Hidden Value (Advertising Expense)
September 23, 2010
October 9, 2010

Mining Exploration–Here Come The Big Boys

Most analysts are too stupid to actually analyze financials; therefore mining stocks are usually valued on a multiple of current cash flow. Two decades ago, mining companies had an epiphany. Exploration costs money. If you explore, it reduces cash flow and hence your valuation. Rather than spend your own money, it’s better to overpay for junior miners who have found something as share dilution isn’t expensed through the income statement. From this notion, an uneasy symbiosis was formed. Large mining companies would focus on cash flow—juniors would handle the risky business of finding deposits. The quid pro quo was that if a junior found something, a major would overpay for it.

Then two problems developed. It turns out that most juniors aren’t very good at finding stuff. Even worse, every major has the same game-plan. All the big boys are fighting for the few good discoveries. Suddenly, we have a big problem—how do you replace two decades of depletion in a hurry?

Let’s take a step back and look at junior mining for a second. It is a pretty silly business when you think about it. You have to wonder why the majors pinned their hopes on these guys. So you have two geologists and an interesting patch of dirt they want to explore. First you go public. That costs money. Next you raise more money to explore. Say you raise $5 million. $500,000 is gone in broker fees. Corporate costs will eat up another $1 million. You need to think ahead about how you will raise your next $5 million. Even if you’re frugal, a good promotion campaign with conference booths, site visits and glossy mailings will cost $500,000. You’re left with $ 3 million to spend on actual exploration—most of that gets wasted on sloppy planning.

If you’re a big company looking to get value for your exploration spending, you have a set method to exploration. First you do mapping and soil sampling. Then you do geophysics. Then you poke a few drill holes in it. You analyze the data and determine if you want to continue. As you gain confidence in what you have, you slowly ratchet up your spending. Drilling is expensive; it’s the last thing you want to do.

If you are a small company, you are always thinking about how to keep investors excited and prepared to fund your next exploration campaign. Drill results produce press releases—soil samples will not cut it. Juniors have no choice but to drill—even if it makes no financial sense. They are burning matches and they know it. If they don’t have press releases, no one will fund their salaries.

Juniors tend to have terrible resource utilization. A general rule of thumb is that after paying for drilling and assaying, you will pay $300 a meter drilled. You should add another $100 a meter in local administrative costs. Say you do a $1 million dollar drill campaign. That gets you 2,500 meters drilled. Next you shut down for two months and analyze the data. If it’s any good, you then spend another month traveling around Canada trying to find investors for the next round. It’s just a terrible use of everyone’s time.

Should you keep paying your drillers for standby time? Should you demobilize and remobilize three months later? It all costs money. Should a top geologist be wearing a cheap suit negotiating with investors in New York? Should you keep drilling when you have no idea what you’re doing? In the end, less than half the money spent actually gets into the ground and what should take a year to accomplish, instead takes three years. It’s the least efficient, most expensive way to find minerals ever conceived. No wonder most juniors have not found much. I don’t know why anyone intelligent ever expected them to.

Even with all the bureaucracy of a large business, the major mining firms have much cheaper costs for finding resources than the juniors. Just overcoming the start-stop nature of junior capital raising and spending accounts for a lot of this. The majors are not desperate for press releases. They take their time and make sure they get the bang for the buck that they deserve. They do soil sampling. When they have something interesting, they spend money on geophysics. Geophysics will tell you where to put your drill holes. You would be amazed how many juniors poke holes all over the place with little more than hunch about where the ore body extends to. It’s insanity. Saving a few bad holes will more than pay for your whole geophysics program. If some junior tells you that they intend to drill something without having done geophysics, they better have a damn good reason for wasting their money. Usually their reason is that press releasing a large anomaly will not get them more funding—a good hole will—even if it takes 20 holes before they find the good one. (Keep in mind that I am a bit biased as my fund is the largest shareholder of a firm that does aerial geophysics).

Once you get the drill program going, a major will contract for a half dozen drills and tell them to get at it. Most juniors will only have one or two drills going—it takes longer and costs more as you get no economies of scale. Unfortunately, the juniors have no choice but to proceed slowly. Majors have long term funding, juniors are always watching the bank account and the equity markets for more capital. That’s not how you want to run a capital intensive business.

Large mining companies do not care about small ore bodies, even if the grades are high. They want big deposits that can produce big resource and production growth. There just aren’t very many of these deposits controlled by juniors. The ones that aren’t in production usually have issues. Either they’re in the wrong countries, in environmentally sensitive areas, are horribly remote or have challenging metallurgy. These are problems that can sometimes be overcome—sometimes they cannot. Mining houses want safe assets in mining friendly jurisdictions. There really aren’t many of these assets left to acquire. If you look at the prices paid for some recent acquisitions, you can sense their desperation. If the majors want to grow, they will need to find it themselves. Heck, if they want to just keep production constant, they need to find resources and fast.

The majors are suddenly becoming desperate. 2009 was the year that everyone used cash flow to pay down debt. They didn’t look at acquisitions when prices were down. They didn’t spend on exploration. Many of them didn’t even spend on mine-site exploration to upgrade resources. They paid down debt and stockpiled cash. After a year of high metal prices, some of these companies are so flush with cash that they are going to have to do something.

I feel a pendulum swing coming in how exploration is done. The majors are frustrated. They know they can do it better, cheaper and faster. They might not have the entrepreneurial zest of a geologist with 5 million options, but they have the cash and infrastructure to get the job done right. When I look at resource company guidance, they keep increasing their exploration budgets each quarter. They are being more adventuresome. They are starting to explore in places that they would ignore in the past. They are taking the reins on exploration. 20 years of mining orthodoxy is being overturned. The major mining firms will begin preparing their 2011 budgets in the next month. Metal prices are high and balance sheets are robust. Reserves are at dangerously low levels and there’s nothing to buy. The Metals Economic Group estimates that 2010 exploration spending will clock in at $11.5 billion, up from original guidance of around $9 billion at the start of the year. I have a hunch that 2011 budgets will be shockingly large from the majors. After barely spending for two decades, the majors are about to embark on a major campaign of exploration.

Whenever you have a tectonic shift in an industry, there are winners and losers. Who benefits? If you do work in crazy countries that have not been adequately explored, you win. If you do greenfield exploration, you win. If you are large enough to service the majors, you win. After giving the juniors two decades to explore for new deposits in their helter skelter manner, the majors are now going to take that over. There are lots of brown field projects that juniors will keep drilling to generate stock promotion schemes. These assets aren’t mines because they have ‘issues.’ The real work of exploration will now switch to greenfield work. Every year, a few juniors will get lucky and find something, but the real spending and discoveries will now come from majors. If you listen to conference calls of mining service companies, you can see the change in order books from just two years ago. The majors are now ready to spend. They certainly have the cash flow to spend big. If you service this type of business, the next few years will be quite lucrative.

Categories: General
Positions Mentioned: none

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