Mining gold or silver is a very risky business. Operations must contend with infrastructure and logistical challenges, rising input costs, labor issues, hedging strategies, political risk, and various production challenges associated with complex geology. Nothing is certain when it comes to mining.
A mine may have a million ounces of proven gold reserves, but a structural collapse could render it useless. Another mine could have wide margins one day, only to report lower ore grades the next, impacting profitability.
Sir Francis Drake, the legendary 16th Century English sea captain, recognized the tremendous risks endured by the Spanish Empire during its campaign to extract gold and silver from the New World. He developed a clever strategy to participate in the bounty without muddying his impressive boots. He let the Spanish build the infrastructure and risk lives and capital during extraction. But when the Spanish attempted to move the treasure back to the motherland, he descended upon the galleons and plundered them.
I raise this anecdote not to condone piracy, but rather to demonstrate that there are ways to participate in precious metals mining while letting others do the digging. Such modern-day Sir Francis Drakes may want to consider precious metals royalty companies as a source for exposure. These companies, many of which trade publically on American and Canadian exchanges, engage in the following three basic strategies (some are active in all three):
Royalty companies make early-stage investments in start-up mining companies, effectively operating as venture capitalists by providing capital in exchange for a percentage of production. Typically these deals involve a fixed price for the metal over the life of the mine. This feature provides the royalty company with protection from rising operational costs, while ensuring that the royalty company maintains exposure to exploration and production upside.
Royalty companies provide capital to well established miners that are looking to acquire new operations. Due to the high capital costs involved in mining, even the larger and more successful companies don't usually carry large pools of acquisition capital over and above their operating budget. But miners can be great candidates for mergers and acquisitions. Oftentimes particular mines are hamstrung by mismanagement, poor mining techniques, and inexperienced geologists. The unlocked potential of such operations provides takeover opportunities for other operators, particularly those in close geographic proximity, who may have the expertise to take over but who lack the funds to pull the trigger. Royalty companies provide the funding to make these deals happen and specialize in matching management teams who have established track records with failing mines in need of rejuvenation. As with direct investments in start-ups, royalty companies typically take a fixed percentage of production at a fixed price from the acquired properties. Thus, the royalty company is protected from rising costs while maintaining upside to potential increased production.
A significant amount of gold and silver is actually produced residually by companies digging for something else. Royalty companies also help miners of base metals like zinc, copper and lead to monetize the precious metals produced as by-products of their dominant operations. In order to maintain focus on their prime businesses, base metal miners often take upfront payments from royalty companies in exchange for a fixed percentage of their gold/silver production. It's an equitable solution for both parties. The miner gets an immediate infusion of cash and seasoned help in monetizing a non-core asset, while the royalty company locks in gold or silver at a fixed price for a predetermined period of time. As is the case with the previous two examples, the streaming agreement leaves the royalty company with virtually no exposure to mining costs while preserving potential production upside.
Royalty companies also help mitigate risk through due diligence and diversification. Royalties employ world-class geologists and mining experts that can objectively evaluate prospective royalty partners. They perform a tremendous amount of analysis before entering into a royalty agreement with mining partners.
Moreover, because royalty companies make agreements with multiple partners, they create a diversified portfolio of income streams. This has proven to be crucial over the past decade, as we have seen numerous production declines and delays among the big mining names even as global output of precious metals has increased. In 2012, many of the world's largest mining firms experienced delays and downward revisions in production. South African miners, on the other hand, were hampered severely by disruptive labor strikes.
But this risk reduction through diversification has not necessarily translated to lower upside potential. Although past performance is no guarantee of future results, some of the largest and most well-known royalty businesses have significantly outperformed their traditional mining peers in the past year. They have risen more in the bull markets and have fallen less during bear markets.
Factoring in the vicious sell-off over the past six months, the GDX gold mining index is now down almost 30% over the past five years. At the same time, the price of gold is up nearly 60% and silver is up more than 40%. Given this, it is understandable that investors may be looking to now move into the potentially oversold sector. Directly purchasing a mining stock, however, adds a significant degree of risk in excess of commodity risk. According to a recent report from Bloomberg, cash costs for gold miners rose 17% during the first nine months of 2012.
In essence, investors have paid for the inflation that they bought gold miners to help protect themselves from. By locking in the price of the metals and outsourcing the costs to the miners, royalty companies have been able to help insulate investors against this margin compression.
However, royalty companies themselves are not immune from sector and market risk. They will be negatively impacted if metal prices were to fall and they may fall with downward movement of the broader markets.
For investors seeking exposure to precious metal mining, but who hope to contain the considerable risks, royalties may be worth considering. Euro Pacific brokers would be happy to discuss specific options suitable to clients based on their investment objectives and risk tolerance.