Christos Doulis travels the world for Stonecap Securities looking for mining companies that can contain costs; companies that can't contain costs because of rising labor and energy bills are not profiting from higher gold prices. From Mexico to Europe and Canada, he has singled out four companies that could actually make money for shareholders—and one that probably won't. And for those not ready to pick one company, Doulis, in this Gold Report interview, names his first small royalty company selection that could profit from the current challenging financing environment.
The Gold Report: Christos, in a recent research report, you referred to "pressure on margins as the chief impediment to increased shareholder value." Please explain what you mean by that.
Christos Doulis: In the last 10 years, the operating margin for mining companies has not kept up as expected with the price of gold, which has more than quadrupled. Costs are going up at a similar pace to the rise in the gold price.
TGR: If mining input costs keep rising at current rates and precious metals prices can't keep pace, what's the ultimate result?
CD: Metals prices are unlikely to go down while input costs are going up. They should remain in lockstep, but if for some reason they do decouple, it would cause some marginal mines to shut down over the next five years resulting in a decrease in global gold production.
TGR: In percentage terms, which precious metal do you think is going to have a better 2013?
CD: It's very difficult to say in any calendar year which metal is going to have a better performance. We will see precious metals start to move upward in price again. Markets tend to overshoot, consolidate and then move up again. We reached a high for gold at $1,900/ounce in September 2011. Gold has now settled back and has basically traded between $1,550/oz and $1,800/oz for a year and a half. Trying to predict the calendar date that the metals complex is going to start moving is a bit of a mug's game. When the precious metals complex starts to move up again I would not be surprised to see the gains in silver exceed the gains in gold on a percentage basis.
TGR: How are higher input costs affecting investors?
CD: It's a much less ebullient party for goldbugs and gold investors. Back when gold was $400/oz, investors were dreaming about what the share prices would be of their favorite mining companies if gold ever got to $1,250/oz or higher. Well, we've gone through that number and the returns for mining equities have been abysmal, although there have been a couple of good years. Last year and this year have been brutal, with reduced returns in the mining space.
TGR: How do investors make money in this space?
CD: By seeking out investment vehicles that limit exposure to input cost creep, but also deliver the benefits, assuming that the metal price continues to go up. Some of those investment vehicles may be royalty companies, which tend to pay a big lump sum upfront for a royalty stream and then receive a certain amount off the top of ounces produced every year after a mine begins production. They don't pay an ongoing cost associated with the ounces that are delivered to them and therefore avoid the creep of input prices.
One of the reasons that these royalties companies have tended to trade at a premium relative to mining companies on a net asset value (NAV) basis is that you do not pay for extended mine life. Even though mine planning can keep the margins constant and can reduce ounces produced from a deposit as the grade goes down, it also tends to lengthen the life of that deposit. It's a question of would you rather have a 1% net smelter return (NSR) on 100,000 ounces for 10 years or a 1% NSR on 80,000 ounces for 15 years? At the end of the day, the total ounces you receive under that second scenario is larger, though in any one period the total ounces received is less than the first scenario. Royalty companies offer investors exposure to gold without a lot of the risks associated with owning mining companies.