By Doug Casey
You'd have to be a monk living in isolated penury to miss the fact that the Gold Market is on a tear, writes David Galland, managing director of Casey Research.

The spot Gold Price has risen from $277.75 on 4th January 2002 to $950 at the end of Feb. 2008, a gain of 242% in just over six years.

Over the same period, the trembling S&P 500 index of US stocks is up an anemic 22%.

In a gold bull market, an investor would expect the profits on Gold Mining Stocks to be a multiple of those to be had from Gold Bullion. That seemingly intuitive leverage comes from simple arithmetic.

Once a gold producer covers its production costs, then each 1% rise in the price of gold can translate into a 5%, 10% or even richer improvement in the bottom line. For a company such as Barrick Mining – the world's No.1 producer with 125 million ounces in proven and probable reserves – even a $1 per ounce increase in the Gold Price can mean big money.

And so we see that between January 2002 and last week, the gold stocks were in fact up 612%. So far, so good.

Yet the gold stocks have stalled in recent months; between August 2007 and Feb. 2008 gold bullion rose 42%, but Gold Mining Stocks were up just 37%.

What's going on? Is it that, in their concern over the broader equity markets, people have forgotten that gold stocks are associated with gold? Or is something else at work here?

The answer, we believe here at Casey Research, is "something else".

The Mothball Years

While there are a number of plausible reasons for Gold Mining Stocks lagging of late, we have come to the conclusion that the true explanation reaches much farther into the past. It's that the managements of the gold producers have only recently escaped the state of fear they operated under during gold's 20-year bear market.

Consider the fact that as recently as 2002, the price of Gold was still trading near $280. Against that number was a cash cost of around $250 per ounce for a typical company. That cost figure is about as low as the number could go, and it was the response of an industry beaten down and huddling in a trench.

Caution lingers after the reason for it has gone. As gold began its upward move in 2002, it did so against the backdrop of an industry still in mothballs and still run by managers whose primary skills were cost cutting and frugality. This is important on a number of fronts.

Having been trained in the acid bath of razor-thin margins, management was intensely skeptical about gold's rally. They suspected it might be just another bear market trap, ready to punish unwary optimists who parted with cash to ramp up production.

In the hunkered-down years, miners focused on the higher-grade, easy-to-mine material that gave them the best shot at turning a profit, however small that might be. And being in survival mode, they were extremely cautious about buying new equipment or maintaining a large workforce. Employee rosters were reduced to the bare minimum.

Because staying in business was such an urgent goal, they were willing, even eager, to sell future production at a set price. That was a perfectly rational strategy in a bear market, because it at least assured they would receive a price that covered the known costs.

With all these factors taken together, it's easy to understand why the industry was slow to respond when gold started rising. In fact, it was only in February 2003, with the Gold Market trending over $350, that Barrick Gold Corp. – the world's largest Gold Mining Stock – began the expensive process of unwinding its hedges. And it wasn't until November of that year that the company announced it would stop forward selling altogether and would eliminate its entire hedge book.

Once the turning point came – when management finally realized the bull market was for real -- the industry began to scramble to catch up. Which, in a choo-choo industry like mining, means hiring and training lots of people, buying or refurbishing the equipment needed to reestablish production on second-tier deposits, upgrading facilities, building expensive new mills, etc., etc. And, of course, dealing with the challenge and expense of unwinding hundreds of millions of dollars worth of forward hedge contracts.

The rebuilding of the gold mining industry, in short, really only began in earnest over the past few years.

The Ugly Duckling Years

As would be expected, the costs associated with rebuilding the industry sent big hits to the bottom line, resulting in the kind of ugly financial metrics that repel institutional investors.

The metrics were not at all helped by the shift away from high-grade ore, because the lower the grade, the more the material you have to dig, hoist, haul and process, meaning increased production costs. In addition, the industry rebuild occurred against a backdrop of generally rising inflation and a falling dollar, which helped push the cash cost of production up by more than double from the mothball years, keeping the miners unattractive as investments.

By contrast, the base metals companies, which had hit bottom earlier, near the end of 1998, had already emerged from the mothball stage, thanks to increasing demand from China and elsewhere. They were, as a result, well on the road to recovery when the big price increases for base metals kicked off in 2004. So, while the gold miners have been widely shunned as ugly ducklings in recent times, the base metals sector has been enjoying salad days, reflected in multi-billion mergers and acquisitions and, of course, sharply higher share prices.

The Golden Years

Here at Casey Research, we are of the firm opinion that, now that the biggest costs related to restarting their industry are behind them, the big gold companies are poised to take off. The proof should come in rapidly improving margins which, lo and behold, we have begun to see in the quarterly reports now being released.

Just last week, Goldcorp announced that fourth-quarter profit had nearly quadrupled over the same quarter the year before. And then Kinross announced that it, too, had posted a record quarter, with profits up almost three-fold over Q406. Meanwhile, Barrick reported that net profit for 2007 was 28% ahead of 2006. In addition, Barrick is feeling sufficiently flush (and optimistic) that it's buying out Rio Tinto's 40% interest in the Cortez Hills joint venture for $1.695 billion...cash.

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