Wednesday, October 1, 2008
Gold Mines and Operating Leverage
"Valuing asset-backed securities is tricky. But commodities producers are easy right? ... Unfortunately for speculators, reality is more complex. ... Since the start of July, the miners have performed much worse than would have been expected, having fallen 40% while gold is down just 18%", my emphasis, Liam Denning (LD) at the WSJ, 11 September 2008.
The WSJ should do better than this. Apparently LD does not understand 'operating leverage". I'll explain. Assume gold is $800 an ounce. Our mine has current operating costs of $600 an ounce, leaving a $200 an ounce margin. Suppose gold falls to $700 an ounce, a 12.5% decline, the mine's margin falls to $100, a 50% decline. Why was LD surprised with this result? I would expect the mine's stock price to fall more than 50%. Why? At least some of its ore will become "extramarginal" as the gold price falls so will not be mined at all.