Read This Before You Buy a Gold Stock

On the surface, you'd think the gold mining industry would be pretty simple: dig a hole, pull gold out, and sell it. While that's the basic idea, there's so much more going on that an investor in the gold industry needs to know before jumping in. To gain a deeper understanding of the industry, let's peer through the lens of Newmont Mining Corp. -- a major global gold miner -- and see how the company stacks up against competitors in an industry that is more than what it seems.

Gold: The beautiful complexity of a simple industryThe first thing you need to know about gold is where it comes from. Although most of the gold used in a given year comes from the ground, a fair amount is recycled or sold into the market by central banks, financial institutions, or private owners. For example, in 2014 about 70% of the gold supplied to the market came from mining activities, the rest came from existing stocks.

Source: Agnico-Eagle, via Wikimedia Commons.

This means that supply and demand isn't just a matter of miners and gold consumers. For example, central banks selling gold can lead to oversupply situations and cause gold prices to fall, even if gold miners are trimming output. And with 30% of the supply coming from non-mine sources in 2014, it means this is an issue that's important to at least keep in the back of your mind.

Another factor to consider is that there's more than one way to make money from gold. For example, Newmont owns gold mines around the world. Roughly speaking, it digs up gold and sells it. Royal Gold, however, makes money from gold, but isn't really a gold miner. It invests in gold mines around the world and gets a piece of the action when the gold from those mines is eventually sold. Royal Gold can either buy royalty interests in existing mines or help fund the development of mines in exchange for royalty payments down the line. In fact, Royal Gold counts Newmont as a partner. Many gold players have a mix of direct mining and royalty interests.

That said, gold can only be mined where there is gold to mine. And while there are numerous locations around the world where gold can be found, all mines are not created equal. For example, in 2014 Newmont Mining's all-in sustaining costs (an industry metric that calculates a mine's costs on a per ounce basis) were around $1,002 an ounce across all of its gold mines. But the range spanned from $423 an ounce to $1,458 an ounce.

The geology of a mine and mining methods are two of the biggest factors impacting how much it costs to produce an ounce of gold. As a mine gets more complex to mine, the more it costs. And the harder it is to refine the gold, the more expensive the mine. In some instances, mining gold is as easy as crushing up rocks to free up the gold with relatively simple chemical processes. In others, more complex methods are needed. The science is less important then understanding that some mines cost more than others because the gold is simply harder to get at.

Other issues to watch, however, are the age of a mine (mine costs tend to go up over time) and the location of a mine (politically stable regions are better than unstable ones). With regard to location, regulation and taxation are two common themes that can cause costs to become major issues. In some instances, however, government takeovers can also be a legitimate concern. So, it's important to know where a company's mines are located, in addition to other factors.

One of Newmont's defining features is a large collection of mines in stable areas like the United States and Australia (about 50% of the company's assets in 2014 were in these two regions). That said, a key asset in Indonesia has opened it up to geopolitical risksthat could be a big issue even though that single country only accounted for 15% of its assets last year.

For example, 2014 regulations limiting the export of raw copper could hamper Newmont's assets in the country because there is limited copper processing capability in Indonesia. Moreover, Newmont's controlling stake in its Indonesian Batu Hijau mine has been reduced in accordance with Indonesian government contracts, but the legality of these contracts has been in dispute and this process could eventually result in Newmont no longer having a controlling stake in the operation.

How much gold is there?According to the World Gold Council, miners produced 3,114 tonnes of gold last year. That's a huge number, particularly when you consider that gold miners generally look at production in terms of ounces. Newmont, for example, produced 4.2 million ounces in 2014, or about 119 tonnes. And Newmont is one of the largest publicly traded miners in the industry, which means the industry is fairly fragmented.

Source: Amitsalla, via Wikimedia Commons.

Gold consumers, meanwhile, span the gamut from central banks hording the yellow metal to dentists using it for fillings to electronics companies benefiting from its conductive properties to jewelry manufacturers using it as a precious metal to gold bugs putting it in safe deposit boxes and under mattresses. And, as a globally traded commodity, there's a ready market for gold sales that has, for the most part, plenty of demand. That remains true even if supply and demand go out of balance at times causing prices to spike and fall for this often volatile commodity that some consider an important store of wealth.

The thing about gold, however, is that it's a commodity and one ounce is just like another. So there's really no way for a miner like Newmont to differentiate its product in the market. That leaves cost as one of the most important determinants of profitability since there's little control over prices received in the market.

On this score, Newmont's overall costs are middling, so it doesn't particularly stand out. As noted above, it's all-in sustaining costs were around $1,000 an ounce last year, but Barrick Gold, the world's largest publicly traded gold producer, had all-in sustaining costs of around $864 an ounce last year. The advantage clearly goes to the cheaper producer.

The future is uncertainAnother factor to keep in mind, however, is future supply. Since gold is naturally occurring, once you pull it from the ground it's gone. If a miner wants to maintain production over time it has to replace the gold reserves it produces in any given year. So mining costs are a key factor, but you'll also need to watch reserves and expansion and development efforts.

But building a mine is costly, time consuming, and risky. For example, Barrick Gold's Pascua-Lama mine project in Chile and Argentina saw massive cost overruns and, at this point, may never even get up and running because of environmental and political issues. Newmont, for comparison, has a collection of smaller projects at existing mines in the works that are far more certain and should help it maintain production levels over the next few years. So keeping growth opportunities in mind, and not getting caught up in a good story, is important; Noting that bigger isn't always better.

Another issue to look at in the gold industry when it comes to the future is hedging. Often gold miners will use hedging to lock in future gold prices so they don't have to worry about this frequently volatile aspect of the industry. That can be good and bad, however. For example, it makes earnings far more predictable, but it can limit upside potential if prices start to quickly move higher. That said, some producers, like Newmont Mining, don't hedge at all. That means that rising gold prices will have a more material impact on their financial results -- though so, too, will falling gold prices.

A not so simple, simple industryAt the end of the day, the gold industry is fairly simple to understand at a high level. However, that doesn't mean it's really a simple industry. There's not only a lot of competition in the gold business, but there's little way for a producer to differentiate its products for the plethora of buyers out there. And that means that costs and expansion are the two most important ways for a company to distance itself from the pack. Newmont, however, isn't a stand out on either. That said, it should produce solid results if gold prices go up. But lookout if they start to fall.

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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.

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