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With enormous stakes resting upon the shoulders of second-quarter earnings results to telegraph the broad direction of the global economy, you can sense the tension in the air.
For those who have sought refuge from turmoil in the miners of gold and silver, however, the outlook for these particular earnings results could hardly be clearer. I expect the profitability reported by precious-metals miners over the next several weeks to be nothing short of spectacular.
Gold spent the entire second quarter north of $1,100 per ounce, while the average realized gold price for (unhedged) miners will likely be closer to $1,200 per ounce. The long-awaited margin expansion for low-cost gold miners has finally arrived in earnest, and I anticipate a rising tide of awareness regarding the alluring profit potential of quality miners.
The oil equation
Now that erroneous presumptions about the extent of correlation between the prices of gold and oil have lost their allure, we find in oil's range-bound trading a key element of the miners' enhanced profitability. Whereas the price of gold has sustained its upward momentum, oil has not. Although geological factors like ore grades, depth, and byproduct concentrations form the nucleus of a mine's underlying cost structure, energy-related inputs account for a major share of cost variability.
Because this topic is too often oversimplified to portray energy as the only meaningful variant, I hasten to remind Fools that a symphony of complex factors plays perpetually in the background. Before metal prices plummeted in the spring of 2008, for example, the impact of skyrocketing oil prices was exacerbated by an acute global shortage of those gargantuan tires that keep monster mining trucks moving. All the same, oil's important enough to the cost equation for Fools to anticipate expanding profit margins whenever oil fails to keep pace with metal prices over time.
The reigning kings of margin
Let's take a peek at this unfolding trend by examining one of the worst-performing names in the sector. Yamana Gold (NYSE: AUY ) has been a colossal disappointment to longtime shareholders, but it weaves a compelling story of value in the process. A reader recently asked me why I continue to recommend Yamana as a top choice among gold miners despite its abysmal performance. I'm bullish precisely because of the expanding margin trend we are about to witness.
Yamana reported an industry-leading production cost of just $161 per gold-equivalent ounce (GEO) in the first quarter, and foretold of still lower costs to come as 2010 unfolds (plus higher production volumes to boot!). Selling its gold for an average of $1,114 in the period, Yamana experienced a 67% surge in gross margin, to yield $842 for every ounce produced. Plugging in a realized gold price near $1,200, and costs trending lower still, we discover a margin expansion on increasing volumes that not even Yamana's unproven management could fail to convert to meaningful cash flow.
Major producer Newmont Mining (NYSE: NEM ) overtook rival Goldcorp (NYSE: GG ) on a production cost basis, expending just $241 for each of the 1.3 million ounces produced in the first quarter of 2010. While these two quality majors battle it out for the title of low-cost king, ultimately we will find both miners awash with fresh cash flow to fund their aggressive growth strategies.
Although silver, incredibly, has yet to break through the $20 barrier last breached in March of 2008, I anticipate a similar margin expansion for silver miners as second-quarter earnings emerge. With its highly stable cost structure, I expect Silver Wheaton (NYSE: SLW ) to enjoy a cash margin above $14 per ounce for the second quarter, applied to rising sales volumes. This time last year, the price of silver itself languished below $14. What a difference a year can make!
Three more stocks to watch
When margin expansion opens a new chapter of profitability for an entire sector, I find the greatest investment prospects among operators who may have fallen out of favor with investors for reasons that are no longer at issue.
Coeur d'Alene Mines (NYSE: CDE ) provides a prime example. This stock became the favorite whipping post of disenchanted silver investors whenconstruction delays and an oversized debt burden brought the company to the darkest hours of its 82-year history. In just over one year, however, the Kensington gold mine in Alaska has transitioned rapidly from an uncertain legal limbo into successful and timely inauguration. Production costs at Coeur's Palmarejo mine continue to decline as volumes improve, and are expected to reach just $2.50 per ounce of silver from a first-quarter mark of $5.41. All told, the company expects to produce more than 17 million ounces of silver in 2010 ... not to mention 170,000 ounces of gold. With a turnaround story that coincides beautifully with the sector's long-awaited margin expansion, and a share price that I consider massively undervalued, I consider Coeur d'Alene Mines among the top potential growth stories of the next few years.
Turning our gaze back to gold, I encourage Fools to take a close look at IAMGOLD (NYSE: IAG ) and Northgate Minerals (AMEX: NXG ) . Northgate Minerals presently leads the vote in our Motley Poll comparing five potential all-stars of the junior gold producers, and IAMGOLD recently announced an early start-up of its long-awaited Essakane mine in Burkina Faso. As improving profitability demands greater investor interest in the sector at large, I expect these high-quality producers to find substantial bids into higher share prices.
I have selected all seven of the aforementioned precious-metal producers as outperform picks within my silverminer CAPS portfolio. I invite each of you to pore over my picks and consider adding some to your own CAPS portfolio.