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The Best Way to Play a Rebound in Gold Prices

A good investment keeps a handle on risk while providing acceptable returns. Royal Gold  (NASDAQ: RGLD  )  uses an innovative structure to provide gold exposure while limiting downside risk. As inflation continues to push prices upward, Royal Gold is in a great position to grow its revenue and profits. 

Royal Gold 101
Royal Gold gives financing to miners in exchange for royalties. The miners benefit because they do not issue dilutive equity or increase their debt load. The benefits are not one-sided. As rising energy and labor costs push gold prices upward, Royal Gold sees its income grow relative to its initial fixed investment. 

Proactive risk management
Smart investing is all about managing risk. Royal Gold's downside risk is limited to the initial amount it invested. Canada, Australia, and the U.S. account for 84.07% of its properties. By basing its assets in stable jurisdictions, rising taxes pose a bigger threat than nationalizations. 

Counterparty risk 
Since Royal Gold's royalties provide long-term payouts, it is very important that the company partners with quality miners that will be able to carry a project to completion. Thankfully Royal Gold tries to limit its exposure to smaller miners. 

A quick look at its principal producing properties shows that Royal Gold is quite diversified. It has rights to 75% of the gold produced in Teck's  (NYSE: TCK  )  Andacollo mine in Chile, though the royalty will eventually fall to 50% once a certain amount of gold has been produced. It has a sliding scale 1.5% to 1% Net Smelter Return (NSR) on Yamana's and Agnico Eagle Mine Limited's recently acquired Canadian Malartic mine. It also has rights to Vale's  (NYSE: VALE  )  Voisey's Bay mine in Newfoundland and Goldcorp's  (NYSE: GG  )  Peñasquito mine in Mexico. Overall Royal Gold has a good mix of well-known miners and smaller miners. 

Combing returns and risk adversity
Sadly, many miners have little choice but to watch their margins shrink as they try to deal with inflation. From Q1 2013 to Q1 2014 Teck's revenues fell 10.6% while its total operating costs rose 8.7%. Teck's solution is to diversify into a completely different sector -- energy. The big miner Vale tells a similar story. In the last four quarters its revenue fell 13.9% but its EBITDA took a bigger fall of 16.6%. Vale's strategy is to slash capex and focus as much as possible on maintaining capex.

Goldcorp is the exception to the rule. From Q1 2013 to Q1 2014 it managed to boost production by 10.6% and push its all-in sustaining cost (AISC) per ounce down 25.9%. By shifting Peñasquito to a higher-grade area, Goldcorp was able to increase its margin, but eventually it will have to return to lower-grade material. Now that its AISC is at $840 it is likely that Goldcorp's costs will start to rise in line with inflation.

Back to the basics
We cannot control the future, but to a degree we can manage our exposure to the future. Royal Gold takes long-term positions in a diversified group of mines to gain upside exposure without the headaches of running a mine. By partnering with top miners like Teck, Vale, and Goldcorp, Royal Gold provides value for investors and miners alike.

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Joshua Bondy

Joshua Bondy works in the energy and materials sector. He works hard to bring to light the underlying forces that drive prices and move the market.

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