Mining Stocks: Will the Downturn Last?

Over the last twelve months mining stocks have substantially underperformed the market.

In fact, the Standard and Poor's Metals and Mining select industry index (INDEXSP: SPSIMM) is off 35% in the past year, while the overall market is up 2.5%.

Admittedly commodities prices are down, but only by 14% in the last year. Meanwhile, the cost of some commodities -- notably gold prices -- are much higher than they were.

Given the buoyancy of global monetary policy, this is surprising. For investors, the big question is: will the downturn in mining stocks last?

It truth, though, when you look more closely at operating numbers, the weakness in commodity shares is easier to explain.

Mining Stocks: Breaking Down Barrick Gold

For example, Barrick Gold (NYSE:ABX), a gold and copper miner that is generally well regarded, posted first quarter earnings which were up just 3% from the previous year. That was a surprisingly weak performance given that its gold sales price was up 22% -- even though its copper price realized was down 11%.

However, gold cash mining costs were up 25% and copper cash mining costs were up a startling 66%. So even though copper production and sales were also up sharply, margins on those sales were down 43%.

In other words, even though Barrick enjoyed a favorable operating quarter with good prices, mining costs for both gold and copper were up so sharply that Barrick enjoyed little benefit from this success.

The same picture is clearly seen around the mining sector, and indeed in the related energy sector.

Strong sales prices over the last few years have had two effects.

They have led producers to extend operations to higher-cost mines that were not previously viable. Further, they have increased wages in the mining sector.

Additionally, energy prices -- which represent around 25% of the operating costs of the average gold mine -- are also higher, putting more pressure on margins.

Naturally, with commodities prices somewhat weak and costs increasing much faster than general inflation, mining profitability has been hit.

A further problem is that, for mining companies engaged in major expansion projects, which many of them are, escalating construction costs have caused them to run seriously short of cash.

That has forced them to raise equity at prices that are currently unfavorable.

The molybdenum producer Thompson Creek Metals (NYSE:TC) is a good example of this. In the middle of a $1.5 billion gold mine project at Mount Milligan, Thompson Creek sold equity shares at 50% of book value.

Even so, many mining stocks are trading at low single-digit price-earnings ratios-- far below the value of their operations.

For these companies, the best solution would be to cut back capital expansion plans as far as possible and sharply increase dividends to maximize the benefit to shareholders.

If that were the case, their stocks would then trade up because of their dividend yields, and shareholders would benefit from both the dividends and the higher share price.

After all, a large surplus cash flow with a mining company is a recipe for trouble in the form of foolish acquisitions or ill-thought-out exploration.

The Fundamental Case for Mining Stocks

Going forward, the outlook for gold and silver prices, at least, remains bright.

It seems inconceivable that the Eurozone crisis can be resolved without the European Central Bank pumping more money into the system, while Federal Reserve Chairman Ben Bernanke needs only modest encouragement to engage in another bout of inflationary "quantitative easing."

Inflation itself has not disappeared as many predicted. It may in fact accelerate quite rapidly if conditions are right, as unemployment has declined and the labor market has tightened.

Further, the deflationary boost we all gained from easier global sourcing and the entry of India and China into the world economy seems to have ended, with both India and China experiencing substantial inflation. For energy and other commodities, the future depends on global growth.

Of course, if China really is entering a downturn, with losses in the banking system causing a recession, then the bull case for commodities such as iron ore and coal is much weakened. With overall inflation continuing, producers of those commodities may continue to suffer earnings stress, and therefore remain somewhat undervalued compared to the market as a whole.

For gold and silver miners, however, the outlook is bright.

Their output prices should increase, while their inputs of energy and mining engineer talent will become cheaper as supply increases and energy prices remain at around current levels.

That should bring them both increasing margins and profits. As gold and silver prices increase, it should also raise their valuations relative to those profits.

In short, if you own gold and silver mining stocks, hold tight. You shouldn't regret it.

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