Guide to gold

Gold Mining

Buying gold mining shares is widely seen as a way of gaining exposure to movements in the gold price. If that is your aim you should also check out buying gold bullion which is increasingly popular, having become very much easier over recent years.

Gold Mining - What does the term include?#

In the broadest terms gold mining covers exploration, drilling, geological assessment, financing, development, extraction, initial refinement, and delivery of Gold doré bars to a bullion refiner.

Gold Mining - Abundance of ore#

Gold is extremely rare. According to geological experience essentially all gold is found only in low concentrations in rocks.

Gold is rarer even than platinum, although because of platinum's more even dispersion in the Earth's crust it is actually harder to find commercial deposits of platinum.

Gold is more frequently deposited in the concentrations which make gold mining viable.

Gold's average concentration in the Earth's crust is 0.005 parts per million. The technology of extraction is expensive primarily because the process always requires gold mining companies to manipulate large physical quantities of ore for small results. The energy required to heave, grind and process ore is itself valuable, as are the chemicals used in the process, and this places a lower limit on the quality of ore which can be profitably worked in the gold mining process.

At different points concentration of minerals within the earth's crust varies from their average, and it is those variations which produce workable ores for gold mining. Iron, for example, accounts for an average 5.8% of the content of the Earth's crust. It needs to be concentrated by natural variations to about 30% to be considered an ore, indicating a required geological concentration of about 5 times. A lower grade gold ore would contain something like 5 grams per tonne (5 parts per million). So gold ore needs to be concentrated by about 1,000 times above its average dispersion to become viable for gold mining.

The process of gold concentration happens both above and below the surface of the Earth. On the surface there is alluvial gold which has been concentrated by the effects of running water, usually rivers. Because of its extreme density metallic gold will readily fall out of suspension as water slows down. So where a river cuts through gold bearing rock, and then slows down as it hits a flatter/wider river bed, gold will concentrate in a 'placer' deposit, allowing extraction of gold particles by panning and the modern day industrial gold mining equivalents.

Underground gold veins or 'lodes' are produced in association with various metallic deposits, often including sulphides and pyrites. Gold concentration may occur as other minerals are leached away over a long period. Ore of sufficient yield to support gold mining is very rare.

Gold Mining - Extraction and Purification#

Because of gold's inertness some 80% of gold within ore is in its elemental state. There are several processes used in gold mining for extracting, and then purifying it.

Amalgamation is a mercury based process which works because of gold's willingness to be dissolved by mercury. The mercury is applied on an ore, picks up the gold, and the resulting amalgam is distilled, with the mercury being boiled off to remove it. Mercury is highly toxic and therefore environmentally sensitive, making the industrial plant to perform this type of extraction expensive.

The most important purification process in gold mining is cyanidation. Sodium cyanide solution in the presence of air causes gold to enter into solution. Good quality ores give up their gold under cyanidation in what is called vat leaching. Lesser quality ores require heap leaching, which involves huge piles of ore being repeatedly re-sprayed with the cyanide solution over a prolonged period.

Relatively raw gold is purified in two main ways. The cheaper first stage of purification is the Miller process which uses chlorine gas and reaches purification of 99.5%, and then there is the more expensive Wohlwill process which electrolyses gold to purities of 99.99%.

Gold Mining - Stocks#

Gold Mining stocks are a popular way of investing in gold - albeit indirectly.

Advantages of gold mining shares

  • The perceived advantage of investing in gold mining shares is that their value is usually more sensitive to the price of gold than even a gold bar. This is because gold mining shares are valued on the basis of their anticipated profits through the life of the mine, and these depend on the reserves, and on the relationship between gold mining production costs and the anticipated value of the gold extracted.
  • Suppose a gold mine has 1,000,000 ounces underground and the above ground value is $1,000 per ounce. If the production cost is $800 per ounce the mine will make $200,000,000 over its life. But if the gold price rises by 20% to $1,200 the mine will make $400,000,000 overall. This demonstrates a 'gearing' effect of 4 times - i.e. for a rise in bullion of 20% the share will rise by the 20% plus another 4 times 20%, i.e. 100% (all other things being equal, which they rarely are).

Of course the flip side means that these gold shares would fall five times faster on a declining bullion price.

Disadvantages of gold mining shares

  • The quantity of a gold mine's reserves is never accurately known. Gold mining reserves (and their poor relative 'resources') are assessed by miners' core drilling programs which sample a prospective gold seam to measure gold concentrations in the rock at different locations. The amounts discovered in chemical analysis are extrapolated over a wider area to identify the likely reserve amount overall, but there is no guarantee it will be found during the extraction of commercial gold mining. Consequently there is a risk that recorded reserves do not reflect reality. Human nature gets in the way of accurate sampling, especially in companies whose function is principally exploration rather than the operation of mines. Prospectors raise money by encouraging investors that there is gold underground, and although a great deal of effort may be made to keep the process honest you only have to overlook a couple of poor rock samples (let's just call them damaged) to manipulate the likely reserves upwards. In the end the investor must trust both the geologists and the company's financial controller - both of whom may have to make the occasional fine judgement. It is almost always in their interest to err on the side of optimism. A pessimistic outlook rarely got a gold mine built.
  • There can also be unforeseen engineering problems in extracting ore. These can increase the production costs of gold mining, and only small percentage increases can eat into the mine's profitability.
  • Another issue is that the costs of the mine can be borne in a currency other than dollars - the trading currency of the output. Exchange rate movements can greatly affect mine profitability by creating currency translation adjustments - both profits and losses.
  • Perhaps the greatest variable is shareholder sentiment. Because of the wide attraction of gold shares during good gold bullion markets the shares tend to outperform not only gold, but also any reasonable valuation of the mine's future cash-flow. Investors are often not familiar with the yield numbers they should expect on a mine compared with - say - a supermarket, because whereas there is no reason that using a supermarket will wear it out, the mine certainly will be worthless within a few years, once its ore is gone. So the return on gold mining must pay back both the original investment and provide some profit during its life. A 20 year lifetime mine must yield in excess of 5% per annum before it makes any profit for the long-term investor at all. Few gold mining shares can do this, so in effect the share price of many mining shares already discounts a substantial bullion price improvement. That is an indication that they could be overvalued.
  • Adding to the problem of evaluating the investment quality of even well-established mines is the fact that their accounts are unusually opaque. Many people (including your author) who are perfectly comfortable with general purpose financial statements, for ordinary commercial businesses, start to tremble when presented with gold mining company accounts.
  • Corporate culture is another problem. These days many companies (not just gold mining companies) are run more for the benefit of their managers than their shareholders. Many managers don't like paying dividends because it diminishes the cash pile remaining for staff salaries and new corporate adventures - like exploration or takeover activity. Very few gold mining companies could be accurately described as vehicles for the straightforward exploitation of underground gold ores in the interest of shareholders. Instead the assets can become the playthings of boards of directors whose best interest tends to be served by punting shareholders' money on opportunities which are sufficiently credible to grant a possible future beyond the current working mine's life. In the absence of strict and generous dividend policies shareholders in gold mining companies are investing in the strategic competence of their board at least as much as in gold.

These disadvantages of gold mining shares have got worse in recent years. Exploration businesses which have found gold in smaller countries have been forced to build roads, hospitals, schools and other social infrastructure, as well as repair the damage they do. The host government is quite quickly able to assess the value of a newly discovered resource, and to load the permission to mine accordingly. The social costs have increased far faster than the value of the gold found.

Gold mining shares are a potentially risky but simultaneously exciting investment. They tend to be reasonably correlated to gold prices but typically much more volatile, and subject to many variations which are independent of bullion market forces. Buying gold bullion is less expensive on dealing costs.

Choosing the right gold mining stocks - or even just the right gold mining index to follow - is crucial. But while individual gold mining companies can offer the potential of high-risk returns, the gold mining industry as a whole is facing growing problems of cost, politics and finance.

Gold Mining - No more easy gold#

First, the "easy gold" available in relatively safe and secure parts of the world has already gone. Annual gold mining output in increasingly unpredictable South Africa - until recently the world's No.1 gold mining producer - has halved since 1998. China - now the world's top producer - remains dangerous both to its miners themselves, and in financial terms remains dubious. In the world's safest mines in North America gold mining output is now just 78% of 2002 levels.

The quality of gold ore mined is falling fast too, meaning more digging is needed to produce each ounce, and less stable regions have yet to pick up the pace. Zimbabwe's gold output, for instance, has fallen to "pathetic levels" according to press reports from Harare.

Gold mining stock investors also face the classic problem thrown up by a commodities boom - populist governments stealing their assets. In the winter of 2006/07 alone, the military government in Fiji seized the Vatukoula mine belonging to DRDGold, while the Russian environmental agency Rospriradnadzor revoked two mining licenses owned by Peter Hambro, the London-listed gold producer.

Western gold mining companies must also contend with a new political threat bred closer to home - environmental activism backed by charities like Greenpeace, Friends of the Earth and American Oxfam.

Gabriel Resources' project at Rosia Montana in Romania, for instance, may hold the largest undeveloped gold mining reserves in Europe. But upturning five mountains to get at 450 tonnes of gold just doesn't fit with today's green politics. There are no "carbon offset" contracts for spilling mercury, cyanide and heavy metals into local rivers.

China's gold mining output has surged recently, but this growth could reverse sharply according to a leading industry figure. "It's urgent for Chinese companies to develop gold mines overseas," says Ren Guangzhi, investment manager at Zijin Mining Group, owner of China's biggest gold mine. Unless new deposits are found and developed soon, he believes China's reserves - including gold-only mines now producing 200 tonnes per year - could run out within six years.

Gold Mining - Big finds lacking#

As gold miners extract their ore, the value of their balance-sheet shrinks. But replacing gold-in-the-ground with new discoveries is proving tougher than ever.

Westhouse Securities estimates that between 1985 and 2003, new gold ounce discoveries slipped by 30% from the previous 15 years. Each new troy ounce discovered also cost 2.6 times as much to locate, too. And large deposits - judged at 2.5 million ounces or more - have simply been too few and far between to replace the major gold mining companies' current rate of production.

Between 1992 and 2005, global gold mining output totaled 1.1 billion ounces. Discoveries of large new gold reserves were barely half that size.

Indeed, gold mining geologists have started to worry that the next big "elephant" find just isn't out there, according to Philip Klapwijk of the GFMS consultancy.

Gold Mining - Soaring Costs Eating into Profits#

With new gold deposits proving costly and difficult to locate, gold mining companies are trying to mine more gold from their existing properties. Again, this adds to the growing costs of gold mining, and it also increases risks for gold mining workers.

Gold Fields, the world's fourth largest gold mining company, is now starting work on the world's deepest-ever mining projects - more than 4 kilometers below ground. According to Mining Weekly magazine, Gold Fields will spend 4.7 billion Rand (almost $0.7 billion) to deepen both its Kloof and Driefontein mines near Carletonville, South Africa, giving it access to 10.8 million ounces of gold from 2011 onwards.

"Mining deeper and deeper does not come cheaply," says Mining Weekly. "At Driefontein, apart from the capital costs to get there, mining at depth will cost ZAR66,000 per kilo ($296 per ounce) over the life of the mine."

South Africa already has higher gold-mining costs per ounce than even North America, where Newmont Mining, the second largest gold miner in the world, saw its average gold mining costs rise by two-thirds per ounce between 2002 and 2007.

Thanks to soaring costs and shrinking reserves, Prudential Equity forecasts that Newmont's combined output with Barrick Gold, the largest gold mining stock in the world, would be 40 or 50 tonnes less than expected in 2007.

Gold Mining - Mergers & Acquisitions#

How can the world's major gold mining companies defend their share price? "It is still easier and cheaper to find gold on the stock market than to find it through exploration," noted Michael Martin, a 28-year veteran of gold stock investing at R.F.Lafferty in New York, recently.

But while gold-mining M&A (mergers & acquisitions) can help boost an individual gold mining company's shrinking reserves, digging for gold on the stock market does nothing to increase total global supplies. The net effect, in fact, is to cut exploration spending.

Over the last ten years, post-merger exploration budgets have shrunk by 20% compared with the money spent 12 months' previous by the individual gold miners involved. And at the very same time, falling reserves replacement over the last 10 years "may result in gold supply shortages in the long term," warn analysts at the Metals Economics Group.

Gold Mining - Know Your Risks#

Some investment advisors have compared investing in gold mining stocks to playing the "lottery". Sound analysis and detailed research should certainly give you a better edge than that, but the risks to any gold mining investment can be severe - and they are now mounting.

Unlike buying gold bullion itself, investing in gold mining stocks invites political & management risk, plus the danger of rising costs eating into new profits. If you're looking to buy gold for security - rather than the chance of high-risk, turbo-charged returns - then you should beware chasing the idea of "leverage" to the gold price.

Gold is a separate asset class from gold mining stocks altogether. And with the gold mining industry struggling to raise output, growing demand for the security of gold bullion is now crashing into slowing supply.

HUI Amex Gold Bugs Index#

(components & weightings, Dec. 2007)

Newmont Mining NEM 15.46%
Barrick Gold ABX 14.62%
Goldcorp Inc GG 10.71%
Hecla Mining HL 6.65%
Kinross Gold KGC 5.70%
Randgold Resources (Ads) GOLD 5.53%
Coeur d'alene Mines CDE 5.29%
Yamana Gold AUY 5.05%
Agnico Eagle Mines AEM 4.78%
Iamgoldcorp IAG 4.77%
Northgate Minerals NXG 4.67%
Eldorado Gold Corp EGO 4.60%
Gold Fields Ltd (Adr) GFI 4.38%
Harmony Gold Mining (Adr) HMY 4.32%
Golden Star Resources GSS 3.44%

XAU Philadelphia Gold/Silver Sector Index#

(components & weightings, Dec. 2007)

Barrick Gold Corp. ABX 19.00%
Agnico Eagle Mines Ltd. AEM 3.52%
AngloGold Ashanti Ltd. AU 7.31%
Yamana Gold, Inc. AUY 2.50%
Coeur D' Alene Mines Corporation CDE 0.64%
Freeport McMoran Copper Gold FCX 21.48%
Gold Fields Ltd. GFI 6.08%
Goldcorp, Inc. GG 12.57%
Randgold Resources Ltd. GOLD 1.32%
Harmony Gold Mining Co. Ltd. HMY 2.33%
Kinross Gold KGC 5.83%
Meridian Gold, Inc MDG 2.00%
Newmont Mining Corporation NEM 12.36%
Pan American Silver Corp. PAAS 1.36%
Royal Gold, Inc. RGLD 0.46%
Silver Standard Resources, Inc. SSRI 1.26%

Please Note: This analysis is published to inform your thinking, not lead it. Previous price trends are no guarantee of future performance. Before investing in any asset, you should seek financial advice if unsure about its suitability to your personal circumstances.

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