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January 21, 2006

Gold and Silver at Risk?
by T. Stein / S. McIntyre

In our May 2005 issue, we touched on the risk/reward profile of investing in mining equities.

Gold and silver mining stocks carry with them far greater risk than does the bullion. Mining is an utterly wretched business - don't let anyone tell you otherwise. It's an extremely capital intensive and cyclical business whose hallmarks have been a sickeningly low return on assets for nearly two decades now. In buying a mining stock, one is not getting a Coca Cola or a Walgreen's where steady earnings and free cash flow growth are the norm. Rather, especially after the brutal years in the 90's many of these companies' profits are anemic and are only now beginning to rebound.

In addition to metal price risk, one also has to face operational risk in a mining stock. Say, for instance, gold goes to $500, but a mining company gets squeezed by high energy costs, rising local currencies, or poor mining results, an investor in a gold mining company runs the risk of missing out on the metal's appreciation if he is in the wrong stock. How frustrating that would be." - Texas Hedge, May 2005

Eight months later, the price of gold has jumped $100/oz (25%) and the price of silver has jumped $2/oz (27%). The XAU, a weighted index composed of the common stocks of 9 companies involved in the gold and silver mining industry, has increased 75% from its May bottom, yet quite a few mining equities are hovering near their 52-week lows.

High energy costs have certainly done their part to squeeze profit margins of several mining companies around the world. Additionally, quite a few high profile miners have had run-ins with environmental regulatory agencies of various countries. And finally, it is a fact of life that mining results at some mines will always turn out worse than expected. But the one new development in the raw materials sector is the dramatic rise of government interference and increased nationalization risk.

One day last September, shares of Canadian gold miner Crystallex were cut in half after Venezuelan President Hugo Chavez said the company's Las Cristinas mine belongs to the Venezuelan state and should be exploited through a new state mining company. Chavez continues his antics as he just completed the process of nationalizing 32 major Venezuelan oil fields earlier this month. In our May 2005 issue, we advised readers to keep their eyes on political developments in Venezuela. Today we are advising readers to keep their eyes on the entire region.

In Bolivia, a man named Evo Morales was recently elected president. Morales, who during his campaign promised to be Washington's "nightmare" as well as legalize coca leaf production, is an ideological soul mate of Fidel Castro. It is too early to tell which direction Morales will take Bolivia - will it be the "Brazil" route of respecting private property rights and creating a climate favorable to foreign investment or the "Venezuela" route where we see a Crystallex-type headline every week or two? One interesting thing to note is that Morales has gone out of his way to invite the Chinese to develop Bolivia's vast gas reserves.

Perhaps the most important country investors in mining equities should follow is Peru. On April 9^th, Peruvians will go to the polls to elect a new president. Lourdes Flores, the frontrunner candidate who is pro-business, is locked in a close race with former military rebel Ollanta Humala and several other candidates. Humala is the one guy readers should pay attention to as he has already found staunch supporters in Hugo Chavez and Evo Morales. According to Resource Investor, Humala has "threatened to review contracts of companies, arguing that they don't meet tax and royalty obligations and extract minerals and hydrocarbons without benefiting local communities." Nearly every major mining company is producing, exploring or developing in Peru these days, so what happens in April could have a huge impact on mining equities.

Other Latin American countries with elections coming up include the following:

Brazil Oct 06: Pro-business but left-leaning incumbent Lula da Silva favored over centrist Jose Serra.

Colombia May 06 : Conservative incumbent Alvaro Uribe looks unbeatable.

Ecuador Oct 06: Two pro-business candidates: Leon Roldos Aguilera favored over Jaime Nebot.

Mexico Jul 06: Left-leaning (possible Chavez Ally) Andres Lopez Obrador leads in the polls.

Nicaragua Nov 06: Pro-business incumbent Enrique Bolanos threatened by Sandinista Daniel Ortega.

For those of you who prefer to invest in gold & silver bullion directly, the elections in Latin America shouldn't have too much of an impact on the commodity prices themselves. If anything, production aggravations would decrease the supply of physical gold and silver which could mean higher prices in the short run. If you happen to be an investor in a mining company, you'd be doing yourself a favor by calling the company's investor relations department and asking them how they are preparing for any potential turmoil in Latin America. Even though Latin American electoral politics are hard to predict, a well-run mining company should always have contingency plans in place in addition to geographical diversity.

Todd Stein & Steven McIntyre
Texas Hedge Report

Todd Stein & Steven McIntyre are internationally known analysts and editors of The Texas Hedge Report, a market newsletter that highlights under and overvalued securities in the equity, bond, currency, and commodity markets. For more information, go to http://www.texashedge.com