There was little
reason for optimism and certainly no optimists that we could find in the
junior space this month.
This month's editorial
continues the discussion of what large companies seem to be looking for and
what Juniors should be looking for too. This sort of shift is not a short
term scenario. By definition it's going to take some time for companies to
retool and approach projects from a different direction with different
assumptions. Even then, this will only work for a sub set of companies.
Short term, I still
think discoveries are the best path to salvation for individual companies and
perhaps the broader sector. Maybe gold gets a big bounce in the next few
weeks but with the drubbing everyone has taken I don't see traders heavily on
the bid unless higher gold prices are already in the rear view mirror.
The "currency
war" scenario remains in play and this is almost always going to favour the $US. War is too dramatic a term for it. Japan
is pushing the Yen down but Euro weakness has more to do with political
ineptitude than formal policy. Traders are having trouble buying into the
idea of second half growth in Euroland. Gold is
testing lows as this issue is released which may determine the length of the
bottom.
In the last issue of the Journal
I talked about the paradigm shift in the resource space that has been adding
to the pain of Juniors and their shareholders. Major companies seem to be out
of the market for new deposits and there has been a shift in the type of
deposit they are looking for. This has left many Juniors high and dry.
I am not assuming that
the change that has taken place in the past two years is permanent. It
probably isn't. Industries move in cycles and management practices are more
subject to fads and herd behavior than most things.
At some point in the
future, and it may not be far off, many large low grade projects will be back
in fashion. There are two reasons for this. One is that it's not going to get
easier to find large deposits. While we might hit a rough patch as large mine
startups lift the supply of metals like copper or iron ore but those changes
are also cyclical. Metal prices aren't going back to pre-2000 norms and there
are always mines getting depleted and closing.
Miners will not be able
to rest on their laurels and prices should stay high enough that bulk tonnage
will always have its place--if costs get under control. While miners will not
prefer lower grade deposits and they may not be the
first ones bought, at some point many of them will still get mined.
The second reason is the
psychology of management in larger organizations. Many CEOs got chopped in
the past year. That lesson is not lost on their peers but don't count on the
lesson maintaining its power forever.
People who work their way
to the top of large organizations tend to be empire builders. It's in their
nature to want to maximize the size of the organization and the importance of
their position.
We've seen this over and
over again in other sectors. Every decade or so there is a rash of mergers. A
lot of them end up being non-accretive at best or disastrous at worst.
Shareholders and analysts decry them and CEOs promise to forget they ever
heard the term "M&A". A few years later they are back at it
again. I see no reason to think the mining sector will be any different.
That's light at the end
of the tunnel, but it's a long tunnel. A few juniors could cycle through other
projects or hunker down while maintaining interest in a large resource no one
currently wants. I'm pretty sure that is exactly what will happen in many
cases.
I also expect the
creation of a number of mid-sized companies that will cast their nets more widely
for projects and generate new takeover demand. In a normal bull cycle this
sort of company gets created organically. Some companies go into production
successfully and keep doing it until they control a number of mining
operations and a substantial top line revenue stream.
This happened this cycle
but it's not as evident because there was a rash of takeovers mid-decade that
saw mid-sized producers either merging or being bought out by their larger
brethren. The mid-cap space was hollowed out. That normally takes a long time
to correct but there is a movement afoot that could accelerate it.
Many large companies are
facing demands to "right-size", splitting into geographic and/or
commodity sub-units. In theory at least this would make the growth path smoother
for these newly minted companies.
If you are a company that
produces two million ounces a year of gold it should, in theory at least, be
much easier to deliver 10% production growth. That's 200,000 ounces a year
which one moderate mining operation or two smaller ones can provide. This
still isn't a piece of cake, but it's a lot easier than adding a million
ounces a year.
The largest miners didn't
seek projects with maximum scale out of some sort of perverse obstinacy. They
had shareholders demanding revenue and profit growth at levels that demanded
large project spending.
It is absolutely no
coincidence that the largest mining houses in the world focused on iron ore
and metallurgical coal for the past decade or more. If you are RTZ or Vale or
BHP it's not just desirable to have projects in these commodities--its
necessity. No other commodities have individual projects that generate
revenues at a scale that delivers the percentage top line growth shareholders
demanded. In order to continue to position themselves as growth stories, they
had to bulk up on this stuff.
This meant plenty of
competition not just for projects but for specialized large scale equipment
and one-off engineering and design talent. It's tricky to build huge
complexes capable of processing and shipping tens of millions of tonnes of material annually, not to mention rail and port
facilities to go with them.
While the situation was
less extreme in the precious and base metal space the large project bias
helped magnify existing bottlenecks for things like heavy haul trucks and
extra-large mills. Combine that with a stressed supply chain and exploding
prices for major inputs like steel and you have a recipe for extreme cost
inflation.
An added problem that I
think exists but doesn't really get talked about much is lack of experience
on the project management and engineering side. You can only train people so
fast. The number of projects under development grew so rapidly that personnel
were spread too thin. Its highly likely that some of the problems with cost
overruns were exacerbated by poor project management and initial cost
estimates by relatively untrained engineers that were just plain wrong.
It will be difficult for
the really large mining houses to escape the vicious cycle of cost overruns
unless they downshift growth plans for an extended
period. The best managers need to be put on the most important projects.
Prices for things like mills and trucks are sticky and it will take several
quarters of relative inactivity before prices stabilize and, hopefully, fall.
I don't see the largest
mining houses "rightsizing" unless they split into commodity groups
but there is room for midsized and large precious and base metal miners to do
it. There should be more spin out transactions as non-core assets are shed
and business units are split off. This will give the new entities the ability
to reset things starting with a sustainable revenue level that would be
easier to grow from based on smaller more manageable operations.
This would give rise to a
new group of small and mid-cap miners. It's been lonely in the mid-cap space
for some years. We haven't seen the rise of many new multi mine producers of
the type that were formed in earlier cycles. I think this growth at the small
end of the mining production sector is coming anyway but it will happen much
faster if some larger companies split themselves up.
The reemergence of the
mid-cap space in the mining sector should generate new demand for projects in
the 1-5 million gold ounce equivalent range. That
gives some hope to juniors sitting on this type of project though I stress
that buyers will be very picky and high margin projects will be the only ones
getting bought any time soon.
What will they be looking
for? Lowest quartile cash costs and, where possible, lowest quartile capital
intensity too.
Capital Intensity is a
measure of the initial capital required to generate an ounce of gold, pound
of copper, etc. Lower capital intensity projects should be easier to finance
and, other things equal, will have shorter payback periods. In some
situations, capital intensity can be so low that it can help overcome even
grade.
A good example of this is
a number of new mines in Sonora, Mexico. These are all heap leach operations
at present and most have low grade resources. Even so, many of them produce
gold in the $400-600/oz cash cost range and
generate impressive returns thanks to good infrastructure and low capex. I expect Mexico and other areas with infrastructure
and cost structure advantages to come back to prominence in the next couple
of years.
Another thing you will
see majors going after again is underground resources. This will come as a
surprise to many. It's been a mantra in the exploration and mining sector for
years that open pit trumps underground. This viewpoint made my dear departed
brother David crazy. Dave went to a mining school and thought investors
vastly overestimated the cost advantage of open pits.
There is a cost
advantage but it's smaller than most people think. A well run underground
mine can have mining costs in the $50-75/tonne
range. If the resource is shallow enough to be ramped to rather than
requiring a hoist and head frame the capital cost can be greatly reduced and
the construction period significantly shortened.
Underground operations
often run at much lower daily production rates. This means a smaller mill
(it's almost always a mill). Yes, milling has higher costs per tonne than heap leach but there are some significant
consolations. The biggest one is recoveries.
While there are simple
oxide resources with high gold heap leach recoveries you'll generally recover
a lot more gold in a well-run mill. Gold recovery per tonne
20-40% higher than heap leach are not uncommon and for silver the amount
recovered is often as much as 100% higher. That is the reason you'll see Silvercrest run a lot of its leached ore through a mill
once it gets one up and running. There is still significant value in the ore
when the leaching is finished--and Santa Elena has high leach
recoveries compared to most.
Underground operations
often have better survivability during bad times as well. It's common
practice to run several stopes or working faces
simultaneously, often producing from areas with different grades. The output
from these different areas is mixed on its way to the mill to produce feed
with an average grade approaching that of the entire orebody.
If metal prices drop the
mine can focus on higher grade areas that produce at lower operating costs and
keep the mine alive. This is not the preferred way to go as you're robbing
grade from the later stage of the mine life but at least its keeps things
going.
This sort of selective
mining is generally not feasible in an open pit scenario. An old miner's saying
is "you can't stope an open pit". By that
they mean that it's difficult and perhaps impossible to adjust head grades by
changing the mining plan in a bulk tonnage deposit. If the price of your
commodity drops below production cost, you're done. This is one more reason
why suddenly risk adverse management might learn to love underground deposits
again.
While all mining
operations have some similar clean up issues like tailings, underground
operations often have much smaller environmental footprints. They are also
just less visible, particularly when it's a ramp only situation. In many
modern operations even the tailings and waste issue is alleviated though the
use of backfill that returns mined rock to underground workings areas that
are no longer active. Lighter environmental impact can simplify and speed up
the permitting process.
I'm not assuming a
wholesale change of direction by every major mining company but I do think
the game has changed. It's now about high margin, low capital intensity
projects. If a project can deliver that and it's a low environmental
footprint situation so much the better. I think underground will be back in
vogue.
That doesn't mean open
pits go away. High grade heap leach operations can also be low cost low capex and some large operations have great returns.
Investment returns will have to be high though, and long payback periods will
be difficult to sell to bankers and investors. If you're looking at companies
with advanced projects be sure that they fit these new parameters. I think it
will be a long time before a project gets developed or sold if it does not.
On the investment side,
there may be no cure but time and success for the sector. In addition to the
mismatch between market value and project cost that you see in scores of
development companies you have a big trust issue. So many companies have
blown up projects with cost overruns and under performance that traders don't
believe the study numbers any more.
In past years one might
look at a company with a $20 million value and a project with a $500 million
NPV and say "that looks cheap". These days we are much more likely
to say "no way can they ever finance that (probably true, alas) and
they'll probably just screw it up if they do".
I don't expect a sudden
rise of "faith based investing" in the Junior space. Failing that
the only way to close the gap between company value and apparent project
value is successful developments. Traders need to see companies bring
projects through development on time and on, or at least near, budget. Having
managed that, the market will also want to see a few quarters of profit
numbers reasonably close to expectations.
If a bunch of development
level companies can pull that off it will help not only their own
shareholders but those of companies earlier in the development cycle.
It takes time to get even
a small operation up and running. The timelines would be much more manageable
than a megaproject though. Small (20-100k ounces/year) projects use off the
shelf mining and recovery equipment. They also tend to have shorter
permitting periods because the amount of disturbance is much smaller.
Getting from development
to production takes money and it's a tough financing environment. It's much
more possible with a small operation however, especially in a region with
good infrastructure. Several companies have managed to get heap leach
operations in NW Mexico going for tens rather than hundreds of millions.
The same thing should be
possible in the SW US, especially in the post-housing bubble era where
construction and earth moving costs have dropped substantially. It's not
going to be easy but management that can convincingly show it has proven
capability to go into production will find money, even in this sort of
market.
I expected to start
seeing retooled economic studies that favor small, low capital intensity
projects. Some juniors will be able to graduate to production with these. One
thing about small production scenarios is that they can't really support
outrageously expensive feasibility work. This is another area that has seen
huge cost inflation.
This will be tricky to
manage because the regulators will not let companies talk about project
economics in anything but very vague terms until a large third party
engineering firm has sprinkled "bankable feasibility" holy water on
it.
I understand that the
regulators are trying to protect investors. Companies can't talk project
economics unless a third party Qualified Person has vetted the estimates.
That is fine as far as it goes but it imposes huge costs on even small
projects unless the company can raise financing without a feasibility study.
On really "capex lite" projects spending
millions on feasibility rather than spending money just putting the dammed
thing in production will not make any sense.
Will some of those low
budget production startups blow up in everyone's face? Yep. Welcome to
business start-ups 101. It will happen in some cases, with or without a
feasibility study. You can't predict everything and failures happen across
every sector and mining is no different. I'm not trying to dump on the
engineering industry but it's worth remembering that many of the current
projects with the worst cost overruns and initial production stats are also
the most expensively over engineered ones. Giant, expensive studies have not
guaranteed success.
When looking at potential
production situation without lots of third party vetting, it will be
imperative to get a feel for the competence of management. Resumes will have
to be checked and should include supervisory experience in mine construction
and operations. Exploration geologists with no minesite
experience should not be trying to develop projects on their own. Thankfully,
most of them have the sense to know that and will add relevant personnel.
Large engineering groups
have been delivering "gold plated" project designs for years. Some
of them were sued in the past when there were production startup issues.
Their response has been to over engineer everything. This makes a failure in
the production flow sheet less likely but it also makes the project
significantly less economic overall and more susceptible to cost overrun.
The whole industry won't
move to seat of the pants mine building but some sort of happy medium has to
be found. One of the most interesting recent news releases came from First
Quantum Mining (FM-T). HRA followed FM from its inception until it
reached $100/share several years later. It got there by developing or
redeveloping several large copper projects, mainly in the Zambian copper belt.
First Quantum has always
done most of its planning and project management internally. Because it's
been so successful it has a great deal of street cred. This means that when
it lays out an economic model for a new operation the market takes it seriously.
FM recently acquired Inmet, and the main motivation for the takeover was to
get control of the giant Panama Cobre deposit. Cobre was mainly designed and costed
by large international engineering firms and has an estimated capex of $6.2 billion.
FM announced a few days
ago that it was cancelling the contracts of all the outside engineering and
construction firms. It plans to spend several months going through the
existing feasibility study, tweaking the design and planning to try and cut
costs.
FM's management thinks it
can take a billion dollars off the cost and I won't be the least bit
surprised if they do it. You'll see a lot more of this in the future I think.
It's similar to the trend in other industries to hire in house legal counsel.
A big part of the job of an inside counsel is policing the billing of
external law firms. Expect mining companies to use a similar model with
engineering and to get a lot more hard-nosed about the costs they will
accept.
The sector is not
disappearing but like any industry that has had a major growth spurt mining
has excesses that need to be dealt with. The cost squeeze will go on for a
while and so will the slow pace of takeovers. Takeovers will return however
and this new paradigm will give select juniors a chance to move to production
on a small scale themselves.
Creation of a new set of
companies that can climb to the mid-tier space is overdue. The current bear
should not stop that transition and may even accelerate it. I'm looking for
contenders for the HRA list.
Market Overview
Metals and the junior
markets continued their dive this month. There is some indication that we
might be seeing a bottom in the gold price but that bottom is in the process
of being tested. It's too early to know if the test succeeds this time.
Gold was finding its feet
when it was knocked back by release of the latest Fed meeting minutes and a
report from Goldman Sachs calling for lower gold prices.
The Fed minutes showed
that several Fed governors were calling for an end of QE3 this year. That is
not too shocking. Several Fed board members have been opposed to the
expansion of the Fed balance sheet from day one. Note also that this meeting
took place before the release of the March employment report in the US. When
the Fed was meeting the consensus estimate was for 250,000 new jobs in March.
The actual number was a very disappointing 88,000. At that rate of job growth
it would take years to get to Bernanke's 6.5% unemployment target for ending
QE3.
Goldman's report just
came out but I don't expect it to say anything too compelling. Wall St is
basing gold forecasts on QE3 and not much else. Gold went up for years
without QE1-3. Buying was based on an easing US Dollar and also on increased
wealth levels in developing countries, particularly India and China.
Recent economic news out
of China has been relatively good. India is a bit of a mess but soft
commodity prices are high and the strength and price of harvests have as much
impact on the appetite of Indians for gold as anything else.
The chart of the $US
below is impressive in that it looks like the US Dollar wants to roll over.
That is meaningful given how hard the Bank of Japan is working to weaken the
Yen and the pandemic of foot in mouth disease in Europe. All the jawboning in
Washington is just that--jawboning. Only a complete idiot would want a higher
currency in this environment.
Note the first chart
above, Chart A, which I stole from Dave Franklin at Sprott
Asset Management. The chart shows the long term trend of gold prices versus global
(US+ECB+UK+Japan) central bank assets. The long
term correlation is impressively high with an R2 of 0.945. Correlation
doesn't mean causation but when it's this high you have a relationship worth
watching.
Central bank assets
actually declined in Q1 as the ECB reeled in some of its 2 year refinance
paper. That has all changed since the Bank of Japan opened the spigots. If
Europe keeps dragging odds are the EBC grows its balance sheet again too.
With Japan's $75 billion
added to the ongoing Fed $85 billion in balance sheet expansion, global
central bank assets could grow by another $1.3 trillion by year end. That
implies a $300/ounce increase in the gold price based on the relationship
graphed above. No guarantee obviously, but a cheery thought to end with.
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.
From The April 2013 HRA Journal:
