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Mining 101: How Mining Companies Provide NATURAL Leverage

Jeff Nielson Jeff Nielson, Stockhouse
0 Comments| March 13, 2019

While experienced investors presumably know all about the concept of “leverage” as it applies to investing, newer investors may have a less precise understanding. In particular, these newer investors may not understand how mining companies provide natural leverage with respect to the metals or minerals they produce.

With Battery Metals opening up new sources of metals and minerals demand and a number of metals markets long overdue for a full-scale rally, increasing numbers of younger investors from the Millennials demographic are looking at mining companies for the first time. These investors may know what leverage is, but not necessarily how it works.

“Leverage” is the use of artificial factors (such as buying on margin) or natural factors (such as investing in commodities producers) in order to attempt to amplify investor returns.

Leverage cuts both ways.

This popular market maxim illustrates a basic principle of leverage. The same factors that serve to amplify investor gains in a rising market also serve to amplify declines in a falling market. With mining company valuations in most metals markets experiencing long-term troughs, newer investors have only seen leverage “cut” to the down side.

What does leverage look like for mining companies in a rising market? Coming out of the Crash of ’08, the precious metals sector experienced the two most explosive years of price gains in what was a 10+ year bull-market run. Peak to trough, the price of gold nearly tripled in price. The price of silver increased by a factor of six.

That’s impressive. But the junior gold and silver mining companies who provide maximum leverage in a rising market were ten-baggers – across the board. The top-performing companies achieved even better returns. And with only a (relatively) tiny number of silver mining companies, the vast majority of those returns were generated from the rising price of gold. That’s leverage.

How did these mining companies generate this strong leverage to the rising price for gold and silver bullion? A simple hypothetical example illustrates the math behind this natural leverage.

Suppose gold is priced at $1,000 per ounce. Company A is a high-cost producer. It costs Company A $900 per ounce to mine gold, leaving a $100 per ounce profit margin.

Company B is a low-cost producer. It costs Company B only $500 per ounce to mine gold, leaving a $500 per ounce profit.

Let’s assume that we have one hypothetical investor investing in each of these three options: Company A, Company B, or gold bullion itself. Investor 1 invests in gold bullion. Investor 2 invests in Company B. Investor 3 invests in Company A.

Now the price of gold rises from $1,000 per ounce to $1,100 per ounce, a 10% gain. But this same $100 per ounce increase has a different impact on each of these three investors – because of leverage.

For Investor 1 who is investing in gold bullion (that provides no natural leverage), the 10% gain represents his or her entire profit margin. What about Investor 2 and Investor 3?

Investor 2 bought into the low-cost producer. When the price of gold rose by $100 (a 10% rise), the profit margin for Company B increased from $500 to $600 per ounce – a 20% increase in profits. While markets often don’t perfectly translate increased profitability into an equal appreciation in share price, Investor 2 has a reasonable expectation of a greater-than-10% return from Company B. Some leverage.

Now observe Investor 3, who bought into the high cost producer. The $100 per ounce increase in the price of gold increased the profit margin for Company A from $100 per ounce to $200 ounce – doubling profitability. Obviously, Investor 3 will reap dramatically better returns from a 10% gain in the price of gold, because of leverage.

Click to enlarge

This not only provides a general explanation of how leverage operates with respect to commodity producers, it shows how higher-risk companies (with lower profit margins) provide much stronger leverage versus lower cost/lower risk producers. The higher risk, the higher the leverage.

How does the natural leverage of commodity production apply to mining exploration companies – who aren’t producing any metal or mineral?

The off-the-cuff response of many newer investors is that since exploration companies produce nothing that they should provide little leverage to the price of a commodity, or perhaps none at all. In fact, exploration companies typically provide even more leverage versus the actual commodity producers.

Upon closer examination, this concept perhaps isn’t as counter-intuitive as it sounds. The basic reality that mining exploration companies face in comparison to actual producing miners is that the valuations of exploration companies are discounted – often heavily.

An early-stage exploration company may never make a discovery. A mining development company may never establish a large enough metal/mineral deposit or demonstrate economically viable grades to support commercial mining operations.

This higher level of uncertainty translates into a discounting of these companies’ assets by the market. When valuations are low and sentiment is poor, this level of discounting is much higher. When valuations are high and sentiment is strong (due to a rising commodity price), the discounting is much lower. Indirect natural leverage.

Generally, the degree of leverage is proportionate to risk. But with mining being a notoriously cyclical industry and many metals markets overdue for a rally, investors may see the natural leverage provided by mining companies as a lower risk proposition (at present) versus using other artificial forms of leverage.

There is yet another means to generate even greater leverage through investing in mining companies: mining company warrants. This is a somewhat technical subject and so it will be covered separately in the next installment of our “Mining 101” series.


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