Why Gold Stocks Divert From Gold Prices

Declining reserves and rising costs can make gold-related stocks move contrary to bullion.
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There's something strange going on in the gold patch.

The poor performance of gold-related stocks, relative to the underlying price of the metal over the past few months, has some gold investors chasing their tails. The

streetTracks Gold Shares

(GLD) - Get Report

exchange-traded fund, for instance, which holds bars of the metal, has increased in value about 4% over the last six months, whereas the Amex Gold Bugs Index, which tracks a basket of larger precious metals mining stocks, has dropped around 5% in the same period.

Investing in gold-mining companies has long been a popular way for investors to play the gold market, but the dynamic between bullion prices and gold-related stocks may be changing. Gold bulls can take solace in the fact that there are a number of reasons stock prices for mining companies can go up or down, which have nothing to do with the future price of gold. They include the rising operating costs for miners and the declining reserves of the mines themselves.

Back in the late 1990s and early 2000s, when gold hovered around $300 an ounce, large companies like

Newmont Mining

(NEM) - Get Report

could mine profitably only by digging out and processing the richest ore possible.

"They high-graded it," says Frank Holmes, chief investment officer of San Antonio-based U.S. Global Investors. What he means is the miners shunned low-grade material in favor of processing richer ore with lower costs per ounce of gold produced.

Now with higher gold prices, miners are processing lower-grade, higher-cost ore. For a while, the higher bullion prices, recently $660 an ounce, helped offset the climbing costs. But lately, costs at some companies have been rising faster than metal prices, so profit margins are squeezed.

A general shortage of labor, energy,

equipment and other raw materials also has contributed to the burgeoning cost burden, further eroding earnings.

As if that wasn't enough, there's another hump faced by the biggest miners, such as Newmont and

Barrick Gold

(ABX)

: reserves.

In some sense, the value of a gold company is the value of the metals contained in its mines, otherwise known as its reserves.

The process of extracting each ounce of metal depletes the reserves, unless the company can continually find new resources. They do this either through exploration by their own geologists or by buying up junior mining companies.

At the extreme, a miner that doesn't replace its reserves will eventually have no ore left to mine and will be worth nothing.

For the biggest firms, replacing reserves is easier said than done. Newmont sold almost 6 million ounces in 2006, while Barrick says it dug up 8.6 million ounces in the same time.

To put that in perspective, these two companies, to keep reserves flat, together must find more than a fifth of the 64 million ounces of gold expected to be mined throughout the world in 2007.

Traditionally, bullion and mining stock prices could be expected to move up and down in tandem, with the stocks historically gaining or losing about twice as much as the metal. This theory held up during back-testing of the broad basket of precious metals stocks in the

Market Vectors Gold Miner

(GDX) - Get Report

ETF prior to its launch last year.

The reason for the tight relationship was because as gold prices increased, earnings at miners grew even more, due to operational and financial leverage. In better times, that's made gold stocks a great way to play the precious metals patch.

Unfortunately, the synchronicity has been breaking down lately. But that doesn't necessarily mean equity investors have one up over bullion buyers in spying a gold bear market ahead.

What it does mean is that investors should be selective and look away from the traditional favorites when picking gold plays. One way is to identify firms which, contrary to some others in the group, will see falling costs per unit, says John Doody, editor of

Gold Stock Analyst

newsletter.

Another alternative is to look at firms which have mines or projects in the early stages of development. Such stocks are still less risky than exploration plays, but typically hold more potential upside than the mega miners.