Many people presume that gold mining companies are good hedges against inflation. It’s not actually true, historically. The major problem is that when the gold price is higher, miners all increase production. Therefore, they also need to acquire new properties to replace depleting reserves, but at a cost that is rising with both inflation and competition for resources. The same applies to their need for increasingly scarce mining equipment and labor. Rising costs limited the potential for margin expansion.
A more elegant approach to earn money from gold is via a royalty company. The gold price doesn’t even need to go up. It can even go down. Royalty companies solve a problem that miners run into, which is that when gold prices are low and there might be development opportunities, the miner often can’t get funding. For one thing, the stock price is usually depressed, such that share issuance would be too dilutive. As to debt funding, the mining business is too cyclical and risky to take on much leverage, particularly since a new mine might take several years to become operational. A royalty buyer, in contrast, makes an upfront cash payment to a miner to develop a particular resource; it doesn’t require a share of the miner’s equity, nor require interest or principal payments. It does entitle the royalty company to buy a certain proportion of future production at today’s price, but deeply discounted for the time value of money. That has very interesting properties. The royalty company is really akin to an investment bank, even though it is lumped, for classification purposes, with mining companies.Read More >