Gold Miners Face an Oily Problem

MARCH 21, 2011   THE WALL STREET JOURNAL

By LIAM DENNING

Gold-mining stocks are leaden. The oil sector offers clues as to why.

It isn't that gold stocks have fallen. Shares of Barrick Gold, for example, have risen 23% since the start of 2010. But gold, which at $1,416 an ounce is near its record amid crises in Japan and the Middle East, is up 28% in that time. On a five-year view, with the gold price having more than doubled it has outpaced shares of Barrick by a factor of almost two to one.

Reuters

In theory, mining stocks should be leveraged bets on the gold price. Consider a miner producing gold at a cost of $400 an ounce. Five years ago, with gold averaging about $600, their profit margin was $200. At $1,400 an ounce, the gold price has more than doubled. But the miner's profits have risen fivefold.

The big miners' big problem? Bigness. Five years ago, the stocks of leading miners Barrick, Newmont,Kinross Gold, and Goldcorp traded at an average forward price/earnings multiple of 28 times, according to FactSet Research Systems. Today, they average 17 times. Bang goes your leverage to the gold price.

Exxon Mobil can relate. In the five years leading up to the oil price's peak in July 2008, the largest listed producer of black gold saw its P/E multiple drop from 17 times to just over eight times. Investors were skeptical this behemoth could offer meaningful growth, either by higher output or ever-increasing prices for oil.

RBC Capital Markets reckons gold miners struggle to expand organically once they hit output of five million ounces a year. At that level, adding 10%, or 500,000 ounces a year, to production requires developing a project with seven million ounces or more of reserves. Like giant oil fields, such large gold deposits are rare.

Barrick and Newmont Mining both produced more than five million ounces of gold last year. Kinross and Goldcorp have more breathing room, having both produced about half that level, and have strong growth prospects.

Raising paltry dividends could bolster the big miners' investment case, but then big payouts to shareholders haven't done much for the oil majors' multiples. The next resort is asset reshuffling or outright acquisitions. ConocoPhillips' restructuring, which has included shedding assets, helped its stock trounce those of the other oil majors over the past two years. Barrick's listing of a stake in African Barrick Gold last year should be seen in this context.

Buying other miners to expand output is another option as demonstrated by Newmont's acquisition of Fronteer Gold last month. Despite their higher multiples, investors should consider owning stocks of potential takeover targets, particularly those focused on development of new projects such as Orezone Gold.

When digging for growth becomes too onerous, big miners often start panning at the local stock exchange instead.

Write to Liam Denning at liam.denning@wsj.com