Since gold bullion has essentially doubled in the past five years, you would think that most major gold mining companies would have seen an appreciable rally in their shares, right?


The economics of gold mines can vary dramatically depending on mining costs as well as the quality of the deposit. A third factor is currency; South African miners pay costs in an appreciating currency, but sell gold in a depreciating currency.

Some background on South Africa
Everyone knows about apartheid and the economic embargo that held back the South African economy. Progress has been made since apartheid officially ended in 1994, but many issues remain.

South Africa is the most developed economy on the African continent, with annual GDP of $495 billion (on a purchasing power parity basis). Yet South Africa's unemployment rate has remained stubbornly high at 24%. Despite the nation's role as a global commodity player, South Africa's economy is surprisingly diversified, with agriculture only 3.5% of the economy, industry 32.1%, and services standing at 64.4%.

Impetus for underperformance
At first, South Africa's currency, the rand, was a big help to the country's mining equities, depreciating dramatically in 2001. Along with the broader commodity rally, the currency began to reverse course as economic conditions in South Africa improved. This meant that as the gold price was climbing for mining companies that pay their costs in U.S. dollars, the rand price of gold was actually declining for South African mining companies that pay their costs in rand but sell their gold in U.S. dollars.

When the rand finally stabilized, other mining costs climbed precipitously as we reached almost $150 a barrel for oil. Combine that with aging infrastructure and an electricity shortage in 2008 and you begin to understand there was little South African mining companies could do against major headwinds.

The other critical reason for the underperformance is extremely high operating costs. And I'm not just referring to electricity rate increases. South Africa has the world's deepest and most dangerous mines, where you have to go miles underground. This is why producers are seeing rising costs as they dig deeper, while output is falling. Gold production in South Africa was at more than 1 million kilograms in 1970, while in 2009 the country produced only a fifth of that, the lowest in more than a century of data.

However, theses high costs could create a "beach ball under water" effect for South African gold miners if gold prices rally sharply from here, as the group could see the biggest improvement in operational performance.

Enter John Paulson
I have written about hedge fund manager John Paulson's big bet on gold before. I am happy to report that the big holdings in South African gold mining giants AngloGold Ashanti (NYSE: AU) and Gold Fields (NYSE: GFI) have not changed, according to his latest SEC filings. Both have appreciated less than 50% since 2005 when gold was near $400! This is why Paulson is interested.

A South African option on gold
The most extreme case in high operating costs is Witswatersrand Consolidated Gold Resources Limited, also known as Wits Gold, a self-proclaimed "long-term option on gold." The company mines no gold. It has instead acquired mining rights from other South African majors including Harmony (NYSE: HMY), which become valuable if the gold price rises substantially.

The properties have uneconomic projected mining costs at present, as many of them are deep underground. There is also uranium on some of the properties. A small part of the rights cover gold that is economically feasible to mine now, although there are no plans at present for that.

If you are looking to play an explosive move in gold bullion in the next five years, South African gold mining stocks appear deserving of your attention.

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Fool contributor Ivan Martchev owns no shares in any of the companies in this story. Try any of our Foolish newsletter services free for 30 days. The Fool has a disclosure policy.