Although the market meltdown in September walloped commodities and equities alike, there is a growing gap between the performance of commodities and the performance of the shares of commodities-based companies. This gap reflects a change in the traditional approach to metals and mining investment.

From October 2001 to this past August, commodities prices rose by more than 200%, says Patricia Mohr, vice president of economics and commodity market specialist with Bank of Nova Scotia in Toronto. Such a bull market has not been seen since the rally that followed the Arab oil embargo in the 1970s. In July alone, Scotiabank’s metal and mineral index rallied by 5.9%.

In contrast, most mining stocks have lagged the metals that underlie them, particularly this year. From mid-May to mid-September, the world’s top 20 mining stocks fell by US$850 billion in market value — each losing an average of 50% of capitalization — even as some metal prices rose. Juniors fared even worse: share prices of most are down by 50%-90% — or more.

“Early in the year, you had commodities rising and equities falling, and the spread was getting bigger and bigger,” says Tony Robson, senior mining analyst for BMO Capital Markets Corp. in Toronto. “What’s happening now is that the commodities are flat to down, but the equities are massively down. Equities are being sold off indiscriminately.”

Traditionally, investors have put more money into companies that mine metals than into the metals themselves — partly because equities tend to be more widely available, but also because they reward investors with the extra kick of higher profit margins should metal prices rise.

So, what gives this time?

One key factor is that soaring costs are eating into revenue, analysts say. Mines are energy-, labour- and equipment-intensive — goods and services that are in short supply and, therefore, at a premium. So, even if a mining company is raking in record revenue, profits may be marginal.

“People don’t realize how distressed the gold mining industry is,” John Embry, chief investment strategist with Sprott Asset Management Inc. in Toronto, told the Gold Report. “Even at US$1,000 an ounce, miners weren’t doing very well. At US$800, the entire industry is in crisis. Costs have risen so much, nobody’s making any real money. In fact, some mines are starting to close.”

Base-metal mines are also suffering. In August, Switzerland-based Xstrata PLC surprised the industry by suspending operations at its Falcando nickel mine in the Dominican Republic, one of the world’s largest nickel facilities. Although the price of nickel has fallen considerably since mid-2007, to about US$8 a pound, it is still 60% higher than it was in September 2003. “Extremely high” oil prices were the culprit at the energy-intensive operation.

Another factor is the failure of mining companies to secure the kind of quality deposits that fuel growth. A lack of investment in exploration in the 1990s is partly to blame. But the reality is that most of the best deposits have been found, even in the remote parts of the world. That leaves a small pool of often substandard deposits to develop into the next mines.

According to statistics compiled by London-based Rio Tinto PLC, only one in 350 prospects Rio Tinto drills will yield a mine. And developing those new discoveries may require taking on considerable amounts of geographical, political and social risk, depending on where the discovery is located.

Political risk, in particular, tends to increase as metal prices rise and host nations demand more royalties or make moves to nationalize mines. There have been several recent examples of investors getting burned as a result of government interventions in private mining projects.

In the Central African Republic, for instance, the government recently revoked Toronto-based Axmin Inc.’s right to mine minerals other than gold, even though the company has spent more than $60 million exploring and discovering a major iron ore deposit in the country. Axmin shares recently traded at about 25¢ each, down from a 52-week high of almost $1.

In Romania, Toronto-based Gabriel Resources Ltd. shut down its Rosia Montana gold project as a result of persistent opposition by non-governmental organizations.

In addition, Bolivian president Evo Morales sent 200 troops to occupy and nationalize the Vinto tin smelter owned by Switzerland-based Glencore International AG.

@page_break@The recent credit crisis has exacerbated an already difficult situation for mining companies. “The money hedge funds borrowed from banks is being called back,” Robson says. “Forced liquidation has been one of the key drivers for the market sell-off. Another key driver is that the market is spooked.”

The explosion of new investment products that allow direct investments in metals have also played a role in steering buyers away from equities and toward commodities investments that are less risky and more liquid. These include gold and silver exchange-traded funds, a public company created to invest in uranium oxide and even a few ETFs that track base metals.

The dichotomy between these metal-backed ETFs and their equities cousins is best illustrated by silver. Although silver ETFs were up by about 48% in the 12 months before the commodities rout started in August, silver stocks have lost 6.5% of their value, on average, during the same period, according to

Of course, there are exceptions to the rule. Toronto-based Barrick Gold Corp., one of the world’s top gold miners, outperformed the gold price by 7% during that period.

“Companies with a proven record and good management will tend to outperform the metal,” says Bart Melek, BMO Capital Markets’ commodities specialist. “You have to know what you’re buying. Gold can go whenever it wants, but if you don’t deliver on the production side, who cares?”

Assuming commodities prices recover from the recent correction and the supercycle resumes, what lies in store for mining equities?

“The driver is more sentiment than reality right now,” Robson says. “So, it will depend on the market perception of U.S. growth and the credit crisis rather than on commodities prices. All I can say is that at current commodities prices, companies such as [Brazil-based] Vale or [Australia-based] BHP Billiton Ltd. are earning huge amounts of money. We have ‘outperform’ ratings on both of them.”

Depressed share prices will also put many smaller companies into play. With financing for their projects getting increasingly difficult to secure, many will have no choice but to sell partial or full interests in their companies or properties to larger, cash-rich seniors.

Even before the recent crash, the predators were circling. In July, Kinross Gold Corp announced a friendly takeover of Aurelian Resources Inc. A few days later, Goldcorp Inc. announced it would swallow Gold Eagle Mines Ltd. All four companies are based in Toronto.

Many analysts remain confident that metal prices will resume their upward climb once investor “fear and terror” dissipates because the fundamentals for most commodities remain robust.

“For many metals and bulk commodities, global demand is expected to grow by as much as 40% to 50% over the next decade,” states Melek in a recent research note. “Since supply is constrained, the sector is projected to operate at very high utilization rates and in an elevated cost environment. As such, metals and bulk commodities prices are very well supported over the long term.”

As for equities, the majority of investors have to buy into the notion that higher metal prices are here to stay before mining stocks can have their day in the sun again. IE