The big news today is the plunge in crude oil prices into negative numbers.
The price shock is a consequence of the disruptive settlement of oil futures contracts as trading moves into a new contract month.
The price of gold slipped significantly along with the collapse in crude. No particular reason. These are two entirely separate markets for commodities.
It’s a buying opportunity for gold. But savvy investors will look at the carnage in the oil market and see an even better buying opportunity for gold
mining companies.
The dynamics are straightforward.
Mining (including gold mining) is an energy intensive industry. And the primarily source of energy for mining is oil.
Only a minority of mining companies operate directly off the electrical grid or via their own renewable energy sources. The vast majority of gold mining continues to be powered by oil.
This means that even when metals prices are high, if oil is expensive it can seriously erode operating margins.
Today, the price of gold is relatively high and rising. With the price of crude oil touching
unprecedented lows (and no relief in sight), this is juicing the operating margins of gold miners.
It’s the best of both worlds for mining companies. For mining investors, it’s yet another reason to be diving into gold mining stocks.
The biggest reason is simple.
Gold mining stocks have never been cheaper relative to the price of gold than they are today. Never.
The price of gold is at a 7 ½ year high. Most mining stocks continue to wallow at multi-year lows, as shown with long-term data on the price of GDXJ, one of the most popular mining-ETFs for gold mining companies.
Mining stocks leverage the price of the commodity they produce. It’s all simple arithmetic.
Suppose a mining company can produce an ounce of gold at a cash cost of $800 per ounce. If the price of gold is $1,000 per ounce, that is an operating profit of $200 per ounce.
Now suppose the price of gold rises to $1,100 per ounce – a 10% gain. For the hypothetical gold mining company producing gold at $800 per ounce, it is now making $300 per ounce profit.
A 10% rise in the price of gold increases the miner’s profitability by 50% (in this example). Natural leverage.
Gold mining companies have become immensely more profitable over the past year. But the stocks of these companies are still trading at 2014 levels.
In order for mining companies to reach fair market value, they not only have to catch up to the big jump in the price of gold. The market must also price in an additional leverage premium to reflect the proportionately larger gains in the profitability of these mining companies.
Rising EPS. Rising share prices.
And the crash in crude oil prices makes these mining companies even more profitable.
Coming out of the Crash of ’08, gold and silver mining stocks led all categories of equities by a wide margin.
Today, inventories of physical gold and silver have been cleaned out at most major bullion dealers due to a massive spike in investor demand. This
bullion supply shortage is more severe than even the tight inventories seen during the Crash of ’08.
Three major drivers guarantee higher gold prices going forward:
- Low (even negative) interest rates
- Rising inflation fears
- Safe haven demand
Yet investors have the opportunity to participate in this 2020 rally in gold by buying into
gold mining stocks that are still at 2014 prices.
An unprecedented disconnect. An unprecedented investing opportunity.
