Marginal Mines in A Bull Market

June 5, 2002

This essay is non-specific to any Precious Metals mining sector. The reaction of a marginal mine to rising (or falling) commodity prices of their sector applies to Gold, Silver, Platinum, etc. I will use Gold mines in my examples that follow, but the fundamentals apply to any sector.

Marginal Mines are those that, at current commodity prices, barely can make a profit. Their production costs tend to be high due to low grades of ore. They are often saddled with high debt payments from loans to stay in business during low price levels or to finance the construction of their mining facilities.

So why even consider a marginal mine when there are many companies out there that are making good profits from current pricing? Because, when the commodity price rises significantly, marginal mines profits and share prices explode!

Let's assume we have three (3) different gold mines. Each produces 1.0 million ounces of gold per year. Each company has 150 million shares of stock. The only difference between the three is their total production costs (but this remains constant as gold moves higher) and therefore their earnings per share. We will also assume that as the price of gold increases, none of the mines increases their production or change the quantity of shares issued. All three will have a 25% tax rate and will trade at a PE of 15. This will give us an apple-to-apple comparison as the price of gold goes up.

Mine "A" is our marginal mine.
Mine "B" was probably a marginal mine not too long ago, but is now breathing easier with a slightly higher gold price.
Mine "C" is a well working, profitable mine.

 

At $300/oz GOLD

 

Mine "A"
Net income $1.5 million/year
Yearly EPS = $0.01
Share price at 15 PE = $0.15

Mine "B"
Net income $15.0 million/year
Yearly EPS = $0.10
Share price at 15 PE = $1.50

Mine "C"
Net income $150.0 million/year
Yearly EPS = $1.00
Share price at 15 PE = $15.00

Note: mine "B" share price is 10.0 times marginal mine "A" and mine "C" share price is 100 times marginal mine "A".

 

At $400/oz GOLD

 

Each mine receives an additional $100 million revenue and $75 million net income after taxes.

Mine "A"
Net income $76.5 million/year
Yearly EPS = $0.51
Share price at 15 PE = $7.65

Mine "B"
Net income $90.0 million/year
Yearly EPS = $0.61
Share price at 15 PE = $9.00

Mine "C"
Net income $225.0 million/year
Yearly EPS = $1.50
Share price at 15 PE = $22.50

Note: mine "B" share price is now only 1.17 times mine "A" and mine "C" share price is now only 2.5 times mine "A".

As you can see, in a bull market, the biggest "bang for your buck" is in the marginal mine. As the price of gold continues to rise, the differential between mine "A' to mines "B" and "C" decreases.

There will also become more marginal mines as the price of gold increases. A mine that is losing money at $300 gold may become profitable at $350. Of course if the price of gold falls, the marginal mine loses profits and share price more rapidly than the other mines.

Only a small portion of your Precious Metals investment portfolio should be invested in marginal mines and this portion should be split among at least two and preferably three different companies as marginal mines are subject to production problems.

To maximize profits as the commodity price rises in your sector, you can drop the higher profit mine (mine "C" in the examples), pick up new marginal mines and rebalance the portfolio.

In my opinion a model PM portfolio would have 15% in the marginal mine "A", 25% in mine "B" and the remaining in "C" at $300 gold.
At $400 gold, rebalance to 25%, 50% and 25%.
At $500 gold pick-up new marginal mines, drop the old "C" mines and go back to 15%, 25% and 60%.

I have not used any specific mines as I believe you should do adequate research on your investments. Know your companies well.

The average human body contains 0.2 mg of gold with the bone containing .016 ppm and the liver .0004 ppm.

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