The Economics of Mining Precious Metals

A number of people with an interest in owning precious metals investigate the possibility of doing so by purchasing shares of stock in mining companies. I am not an analyst of individual mining company stocks, so I do not offer any recommendations for or against specific companies. But, I can explain the aspects of owning these shares that may or may not correlate with precious metals prices.

In decades past, owning shares of mining companies was often an attractive option for those seeking high dividend yields. The reason for the high dividends was that mines generally have limited lives – often only 10 to 20 years. They mostly were not stocks to purchase if interested in long-term appreciation.

There are also resource exploration companies that mostly do not pay dividends. Their goal is to discover promising sites for new mine development, then usually make money as their stock appreciates when larger mining companies seek to buy them to replenish their backlog of “ounces in the ground.”

Overall, when you own shares of a mining company, you are hoping that it can successfully navigate the promises and pitfalls of just conducting operations, factors that are not related to current and future prices of precious metals.

What are some things that can make the share prices of precious metals mining companies more valuable? Here are the two most significant.

• Discovery of additional resources that can be cost-effectively recovered. This could be either a new strike associated with an existing mine or successful acquisition of new properties with promising test samples.

• An increase in the prices of the metals being mined, which has the result in increasing the quantity of recoverable metals and existing mine can economically produce. As an example, a known vein of silver might not be worth extracting at a silver price of $20 per ounce but becomes recoverable at a price of $30 per ounce.

On the other side, what can push down share prices?

• Increased regulatory and environmental regulations can extend 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 of proven samples at a new site to the actual starting of mining operations. Now, it often takes more than a decade to jump through all the regulatory and environmental hoops and build the mining infrastructure. The added time has the effect of increasing the risk that the mine will never come to fruition.

• In order to obtain financing to start a new mine, financiers want to avert the risk of a price drop for the metal. Therefore, many new mines lock in future prices at which they sell their output through the use of hedging activities. While this may protect the financiers of the mine, it also prevents the mining company from reaping any extra profits if the price of the metals shoots up.

• Mining companies can suffer from poor management, mine cave-ins, labor strife and the risk of political confiscation, none of which have any relation to the prices of the physical metals. To offset the risks that could impact any individual mine, well-operated mining companies typically seek to develop a number of mines, especially in multiple countries.

Another factor to consider is that mines generate their profits over time. If you have a sudden major price spike for gold, silver, platinum or palladium, the mining companies cannot suddenly sell all of their in-ground reserves. This time lag in production is one reason why the share prices of gold mines during the 1979-1980 gold and silver price boom did not appreciate anywhere close to the rise in the prices of the physical metals.

One more consideration is that precious metals mining, especially that for the lower-priced silver, is often as a by-product or co-product of a mine primarily extracting other metals. Silver is often produced in mines that were developed to recover gold, zinc, lead and copper.

For instance, one of the world’s largest silver-producing mines is actually a primary copper mine in Poland. For this mine, the price of silver does not matter. What does matter is the price of copper. Whatever it receives for the silver it produces is just a bonus. Similarly, the Red Dog Mine above the Arctic Circle in Alaska is the world’s largest zinc-producing mine. As a by-product, it is the second largest U.S. silver producer.

It is entirely possible that the ownership of carefully selected precious metals mining company stocks could outperform the prices of the physical metals in the future. The risk is that these stocks may also under-perform physical metals prices. Either way, the key point to keep in mind is that owning stocks of precious metals mining companies does not directly correlate to the prices of the actual metals. If you seek to own precious metals for potential appreciation or to protect against the further decline of the U.S. dollar, then acquiring the physical metals meets that choice better than shares of the mining companies.