IMO, we on the verge of an incredible rally in gold stocks, and in particular, junior gold stocks that have, on an overall basis, very poor performance relative to gold since 2004. The article below should convince the most skectible that a bull run is ahead of us:

Gold Underperformance, Part II – The HUI and Inflation –

By Andy Hoffman

Following my earlier commentary regarding the 2007 underperformance of junior gold and silver stocks, I thought I’d expand the analysis to show how the larger Precious Metals stocks (as represented by the HUI) have done over the past four years. There are many ways to interpret the data, but in nearly all cases it becomes clear that the PM mining sector has dramatically underperformed gold and silver prices since early 2004.

My contention has been that $800 gold and $15 silver are not viable for most mining companies (they need to be MUCH higher), as industry returns, PM stock prices, and consequently investor sentiment have been declining since early 2004 despite the inexorable rises in gold and silver. And remember, the HUI represents the largest stocks in the sector, which on average have dramatically outperformed the smaller companies, or those most in need of investment capital to grow the industries’ desperately needed gold and silver reserves.

In the table below, I have broken down the HUI into its 15 components and compared their performance since the interim highs of January 2004 and May 2006, as well as the end of 2006. I have also inserted the prices of gold, silver, and oil to show how PM mining stocks have done versus the underlying commodities, as well as the OSX, or Oilfield Service Index, to show how the stocks of a non-manipulated commodity have performed.

My first conclusion is that the HUI’s 22% increase this year yields little to be excited about. To start, on an average (non-dollar weighted) basis, its increase is just 12%. Moreover, if you take out the performance of three stocks (ABX, AEM, and GOLD, three of the largest stocks by dollar price), the average HUI component is up just 4%. Finally, six of the 15 HUI stocks are actually down this year, with an additional two up less than 10%. Thus, if anyone guides you to the HUI to show how well the gold stocks have performed in 2007, please guide them to this analysis.

And, of course, in Part I of this commentary I described how the average HUI stock has significantly outperformed the average PM stock, as evidenced by the negative performance of the TSX Venture Exchange this year, which itself is significantly skewed to the upside by various factors. In other words, despite respective increases of 32% and 15% in gold and silver prices, the great majority of PM stocks have been losers in 2007.

Next, look at how the HUI has performed since its last interim peak in May 2006, or 19 months ago. Gold (+14), silver (-3%), and the HUI (+3%) have barely budged. In fact, despite a gold price roughly $100 higher over this period, the HUI is down 5% on an average price change basis. Moreover, excluding the performance of the three aforementioned high-priced stocks (ABX, AEM, and GOLD) the HUI is down 14% since May 2006.

Most egregiously for PM investors, since the previous interim peak in January 2004 the HUI’s 60% increase (or 52% on an average price basis) has dramatically underperformed silver (+81%) and gold (+102%). Moreover, taking out the spectacular performance of three stocks (AEM, KGC, and, of course Cartel leader ABX), the average HUI stock is up just 11% since that time (FOUR YEARS AGO!), including negative performances from six of the 15 components (such as “industry bellwether” NEM). To put it in perspective, in January 2004 gold was $416 (compared to $839 today) and silver was $8.16 (versus $14.77 today).

Why is this occurring? In other words, why are the gold and silver stocks (with very few exceptions) acting so poorly relative to gold and silver prices, excluding the impact of a Gold/Silver Cartel intent on quashing sentiment in the sector?

To start, one must simply look at the oil price, which most miners will tell you equates to roughly one-quarter of exploration/production costs. Since the early 2004 interim high, oil has risen by 174% versus the 102% increase in gold, 81% increase in silver, and 60% increase in the HUI (or, as noted above, 11% excluding ABX, AEM, and KGC). Energy price increases (and in some cases shortages) have led to exponential growth in mining costs for individual companies, especially when coupled with above average increases in other mining necessities such as copper, steel, rubber, machinery, and experienced engineers, managers, and general laborers. And don’t get me started on delays caused by a dearth of qualified assay labs, all the result of an industry strangled for capital by a Gold/Silver Cartel intent on hiding inflation expectations and thus holding back investor demand.

Next, note that the U.S. money supply has risen by an astounding 35% since early 2004, actually a low number compared to rates that some other “first-world” nations have been producing currency at. The overall inflationary impact is pervasive across nearly all segments of the exploration/production continuum, and particularly prices of the aforementioned input commodities.

Moreover, don’t forget that the majority of gold and silver is produced outside the U.S. despite the fact that they are priced in dollars. Thus, rising prices of foreign currencies, particularly the Canadian Dollar, South African Rand, and Australian Dollar contribute to mining cost inflation atop the aforementioned commodity price inflation (although in many ways the two are related).

So let’s see how these currencies have done since early 2004:

The Rand/U.S. dollar rate has been relatively stable in recent years, but most mining companies have found the hard way that the “low hanging fruit” in South Africa has long been picked, resulting in dramatically increasing production costs and significant production declines over the last decade despite the stable exchange rate.

In fact, South African production fell by 8% in 2006 to its lowest level in 84 years, and another 4% in 2007. This decline is nearly unstoppable at the current gold price, not to mention the civil unrest it is causing such as massive labor strikes. And, by the way, once strikes are resolved and mines are re-opened, they have a nasty habit of producing permanently lower ore levels. So for those that think the Cartel suppression of gold and silver can last much longer, think again!

As for the Canadian and Aussie dollars, their 26% and 20% increases, respectively, since early 2004 have wreaked additional havoc on mining cost structures, and unfortunately the forecast (at least mine) for these currencies is for continued appreciation (due to their commodity-dominant economies) into the foreseeable future.

To conclude, I emphatically disagree with anyone that states the Precious Metals miners have had a “good year”, aside from the fact that nominally the headline HUI index was up by 22%, nor a “good few years” despite the fact that the same HUI index has risen by 60% since the early 2004 interim high.

On a nominal basis, most large mining stocks haven’t risen at all, and most small stocks have done even worse. Moreover, compared to inflation, the PM stocks have performed horribly, the result of inexorable rises in the supply of paper currency, foreign exchange rates, commodity prices, labor tightness, and thus cumulatively, exploration and production costs.

These increases are part and parcel of an industry plagued by sharply rising demand and falling supply, consequent of a rapidly rising global population and accelerating industrialization, especially in the Eastern Hemisphere. However, monetary inflation is the most significant driver of rising costs, and the Gold/Silver Cartel is the most significant reason why gold and silver prices have not been able to appreciate relative to these costs.

In my view, the contents of this article further prove that the prices of gold and silver need to be MUCH, MUCH higher to enable the industry to produce reasonable near-term investment returns and, more importantly, grow at a rate fast enough to sate accelerating (and you ain’t seen nothing yet!) demand. Given how tight the supply/demand balance has become in the gold and silver markets due to the Cartel suppression, I believe the prices of gold and silver could rise to levels not dreamed of by even the most ardent bulls once this suppression is broken, which in my view will commence is earnest in the first half of 2008.

Remember, when gold and silver prices rise, miners will see improved valuations due to the higher value of their current reserves, the fact that previously uneconomic reserves will suddenly become economic (can you say Novagold?), and the fact that more capital will be available to prove up and/or acquire new reserves. For those sell-side types, this combination should lead to a level of “multiple expansion” not seen since the internet stocks soared in the late 1990s!

Andy Hoffman

P.S. For those whom are curious, I am not the same Andy Hoffman that writes the Precious Metals column for the Toronto Globe and Mail (funny coincidence, though). I am a former Oilfield Service sell-side analyst whom has dedicated his career to the Precious Metals sector since mid-2002. Currently, I serve as VP of Corporate Development for EXMIN Resources (EXM.V), a junior gold/silver explorer/producer operating principally in the Sierra Madre Region of Northern Mexico.