Resource Sector Paradigm Shift: Part I by Eric Coffin

There were a lot of long faces at the PDAC this year. Many of the companies there were pulled off the waiting list when long standing attendee companies decided there was no point having a booth. Others have expressed surprise that few companies seemed to be trying to market financings. This was taken as complacency but it felt more like resignation to me. For the record, resignation is better if you're a contrarian.

The editorial this month deals with the sea change that seems to have taken place among major companies. They are looking for a different type of project and that creates difficulties for Juniors that focused on things majors are not buying right now. It's a long topic and I will cover the remainder of it in the next issue.

It was a very quiet month as you'll see from the update section. A lot of companies aren't active enough to even come up with the traditional "PDAC Look at Me" news release. That reinforced the point I've made before that it will be a slow turnaround and there will be only a small number of companies participating in the early stages of a rally. I'm pleased at how gold has held up against a very strong $US. The type of strong economic stats I feared would knock gold down farther hasn't done that. I hope that means this bottom doesn't drag on too much longer.

This year's trip to the Prospectors and Developers of Canada convention in Toronto was less enlightening than usual but was a good gauge of sentiment.

Just about everyone goes to PDAC and it's a good chance to talk to mining executives, explorers and analysts from across the globe. The conference is also famous for its hospitality suites. Good places to collect intelligence from a large number of people who actually buy resource stocks (sometimes), not to mention hangovers.

Not surprisingly, almost everyone was downbeat. Estimates of when the market would turn around ranged from "at least a year" to "never". A lot of comparisons were made to the post-Bre-X meltdown. That bear market lasted for 5-6 years.

David and I lived through it and it wasn't pretty. The sector was decimated at both the financial level and at the personnel level. Many suppliers disappeared and even more geologists went off to teach high school science, most never to return.

I understand the pessimism after two years of down markets but I have trouble drawing a parallel between now and 1997. After the Asian currency crisis and Bre-X-- the former was at least as large a problem as the latter--commodity prices declined across the board for several years. Precious and base metals couldn't catch a bid for four years and it took a couple more before anyone but the diehards noticed a bottom was in.

This time around there is concern about commodity prices but we are dealing with completely different levels of "concern". If high demand regions (China, the US) don't have good years there will be metals that move into or remain in oversupply. That isn't news and no one expects a commodity apocalypse.

Precious metals and most base metals are up anywhere from 300% to 600% in the past 10 years. Even commodity bears are not expecting pullbacks larger than 10-20% from current levels; the jury is still out on whether even that comes to pass. There is a big difference between that scenario and the late 1990's.

Back then there were widespread mine closures and almost all mines were left operating on razor thin profits or limping along generating losses, eating up equity and praying for a turn in prices. Most producers had mountains of debt back then. Now most have fairly clean balance sheets and large cash balances.

Recently, a lot of top of the mountain, high capex projects have been called off. Not good news but hardly the same as mines going under left, right and center. It doesn't represent the same level of industry decimation, but it does beg the question of where the sector goes from here.

In the past few years the level of project cost inflation has been incredible. Some of that is energy costs. Hard rock operations require a lot of energy .In many parts of the world that means generator sets, usually diesel fired, rather than just plugging into a grid. Oil has been a big winner this commodity cycle and higher fuel costs go right to the bottom line in a mining operation.

That is only one aspect of costs though. The truth is that virtually every cost associated with mine development from steel to concrete to heavy equipment to engineers and designers have gone through the roof. Some of that is super cycle impact on other commodities but some is the cost escalation that comes when any sector has a good run. Everyone associated wants their piece of the action. Everyone raises their prices or level of professional fees.

I think the fun's over for now for these suppliers. Senior miners' shareholders are demanding more accountability and cost control. I was raised in the mining business. I know how hard things were for a long time so I'm the last person to begrudge people in the sector getting a good payday. That said, shareholders have put the mining sector on notice that they only inflation they want to hear about is inflation of the bottom line.

I think you will see suppliers up and down the supply chain getting squeezed hard for the next couple of years. What large company executives can't enforce the markets will take care of. Margin compression that has been the bane of the mining sector is now being passed onto the suppliers of the mining sector and that's not a bad thing.

Cost over runs affect operating costs just as they do capital costs. A big factor in operating cost increases is decline in grade. Most precious and base metal operations have seen the average grade of producing deposits decline for decades. More rock has to be moved to produce the same amount of metal. In large part that is a reflection of the fact big high grade deposits are getting harder to find. That statistic is an argument for higher commodity prices, not lower ones.

While I think difficulty in finding new ore is the main culprit for the drop in grade it's not the only one. I think there has been some "selection bias" in the past decade especially.

Mining companies faced unprecedented increases in demand in the past decade. Commodity prices were rising fast and the market was signaling it was able to absorb larger quantities of new ore than miners dared dream a few years earlier.

Miners had to generate very large increases in production growth. Since mines, be they large or small, need similar levels of executive staffing miners saw efficiency gains in opening a smaller number of large operations. Size mattered.

Large producers wanted deposits that offered the biggest annual metals production and maximum scalability. That meant large, bulk tonnage open pit deposits. Gold miners found themselves drawn to large lower grade deposits where production rates in the 100,000 tonne per day plus were achievable.

Copper miners focused on similar deposits because they were favoring sulphides--large milling operations that allowed for scalability and overall output scale that would be difficult to achieve with an oxide heap leach deposit--assuming you could find a copper oxide deposit that large.

For the junior mining space the preferred end game is take over by a major. Seeing the preferences of the large companies juniors dutifully went out and acquired large low grade bulk tonnage targets. Quite a few of them had some success drilling off large low margin deposits. They were all the rage for a few years and some did indeed get taken out at high prices.

Many more deposits were found than were bought. Quite a few of these are simply not that good for logistical reasons, poor metallurgy, uncertain politics or some combination of all three. They were available because they were uneconomic at circa 2001 metal prices but many of them are marginal even at todays.

When gold and silver were less favored many juniors chased rare earths, or graphite or lithium. Nothing wrong with any of this except that some of these market sectors are not large, at least right now. In the case of most specialty or industrial metals only a handful of new deposits are required short and medium term. Best in class projects can make a go of it but the rest may not find buyers.

Things started shifting in the past 18 months. Metal prices plateaued and the combination of capital cost inflation, permitting and development holdups and increased operating costs shelved scores of projects and made those that did get built less profitable than expected.

Major mining companies didn't deliver promised profit growth and shareholders have been revolting in the boardroom and voting with their feet. Many CEOs have been fired and their replacements and peers are terrified of repeating mistakes that cost others their jobs.

I've had discussions with senior execs at several major companies recently that reinforce the comments above. These companies have shifted from looking for scale to looking for margin. That is a sensible move--it's what they always should have been looking for. It does create a large problem for the Juniors though.

All these small companies worked diligently for years to find resources they thought would be salable. They are now being told they are not. Where is the endgame for these deals now? I can envision several endgame scenarios, which will only work for some of these companies.

The first scenario is companies with resources getting so cheap they become irresistible. I'm not sure what defines "irresistible" in this new paradigm but I'm afraid it may be cheaper than shareholders want to consider.

At some point, majors and mid-size producers will buy up a bunch of these deposits. If they are merely putting them in inventory don't expect miracles when it comes to pricing. I don't think "buyout as endgame" has gone away for these companies but, for the time being, deals will be done at prices that are not accretive to either shareholder value or happiness.

Where does that leave these companies? They could go it alone, but only in theory in most cases. Many companies have generated a PEA (Preliminary Economic Assessment) for projects in the hopes this would smoke out a buyer. I did a quick search for the past six months and found well over 100 PEA announcements. In most cases these have capital cost estimates in the hundreds of millions if not billions of dollars.

Once PEA numbers are released the die is cast as far as shareholders are concerned. They wait for a major to show up and offer to buy them out. If it doesn't arrive quickly the company's value starts to deteriorate.

Post-PEA news flow is often the boring technical variety, and full Bankable Feasibility Studies cost millions. Right now, the market is littered with companies that have $20-30 million market values sitting on resources that will require a billion plus to put in production. You can't make those numbers work. If you're not offered a buyout you need a Plan B.

One alternative is to focus on higher grade sections of the deposit (if they exist) that might be amenable to a smaller, tighter production plan. If there is leachable gold, or high grade near surface that can be pitted or ramped down to the company could come back with a small production scenario that has a sub $100 million cost. It won't be massive but it might be doable and may, on a per unit basis, be much more profitable.

If the cash cost was low enough it could be of immediate interest to a producer. It might even be something the junior could tackle on its own. I'm expecting to see a lot of rejigged studies and some will even make sense.

If management has the skills to get the project through development this could breathe new life into the company. The skills required to get a mine into production are a lot different from the skills needed to find one. SilverCrest Mines (SVL-V), a long time HRA favorite is a great example of a company that has management with both skill sets. Not many do.

Another scenario involves picking up new ground to try and restart the discovery process. This will provide the company with news flow and, hopefully, some excitement to draw in new shareholders and cheer up present ones. This scenario may not please institutional shareholders but I don't think there are institutional shareholders in the space right now. There is no point trying to please shareholders that have already sold.

Perhaps the best recent example of this game plan is Exeter Resources (XRC-T) optioning two projects from HRA list company San Marco (SMN-V; see update). Some XRC shareholders may have wondered why a company with several million ounces in resources would option early stage projects. I didn't. I thought it made total sense.

Returning to exploration gives a company news flow and a shot at new discoveries that they may be able to develop in house. There are some particular attributes I think would work best in this new paradigm. I'll go into that next issue.

From The March 2013 HRA Journal

Eric Coffin recently presented at the Toronto Subscriber Investment Summit on March 2, 2013. To watch this exclusive subscriber only video of Eric's presentation titled "Is This It...Or?" please click here now.

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	There were a lot of long faces at the PDAC this year. Many of the companies there were pulled off the waiting list when long standing attendee companies decided there was no point having a booth. Others have expressed surprise that few companies seemed to be trying to market financings. This was taken as complacency but it felt more like resignation to me. For the record, resignation is better if you're a contrarian. The editorial this month deals with the sea change that seems to have taken place among major companies. They are looking for a different type of project and that creates difficulties for Juniors that focused on things majors are not buying right now. It's a long topic and I will cover the remainder of it in the next issue. It was a very quiet month as you'll see from the update section. A lot of companies aren't active enough to even come up with the traditional "PDAC Look at Me" news release. That reinforced the point I've made before that it will be a slow turnaround and there will be only a small number of companies participating in the early stages of a rally. I'm pleased at how gold has held up against a very strong $US. The type of strong economic stats I feared would knock gold down farther hasn't done that. I hope that means this bottom doesn't drag on too much longer. This year's trip to the Prospectors and Developers of Canada convention in Toronto was less enlightening than usual but was a good gauge of sentiment. Just about everyone goes to PDAC and it's a good chance to talk to mining executives, explorers and analysts from across the globe. The conference is also famous for its hospitality suites. Good places to collect intelligence from a large number of people who actually buy resource stocks (sometimes), not to mention hangovers. Not surprisingly, almost everyone was downbeat. Estimates of when the market would turn around ranged from "at least a year" to "never". A lot of comparisons were made to the post-Bre-X meltdown. That bear market lasted for 5-6 years. David and I lived through it and it wasn't pretty. The sector was decimated at both the financial level and at the personnel level. Many suppliers disappeared and even more geologists went off to teach high school science, most never to return. I understand the pessimism after two years of down markets but I have trouble drawing a parallel between now and 1997. After the Asian currency crisis and Bre-X-- the former was at least as large a problem as the latter--commodity prices declined across the board for several years. Precious and base metals couldn't catch a bid for four years and it took a couple more before anyone but the diehards noticed a bottom was in. This time around there is concern about commodity prices but we are dealing with completely different levels of "concern". If high demand regions (China, the US) don't have good years there will be metals that move into or remain in oversupply. That isn't news and no one expects a commodity apocalypse. Precious metals and most base metals are up anywhere from 300% to 600% in the past 10 years. Even commodity bears are not expecting pullbacks larger than 10-20% from current levels; the jury is still out on whether even that comes to pass. There is a big difference between that scenario and the late 1990's. Back then there were widespread mine closures and almost all mines were left operating on razor thin profits or limping along generating losses, eating up equity and praying for a turn in prices. Most producers had mountains of debt back then. Now most have fairly clean balance sheets and large cash balances. Recently, a lot of top of the mountain, high capex projects have been called off. Not good news but hardly the same as mines going under left, right and center. It doesn't represent the same level of industry decimation, but it does beg the question of where the sector goes from here. In the past few years the level of project cost inflation has been incredible. Some of that is energy costs. Hard rock operations require a lot of energy .In many parts of the world that means generator sets, usually diesel fired, rather than just plugging into a grid. Oil has been a big winner this commodity cycle and higher fuel costs go right to the bottom line in a mining operation. That is only one aspect of costs though. The truth is that virtually every cost associated with mine development from steel to concrete to heavy equipment to engineers and designers have gone through the roof. Some of that is super cycle impact on other commodities but some is the cost escalation that comes when any sector has a good run. Everyone associated wants their piece of the action. Everyone raises their prices or level of professional fees. I think the fun's over for now for these suppliers. Senior miners' shareholders are demanding more accountability and cost control. I was raised in the mining business. I know how hard things were for a long time so I'm the last person to begrudge people in the sector getting a good payday. That said, shareholders have put the mining sector on notice that they only inflation they want to hear about is inflation of the bottom line. I think you will see suppliers up and down the supply chain getting squeezed hard for the next couple of years. What large company executives can't enforce the markets will take care of. Margin compression that has been the bane of the mining sector is now being passed onto the suppliers of the mining sector and that's not a bad thing. Cost over runs affect operating costs just as they do capital costs. A big factor in operating cost increases is decline in grade. Most precious and base metal operations have seen the average grade of producing deposits decline for decades. More rock has to be moved to produce the same amount of metal. In large part that is a reflection of the fact big high grade deposits are getting harder to find. That statistic is an argument for higher commodity prices, not lower ones. While I think difficulty in finding new ore is the main culprit for the drop in grade it's not the only one. I think there has been some "selection bias" in the past decade especially. Mining companies faced unprecedented increases in demand in the past decade. Commodity prices were rising fast and the market was signaling it was able to absorb larger quantities of new ore than miners dared dream a few years earlier. Miners had to generate very large increases in production growth. Since mines, be they large or small, need similar levels of executive staffing miners saw efficiency gains in opening a smaller number of large operations. Size mattered. Large producers wanted deposits that offered the biggest annual metals production and maximum scalability. That meant large, bulk tonnage open pit deposits. Gold miners found themselves drawn to large lower grade deposits where production rates in the 100,000 tonne per day plus were achievable. Copper miners focused on similar deposits because they were favoring sulphides--large milling operations that allowed for scalability and overall output scale that would be difficult to achieve with an oxide heap leach deposit--assuming you could find a copper oxide deposit that large. For the junior mining space the preferred end game is take over by a major. Seeing the preferences of the large companies juniors dutifully went out and acquired large low grade bulk tonnage targets. Quite a few of them had some success drilling off large low margin deposits. They were all the rage for a few years and some did indeed get taken out at high prices. Many more deposits were found than were bought. Quite a few of these are simply not that good for logistical reasons, poor metallurgy, uncertain politics or some combination of all three. They were available because they were uneconomic at circa 2001 metal prices but many of them are marginal even at todays. When gold and silver were less favored many juniors chased rare earths, or graphite or lithium. Nothing wrong with any of this except that some of these market sectors are not large, at least right now. In the case of most specialty or industrial metals only a handful of new deposits are required short and medium term. Best in class projects can make a go of it but the rest may not find buyers. Things started shifting in the past 18 months. Metal prices plateaued and the combination of capital cost inflation, permitting and development holdups and increased operating costs shelved scores of projects and made those that did get built less profitable than expected. Major mining companies didn't deliver promised profit growth and shareholders have been revolting in the boardroom and voting with their feet. Many CEOs have been fired and their replacements and peers are terrified of repeating mistakes that cost others their jobs. I've had discussions with senior execs at several major companies recently that reinforce the comments above. These companies have shifted from looking for scale to looking for margin. That is a sensible move--it's what they always should have been looking for. It does create a large problem for the Juniors though. All these small companies worked diligently for years to find resources they thought would be salable. They are now being told they are not. Where is the endgame for these deals now? I can envision several endgame scenarios, which will only work for some of these companies. The first scenario is companies with resources getting so cheap they become irresistible. I'm not sure what defines "irresistible" in this new paradigm but I'm afraid it may be cheaper than shareholders want to consider. At some point, majors and mid-size producers will buy up a bunch of these deposits. If they are merely putting them in inventory don't expect miracles when it comes to pricing. I don't think "buyout as endgame" has gone away for these companies but, for the time being, deals will be done at prices that are not accretive to either shareholder value or happiness. Where does that leave these companies? They could go it alone, but only in theory in most cases. Many companies have generated a PEA (Preliminary Economic Assessment) for projects in the hopes this would smoke out a buyer. I did a quick search for the past six months and found well over 100 PEA announcements. In most cases these have capital cost estimates in the hundreds of millions if not billions of dollars. Once PEA numbers are released the die is cast as far as shareholders are concerned. They wait for a major to show up and offer to buy them out. If it doesn't arrive quickly the company's value starts to deteriorate. Post-PEA news flow is often the boring technical variety, and full Bankable Feasibility Studies cost millions. Right now, the market is littered with companies that have $20-30 million market values sitting on resources that will require a billion plus to put in production. You can't make those numbers work. If you're not offered a buyout you need a Plan B. One alternative is to focus on higher grade sections of the deposit (if they exist) that might be amenable to a smaller, tighter production plan. If there is leachable gold, or high grade near surface that can be pitted or ramped down to the company could come back with a small production scenario that has a sub $100 million cost. It won't be massive but it might be doable and may, on a per unit basis, be much more profitable. If the cash cost was low enough it could be of immediate interest to a producer. It might even be something the junior could tackle on its own. I'm expecting to see a lot of rejigged studies and some will even make sense. If management has the skills to get the project through development this could breathe new life into the company. The skills required to get a mine into production are a lot different from the skills needed to find one. SilverCrest Mines (SVL-V), a long time HRA favorite is a great example of a company that has management with both skill sets. Not many do. Another scenario involves picking up new ground to try and restart the discovery process. This will provide the company with news flow and, hopefully, some excitement to draw in new shareholders and cheer up present ones. This scenario may not please institutional shareholders but I don't think there are institutional shareholders in the space right now. There is no point trying to please shareholders that have already sold. Perhaps the best recent example of this game plan is Exeter Resources (XRC-T) optioning two projects from HRA list company San Marco (SMN-V; see update). Some XRC shareholders may have wondered why a company with several million ounces in resources would option early stage projects. I didn't. I thought it made total sense. Returning to exploration gives a company news flow and a shot at new discoveries that they may be able to develop in house. There are some particular attributes I think would work best in this new paradigm. I'll go into that next issue. From The March 2013 HRA Journal Eric Coffin recently presented at the Toronto Subscriber Investment Summit on March 2, 2013. To watch this exclusive subscriber only video of Eric's presentation titled "*Is This It...Or?*" please click here now.