Gold miners use huge amounts of oil a low oil price should help them bounce back

And it’s still playing out. There’s a risk that panic could continue to spread in the wider markets next year.  A sovereign default on Russia’s debt has become a very real possibility.

And, as with Russia’s 1998 breakdown, it’s difficult to guess exactly where the risks lie. I mean, who’d have thought that the biggest loser back then would have been a hedge fund in Connecticut – Long Term Capital Management?

Where will the oil crash show up next? Well, I can see an interesting connection to a totally different market; that’s what I want I want to talk about today.

Let me fill you in on what’s been happening with the gold miners.

Gold miners have been crushed

As the following chart shows, gold (the top line) has been pretty stable over the last few months. But faith in the gold miners has been completely shot to pieces. The blue line shows the popular Market Vectors Gold Miners ETF (quoted in New York). During the period, this mining index is off a whopping 25%.

To me, it just doesn’t make sense.

There’s no doubt that sentiment for the whole of the mining industry, not just gold miners, is pretty much rock bottom right now. That doesn’t help. Also, November and December traditionally represent a good time for investors to sell down the year’s losers. It’s a good time to ‘lock-in’ losses on bad trades – selling down these losing positions further depresses the price. Gold miners have had a miserable couple of months, but it’s just the latest blow after a miserable two and a half years.

Over that time, investor sentiment towards gold miners is also down, due to the insidious effects of something called ‘operational gearing ’. You see, during a gold bull market, gold producers get higher prices for their product, but their costs stay the same. For example, a 20% uplift in the gold price can easily produce a 100% uplift in corporate profits.

However, the inverse is equally true – and it has been for nearly three years. A relatively small fall in the gold price can collapse gold miners’ profits. The industry has suffered spectacularly leveraged falls as a result of falling gold prices.

Miners’ costs flew up, too

So the miners’ profits are super sensitive to the gold price. But it gets worse. Over the last few years, input costs haven’t remained stable, they’ve risen. The industry started all sorts of far more expensive mine projects during the good times. Not only that, but other costs of production rose as well. Energy is a massive input for the industry, and over the last three years it got much more expensive.

But the oil price has been in freefall over recent months. That means lower input costs for the industry. Not only that, but the industry has realised its great mistake on ramping up expensive new projects. Over the last year or so, miners have suffered savage write-downs as new projects got shut down. But the thing to be aware of is that these write-downs don’t involve cash. If anything, miners should start to become cash-flow positive.

Overall, the industry looks to be in much better shape. Certainly better than three months ago. And yet, just look at the chart.

A serious contrarian bet

I’ll make no bones about it: investing in gold miners is very risky. There’s no doubt that though the last three months have provided a better environment for gold stocks, something has clearly had investors diving for cover.

I think that ‘something’ is the tightening of the credit markets. The mining industry relies on credit. Should individual producers become unable to service debt, or its lenders unwilling to roll it over, then things can quickly turn nasty.

Perhaps the market is right to feel nervous. At current levels, gold mining is still mostly profitable. But that can change on a sixpence if gold heads lower.  Some miners could go out of business.

That makes investing in the miners a contrarian bet. The good news? Well, a sustained uplift in the gold price should see a triple-whammy uplift for the miners.

First, the operational gearing will, as is normal, bring leveraged returns over and above the uplift in the gold price.

Secondly, lower costs, both in terms of energy and the currency effect will start to shine through as trading figures get published in the New Year.

Last, but not least, fears of bankruptcy will start to ebb – the bankruptcy discount should start to reverse.

Overall, I would say that the fall in gold producers over the last three months was extreme. 25% in the light of a stable underlying price is too much.

However, you need to choose your miners carefully. Over at the Fleet Street Letter. my colleague David Stevenson has found three high quality gold miners (which are going for a song) he expects to bounce back in the next year. To read more about FSL, click here .

This article is taken from our FREE daily investment email, The Right Side

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