Feature: Examining the gold premium – part one

By Jeames McKibben and Antonio Egana of Xstract Mining Consultants

Over recent weeks, the gold price has soared as investors have sought refuge from continuing market volatility, events in Europe and the combined inflationary effects of serial bailouts and western governments’ monetary policy.
Gold’s rise is fundamentally underpinned by confidence, or more specifically, a lack of confidence in the global monetary system. In its present form, the global monetary system relies on paper (or ‘fiat’) money with the US dollar as its reserve currency. When investors lose confidence in central banks or money as a store of wealth they look for alternative assets such as gold or silver.
The gold price has long been a good leading indicator for analysts as equity prices typically follow metal prices. However whilst the gold price has outperformed since July 2009 (surpassing US$1,200/ounce in May 2010) the price of gold equities and ETFs has only recently recorded an uplift.
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. Other factors typically taken into account by analysts and investors may include the costs of production, location, stability of political jurisdiction and development status of the project.
As is well known but probably less well explained, gold projects typically attract a considerable premium to their estimated net present value (NPV) relative to other commodities or projects. Similarly, a gold company’s market capitalisation traditionally trades on multiples of between 1.5 and 2 times the NPV of the underlying assets. In contrast, other commodity companies such as base metals have typically traded at multiples closer to their respective NPVs, such as 1.3 times or below. Though this 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.
Some of the reasons outlined for this so-called ‘gold premium’ include:
• Exploration potential
• Potential merger and acquisition activity
• Cyclical premium expansion
• Resource/reserve convertibility
• Resource scarcity
• Mining methods/metallurgy is well known and thus low risk
• Liquidity
• ‘Store of value’
• Speculation
• Hedging and leverage to commodity price
• Operational efficiencies
• Asymmetry of information between analysts and the market
Previous studies have also shown that there is no significant relationship between the gold premium and a company’s resource/reserve ratio, number of operational mines, hedging levels or realised prices.
Although some of these factors outlined above make intuitive sense for gold, many could equally apply to other metals. In reality, much of the answer concerns how metal prices change with time (i.e. the path followed by the commodity price) and the flexibility of mines to respond to changes in price. In order to appreciate the implications of pricing it is important to understand the market for the various metals.

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 final part of this report see next week’s AJM newswire.