Why are gold shares so volatile?

Geoff Blount, MD of BayHill Capital, explains the upside and downside for gold shares as a result of a change in the gold price.

We were recently asked by a client to build a five-stock bespoke gold share portfolio – this particular client likes the volatility of gold shares and the leverage that these shares have to the gold price. We thought it might be useful to explain exactly why gold shares are so volatile, and hence come with risk on the up and the downside.

Over the first three months of the year, gold shares have performed very well, even though the rand gold price only rose by 7%.

Table 1: Select Q1 2016 gold share returns

This immense change in the share prices relative to a modest change in the gold price is known as the leverage of gold shares to the gold price.

How does leverage work?

Essentially, if your cost of production is largely fixed in the nearer term, and the price you sell your product for changes, every rand your selling price changes by directly results in a rand change to your profits (or losses). Hence if the price of gold rises, your earnings will rise dramatically from a percentage point of view (especially if you are a marginal miner and are just breaking even). This can be shown in the gold industry by seeing how the profits (margins) of the gold firms change relative to any change in the gold price. The table below uses the stockbroking firm UBS’s all-in sustaining cost tracker (AISC) as the estimate of each gold firm’s cost to produce an ounce of gold, to demonstrate the principle.

AngloGold is the lowest cost producer at $860 an ounce, giving it a 22% margin per ounce of gold sold at the start of the year. This margin expanded to 31% by mid-April as the rand gold price rose 7.71%. Essentially the margin increased by 42.7% for only a 7.7% change in the gold price, a leverage factor of 5.5 times.

On the other hand Harmony, with a higher cost of production of $950 per ounce, has much higher leverage. Its margin increased by 73.7% for only a 7.7% change in the gold price, a leverage factor of 9.7 times. Consequently it has performed much better than AngloGold, but would have done much worse if the gold price had fallen.

For DRD Gold, with its far high production costs of $1104 per ounce, the leverage is even more pronounced. Almost at breakeven, any additional income will have a very pronounced impact on the bottom line. Indeed, DRD Gold had a leverage factor of 1742.8 in the first quarter of 2016.

Table 2: Recent changes in gold share margins vs. the change in the gold price

As with much research, there are many caveats:

• The level of leverage is related to how close the production cost is to the gold price and is much higher for marginal firms (such as DRD Gold).
• The level of leverage changes quite dramatically in the near term, as does the cost of production.
• This is not a formulaic relationship but rather helps demonstrate what drives the volatility of gold shares.
• Gold share returns are also driven by many other factors including speculation, the extent to which the firms hedge their production, forecasting the currency or the gold price, and stock specific issues to name just a few.

Gold shares have been a popular form of investment for those bullish on the gold price, given their sometimes significant level of gearing. But investors should also be aware that the gearing works in reverse when the gold price falls and share prices will decline at a higher rate.