The economics of mining precious metals

A number of people interested in owning precious metals are exploring the possibility of doing so by buying shares in mining companies. I am not an analyst of individual mining company stocks, so I do not make recommendations for or against any particular company. But I can explain the aspects of owning these stocks that may or may not be correlated to precious metals prices.

Over the past few decades, owning shares in mining companies has often been an attractive option for those seeking high dividend yields. The reason for the high dividends was that mines generally have a finite lifespan — often just 10 to 20 years. They were mostly not stocks to buy if you were interested in long-term appreciation.

There are also resource exploration companies that mostly don’t pay dividends. Their goal is to discover promising locations for developing new mines, and then typically make money as their stocks rise as larger miners try to buy them to fill their backlog of “ounces in the ground.”

Overall, when you own stock in a mining company, you hope that it can successfully meet the promises and pitfalls of merely conducting operations, factors that have nothing to do with current and future precious metals prices.

What things can make precious metal mining companies’ share prices more valuable? Here are the two most important.

• Discovery of additional resources that can be recovered at low cost. This could either be a new strike in conjunction with an existing mine or the successful acquisition of new properties with encouraging test samples.

• An increase in the prices of mined metals, which means that the amount of minable metals increases and existing mines can produce economically. For example, a known silver vein may not be minable at a silver price of $20 an ounce, but becomes mineable at a price of $30 an ounce.

On the other hand, what can push stock prices down?

• Increased government and environmental regulations can increase the number of years it takes to develop a new mine. At the beginning of this century, it was typical that it took three years from the time samples were verified at a new location to actually starting mining operations. Nowadays it often takes more than a decade to overcome all regulatory and environmental hurdles and set up the mining infrastructure. The extra time increases the risk that the mine will never come to fruition.

• To obtain funding to start a new mine, financiers want to avert the risk of the metal’s price falling. As a result, many new mines secure future prices at which they sell their production through the use of hedging activities. While this may protect the mine’s financiers, it also prevents the mining company from making additional profits if the price of the metals skyrockets.

• Mining companies can suffer from poor management, mine defaults, labor disputes and the risk of political confiscation unrelated to physical metal prices. To balance the risks that could affect a single mine, well-managed mining companies typically seek to develop a number of mines, particularly in multiple countries.

Another factor to consider is that mines generate their profits over time. If you have a sudden big spike in the price of gold, silver, platinum, or palladium, the miners can’t suddenly sell all of their ground reserves. This lag in production is one of the reasons gold mine stock prices did not rise nearly as much as physical metal prices during the 1979-1980 gold and silver price boom.

Another consideration is that the mining of precious metals, especially the lower-priced silver, is often a by-product or by-product of a mine that primarily produces other metals. Silver is often produced in mines designed to extract gold, zinc, lead, and copper.

For example, one of the world’s largest silver-producing mines is actually a primary copper mine in Poland. For this mine, the price of silver is irrelevant. The copper price is decisive. Whatever it gets for the silver it produces is just a bonus. Likewise, the Red Dog Mine above the Arctic Circle in Alaska is the largest zinc producing mine in the world. As a by-product, it is the second largest US silver producer.

It’s entirely possible that owning carefully selected stocks of precious metals mining companies could outperform physical metals prices in the future. The risk is that these stocks may also underperform physical metals prices. Anyhow, the most important point to keep in mind is that owning stocks in precious metal mining companies is not directly correlated to the prices of the actual metals. If you want to own precious metals for potential appreciation or to protect against a further fall in the US dollar, buying the physical metals makes that choice better than stocks in the mining companies.

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