Whence the Windfall Profits From Gold?

With gold prices exhibiting persistent strength, and mining costs declining significantly from last year's oil-fueled spike, the time is ripe for miners to show off some of that golden profit potential I've touted for so long. For weary investors, however, the wait continues.

Kinross Gold (NYSE: KGC  ) this week became the latest in a string of gold miners to report wholly unimpressive bottom-line results in the face of outstanding market conditions.

Despite a record operating margin of $481 for every gold equivalent ounce (GEO) sold, and a healthy 38% increase in production to 560,479 GEOs, Kinross yielded a disappointing net profit margin of just 3.2%. Adjusting for items like a $57.5 million foreign exchange loss, however, earnings increased 70% over last year to a more respectable $84.3 million. I would have preferred to highlight the company's many operational achievements and its bullish project pipeline, but instead that currency loss beckons.

Across the gold mining sector, a clear pattern emerged from second-quarter results: devaluation of the U.S. dollar relative to currencies of mining jurisdictions led to foreign exchange losses on future liabilities like mining taxes and reclamation expenses.

As I pointed out in the case of Yamana Gold (NYSE: AUY  ) , there is an inescapable irony of investors fleeing dollar weakness through exposure to gold miners ... only to have earnings crushed by that same falling dollar. I hope gold investors can chuckle at the irony, because they saw plenty of it. Agnico Eagle Mines (NYSE: AEM  ) took a $16.7 million hit, Yamana lost more than $60 million to these items, and Kinross rival Goldcorp (NYSE: GG  ) recorded an astonishing $326 million currency-related charge.

Because my forecast for substantially higher gold prices is predicated on expectations for further devaluation of the greenback, these currency losses can not be brushed aside as one-time obstacles to profitability. The above miners remain more attractive to this Fool than hedged producers like Randgold Resources (Nasdaq: GOLD  ) or Barrick Gold (NYSE: ABX  ) , but this currency conundrum must be addressed.

Is the solution right under their noses?
If only gold miners had some kind of an asset at their disposal that could serve to counteract the impacts of dollar devaluation. Wait a second, how about gold?

What if miners held back a small portion of production, commensurate with the scale of dollar movements, as a physical reserve for those future liabilities? Could it be that simple? Write a comment and let fellow Fools know what you think about the idea.

Fool contributor Christopher Barker sees a pot at the end of the rainbow for investors with exposure to gold. He can be found blogging actively and acting Foolishly in the CAPS community under the user name TMFSinchiruna. He tweets. He owns shares of Agnico-Eagle Mines, Kinross Gold, and Yamana Gold. The Motley Fool has a gilded disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 16, 2009, at 9:36 AM, abasso47 wrote:

    Yes, it could be that simple and Yamana is holding back on some of its' gold...so we'll see.

    al

  • Report this Comment On August 17, 2009, at 2:12 AM, fongston wrote:

    Holding back a portion of production of gold is not the answer. This is a speculation (anti-hedge) that at some future time, the USD will strengthen relative to foreign currencies. Even if it's crystal ball proves true, will operations support increasing production to cash in on that favorable Fx environment? Why not make life simple and hedge against the foreign currencies risks from the start and return once again to a pure unhedged gold mining company pure play?

  • Report this Comment On August 17, 2009, at 8:05 AM, asdfsdfsdfds wrote:

    The fool writes time wasting articles... I dont bother to read them.... They are more of annoyance then any help to me as an investor....

  • Report this Comment On August 17, 2009, at 9:09 AM, XMFSinchiruna wrote:

    fongston,

    The problem with hedging against foreign currency risk using the common vehicles -- derivatives -- is that they carry a dual risk of:

    A.) exposure to the very epicenter of the global financial crisis, since derivatives are precisely where the deleveraging must continue to occur in order to purge toxic "assets" from the system, and where I believe that systemic risk still lurks in the shadows.

    http://www.fool.com/investing/general/2009/03/24/whos-more-t...

    Investors seeking protection from the dollar's decline or systemic risk to the present financial order via mining stocks are not well served by aggressive gambling through derivative instruments. If they want exposure to the derivatives casino, opportunities abound in every sector. I suggest that gold miners which rebuke derivative instruments in favor of simplification, where their product itself becomes the ideal currency hedge, could quickly become the darlings of the industry.

    and B.) More often then not, I observe their use increasing volatility of bottom-line earnings rather than reducing it, as they're theoretically intended to do. Since they are leveraged bets, the temptation exists for management to surpass a simple hedge against potential losses and reach for ramped-up gains in a manner that transforms the practice from Hedging to speculation. Many companies hedging currency risk through derivatives are in effect running a side business as speculative currency traders. Again, this is a common practice, but one that I believe precious metal investors in particular would like no part of.

    Holding back gold production as a reserve from which to pay future non-USD expenses is far simpler than hedging against dollar weakness using derivatives. It carries the added benefit of adaptability, where miners can adjust the scale of reserve additions as currency swings unfold, rather than locking in bets ahead of time through derivatives.

    Building a small gold reserve for future non-USD expenses would not mean a miner is not a pure play on gold, and we would not call the company "hedged" in the sense that miners with forward sales contract hedges like Barrick and Randgold are. Simply, assuming as shareholders do that we remain in a long-term rising price environment for gold, sitting on a small slice of production represents the most cost-effective means for satisfying future non-USD expenses, and therefore - in my opinion - the most favorable option in the interest of shareholders.

    I welcome the discussion, and hope some industry CEOs are listening. :)

  • Report this Comment On August 17, 2009, at 4:54 PM, rfaramir wrote:

    At first blush, it looks great to me. Then I start thinking of what could go wrong. Do they just stop mining, i.e., leave the gold in the ground? That is tantamount to cutting off one's nose to spite one's face because the market is not offering enough. Do they start stockpiling gold bars at the end of the production pipeline? Then they have to start taking the heavy precautions against theft that the big gold warehouses take. It's even harder, I'd argue, as the central stores are in well-defendable places (I'd imagine), as opposed to isolated mining locations in potentially less law-abiding parts of less stable countries.

    If there is some partially processed dirt+gold concentrate that is easily stored and difficult to steal and easy to finish processing when demand rises, then, yeah, it's a great idea.

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