Posted February 24, 2008, Updated March 6, 2008

A Good Reason for the Underperformance of Gold Mining Shares Relative to Gold: It's Spelled O - I - L

The persistent and disappointing under performance of Gold mining shares relative to Gold has received increasing attention lately. Multiple opinions have been expressed by commentators as to its underlying cause. Here, a straight, simple reason is offered, spelled O-I-L, which is contrasted with other opinions, for instance those proposed by three commentators.

1. Steve Seville's thesis, outlined in an editorial entitled "Gold Stocks vs. Gold Bullion: The Pressure Builds", is that the under performance of gold stocks relative to gold bullion can be explained by interest rates and specifically the US Treasuries yield-spread               (see http://www.gold-eagle.com/editorials_08/milhouse022008.html . This thesis is not well supported by the provided evidence and is considered unconvincing at best.
2. Boris Sobolev's thesis, outlined in an editorial entitled "Why Juniors Are Underperforming", attributes the under performance of gold mining shares, especially small cap juniors, to the mounting risk aversion manifested by investors in connection with the recent credit crisis (see:http://www.gold-eagle.com/editorials_08/sobolev022008.html ). As evidence of such risk aversion, Sobolev cites the dramatic widening of interest rates spread seen recently between Treasuries and Corporate bonds. The problem with this explanation is that it is largely arbitrary and speculative. More importantly, it doesn't explain the under performance of Gold stocks that, while more pronounced recently, actually dates back to 2003.
3. Eric Hommelberg's thesis, outlined in a editorial entitled "Juniors - Buy Of A Lifetime!", simply rests on the observation that Junior Gold stocks some times come alive only in the late phase of a frantic rise of Gold prices and that Gold has yet to reach such a phase (see: http://www.gold-eagle.com/editorials_08/hommelberg022008.html). As example, Hommelberg cites the late seventies when "gold shares really took off in the very latest stages of the bull market." Then he adds "It wasn't until early 1979 before most gold shares went ballistic. What does it tell you?. Here, Hommelberg could have come close to the real reason for the take off of mining shares, if only had made one additional observation to answer his own question: in mid 1979 oil prices were about to peak and enter into a multiyear bear market. Initially, This circumstance proved very bullish for the energy-intensive Gold mining operations since it promised to finally relieve the severe pressure of sharply rising energy costs that prevailed till then That's when gold stocks took off. One has only to take a look at the chart of ASA in late 1979 and early 1980 to be convinced of this fact.  
    

The thesis offered here is that rising Oil prices are, and have been, the primary reason for the under performance of Gold mining shares in general, and of junior stocks in particular, by sharply raising costs of Gold production. This thesis is strongly supported by the combination of charts presented below. In the HUI chart, it can be readily observed that the only two-year period 2001-2002 when Gold stocks outperformed Gold coincided with a final decline of oil prices and their initial weak rebound As soon as the rise of Oil prices became sustained in 2003, the under performance of Gold shares began and kept worsening to the present day. It is striking to see how closely the HUI/Gold ratio tracks the HUI/Oil ratio. Same for the XAU/Gold and XAU/Oil ratios. It should come as no surprise that the under performance of Gold mining shares is now at its worst since 2003 as Oil prices have climbed to an all time high of $100/barrel and above.