Feature: Examining the gold premium – part two

By Jeames McKibben, Luis Martinez and Antonio Egana of Xstract Mining Consultants

To read the first part of this story click here.

Though it is not a recent phenomenon, it certainly seems that marketed products (such as gold) attract a different premium relative to commodities (i.e. base metals, bulk minerals) on a global basis.
Whilst the gold price is not the only driver behind a share’s price performance, history and statistics show that it is a key determinant.
In order to appreciate the implications of pricing it is important to understand the market for the various metals.
Take copper for instance, once it is mined and refined, it is manufactured into a product, such as wiring, where it remains (though it may eventually be recycled). The price of copper is primarily influenced by mine supply and demand from end users. If mine supply decreases or end-user demand increases, the copper price tends to increase, and vice-versa. Over time, this causes the price to revert towards the overall cost of production. This tendency towards a historical average price suggests copper (and other base metal) prices follow a ‘mean-reverting’ path.
By comparison, gold is typically used for investment purposes or made into jewellery and is not consumed in the traditional sense (outside of minor industrial applications). Hence the totality of all gold ever mined (approximately 150,000 tonnes) remains in existence and can be easily resold. This is because gold is considered by many to be money, the price of which is driven by investment demand and speculation. Importantly for investors (as opposed to speculators), gold is seen to provide protection against government and currency collapse.
Here it is important to distinguish between investor and speculator activities. Investment demand is influenced by the rate of return available on alternative assets reflecting the underlying global real interest rate and adjusts slowly in response to longer term trends (i.e. follows a mean reverting path). By comparison, a speculator makes a ‘bet’ regarding the future price trend of gold. Such speculation plays a significant role in driving gold prices as speculators typically move into and out of a commodity over very short timeframes (often a matter of hours or days). As such the fortunes of gold are closely aligned with speculation which is widely regarded as a non-mean reverting process (commonly known as ‘random walk’).
For mine producers, this ‘random walk’ means that in some years the mine will ramp up production to take advantage of higher prices, whereas during times of low prices the mine has the option to either slow production or suspend production. This optionality provides value to the mine operator and should be factored into the traditional NPV valuation using techniques such as real options.
In summary, gold prices typically follow a non-mean reverting path driven only by investor’s and speculator’s willingness to hold gold in preference to other assets. Gold equities tend to trade at a premium to NPV because of the non-mean reverting nature of gold prices, where the supply-demand factors affecting gold (i.e. real interest rates and investment demand) are different to other metal commodities (i.e. mine supply, cost of production and global economic growth). This is further compounded by the inherent flexibilities available to mining companies to respond to metal prices which are not accurately captured by traditional NPV analysis resulting in a differential between pricing expectations of the equity markets and analyst’s valuations.

Xstract’s team of consultants and specialists have extensive operational and consulting experience in the fields of geology, resource/reserve estimation, mine engineering and planning, mineral processing, mineral asset valuation and business analysis. 
For more information contact tel: +61 (0)7 3221 2366 or email: jmckibben@xstractgroup.com or visit: www.XstractGroup.com

To read the first part of this story click here.