Check Your Gold Miners for Copper Exposure

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Investors tend to invest in gold at least in part to protect themselves against economic weakness. Should we see economic weakness the price of gold should perform very well, as investors will shift their capital out of economically sensitive assets such as stocks and in to safe havens. One asset class that will likely perform poorly should we see economic weakness is the base metals market, and copper in particular. This is the case because if the economy is weak, then there will be less demand for consumer and industrial goods, and therefore there will be less demand for the copper that goes into these goods.

Over the past several days we have seen a rapid decline in the price of copper, which now trades comfortably below $3 per pound. Gold, on the other hand, has breached its $1,350 resistance level and appears to be moving higher. This is precisely what we would expect in a weak economic environment.

With gold rising we should expect gold mining companies to see an increase in their profits and in their share prices, and many investors choose to buy mining companies as a way to bet on higher gold prices. While I think this is a great idea investors need to be very careful in choosing their gold miner holdings. There are many criteria that investors should use to screen for what will be the top performers, but one screen I think investors need to focus on in this particular market environment is copper exposure.

There is no such thing as a pure gold mine. Mines contain all sorts of metals, and those that occur the most are extracted from the ore that is produced and then sold into the market. Many gold mines contain copper, and so the company that operates the mine will naturally want to sell both the copper and the gold despite the fact that it may be a self-defined “gold miner.”

Companies that define themselves as “gold miners” but which mine and sell other metals will often use the copper they mine to offset the cost of mining for gold. Consider the following example. Suppose a company mines 1 ounce of gold and 10 ounces of copper, and that it costs the company $1,000 to do so. If the company is a gold company it might just say that it mined one ounce of gold at $970 per ounce assuming the copper price is $3 per pound. In other words, the $30 that the company made selling the copper is used to lower the reported cost of mining for gold.

This is just an accounting trick and it doesn’t make the copper any less important to the company’s bottom line. However as an investor you need to know how much of your gold mining investment is exposed to the copper price, and some are far more exposed than others.

Take, for instance, New Gold (NYSEMKT:NGD). New Gold’s most valuable producing mine is its New Afton mine, which produces both copper and gold. In fact the copper revenues are nearly twice as great as the gold revenues. But New Gold is a gold miner, and so it uses the copper to offset the cost of gold mining for accounting purposes. As a result the company reports New Afton’s production costs at negative $600 per gold ounce! But this assumption is made using a copper price of $3.25 per pound.

If the copper price falls, the mine’s revenue falls as well, but as New Gold reports it the cost of mining gold increases. Given how much copper the New Afton mine produces it doesn’t take a huge move in the copper price to change this number meaningfully. With 80 million pounds of annual copper production and about 100,000 ounces of gold production, if the copper price falls by just 10 cents the company’s revenue falls by $8 million. But the way that the company reports its costs what actually happens is that New Afton’s production costs increase by $80 per ounce.

Since New Afton comprises about a quarter of New Gold’s total gold production, a fall in the copper price of just 10 cents means that the company’s reported cost rises by $20 per ounce excluding any changes to the company’s other three producing mines. Investors in New Gold who don’t realize this are unaware that the value of their investment has been going down as the copper price has been plummeting.

Other gold mining companies have a lot of copper production as well, including two of the biggest names out there: Newmont Mining (NYSE:NEM) and Barrick Gold (NYSE:ABX). Again, these companies won’t report a reduction in revenues, but rather they will report an increase in production costs due to their accounting practices.

With this in mind gold miner investors who don’t want copper exposure need to find investments that have minimal copper exposure. One way to do this is to take a look at the Global X Pure Gold Miners ETF (NYSEARCA:GGGG). I don’t recommend buying this ETF because it is so illiquid and because it holds a lot of companies that produce in high-risk parts of the world. However, its stated purpose is to only invest in gold miners that get at least 95 percent of its revenues from gold.

Therefore this fund’s holdings can be used as a starting point for investors looking to maximize their gold exposure and minimize their copper exposure. So far the strategy has paid off in 2014, with the shares rising 30 percent versus shares of the Market Vectors Gold Miner ETF (NYSEARCA:GDX) rising 22 percent. If you are concerned that the economy will weaken, then it follows that this outperformance will continue, and that you should consider owning stocks held in this fund.

Disclosure: Ben has no positions in any of the stocks mentioned in this article.