Why Gold Exploration Companies Provide Maximum Leverage Versus A Rising Gold Price
I’ve had lots of [gold mining] tenbaggers and the important thing is to stay in it.”
- Billionaire mining investor, Eric Sprott, The Financial Post December 2019
When successful investors talk, people listen. When a successful billionaire investor talks, lots of people listen.
Eric Sprott, founder of Sprott Asset Management, is a billionaire who has acquired much of his personal wealth through successful investing in gold mining stocks.
A December 2019 interview by The Financial Post focused primarily on Sprott’s investing success with Kirkland Lake Gold
(US:KL / CAN:KL), a major gold-producer based in Ontario. But that’s not his passion
in mining investing.
Ten-baggers in junior gold exploration stocks
Eric Sprott is a very aggressive (and active) investor in many promising junior gold exploration companies.
“I keep reading that people are never making (gold) discoveries, the rate of discoveries is going down. The funny thing, well, I guess I’m the sucker then because I keep buying guys who say they’re making discoveries.”
Those discoveries then (in many cases) become new gold deposits. That’s where Sprott has generated most of his investing ten-baggers: gold exploration and development companies.
How? Superior leverage.
Most mining investors understand that mining companies with operating mines provide natural leverage versus the price of the commodity they produce. For newer investors unfamiliar with this concept, it’s all a matter of simple arithmetic.
Suppose a particular gold mine can produce gold at a cash cost of $900 per ounce and the current price of gold is $1,000 per ounce. The mine generates $100 per ounce (gross) profit.
Now suppose the price of gold rises to $1,100 per ounce – a 10% gain for gold itself. But the mining company is now making a profit of $200 per ounce ($1,100 - $900).
A 10% gain in the price of gold makes this gold mine 100% more profitable. Presumably, a 100% increase in profitability will drive that gold stock up much more than 10%. Natural leverage.
What may not be as apparent to mining investors is that this concept of “natural leverage” doesn’t only apply to the companies that are currently mining gold. The principle applies equally with respect to companies exploring for gold.
Gold exploration companies deliver even more leverage
In fact, exploration companies ultimately provide the most leverage to a rising gold price.
Again, it’s all in the numbers. But to understand this requires a deeper understanding of the mining ecosystem.
Very few mining companies explore and develop all of the projects for which they operate mines. Indeed, typically, the larger the mining company the less they spend (in proportionate terms) in mining exploration.
Instead, major mining companies typically buy exploration/development projects in order to replenish their pipeline of mineral reserves and mining projects. These larger mining companies are perpetually feeding on the junior exploration companies.
Now let’s engage in another simple hypothetical example.
A junior exploration company discovers and drills out a multi-million ounce deposit of gold. Billions of dollars of metal in the ground.
But it is low-grade gold ore, averaging less than 1 gram per ton of gold. An economic study of the deposit (a “feasibility study”) determines that the ore can be mined at a cash cost of $900 per ounce, given a specific set of production parameters.
With the price of gold at $1,000 per ounce, this large gold deposit has very little commercial value. Because of the high capital costs in mine construction (which can be in excess of $1 billion), mining projects are subject to heavy discounting due to capital risks.
A mere (potential) 10% profit margin on the ore is not enough to commercialize this gold deposit. The project – and the company – has a near-zero value.
At a gold price of $1,200 per ounce, the economics start to become more attractive, especially if the capital costs for mine construction are relatively reasonable.
The price of gold has only increased by 20%. However, the Net Asset Value (NAV) of the project will have changed from some negative figure (after discounting) to what could have become a multi-billion dollar asset.
Now assume a gold price of $1,500 per ounce. The $900-per-ounce gold project now has very attractive economics. The price of gold has only risen by 50%, but the value of the gold project increases by several (many?) additional multiples.
Considerable money is currently being made by investors in the shares of gold producers, in particular the larger miners that tend to move first in new rallies in the sector.
Much more money is still on the table as this gold rally unfolds, with most of it coming from the smaller gold producers who are generally just starting to move.
Ultimately, however, most of the ten-baggers in gold will not come from the companies actually mining gold. They will come from the junior gold exploration companies that are finding and developing new gold deposits.
The gold mines of tomorrow.