Some people make the argument that mining stocks are leveraged to commodity prices. (I would agree with this.) One might think that low-margin deposits would be more leveraged to commodity prices than high-margin prices. I’m not so sure that this will work out the way most people will think it will work out.
On first glance, you might apply the following math:
Suppose a commodity can be sold for $1000/ton.
Mine A has production costs of $900/ton. It makes $100/ton in profit.
Mine B has production costs of $500/ton. It makes $500/ton in profit.
Suppose commodity prices rise to $1100/ton.
Mine A’s profit jumps to $200/ton. This is a 100% increase.
Mine B’s profit jumps to $600/ton. This is only a 20% increase.
Mine A is insanely leveraged to the price of gold. Small increases in the commodity price leads to large increases in profits.
In practice, I think that the following factors can make mine B a better investment if commodity prices rise even if they had the same P/E ratio (and we make the simplifying assumption that deposits do not deplete). (Obviously if commodity prices fall you’d much rather own mine B.)
Tip of the iceberg / exploration potential
Many geologists say that the best place to look for a mine is beside an existing mine. Historically, this has been true. The areas beside an existing mine typically have similar geology and are therefore likely to also contain another mineral deposit. Secondly, the existing mine will have supporting infrastructure in place and paid for. This makes the economics of surrounding deposits much, much better.
Usually a mining company will own almost all of the surrounding land. Everybody in the industry knows that the best place to look for a mine is beside an existing mine. Whenever a promising deposit is discovered, there will be a crazy rush to stake the surrounding areas. The company that discovers a promising deposit will have a huge advantage in staking the surrounding areas and will invariably end up staking most of it. So when you buy a mining company, you usually end up owning the surrounding land and a lot of exploration potential.
When commodity prices go up, all this land will be worth a lot more. If people decide to explore for new deposits again, they will usually be much more interested in mine B’s land than mine A’s. You want to find a high margin-deposit so that you can maximize your rate of return.
Similarly, if it makes sense to expand a mine, it will usually happen for mine B first. You want to invest capital where it will see the highest rate of return. Mine B provides opportunities to re-invest capital at higher rates of return than mine A.
The mining sector is perverse
Mining companies typically overstate the economics of their deposits. This practice is extremely common and it is extremely rare for individuals to pay fines or to go to jail for being overly optimistic. Even if none of these mining companies could raise money from the stock market, they may be overly optimistic due to human nature. Human beings tend to be overly optimistic about the future, their abilities, etc. Overstated economics hurts investors in mine A more than investors in mine B. If production costs are off by $100/ton, mine A isn’t making any profit while mine B is still making a lot of profit.
*In general, I’m not a fan of mining stocks. Shareholders will not make as much money as they “ought” to make. This is one of the reasons. If you are going to invest anyways, I think that it is a much better idea to stick to the high-margin stuff.
Mining costs are rising
Over the past decade, the cost of mining has steadily gone up.
- The price of diesel has gone up. (This is related to the price of oil, which is easier to track.)
- Lower grades mean that the industry needs more manpower and equipment to maintain the same level of output.
- Lead times on equipment has increased.
- There are shortages of labour and the cost of labour has gone up.
- Technology has not done much to reduce the cost of production or exploration. There hasn’t been a game-changing technology like what shale/fracturing technology did for natural gas.
- Politics, environmentalist NGOs, and NIMBYism will affect costs. I do not expect environmental rules and regulations to go down in the future. Almost all countries are increasing the regulatory/environmental/compliance/paperwork costs that miners face. (While I think that most NGOs are run by incompetent people, I believe that governments play a necessary and important role in protecting the environment. If mining companies cannot make a profit, they should stop mining. I do not believe that mining companies have a right to make a profit and I do not believe people have a right to have a job in mining if it infringes on others’ health and welfare. If mining stocks did not exist, I would be fine with that.)
A simple way to check this is to do a Google image search for “gold cash costs”. Here is one example:
*The cash costs in the image above are probably misleading. The profitability of the gold industry has been disappointing even though the price of gold has skyrocketed. Remember, the mining sector is perverse. Almost every company overstates the economics of their mines.
I believe that the trend in increasing production costs will continue. Margins will naturally decline since mining companies go after the high-margin deposits first. The only way that production costs will go down is if there are significant advances in technology. Unfortunately, technological advances in mining (e.g. paste fill, slurry pipelines, computerized modeling) have not been very significant in reducing costs.
I am heavily biased against investing in low-margin deposits and operations. The main reason is because almost everybody is trying to promote their stock and is inflating the economics of their deposit. In my opinion, the perversity of the mining sector is the biggest thing to watch out for. The other factors I have mentioned aren’t nearly as important.