While there are a number of plausible reasons for gold stocks lagging of late, we have come to the conclusion that the true explanation reaches much farther into the past. It’s that the managements of the gold producers have only recently escaped the state of fear they operated under during gold’s 20-year bear market.

Consider: as recently as the year 2002, gold was still trading near $280. Against that number was a cash cost of around $250 per ounce for a typical company. That cost figure is about as low as the number could go, and it was the response of an industry beaten down and huddling in a trench.

Caution lingers after the reason for it has gone. As gold began its upward move in 2002, it did so against the backdrop of an industry still in mothballs and still run by managers whose primary skills were cost cutting and frugality. This is important on a number of fronts.

1) Having been trained in the acid bath of razor-thin margins, management was intensely skeptical about gold’s rally. They suspected it might be just another bear market trap, ready to punish unwary optimists who parted with cash to ramp up production.

2) In the hunkered-down years, miners focused on the higher-grade, easy-to-mine material that gave them the best shot at turning a profit, however small that might be. And being in survival mode, they were extremely cautious about buying new equipment or maintaining a large workforce. Employee rosters were reduced to the bare minimum.

3) Because staying in business was such an urgent goal, they were willing, even eager, to sell future production at a set price — a perfectly rational strategy in a bear market, because it at least assured they would receive a price that covered the known costs.

With all these factors taken together, it’s easy to understand why the industry was slow to respond when gold started rising. In fact, it was only in February 2003, with gold trending over $350, that Barrick Gold Corp., the world’s largest gold miner, began the expensive process of unwinding its hedges. And it wasn’t until November of that year that the company announced it would stop forward selling altogether and would eliminate its entire hedge book.

Once the turning point came – when management finally realized the bull market was for real — the industry began to scramble to catch up. Which, in a choo-choo industry like mining, means hiring and training lots of people, buying or refurbishing the equipment needed to reestablish production on second-tier deposits, upgrading facilities, building expensive new mills, etc., etc. And, of course, dealing with the challenge and expense of unwinding hundreds of millions of dollars worth of forward hedge contracts.

The rebuilding of the gold mining industry, in short, really only began in earnest over the past few years.

As would be expected, the costs associated with rebuilding the industry sent big hits to the bottom line, resulting in the kind of ugly financial metrics that repel institutional investors.

The metrics were not at all helped by the shift away from high-grade ore, because the lower the grade, the more the material you have to dig, hoist, haul and process, meaning increased production costs. In addition, the industry rebuild occurred against a backdrop of generally rising inflation and a falling dollar, which helped push the cash cost of production up by more than double from the mothball years, keeping the miners unattractive as investments.

By contrast, the base metals companies, which had hit bottom earlier, near the end of 1998, had already emerged from the mothball stage, thanks to increasing demand from China and elsewhere. They were, as a result, well on the road to recovery when the big price increases for base metals kicked off in 2004. So, while the gold miners have been widely shunned as ugly ducklings in recent times, the base metals sector has been enjoying salad days, reflected in multi-billion mergers and acquisitions and, of course, sharply higher share prices.

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This entry was posted on Thursday, March 6th, 2008 at 1:34 pm and is filed under 1 - Gold, 3 - Understanding The Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.