How Risky Is Royal Gold, Inc.?

By Markets Fool.com

Pueblo Viejo mine. Image source: Barrick Gold.

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Barrick Gold (NYSE: ABX) and Royal Gold (NASDAQ: RGLD) partnered up in 2015 on the Pueblo Viejo mine located in the Dominican Republic. The nature of this roughly $600 million relationship helps explain a lot about how different the two companies are and, in the end, how risky Royal Gold is.

Show me the money

When the commodity downturn started in 2011 or so, miners were in the midst of debt-fueled expansions. As precious metals prices fell, those growth initiatives often turned into unaffordable expenses. Barrick Gold was no different from its peers. To shore up its balance sheet and keep funding its best projects, it needed cold, hard cash.

That's where Royal Gold comes in. Barrick Gold is a miner and it gets its hands dirty digging up the earth to reveal the precious metals held underneath. It's an expensive and time-consuming process. It also comes with huge risks, ranging from work stoppages to mine accidents to, well, picking the wrong place to dig. Royal Gold, meanwhile, is a streaming and royalty company. That's a different business altogether.

Royal Gold provides miners like Barrick cash up front for the right to buy gold and silver at reduced rates in the future. So, for the Pueblo Viejo mine, Royal Gold simply wrote Barrick a check for $610 million. In return, Royal Gold will be able to pay Barrick 30% of the spot price for gold and silver from the mine until 550,000 ounces of gold and 23.1 million ounces of silver have been delivered. After that it will pay 60% of the spot price for each.

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Image source: Royal Gold.

So Royal Gold is more like a specialty finance company than a miner, and that changes things a lot. First off, low costs are pretty much locked in to its contracts. That helps it weather weak commodity markets. At the Pueblo Viejo mine, for example, it doesn't matter what the market price for gold is -- Royal Gold's costs will always be lower. This helps explain why Royal Gold has been able to increase its dividend annually for 15 consecutive years while most miners were forced to trim their payouts during the commodity downturn.

Can't avoid it all

But that doesn't mean Royal Gold avoids all the risks of mining. For example, a problem at Pueblo Viejo mine could affect Royal Gold if production stopped. Employee-relations problems or a mine accident are good examples of things that could grind Pueblo Viejo to a halt. However, if the issue were cost overruns or lower ore grades than anticipated, that wouldn't be as big a deal to Royal Gold.

It's also important to remember that Royal Gold isn't immune to the impact of commodity markets. For example, simplifying things a great deal, if gold were $1,000 an ounce, Royal Gold would pay Barrick $300 per ounce for Pueblo Viejo's gold and pocket $700. If gold were $2,000 an ounce, that changes to $600 for the gold and $1,400 in Royal Gold's pocket. Royal Gold's costs, in percentage terms, don't change, but the impact on the top and bottom lines is vastly different. So commodity prices are still an issue that needs to be watched.

One more mine-specific issue comes up, too. Often Royal Gold provides funds used to build new mines. If those mines don't get completed for some reason, that investment will never bear fruit. Although streaming deals often come with clauses that require the miner to return Royal Gold's cash in such a situation, that money ultimately sat idle for a period of time, not earning Royal Gold a dime. It's a time value of money issue, but it's a real risk.

Pueblo Viejo mine. Image source: Royal Gold.

Money costs money

There is one more key difference between Royal Gold and a miner that you'll need to keep in mind -- access to the capital markets. It's important for both, but Royal Gold's business is built on selling stock and using the cash raised to fund streaming and royalty deals. It doesn't make anything itself, so if Royal Gold can't access the capital markets for some reason growth will become more difficult, if not impossible. And that would likely put a serious damper on the company's stock price. So far that hasn't been too much of a problem, but it's something to keep in the back of your mind.

At the end of the day, Royal Gold is less risky than a miner like Barrick because it avoids many of the inherent risks of mining. Indeed, the company has rewarded shareholders well because of this, with a steadily increasing dividend throughout the precious metals downturn. However, don't let that fact blind you to the very real risks Royal Gold does face. It may be a good option for risk-averse investors looking for precious-metals stocks, but it isn't a risk-free option.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.