Fresnillo (LON: FRES) shares should, using one set of analytical tools, be the toast of the current stock market. They’re not – so, the question to answer is why not?
The thing to understand is that normally – normally – mining profits, thus share prices, are leveraged on the price of the product. What this means is that if the gold price goes up then gold miners’ shares go up by more than the rise in the gold price – leverage. The reason is that the costs of gold mining don’t change when the global price of gold does. The costs of building the mine have already been spent, they’re a sunk cost. The operating costs don’t change, therefore the extra revenue should flow through directly to the bottom line, into the profits.
Leverage can also come back to bite us of course, when product prices start to fall this process goes into reverse.
So, since Jan 2019 the global gold price has risen 55% and silver 69%. We’d thus expect a mature gold and silver miner like Fresnillo to have done well – expect the Fresnillo share price has fallen 18% over this time. Which really is odd, given the 46% of revenue that comes from gold, the 41% from silver. The other two products, zinc and lead have also done well pricing-wise.
So, we’d rather like to know why this has happened. For if we can work out why then we can try to decide whether normality will return and there will be a boost to that Fresnillo share price.
One part of the answer is simply Covid. This lowered production in the last reporting year. Well, OK, but that is presumably past. The other problem is that costs are rising, strongly.
This is not a breach of our assumption that costs do not increase because product prices do. Fresnillo would still have these rising costs whatever happened to the gold and silver prices. Mexico is simply becoming a more expensive place to go mining. Such production costs were in fact up near 10% last year alone. That’s eating those higher product prices that is.
We can also throw into the mix the fact that new development projects are likely to increase production over the next couple of years.
It’s that rising cost base that causes the trading decision difficulty. In the absence of that then Fresnillo shares become that leveraged exposure to the global gold and silver prices. The current unpleasantness might be thought to increase that, the likely coming rise in interest rates reduces it. The balance of those two would be what affects Fresnillo.
That’s true of other precious metals miners of course but Fresnillo is markedly cheaper, at a price-to-earnings ratio of 17 as opposed to Newmont on 27 and Barrick at 22.
What produces the uncertainty is that worry over what production costs – largely labour rates – are going to be in Mexico. It’s possible to take either view on that of course, as with the global gold and silver prices.
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Tim Worstall is a freelance writer specialising in economics and the financial markets.