Stock Gravity – Free Market Forces! - Stock Market Trading & Investing – Free Market Forces

If you believe the United States will be an inflationary environment over the next five years you have to believe in a major bullish move for precious metals like gold and silver. If you go one step further you will realize just how lucrative micro-cap gold and silver miners are. Rising profit margins can propel earnings for junior mining companies.  In a nutshell, rising precious metals prices turn (uneconomical)  gold and silver reserves into valuable assets. The basic scenario goes something like this:

Feasibility  ($1200.00 – $1300.00 = - $100.00)

In 2010, Company XYZ has 1-million proven ounces of gold with extraction costs of $1300.00 per ounce (when accounting for input costs like infrastructure). Since gold is currently trading at $1200.00 per ounce this company cannot profitably mine any gold in their reserves. All reserves sit idle and are deemed uneconomical for the time being.

Increasing Asset Prices ($2400.00 – $1800.00 = + $600.00)

Three years later (2013) gold doubles in price going to $2400.00 per ounce. Since Company XYZ couldn’t mine any reserves economically they devoted the past three years to building up reserves. Extraction costs like energy and labor have definitely gone up as well, but not at the same rate as gold. Extraction costs per ounce are now $1800.00 per ounce. Company XYZ can now start the long process of bringing gold production online. Permits must be built and infrastructure must be put in place to start extraction. Since this often takes years, we will assume Company XYZ goes “online” two years later (2015).

Proportion: Asset and Extraction Cost ($3250.00 – $2250.00 = + $1000.00)

To their good fortune the long process of bringing a gold reserve asset to production has taken a long time – for this example 2 years. To much amazement gold continued its climb up the “wall of worry” reaching $3250.00 per ounce. Again, production costs like energy and labor went up – not as much as gold though. Production costs increased to $2250.00 per ounce.

Massive Leverage!

Fortunes have certainly improved for Company XYZ, going from an economic production value of -$100.00 per ounce to +$1000.00 in just five years. Company XYZ started off with worthless reserves in 2010, but now has 1.5 million ounces of gold reserves with huge potential. On paper their gold reserve value may look something like this:

($1,500,000 ounces x $1000.00  = $1,500,000,000 )

Increasing prices for gold and silver have huge implications for small mining companies. Upward moves in precious metals prices can literally take a company from worthless to extremely valuable. The process described above may be happening for several small publicly trading mining companies and pan out nicely in the next 5 to 10 years.

The Right Ingredients

In looking for speculative precious metals mining stocks it is important to look for companies that fit the description of Company XYZ in the example above. Find gold stocks with large reserves deemed uneconomical with current gold prices. When gold prices move higher these companies should have dramatic profit potential. For those of you that understand options trading, this strategy could be reasonably compared to buying an “out of the money” call option. The best part about these speculative stocks is the lack of time expiration. Downside is somewhat limited while upside is potentially huge.

For the above scenario to take place, we would first of all need a dramatic rise in gold price. Secondly, a smaller proportioned rise in input costs like energy and labor would need to occur. Mining companies that hedge against rising input costs like energy and infrastructure could add to profitability. Companies with huge reserves of gold also benefit from “economies of scale” where the average cost per unit ounces decreases, since fixed costs are spread over a larger number of goods. Lastly, a given gold company must be able to bring a mine “online” or be able to find a buyer for its assets. Since so many variables are involved in the given scenario, this type of investment strategy is extremely speculative. Finding the right gold stocks will be the most difficult part of this strategy.

One Possible Example

One name that comes to mind is a gold miner called Novagold (AMEX: NG, Free Report). Back in late 2007, Teck Caminco (NYSE: TCK, Free Analysis) and NovaGold terminated plans to bring their 50% joint-venture Galore Creek property online – sending shares from $22.00 to less than $1.00. The two companies indicated the property wasn’t economical with surging construction costs and gold price levels of $825.00 per ounce. You really have to wonder if Galore Creek is still deemed uneconomical in 2010 with gold near $1250.00 per ounce and energy prices slightly down from where they were in 2007. Paulson and Soros funds seem to be catching on to this concept – buying institutional positions of 9.13% and 8.46% respectively.

Criteria

• Based in Foreign Countries (Currency Benefit)
• Large Un-hedged Reserves (Economies of Scale)
• Stable Governments (Safety)

Risks*

• Gold Decreases in Value (obviously)
• Mining Permits not Granted
• Gold Value Doesn’t Increase Faster than Production Costs

Want to become a better trader? Click here to sign-up for a FREE trading e-course taught by a former floor trader!

[wordbay]gold bar[/wordbay]