While still below its all-time highs of September 2011, gold, currently at $1,525/oz has enjoyed quite a rally off the late 2015 lows of ~$1.075/oz. Unsurprisingly the gold miners have also been on quite a tear. Steve Grasso has frequently made the point on Fast Money that the miners represent a more levered way to play gold explaining that they “always outperform by 2-3 times” (versus the commodity itself), and given their 135%+ gains since 2015 versus ~45% for the metal, it seems he’s right. Steven Chiavarone, asked about gold by Scott Wapner said “I don’t care…there’s no cash flow. So I’m left trying to wonder what people are going to pay for a gold rock.” Guy Adami meanwhile, discussing the technicals, noted that the miners – and mentioning Newmont Goldcorp specifically – are breaking out.
Given the fact that gold is rallying, and that the miners tend to move more than the metal, it may not be surprising that the sentiment in the options markets was bullish with significant call buying in the commodity, the miners and the GDX ETF, but a reasonable question investors may ask is why buy options rather than the underlying stocks? The reason is valuation. Miners, like any commodity company, ultimately, are valued by 3 primary factors. How much can they produce? How much will it cost to produce it? How much can they sell it for?
In FY2018 (prior to the Goldcorp acquisition) Newmont realized ($1,260/oz – cash cost of $708/oz) = Gold cash margin of $552/oz x 5.5mm ounces sold = $3 billion in gross profit. It’s important to bear in mind that these are approximate figures, Newmont is primarily a gold producer, not exclusively, however, I generally prefer to look at the back of the napkin figures which are the real drivers, rather than the minutiae which rarely are. The gross profit margins appear quite attractive, however, the net income which accounts for SG&A, R&D, Taxes, and Depreciation was only ~ $700mm. At a high-level, it seems that at current prices an ounce of gold production, at $1,260/oz average selling price, translates to between $120-$130/oz in net income. Another way to think about it is how much proven and probable gold reserves does the company own (~120mm ounces it turns out) and the company is targeting production of ~6-7mm ounces per year.
The company’s current Enterprise Value is ~ 41.3 billion USD. That translates to a valuation of ~$345/oz of their proven and probable reserves, nearly 3x the net income shareholders saw per ounce produced in FY2018. Like many resource companies NEM will continue to explore and develop to replace reserves along the way, and some of the costs I outline cover that. Nevertheless, gold ore grades – which measure the density of gold in mined ore as grams per ton, have been declining. If that trend continues NEM will need to mine more ore to maintain production rates, and all else equal, production costs will rise.
The current EV/Valued Reserves are now at the upper end of the 10-year range. Could gold prices rise further? Certainly. Would miners rise even more? If history is our guide, yes, but when a resource company’s valuation multiple is high AND the price of the commodity they sell is also high the downside risk can be material. Perhaps that is why an options trader elected to risk just .21/share by purchasing January 45.5 calls in NEM rather than buying the stock to make a bet the rally could continue.
For more, take a moment to what this video.
Photo by Igor Rodrigues on Unsplash
