What Does Cheap Really Mean?
March 15, 2010
Victory For Gold
March 20, 2010

Mining Services (Part I)

Gold is going higher, but it’s hard to find an intelligent way to gain leverage to it. Sure you can own gold, but if it more than triples from here in the next five years, I’ll be shocked. You can buy the producers, but they all have warts. Either they’re overvalued, they keep diluting investors, their mines are in countries that you’d be scared to vacation in, or they’re poorly managed. In most cases, it’s a toxic combination of the above. That leaves you with the junior miners. Even the geologists often have trouble investing in these—what are your odds of success? At the same time, if you’ve watched the investment landscape, you intuitively know that countless mining penny stocks will go up ten and twenty-fold in the next few years as gold goes higher and hot money floods into the sector. The same thing has happened to ethanol, nanotech, dotcoms and other formerly hot industries. Rather than playing Vancouver roulette, it makes sense to consider an underappreciated segment of the mining universe—mining service companies.

Simply put, geologists are often not good businessmen. When they have cash, they spend it looking for new mines. They literally cannot help themselves. That cash either comes from increased profits as gold goes higher, or from investors funding the hopes and dreams of junior mining stocks. While you can invest in these ‘hopes and dreams,’ I think it’s much better to just figure that with gold going higher, mining companies are about to come into a lot of money—they are going to spend it—and if you own a company that helps miners to explore for ore, it’s the equivalent of owning a casino. As long as patrons (mining companies) come to spend on exploration, you will make a good deal of money. Who cares if they find anything? It’s like owning Cisco (CSCO: Nasdaq) in 1995 going into the tech bubble—or owning Levi Strauss in 1853. If you look back at all past gold rushes, a few guys got lucky, but the real money was made by the guys selling the picks and shovels. I don’t think it should be any different this time.

Over the past twenty years, worldwide exploration budgets ranged from just under $1.9 billion in 1989 to a peak of about $5 billion in 1997. By 2002, they were again at 1989 levels. Only in 2006 did exploration spending increase to over $7 billion, peaking out at $13 billion in 2008. Based on numerous estimates, it takes from $10 to $15 billion in exploration spending a year just to replace the ore that was depleted that year. This implies no growth in metal production—which is basically what is occurring. For there to be any growth in production, exploration spending needs to remain well over $15 billion for years into the future.


For the mining industry, this means that for most of the past twenty years, more ore was mined than discovered. Mining is unique in that you slowly deplete your assets. Unless you find new ore, you no longer have a business. During the last two lean decades, there were only two years that had more ore found than depleted. This is not sustainable. Not only is demand for metals increasing, necessitating more mines, but many of the largest existing mines are nearing the end of their economic lives. These elephants will soon need to be replaced.


The above graph somewhat understates how much reserves are down since higher prices are lowering cut-off grades and somewhat offsetting depletion. It’s an accounting measure and not sustainable. Still, it shows the effects of depletion and higher exploration budgets not offsetting depletion.

Mining companies have been hesitant to spend money on exploration because it is an expense that goes through the income statement. Furthermore, most mining companies have not had much excess cash because even at current prices, they aren’t earning all that much money. The majors all took the view that they could use overvalued shares to acquire whatever the juniors found—the problem is that excluding a few discoveries, the juniors didn’t find all that much, despite spending billions in the effort. The only way to fix this is to spend significantly more money. If I know mining companies, they are finally seeing some profitability and they are about to start spending—MASSIVELY. At the same time, speculators are about to pump a lot of money into small cap exploration.

There are three genres of exploration spending; producing mines, brownfield and infill drilling and true greenfield exploration. The vast majority of all spending is in the form of drilling, with lesser portions for geophysics and surface sampling. For most of the last two decades, most spending was done just to keep existing mines producing ore. Once you build a mine, you must constantly do definition drilling so that you can update your mine plan and ensure that you only process economic ore. It has been said that the best place to look for a new mine is next to an existing mine. A mine is really just a hole in the ground next to a giant chemical plant. As the mine depletes, you are left with a worthless chemical plant, unless you find more ore nearby. This has been the second main use for exploration dollars. Unless a mine is shut down, this expenditure is rather constant—for without it; you cannot feed the mill or maintain the same ore grade.

Brownfield and infill drilling describe old mines that are looking to restart due to rising metal prices, or past discoveries that were never turned into mines for whatever reason. People know where these assets are, and they know what’s wrong with them. The reason they are not currently mines has something to do with their lower profitability or the country where they are located. Turning them into mines now takes significant drilling to prove up more ore and build the mine plans needed for funding. There are hundreds of properties undergoing this process in one stage or another. The problem is that most of these assets have issues—only higher metal prices will cure these issues. Even then, only a few of these will ultimately become mines. So while a lot is being spent on them, the vast majority of them will never be built—they are just speculative toys. Only recently has any significant money been spent on this segment of exploration.

Finally, there are the true greenfield projects. These are all hopes and dreams—but unfortunately, most of the world’s future metal will have to come from these as the first two categories mainly include assets that are either depleted in the first case, or deficient in some way in the second case. Throughout history, ore bodies that were higher grade and easier to mine were mined first. As these were depleted, economies of scale allowed large—yet low grade assets to be mined. The problem is that people have combed the first world looking for good assets. This means that the next generation of mines will be either in remote places in the first world, under overburden—hence undiscovered so far—or located in hostile business environments in the third world.

Producers are now starting to realize that in order to grow—or even maintain current production rates—they need to find new assets to mine. The big guys like to mine big, high grade deposits. There simply are not a lot of these out there that aren’t already being mined. They will need to be found and it takes a lot of money to find a true elephant deposit. The real growth in future spending will have to be in greenfield areas that haven’t been explored adequately. That means, taking on political risk, going into remote places or looking deeper. In part II, I will talk about my two favorite ways to play this trend.

I want to note that about a year ago, all exploration spending ceased. Even though most existing mines continued to produce metals, they even stopped spending on definition drilling. All activity simply stopped. Juniors could no longer raise capital, and the producers were focused on paying down debt. This sharp pullback is now reversing itself. Q3/2009 saw the most money raised by junior miners since Q4/2007. Q4/2009 has shown similar demand for financings. Anecdotally, I also hear that 2010 exploration budgets for majors are quite robust. This money has to go someplace. Ironically, many of the mining service companies are still priced as if the world is ending.


Junior Miner Financings (in $AUD)

Source: Boart Longyear

Categories: Current Investments
Positions Mentioned: none

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