Monday, 29 May 2023

By Brian Chu Editor, Fat Tail Commodities

[4 min read]

Dear Reader,

Gold stocks have had a solid run in the last eight months. The ASX Gold Index [ASX:XGD] rallied more than 35% in six weeks from late February to mid-April. If you take it from the time the bear market ended, it’s increased by around 85%.

We’re amid a second correction in recent weeks and the index has given back 13.5%.

How much lower can it go?

I’d be concerned if the index sinks below 6,000 points.

What could cause that to happen?

The first is obvious. If gold retreats to around US$1,800 an ounce and stays there, that might scare investors out of gold producers (which happened this time last year).

Another is if the price of oil suddenly takes off and heads towards US$100 a barrel.

And lastly, changes in legislation to restrict mining activity could also cause a sharp sell-off.

While all of these can occur, I have a feeling that it’s increasingly unlikely now that central banks are halting on rate rises. On top of that, a global push to transform our society via an energy revolution means that mining remains a high priority.

In short, I reckon the bullish case for gold stocks remains intact. So, you might want to take this corrective phase for gold producers as a good time to consider grabbing some.

Recent performance is unimpressive, but the outlook is more positive

Over the past fortnight, I’ve been collating and analysing gold producer company results for the 2023 March quarter.

In today’s article, I’m going to share some thoughts on how these companies performed and my opinion on their future potential.

Let’s start with their operational performance. What I found in the 2023 March quarter was that most producers struggled to increase their gold production.

This is a necessary ingredient to stoke a rally for gold producers. It reflects the amount of growth across the industry.

Here are the key reasons for companies reporting stagnant production:

1. Weather-related events, which led to mines suspending production or difficulty in accessing or transporting ore.
2. Planned temporary shutdown of equipment and facilities for repairs and maintenance.
3. The grade of ore mined or processed is reduced as mines deplete or replaced with low-grade ore that had been stockpiled.
4. Employee absentees and equipment failure.

That’s the bad news.

Here’s the good news…

Gauge future potential with this neat metric!

Gold producers reported better profit margins this quarter despite a lack of growth in production. Part of this comes from the price of oil remaining at current levels, which has reduced production costs.

For several years, I’ve kept track of the gold-oil ratio to help me track the profit margins in this industry. It helped me to buy producers at a discount before other investors crowded into the market. I’ve written about this before, you can check it out here.

Here’s a figure showing how this ratio has performed since 2021:

The current setup has me quite excited. It’s largely because the gold-oil ratio has been in an upward trend since mid-2022.

This means the gold price has been improving in relation to the oil price.

My analyst found that the ratio therefore correlates with the cash flow of gold producers. They tend to become profitable one or two quarters after the gold-oil ratio starts to trend upward. What we found was that 25 and above is the key ratio level for improved profitability.

That’s why I believe you should be bullish about gold producers since the gold-oil ratio has been above 25 in the past three months.

Now, not all producers will closely follow the relationship that I’ve outlined above. However, my observations over the long term have shown me that it works well.

Should the bullish trend for gold-oil ratio hold, now is a good time to review which gold producers are worth buying.

Selecting the right producer

You may’ve noticed that some producers rallied strongly from last September to mid-April, while others languished.

It wasn’t simply about ‘bigger is better’. For example, junior producers like Alkane Resources [ASX:ALK] and Ora Banda Mining [ASX:OBM] delivered strong returns. Meanwhile, a large producer like Regis Resources [ASX:RRL] is still trading much lower compared to what it was in 2021.

Operational performance such as the amount of production, all-in sustaining costs, amount of cash flows generated, and plant efficiency all play a part.

These are sensitive to economic conditions, weather and forces of nature, mine conditions, equipment reliability, and labour relations.

Some of these affect a region, while others are specific to the company.

Things can turn at the drop of a hat, so it’s unpredictable.

For example, a sudden spell of heavy rain can cause flooding that leads to a company suspending mining activities.

Or a drilling campaign reveals a rich seam of minerals that extends the mine life and suddenly increases the profitability of an ore body.

Individual events are hard to anticipate.

This is where digging into reports and knowing the right questions to ask can help you unearth companies that have a better track record in running a smooth and profitable operation. Additionally, this may help you avoid or minimise the impact of unfavourable outcomes.

Getting the right timing and price

Finally, you might grasp how the economy and financial markets are faring and know which companies are a bargain and which aren’t.

However, the market can stay irrational longer than you can stay solvent.

That’s why some people invest while others speculate.

What’s the difference?

Investing requires patience while speculating is all about timing.

I’m more an investor who prefers to hold a portfolio of gold stocks across the gold price cycle. I use my own valuation metric to help me determine which companies are more attractively valued relative to their future potential.

Others speculate by swooping in and out of companies, using their superior skill in timing the market. They look for price trends and buying momentum to inform their trades.

However, I’ve recently developed an index that helps me improve my timing.

It accounts for more than just the current price and the direction. I’ve managed to incorporate the drivers of value for gold stocks — the price of gold and the potential profitability of gold stocks — by way of the gold-oil ratio.

This index adds to the tool kit that I use to deliver outperforming returns with gold producers.

I’ve used this index to help my subscribers at The Australian Gold Report take some profits in the past month as gold producers started its corrective phase.

Interested in finding out more?

Check out my newsletter service and consider signing up!

God bless,

Brian Chu,
Editor, Fat Tail Commodities