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The Hidden Costs of Precious-Metals Miners' Optimism

Stocks in this article: GLDSLV

By Andrey Dashkov, Research Analyst

NEW YORK ( Casey Research) -- The junior resource sector is struggling financially, something most investors seem to agree on -- and rightly be wary of. Here at Casey Research, we've analyzed both producers and explorers to see how profitable (or value-adding) they may be under current market conditions.

The rather obvious conclusion, shared by many company executives, is that now is the time to be frugal.

Producers have started to focus on cutting costs and pulling back from development projects that have diminished prospective returns or otherwise unacceptable risk profiles.

Developers have sinned in their own way, too: as gold prices rose year after year, the price assumptions used in economic studies likewise went higher and higher. Some used assumptions that were too optimistic. And now that trend is coming back to bite them - as well as any investor who buys into those assumptions.

Naturally, when the gold price continued rising, it seemed to justify using a higher gold price when calculating how profitable a mine might be. This worked well to persuade banks to loan money and investors to buy stock, and some mines were built without enough consideration of a protracted price reversal, which has caught less prepared companies and investors off guard.

We believe gold will rebound and head higher, as you know, but that hasn't happened yet, and some mines that went into construction or production based on unrealistic assumptions are facing greater costs and lower revenues, resulting in net incomes far below investors' expectations.

All of this is fairly predictable, but that doesn't prevent many executives from making bad decisions, and it only adds to the overarching skepticism about the future of the industry.

Some of this could have been avoided during the feasibility stage.

For the following chart, we pulled data on 86 Canadian economic studies filed on gold (and multi-metal projects containing gold) from 2011 onward. The studies cover projects in scoping, prefeasibility, feasibility, and expansion stages.

Consider: if the gold price is significantly lower now than, say, a year ago, the internal rate of return (IRRs) of these projects should be lower, too (given similar cost structures and interest rates). But that's not the case. There was a drop in 2012, but so far in 2013, companies are on average projecting almost the same rates of return they were in 2011.

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