How to Play the Spike in Gold

It was a little over a month ago that gold was plunging, sending investors into a panic and driving gold miners' share prices to new 52-week lows. This sell-off saw gold at a low of just over $1,200 per ounce with naysayers speculating that it would fall to under $1,000 per ounce.

What is the outlook for the price of gold?
Much of the speculation was based on the belief that the Fed would start tapering its quantitative easing program earlier than expected. This has artificially reduced interest rates near zero while injecting billions of dollars into the U.S. economy through a bond-buying program.

It was also based on better than expected economic data coming out of China and the U.S. But with the Fed now providing clearer guidance as to when and how that winding down will take place, much of the panic has subsided.

This, combined with growing civil unrest in the Middle East, has caused gold prices to spike, now up by almost 8% to around $1,415 per ounce for August. Gold mining stocks have made a sharp comeback over the last two weeks as a result. However, there is still considerable uncertainty as to whether this is a sustainable rally or a short-term price spike driven by geopolitical events.

Regardless of the short-term direction of gold, there are a range of factors that indicate a price floor has been created. And that's because gold supply will fall with the majority of miners having slashed exploration and development programs during the second quarter of 2013.

While central bank buying is uncertain, there is still strong demand for jewelry, gold bullion, and coin investment. In the second quarter of 2013, jewelry demand climbed 37%, while gold bar and coin investment soared by 78% year over year. Despite the rise in the price of gold and the rally among mining stocks, the group has underperformed due to rising crude prices.

This is because gold miners are stocks first and a leveraged play on gold second, with gold mining being an energy-intensive activity. Accordingly the cost base of gold miners increases as energy costs rise. For August alone, crude rose 3% to well over $100 per barrel. Given the energy-intensive nature of gold exploration, mine development, and gold production, this has caused production costs to rise.

How to play the spike in the price of gold
The best way for investors to play the spike in gold and the ongoing uncertainty facing gold miners is to identify those miners that are undervalued, with a low production cost per ounce of gold. Typically, the highest-cost gold miners are those that are reliant primarily on underground mines to produce gold, while open cut mining is far more cost effective.

The world's largest miner, Barrick Gold is one of the lowest-cost producers in the industry with an all in sustaining cost of $919 per ounce of gold produced.  For the second quarter 2013, Barrick reported particularly disappointing results, but this was to be expected by investors because of the difficult operating environment. It also slashed its dividend by 75% further disappointing investors and driving a sustained sell-off of its shares.

This has made Barrick's valuation appear quite appealing, with it now trading wiith an enterprise-value of only four times its EBITDA. But impressively for the same period Barrick grewe its gold production by 4%, leaving Barrick well positioned to take advantage of any increases in the price of gold. 

Furthermore, Barrick cleared the decks by taking a $5 billion charge against the value of its troubled Pascua-Lama mine, and commenced the divestment of a range of non-core assets. This leaves it well positioned to focus on its core gold producing assets so it can build value for investors.

Another low-cost producer is mid-cap miner New Gold , which has an all in sustaining cost of $931 per ounce.  This like Barrick is one of the lowest in the industry. New Gold was also able to grow its gold production in the second quarter, despite slashing capital expenditures for exploration and mine development. For that period New Gold's production, grew by 8% year-over-year.

New Gold also has a solid project development pipeline and has been able to mitigate much of the risk from its troubled El Cerro mine development located in Chile. But unlike Barrick, New Gold's appears fairly valued trading with an enterprise-value of 10 times EBITDA.

The final candidate is mid-cap Eldorado Gold , trading with an enterprise-value of eight times EBITDA. It is also a relatively low-cost producer having an all in sustaining cost of $1,010 per ounce. 

But even more exciting for investors is that Eldorado-despite slashing its exploration and mine development programs-was able to grow second quarter production by a stunning 32% year-over-year. This leaves it well positioned to boost its revenue and margins on the back of the recent spike in the gold price.

Foolish final thoughts
It is unclear whether the recent spike in the price of gold is the start of a sustainable rally or a short-term recovery. There are too many mixed signals indicating that it could move either way. But what is clear is that there are a number of bargains to be found in the gold mining industry. Like Barrick, New Gold, and Eldorado, the best are those that over time will reward patient investors.