The bull case for gold miners

The subject of investing in gold and gold miners evokes similar sentiments as suggesting an investment in Australian property. People tend to fall into one of the two camps who either love it or hate it, and very few people will sit on the fence.

Earlier this year, my Motley Fool colleague Scott Phillips outlined the potential risks when investing in gold or gold miners, but we may have reached a point where there is significant upside potential from here.

Further to fall?

The gold price tumbled 3% overnight to US$1,289 an ounce, hitting a two month low as traders reacted to the US government shutdown, and has now fallen 23% so far this year. But according to the London Bullion Markets Association annual survey of around 25 of the largest bullion dealing banks and trading houses, this year’s decline is being viewed as a correction rather than the start of a continuing slide in the gold price.

It’s entirely possible though that the gold price could fall further from here, if the US Federal Reserve begins tapering its stimulus program, and could stay down for much longer than expected. But for risk-tolerant investors, some well-chosen gold miners might be worthy of consideration.

Having hit a low of US$1,180 an ounce in June, the gold price has been held up by physical demand from consumers, particularly in China and India, as well as the US Federal Reserve’s ongoing stimulus program. According to the World Gold Council, consumer demand jumped 53% in the second quarter, with jewellery demand up 37% over the same quarter last year. Bar and coin investment rocketed up 78%, with Chinese demand up 157% and Indian demand up 116%.

Supply has been reduced

At the same time supply of gold is 6% lower than a year ago as miners shut down high cost gold mines, and optimised other operations to reduce costs – even if it means lower production. At the current price many gold mines are unprofitable or breaking even and supply is like to fall further, putting more upward pressure on the gold price.

As Scott put it in his article, you want to buy gold miners when the price has fallen to the point at which it is almost unprofitable to mine for more gold. At that price, new mine expansion is unlikely, keeping supply in check.

Only the very low cost gold projects, such as Beadell Resources’ (ASX: BDR) Tucano mine in Brazil, with a cash cost of A$640 in the first half of this year, will ramp up production or expand. But there are not many similar low cost gold mines around the world, and the trend is for rising gold production costs, as it becomes more difficult to find and then higher cost to mine, which suggests a positive long-term outlook for gold.

Biggest isn’t always best

While many analysts would recommend Newcrest Mining (ASX: NCM), Australia’s largest listed gold miner, the company is likely to be forced to close some of its higher cost mines, and given Newcrest’s issues with overly optimistic product forecasts, disclosure, mistimed asset purchases and writedowns, shareholders can’t be certain that the company will act in their interests at all times.

On the other hand Silver Lake Resources (ASX: SLR) has just announced record quarterly gold sales for the quarter ending June 2014, is focused on lowering its costs, has two mine sites with multiple mines, reserves of around 1.7 million ounces of gold and is looking at establishing a third gold mining centre. Additionally, the current share price is less than the net current tangible assets per share, meaning the market is assigning zero value to future gold production.

Similarly, Kingsgate Consolidated (ASX: KCN) which owns the world-class, low-cost Chatree gold mine in Thailand, is trading at around half of its book value – and that’s after taking asset impairments of more than $300 million last financial year.

Foolish takeaway

Jewellery and consumer demand for gold bullion already represents more than half of the supply of gold annually and could increase its share as the rising middle class of India and China clamour for more gold. Rising demand and falling supply usually mean one direction for prices – and that’s upwards. Now may be the perfect time to consider an investment in well-run, shareholder friendly gold miners.

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Motley Fool contributor Mike King owns shares of Silver Lake and Kingsgate Consolidated.

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