has consistently been generating between $30M and $40M of operating cash flow. They should be able to bring on their next project Didipio, without having to raise any money and while maintaining a decent cash balance.

As I’ve tried to point out above, while the company has had some operational issues, these are by no means debilitating. Moreover, the company has a strong growth profile, with Didipio expecting to add to gold production at low costs (because of copper by-product credits) in a little over a year. The company should, if anything, be trading as a growth story, not at the tremendous discount that it is given.

So I bought a position. We’ll see how it goes.

Aug 20

Torn

This is a very difficult time to invest in stocks.

I am torn. I want to stay invested in companies that I believe will grow their business in a normal, even slow growth, environment. And I want to get out of all stocks because I have no faith that the situation in Europe will return to a normal environment any time soon.

On the bright side, the gold stocks that I own broke out yesterday. Jaguar Mining was up 6%. Argonaut gold was up 4%. Lydian International was up 4%. Even OceanaGold was up 4%, and at one point was up more than 10%. When I saw Jaguar Mining up first thing in the morning I added to my positions in Argonaut and OceanaGold. I reasoned that if Jaguar is on the move, then something must be up.

The chart of Argonaut Gold looks particularly good.

Jaguar Mining is potentially on the verge of breaking out.

The positive move in gold stocks yesterday more than offset the losses I had in my non-gold holdings. Coastal Energy and Arcan Resources were both down a couple percent. Gramercy Capital and Equal Energy were down less than a percent. Leader Energy Services is looking more and more like a terrible mistake, and was down more than 5%. My small position in Community Banker Trust took a drubbing, down 10%, though I don’t know why?

I changed the composition of my short positions yesterday. I exited my short in St. Joe and in Migao, and I added shorts to a number of banks. I shorted Citigroup, HSBC, and UBS.

As for the gold stocks, I had a friend remark yesterday that he was finally seeing his gold stocks act as a hedge of his positions. My reply was:

I hope you are knocking on wood, crossing your fingers, stepping between the cracks, holding a rabbits foot and wearing your clothes inside out when you say that.

Gold stocks have had so many false breakouts and so many months of disappointment that its hard not to be skeptical.

Having said that, I think that there are a few legitimate reasons here for gold stocks to move higher.

First, you have to always remember that the best environment for gold stocks is a low growth economy. Gold stocks do best when the price of gold is doing well, but the prices of the basic inputs for gold mining (oil, metals, labour) are not doing well.

You saw this last year. Gold stocks did great from August to October, when the economy was still perceived to be sluggish and a double dip was still on the table. Once oil and other costs began to take off, gold stocks faltered. The market rightly perceived that costs would rise for gold miners. They did. The market is smarter than you think.

So now, as growth expectations are ratcheted down and as oil prices come down, expected margins for gold producers are expanding. The market is probably anticipating this.

The second cause could be the expectation that Bernanke will react next week at Jackson Hole. The following is an excerpt of a Goldman Sachs report released yesterday. Goldman discusses what Bernanke might propose at Jackson Hole.

The Fed has three main easing tools: 1) communication; 2) asset purchases; and 3) cutting the interest rate on excess reserves. At the August meeting, it exercised option #1 by making a conditional commitment to keep the funds rate low until mid-2013. Option #3 is often mentioned but in our view is unlikely for several reasons. That leaves only option #2, asset purchases.

We believe Bernanke’s Jackson Hole speech will include a detailed discussion of the potential for more easing through large-scale asset purchases. A variety of indicators suggest many investors already expect more QE. For instance, a recent CNBC survey shows that more than $300bn of purchases may already be priced in. The sharp decline in forward real rates is also partly related to QE expectations, in our view (Exhibit 2).5 Based on our conversations with clients, we believe investors would be very surprised if the speech did not include a discussion of asset purchases.

We see two main reasons why Fed officials may prefer to change the composition of the balance sheet as a first step. First, as we showed in Monday’s US Daily, if used aggressively this could have a sizable impact. For example, if the Fed were to sell its Treasury securities that mature over the next two years and buy securities in the 10- to 30-year part of the curve—apportioning them based on amounts available in the market—it could take a similar amount of duration risk onto its balance sheet as in QE2 (around $350bn in 10-year equivalent terms, or 80-90% of QE2). The policy could be scaled up further by weighting purchases toward even longer maturities, or by changing the mix of the mortgage portfolio.

Second, policies that keep the size of the balance sheet (and excess reserves) unchanged may be less controversial among politicians and the broader public. A detailed discussion of possible changes in balance sheet composition seems a likely component of the Jackson Hole speech.

Bernanke may of course also discuss conventional QE. Arguments in favor of this approach include a less complicated exit strategy—if securities mature faster, the Fed may not need to sell actively—and potentially a larger impact on confidence and expectations. We do not think Bernanke will signal anything more unconventional, such as a higher inflation target, price level targeting, or a long-term interest rate target.6 However, these ideas may turn up in the FOMC minutes published on August 30.

While listing the easing options looks probable, Bernanke is very unlikely to pre-commit to taking action next week. This is a monetary policy decision, and any announcement would come at an FOMC meeting. In addition, core inflation continues to accelerate, and Fed officials seem to have a rosier outlook than our forecast or the consensus. While we expect additional QE and the odds are rising at the margin, it is not yet a done deal.

So what GS is expecting is not the same type of QE that occured last time. They expect a rearrangment of the Federal Reserve balance sheet to longer dated securities. True QE means an expansion of the Fed balance sheet, so what is expected to be proposed is not true QE. So its not directly supportive of higher gold prices. What these sort of policies would be supportive of is lower long dated rates. In other words lower interest rates for a longer time.

I remember reading Mish Shedlock a number of years ago. He was (still is?) of the mind that gold prices at the time were in for a rough ride because interest rates were headed up and the real rate of return on treasuries were going to get more positive. His basic reasoning was that if you can get a real return from a safe interest bearing asset you will move out of gold into that asset. Conversely, if the real rate of return is close to zero (or negative!) you will tend to prefer gold.

At the margin demand for gold is determined from the real rate of return on other (perceived) safe haven assets.

What the Fed would be doing is effectively lowering interest rates across the curve.

That should be supportive of gold and good for gold stocks.