Richard Karn: No. We continue to see more junior mining companies
failing from here and have been waiting for a final wash out of the junior mining
sector for some time.
At the end of the day, capital is the most vital of all resources in
producing commodities, and too much capital has been misallocated in the last
few years for there to be a sudden resurgence in lending, especially to
the junior mining sector. And as we all know, global commodity prices as
measured by the S&P GSCI index are down 34% over the last year due to
overcapacity and overly rosy projections about future pricing power and
consumption and emerging market growth and endless expansion, etc.
Less discussed, however, is the way this misallocation of capital is
likely an unintended consequence of years of unprecedented capital injections
by central banks globally, which is more than mildly ironic because the
Federal Reserve blamed the global financial crisis on the "surfeit of
savings globally." As with the housing bubble in the run-up to the
global financial crisis, there was such a thorough relaxing of lending
standards, not to mention the push to "get deals done," that
projects and expansions that should not have been funded were, and now the
world is awash in not only oil and iron and cotton and labor but also
capital itself.
Belatedly, institutional capital today is increasingly anxious because
resource investments made over the last few years are now money-losing
positions from this rapid collapse in commodity prices. The knock-on effects
have yet to play out, but the market seems to be fervently hoping that
commodity prices recover before the bond markets, especially the junk bond
market, pitches a fit.
Think about it: institutional capital is now so scared it would prefer
to in effect pay profligate governments and central banks a fee to use their
money to do more of what has clearly not worked—only harder—than to tie up
their funds in infrastructure or mining projects capable of producing a
long-term return and benefitting the global economy. Such an approach to
fiduciary responsibility smacks of that Mark Twain quip about seeking "a
return of his money not a return on his money."
Negative interest rates can only be seen as a condemnation of failed
interventionist policy. There can be no recovery until the excesses have been
worked off, and we just don't see the resolve to make long-term commitments
of capital returning any time soon—and today the junior mining sector is way
down the list of possible investments.
Keep in mind that specialty metal projects were either drowned in capital,
starving other arguably more deserving projects, or totally ignored, and now
all have been left high and dry as capital recedes. Ironically, a number of
the projects that were flooded with cash and have failed or are failing were
projects that could not possibly have lived up to the frenzied hype because
the specialty metals they produce were not what the market needed.
That's what happens when people do not understand what they are investing
in—or why—and demonstrates how so-called industry professionals can be as
guilty of shallow, shoddy research as a novice retail investor.
This is also why, despite the collapse in broad commodity prices, numerous
specialty metal prices have held or even gone up in the last few years:
companies with the potential to produce these metals couldn't attract
capital, and the tightness today is now likely to become shortages tomorrow.
Eventually the market will accept this new reality, and investment dollars
will flow from "story stocks with potential" to producing
operations.
When institutional capital eventually comes back to the resource sector,
especially to the specialty metal sector, because it is scared, money will
flow first to what has been proven to work, that means companies that are
funded and in or nearing production now, which will be seen to be a
tremendous advantage. Then, because mining costs will have declined so far
and cost curves will have been re-based, improving especially private
equity's return on investment, merger and acquisition activity will
accelerate.
But private equity firms know the longer they wait, the more the resource
sector will be starved for capital and the cheaper the deals will become. In
other words, because they cannot be sure the bottom in commodity prices is
in, they will wait for slam-dunks.
So no, generally speaking we don't see a light at the end of the tunnel
for the majority of junior mining companies. That being said, specialty metal
companies with good managements and good projects are still finding ways of
getting funded and into production, and that is where investors need to be
looking—at those companies that are getting the job done despite the collapse
in commodity prices.
TGR: Are specialty metals companies, say those producing graphite,
tungsten, rare earth elements (REEs), niobium, etc., in a better position
than gold and silver companies?
RK: No. If anything, it's probably worse, but they are entirely
different situations. Gold and silver is pretty easy to understand; the
roughly 50 specialty metals we follow are anything but. Gold and silver are
hedgeable, which is critical in securing commercial finance; most specialty
metals are not.
For the last couple of years, gold, and to a lesser extent, silver
companies with proven management and good projects have been able to secure
funding because demand remains pretty robust. Over the last decade China has
surpassed India as the premier gold buyer, but where India re-exports a
portion of its gold, it appears that what gold goes into China tends not to
come out again. Only something on the order of 12% of gold production is
consumed, primarily in electronics—and most of that is easily recovered—so
the global stock of gold increases every year with the majority going either
into jewelry production or saved as a store of wealth.
Specialty metals are more utilitarian so their stocks are perpetually
drawn down, but projects are difficult to get financed because many specialty
metals are not hedgeable. Despite the aforementioned decline in commodity
prices, which has certainly caught a number of specialty metal prices in the
rip tide, demand and prices on the whole have held up pretty well because
these metals are regularly consumed and must be replaced—and I'm not just
talking about consumer electronics, but also about the specialty metals used
in automobiles, household appliances, military materiel, renewable energy,
super alloys, etc., all of which continue to consume specialty metals like
there's no tomorrow.
There are exceptions, of course, but by and large only a few high value
specialty metals, such as platinum, palladium, silver and gold, have economic
recycling protocols, so every year we drain the finite global specialty metal
resource base by that much more.
TGR: Is investor interest in specialty metal companies more closely
tied to the larger economy or to a specific story?
RK: My experience has been that investor interest is geared toward
a specific specialty metal story that both piques their interest and is
easily understood. But I don't think the broad market appreciates what it
takes to secure funding for a specialty metal project these days, or what a
testament to management innovation and perseverance it is to get a project
into production.
To take but one well-publicized example, the electrical storage sector has
been attracting a great deal of attention recently. The Tesla/Panasonic
lithium-ion battery 5-Gigawatt-hour Gigafactory is slated to consume about
25% of current global lithium production, 35% of current global graphite
production and 15% of current global, non-Democratic Republic of Congo cobalt
production.
Investors read that BYD, Foxconn, Apple, LG Chem and Samsung are all
planning their own similarly sized lithium-ion battery Gigafactories and
rightly conclude current supply of these specialty metals cannot possibly
meet future demand, so they look to invest in companies producing these
specialty metals. This is much easier said than done because what they find
is that despite five years having passed and World Trade Organization (WTO)
verdicts condemning certain behavior, the situation is largely unchanged and
the world is still dependent on China for many of the most critical specialty
metals. Further, the broader specialty metal space has been starved of
investment capital for at least three years now, which means in real terms
very few projects have been put into production.
Graphite was one of those specialty metals that everybody had to have a
few years ago, and there were suddenly more graphite companies promoting
their deposits and bad-mouthing others' projects than you could shake a stick
at. And the best of them were years away from production—and still are.
TGR: Could you tell us about a graphite company that you like?
RK: Valence
Industries Ltd. (VXL:ASX) is a graphite company that has largely escaped
North American and European investor attention despite being in production
today. For the last couple of years I've been modeling Valence in my
presentations as one of three Australian specialty metal companies that has
been "doing it right" in this dreadful funding environment: the
company is actually producing graphite from its Uley Graphite project in
South Australia—not talking about it, Valence is actually producing and
selling graphite today.
TGR: That was a brownfield project, wasn't it?
RK: Yes, Managing Director Chris Darby and the board raised $22
million ($22M) during 2014, bought the project from Strategic Energy
Resources Ltd., refurbished the plant that had been on care and maintenance
for nearly 25 years, did a compliance listing on the Australian Securities
Exchange and, after fighting through a jungle of red tape, put Uley back into
production earlier this year.
Valence recently completed the processing of its first 1,500 tonnes of
run-of-mine stockpiles and exported its first 20 tonnes of graphite products;
it is currently ramping up production, which by Q3/15 should reach nameplate
capacity of 14,000 tonnes per year (14,000 tpa). Flake size and purity have
exceeded expectations, and customers are lining up for their graphite products
for use in refractory, foundry, lubricant, battery, electronics and
biomedical applications. Importantly, Valence has discovered a new,
high-grade deposit adjacent to its first pit that has already led to a 43%
increase in its JORC-compliant Ore Reserve, taking it to nearly 3
million metric tonnes (3 Mmt) at 12.1% graphitic carbon, and extending mine
life to beyond eight years.
TGR: Valence Industries recently secured US$75M in loans. How will
the company use the funds to add value?
RK: The loan facility will be drawn down in stages primarily to
complete the current drilling program, to increase production in two steps to
39,000 tpa and then to 64,000 tpa, and to pay for the construction of both a
materials handling facility and a new advanced manufacturing facility in
Adelaide. This advanced manufacturing facility is what interests me most
because this is where Valence upgrades its standard products into highly
sought-after, higher-margin graphite products.
With a product line that ranges from $1,335/tonne to $3,819/tonne in
price, the more of the latter Valence can produce, the higher its profit
margins. Originally, the company was planning to upgrade about 5% of its next
stage of production (39,000 tpa) to the high-margin product, which would have
given it an average profit margin across its entire product line of about
$890/tonne. But customer product approval and demand for the high-purity,
large-flake product has convinced Valence to increase its upgrading capacity
to about 40% of production, which will increase its average profit margin
across its entire product line to about $1,650/tonne—an 85% improvement.
TGR: How important is it to secure an end user in the graphite
market?
RK: End-user product approval is vital. Keep in mind that many
specialty metals do not trade on an exchange so the pricing is often about as
clear as mud; in numerous instances the specialty metal prices paid, as well
as the customers' identity, are closely guarded secrets because they
constitute a competitive advantage. The price you read about in the paper or
on the Internet is often just a best guess. And when a company sells a whole
range of products from the same deposit, as is the case with graphite,
prices—as well as demand—are all over the place depending on flake size, purity,
etc.
So Valence has spent a lot of time giving samples of its graphite line to
potential customers, seeking product approval. To date, the company has
received product approval from nine customers and has signed sales contracts
for 8,000 tonnes of graphite. Valence also has multiyear memorandums of
understanding pending product approval for contracts amounting to an
additional 37,000 tpa.
TGR: What is the long-term growth trajectory for this company?
RK: I think Valence Industries is ideally positioned to profit from
increased demand for graphite. I expect another significant upgrade in both
the size and grade of the Uley deposits in the next six months or so.
Valence has gone through the typical specialty metal IPO insanity in which
hot money in Australia and Asia chased the graphite fairy tale, and the share
price ran from AU$0.20 up to about AU$0.65 in the first six months of
trading. Then, as is usually the case, when Valence knuckled down and got to
the hard work of actually going into production, the hot money lost interest
and moved on to the next big thing and the price has drifted back down to
AU$0.25 or so.
Some people take issue with the debt facility Valence has arranged in
order to expedite expansion and improve profit margins, disregarding the fact
that securing any financing at all in this market is testimony to the
superior nature of the project. People doubt that at some point non-Sino
supply of specialty metals like graphite are likely to command a premium. So
Valence's share price has drifted down. But what's starting to replace the
hot money are serious investors interested in accumulating a real long-term
growth story, real graphite production, real profits.
Just as Elon Musk and Panasonic would not have funded the construction of
their lithium-ion battery Gigafactory without securing supplies of the
specialty metals they will require, neither will the other five companies
mentioned above as having announced plans for Gigafactories of their own.
When another lithium-ion battery Gigafactory breaks ground, supply of
graphite will clearly get squeezed; if two or three more break ground, that
will consume more graphite supply than currently exists globally, prices will
explode, especially for the large-flake, high-purity product. Even assuming
financing can be arranged, and there a number of graphite projects getting a
lot of press, it takes a lot more time than people realize to put new
projects into production, which puts Valence into a very good position
strategically.
Uley is not on the drawing board; Valence isn't promoting its
"potential." It is real; it is in production; it is fully funded to
both quadruple production and to double its profit margins—right here,
right now.
TGR: And this "right here, right now" aspect is critical
to your overall specialty metal investment thesis, isn't it? Can you take a
moment to explain that to our readers—and how it ties in to the companies
under discussion today?
RK: Sure, but please understand we're not moralizing or condemning
anyone: the situation simply is what it is; the West let the situation
develop, and the West will continue to pay for the mistake. We just aim to
profit from it.
Our investment premise regarding specialty metals is simply this: Any
lingering notion that free market economics apply to specialty metals has
been dispelled by China. Through a centrally planned policy decision, China
has spent at least 35 years attempting to take control of the global
specialty metal market—and it has largely succeeded.
Unburdened by labor, energy or materiel costs, not to mention competition
or environmental concerns, China simply undercut the production costs of most
specialty metal projects in the West, and the West with a "New
Economy" focus on short-term earnings rather than long-term security of supply
simply went along with it.
Then in 2010 when China used REEs as an economic cudgel against Japan over
a minor fishing incident, the West finally caught a glimpse of the
predicament their dogmatic belief that "free market economics will
prevail" had landed them in. The West forgot that in war, even economic
war, the first victim is always truth—and the second is always access to
strategic raw materials.
Reflective of the litigious society we've become, our first response was
"to sue the bastards" in the WTO, conveniently overlooking that
China had never qualified for the WTO membership the West had ramrodded
through in the aftermath of the dot.com bubble collapse—or more ironically
that Wall Street had been heralding communist China as the "future of capitalism"
for nearly a decade.
So by 2011, organizations like the British Geological Survey were falling
over themselves decrying that China was the largest producer of 50% of the 52
elements, minerals and metals they had determined to be under critical supply
threat; further, China produced more than 85% of a host of minerals including
but not limited to graphite, tungsten and rare earth elements, which we're
discussing today.
The West responded by throwing money at anything even vaguely resembling a
specialty metal project, with the rare earth element projects becoming the
poster child for this panicked, gross misallocation of investment capital.
Five years on, there have been some stupendous failures, but the problems
remain largely unaddressed. China still controls large swathes of the
specialty metal space. As predicted, China is effectively thumbing its nose
at the WTO ruling, simply replacing export quotas with taxes and production
quotas, and pretty much doing as it damn well pleases while the West sputters
impotently, and little real progress has been made in reducing China's
control over specialty metals.
So my publication focuses on specialty metals projects that can be used to
replace Chinese supply—but only if they are located in North America or
Australia. We look at both brownfield projects that were shut down because
the Chinese undercut the project on price, as well as at greenfield projects
of extraordinary caliber that we believe will be funded despite the hostile
environment. So of the three projects under discussion today, two are
brownfield and one is greenfield, and thanks to its unique geology all three
are located in Australia.
TGR: Valence Industry's Uley graphite project was one of these
brownfield projects; what's the other?
RK: Carbine
Tungsten Ltd.'s (CNQ:ASX) Mt Carbine project in Far North Queensland,
which was once one of the largest tungsten mines in the world and was last
operated as a joint venture by the Roche Brothers, Sandvik AB and Treibacher
Industrie AG in the 1980s. It was a classic case of what I'm referring to as
a perfectly good project that was operating profitably one day and mothballed
seemingly the next. No management or labor problems, no decline in grade, no
indication the deposit was being exhausted—it was just rendered unprofitable
by the flood of cheap Chinese tungsten that suddenly appeared on the market.
So a few years ago, at a time when no commercial interest on the planet
would fund putting Mt Carbine back into production, management scraped
together the funds to buy a small, used processing unit and set about
reprocessing tails from previous operations in order to recover what
wolframite previous operations had missed and all of the contained scheelite,
which hadn't been targeted at all by the visual sorting methodology employed
at the time, to produce a tungsten concentrate for end users to evaluate.
What Carbine Tungsten demonstrated was not only how inexpensively these
brownfield projects could be put back into operation, but also how low
operating expenses can be, which has turned out to be competitive with
Chinese tungsten projects today.
In the aftermath of the Chinese using REEs as a weapon, Japan was eager to
start diversifying its supply of specialty metals away from a dependence on
the Chinese, and Mitsubishi tried and then started buying Carbine Tungsten's
tungstic trioxide (WO3) 72% concentrate. In fact, Mitsubishi liked
the product enough to begin prepaying for all of the concentrate Carbine
Tungsten could produce from the tails.
TGR: How important is Carbine Tungsten's relationship with
Mitsubishi both to operations and symbolically?
RK: I would be hard-pressed to think of a better partner for
Carbine Tungsten than Mitsubishi. Some people take issue with the idea that
up to now Carbine Tungsten has being reliant on one customer for all its
product sales, which we find ludicrous: had Mitsubishi not stepped up, the
project may well have foundered. And Mitsubishi has been a very good partner
with Carbine Tungsten; in fact, Jim Morgan, the managing director, frequently
comments about the way Mitsubishi often has had more people on site conducting
due diligence and research than he does running operations.
Symbolically, what better validation for your project can you ask for than
to have one of the 50 largest corporations in the world as your primary
offtake partner? In March of this year Mitsubishi and Carbine Tungsten agreed
to terms and offtake conditions for a $15M loan to advance stage 2 of
returning Mt Carbine to full production, which involves processing
approximately 12 Mmt of ore stockpiled from previous operations.
The deal, which will be finalized within the next quarter, will enable
Mitsubishi to purchase, at prevailing market prices, as much as 80% of
stage 2 production of 76,500 metric tonne units (76,500 mtu) of tungsten
concentrate per year starting in Q2/16 and then as much as 50% of stage 3
production of 270,000 mtu per year with the resumption of full scale hard
rock mining.
TGR: What other catalysts should we be looking for from this
company?
RK: Foremost is that Carbine Tungsten's management is currently
engaged with another group of investors about securing the estimated $55M
necessary to expedite a return to full mining operations. I have no doubt
Carbine Tungsten is on the right track with its incremental approach to
putting Mt Carbine back into full scale production, but if the company were
able to secure funding to skip reprocessing entirely and go straight to
mining larger volumes of higher grade ore in the open pit and adjacent
deposit, we think the share price would go ballistic.
Are we counting on it? Not at all, but it is a distinct possibility, not
least because of the current geopolitical situation.
I think it prudent to mention here that most people do not recognize that
there are few metals more vital to either industry or the military than
tungsten. Without it there would be no cutting tools, no super alloys, no
armor piercing ammunition. Also, there is no shortage of hot spots globally,
especially with tensions now rising because China has announced that it owns
virtually the entire South China Sea and has started building an island and
military base on some disputed shoals. Or the way it is looking increasingly
unlikely that the U.S. will be able to deal effectively with ISIL without
putting boots on the ground. Or the way things in Eastern Europe are
deteriorating.
And strangely, we've just heard rumors the Chinese are now sniffing around
Carbine Tungsten—and we would remind investors that in recent years
Chinese companies have bought Australian specialty metal resource companies
not to put them into production, but to ensure they did not go into
production, thereby protecting market share.
TGR: What is your greenfield project? How is it looking?
RK: It is Alkane Resources Ltd.'s (ALK:ASX; ANLKY:OTCQX) Dubbo
Zirconia project (DZP). The company received the last of its approvals from
the New South Wales government in April. Ironically, where some "fairy
tale stocks" are assigned dot-com-like valuations, real operating
companies with real earnings are arbitrarily discounted.
The Emerging Trends Report has long maintained that Alkane
Resources is a de facto exchange-traded fund for the Australian specialty
metal sector in that its Dubbo Zirconia project will produce roughly 20 of
the 50 specialty metals we believe to be under long-term supply threat.
Alkane also happens to own and operate the Tomingley gold project effectively
as a sideline—one that is throwing off about $20M a year in free cash
flow—while it pursues the development of the DZP.
Exemplifying how poorly understood the specialty metal space remains, as
well as the Alice-through-the-looking-glass markets today, fund managers are
openly assigning a negative value to the DZP, which has resulted in Alkane
trading for less than the net present value of its producing gold mine.
Underperformance by market darlings Molycorp Inc. (MCP:NYSE) and Lynas
Corp. (LYC:ASX), which produce predominantly low-value light rare earth
elements (LREEs), taint perceptions of other specialty metal mining projects;
that must make sense somewhere, but to us it is akin to branding the Saudis
as "frackers" because we're too lazy to do a little research.
The simple truth is that the DZP is a difficult but arguably the most
promising, and certainly the most interesting, specialty metal project on the
planet. The DZP's unique trachyte volcanic intrusive ore body hosts
zirconium, niobium, light and heavy rare earth elements plus yttrium in a
remarkably homogenous form that is readily soluble in sulfuric acid for
processing. It is a monster deposit with an 80-year mine life and a
megaproject price tag of $1 billion. That makes the name something of a
misnomer: zirconium and zirconia products constitute about two-thirds of
Alkane's product line by volume but only approximately 33% of its projected
profit stream.
Alkane has been developing the DZP flow sheet for 15 years, the last eight
of which have seen its demonstration plant at the Australian Nuclear Science
and Technology Organization (ANSTO) perpetually fine-tune the flow sheet to
the point it has been producing samples of its entire product suite for
end-user evaluation for the better part of six years. And heavyweight end
users like Treibacher are lining up to either buy, market or refine Alkane's
products.
What has captured our attention recently, however, is that this constant
optimization of the flow sheet for the demonstration plant at ANSTO has
resulted in the addition of hafnium oxide to Alkane's product line—the
significance of which is clearly not yet grasped by the market.
TGR: What's so important about hafnium?
RK: Hafnium is a peculiar metal, even by specialty metal standards.
Because of its near identical chemical composition to zirconium, hafnium is
widely considered to be the most difficult of all metals to separate and
recover economically.
Historically it has been used in nuclear reactor control rods and rocket
nozzles, but today well over half of all hafnium is consumed by the aerospace
industry in super alloys for turbine blades (rotating parts) and vanes (stators).
ATI Inc. (ATI:NYSE) and AREVA SA (AREVA:EPA) are currently the largest
producers of hafnium metal, which they recover as a byproduct of zirconium
refining for the nuclear industry, and together account for well over
two-thirds of global production of 50–60 tpa.
With demand for hafnium metal being in the 70–80 tpa range, however, the
price has escalated and remained in the vicinity of $1,200/kilogram despite
the aforementioned downturn in overall commodity prices. Both Airbus and
Boeing are predicting strong continued growth in the commercial aviation
industry (e.g., Boeing claims 35,280 new planes will be built by 2032), so we
expect strong hafnium demand well into the future.
I won't pretend to tell you how they do it, but the fact that Alkane has a
process that can now recover a high-purity hafnium oxide product will make
Alkane the world's first primary mine supplier of hafnium.
And that is a big deal.
Hafnium is similar in this regard to another specialty metal we like a
great deal, scandium, in that it is not demand for hafnium that is the
limiting factor but its very availability due to it being supplied solely as
a byproduct.
Myriad new and expanded uses await increased hafnium supply, and Alkane is
uniquely positioned to become the first company to offer primary mine supply
of roughly 200 tpa at the cost of little more than another circuit in its
processing plant. Hafnium oxide trades for roughly half the price of the
metal, or $600/kilogram.
One would expect a near quadrupling of supply of any specialty metal would
result in lower prices, but reduced hafnium prices would also spur new uses
and bolster demand. Over time, hafnium prices would find equilibrium, in all
likelihood at lower prices, but even assuming prices are halved, 200 tpa would
still represent $60M per year in additional revenues for Alkane for 80 years:
you do the math.
The addition of hafnium to Alkane's product suite, and its importance to
the aerospace industry, may well be the catalyst that gets the DZP funding
commitments across the line. And once Alkane secures funding, the rerating of
the stock will be substantial and will take the market by surprise—and Alkane
will become another overnight success 15 years in the making.
It has always been thus in the mining sector.
TGR: Richard, thank you for your insights.
