3 Reasons Gold Stocks Are Set to Rally in 2020: August Update
Gold prices, and gold mining stocks, continue to soar as central banks across the world flood the markets with cheap money via quantitative easing and 0% interest rates. Historically low bond yields are driving new investors to gold as an alternative store of value during this period of heightened geopolitical risk and COVID-19 fears.
This is a follow-up article to my April coverage, “3 Reasons Gold Stocks are Set to Rally in 2020.” In that coverage, I stated the following:
” Gold (GLD) has done a fantastic job of holding its value during the COVID-19 pandemic and it should continue to do so as central banks flood the market with cheap money… History says that if you think gold is about to go on a run, then you should own gold stocks, which provide leverage to gold prices.”
This has turned out to be the right call. Check out the performance of the VanEck gold miners index (GDX) and the price of gold since April, compared to the Dow Jones Index:
(Gold miners are up 77.86% since April 1, compared to a 20.65% gain in gold prices.)
However, investors today want to know just one thing: does gold’s rally still have steam, and are the gold mining stocks (GDX) still worth buying after many of them have more than doubled in price since April?
I believe this secular bull market in gold and gold mining stocks is just getting started – the conditions for gold to rise in price are perfect, and gold bull markets typically last 5-10 years or more (see 1971-80, and 1999-2011 as examples).
Here’s an update on gold and gold mining stocks, and my thoughts on where I think we are headed next.
1. Gold supply down, demand up
(Quarterly gold supply. Credit: World Gold Council)
In the short term, COVID-19 impacted several gold mining operations, as many were forced to temporarily suspend or reduce operations, therefore, reducing supply. In fact, close to $9 billion in mining revenue was classified as at risk due to COVID-19, according to S&P Global Market Intelligence.
Most of those mines have resumed operations, and the impact on mining shares was limited.
The bigger story here is the likelihood that we’ve already seen “peak gold,” meaning that global annual gold mine supply has potentially reached its highest levels. Total gold mine production was 3,463.7 tons in 2019, which represented the first annual decline in production since 2008, according to The World Gold Council.
Gold production for the first two quarters of 2020 was 1,602 tons, putting it on an annual pace for 3,204 tons of gold, which would represent a decline of 6-7% from 2019. Still, before COVID-19 supply was still likely to decline by about 1-2% from 2019.
We should see a bounce back in production in Q3. However, there’s really no huge, new gold mines coming into operation this year or anytime soon (for example, Seabridge’s (NYSE:SA) KSM project is the largest gold project currently with 38.8 million ounces, but it’s many years away from producing.) I expect supply to normalize to between 850 and 900 tons per quarter for the foreseeable future.
Investment demand continues to be very strong; in Q2 investors bought a total of 582.9 tons of gold, up from 300 tons in Q1 2019. Central banks added less gold to their vaults (114.7 tons) but that could change once COVID-19 passes.
(Annual central bank gold demand. Credit: World Gold Council).
According to the 2020 Central Bank Gold Reserves (CBGR) survey, 20% of central banks intend to increase their gold reserves over the next 12 months, compared to just 8% of respondents in the 2019 survey. Central banks have added more than 1,200 tons of gold to their vaults since the start of 2018.
It’s going to take quite some time for production to keep up with the increased investor and central bank demand, as it takes several years to develop and finance a gold mining operation, and many gold companies have only just begun re-investing in growth projects.
2. Gold miner margins: Getting stronger
What’s most spectacular about the latest gold price rally is the fact that oil prices and energy prices as a whole have not increased by much since April, and any cost increases due to COVID-19 suspensions and closures are only temporary.
The gold to oil ratio measures how many barrels of oil you can buy with one ounce of gold. The ratio is currently 48.96X, after peaking at 91X in April. Therefore, gold has gained a ton of value compared to oil.
As I pointed out in my April article, the mining and processing of gold requires the consumption of oil, especially with open pit gold mines where haul trucks and dump trucks are required. It’s a major component of a gold miner’s “all-in sustaining cost” of an ounce of gold, which is the true cost of mining gold with all capex included.
Most AISCs I’m seeing have either remained flat, while some have actually reported declines, since my original coverage in April. With gold prices up $400+ per ounce since April, miners’ operating margins have expanded quite a bit, since many of them have their costs under control.
For example, Eldorado Gold (EGO) saw revenues rise 47% Y/Y to $256 million and Q2 adjusted EBITDA doubled to $135 million from $66.8 million in the prior comparable quarter; sector standout Kirkland Lake Gold (KL) pumped out $219.3 million in profits, double its Q2 2019 level; AngloGold Ashanti (AU) says to expect earnings per share to more than triple from Q2 2019.
In addition, Q3 2020 should be a far better quarter for gold miners, with gold prices nearing $2,000/oz, or $300/oz higher than Q2 averages.
With most gold miners reporting AISC at or below $1,000/oz, we should see record margins, cash flow, and earnings in Q3 and Q4, assuming gold continues to trade above its Q2 averages of $1,700/oz.
3. Gold is still undervalued compared to stocks
(The Dow-to-Gold ratio has fallen to 13.46X and is likely headed lower. Credit: MacroTrends)
Gold has risen quite a bit, but you can make the case that gold is still undervalued compared to stocks.
The Dow-to-Gold ratio is a good indicator to see how many ounces of gold it takes to buy one share in the Dow Jones Index. Historically, this ratio has ranged from a high of 41X (1999) to lows of 1.29X (1980) during a gold bull market.
Gold has been making serious gains when compared to stocks, but you can see in the above chart that the trend is still lower. During the gold rally in 2011, the ratio hit a low point of 6.36X, and I believe we’re likely heading to 5X at some point over the next 1-2 years.
If we were to apply the same 6.36X ratio today, and assume the Dow Jones trades at 26,600, then the price of gold would be $4,182/oz. If the Dow fell to 20,000, the price of gold would be $3,144/oz; at 15,000 Dow, the price of gold would be $2,358/oz.
But what about gold stocks? They are looking undervalued compared to gold prices.
The HUI-to-gold ratio is the best way to measure the value of gold stocks compared to the physical metal. It takes one share of the Gold Bugs Index, which consists of 15 of the largest and most widely held public gold production companies, and divides it by one ounce of gold. The HUI currently trades at $350 per share and peaked at $600 in 2009.
Here’s the current HUI-to-gold ratio above, which sits at .18X, and is on the verge of a technical breakout. Over the past 20 years, this ratio has ranged from a low of .10X to a high of .62X, and we’re nowhere near the .41X ratio we saw back in 2011.
I believe gold stocks still have a lot more ground to make on gold, and I would not be surprised to see the HUI-to-gold ratio hit the .50X mark, which we last saw in 2007. With gold at $2,000/oz, the HUI would need to trade at $1,000 per share, or more than triple current levels.
Gold stocks: Final thoughts
I still very much believe we are just now entering the “golden age” of gold (and silver) mining, where mining companies and the royalty/streaming companies report record earnings, start to pay dividends or increase dividends, and provide excellent shareholder returns that outperform other sectors.
To sum up my thoughts:
- Higher gold prices are likely here to stay, and oil prices will remain depressed for the foreseeable future, which means gold miner margins will likely remain elevated.
- Very few new gold mines have been brought to production this year, and it will likely take several years for supply to keep up with demand. There is generally a lack of “Tier 1” gold mine projects capable of adding significant supply to the market (500K ounces per year.) Most economical mining projects are smaller in size, and higher capex projects are more difficult to finance and develop.
- I believe gold stocks, including gold mining stocks and streaming/royalty companies, are very likely to outperform the price of physical gold, and I feel gold stocks are deeply undervalued compared to gold, and likely to hit the .50X HUI-to-gold ratio in the future.
- I expect gold miners to continue to pursue M&A opportunities in 2020 and beyond, and I think we’ll likely see a wave of consolidation in the sector, especially among the mid-tier and larger miners ($3-5+ billion market cap). Gold miners should continue to pursue M&A, but only if the whole of an entity is worth more than the sum of the parts.
- However, there are still many mismanaged gold companies that will underperform, and investors should continue to be very selective and focus on investing in the best assets and strong management teams. The junior miners and explorers (under $1 billion market cap) currently provide the best value in the sector.
What gold stocks are you looking to buy? Let me know in the comments.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.