But mining is a strange business: The more you mine – the less you have left to mine. Mining is a depleting business and in real life mineral deposits are depleted fairly rapidly while at the same time discovering new mineral deposits happens only occasionally. Even after discovery, it takes a long time to develop mineral reserves and complete the construction of a mine. Hence the lead-time to bring a new mine into production, from the time a discovery is made, can be five, ten or ever fifteen years. Yet for economic reasons, the optimum life of a mine is often planned to be between ten and twenty years. If a deposit is mined too fast, the initial capital requirement can be prohibitively high and if the deposit is mined too slowly, the end years contribute very little to the net present value of the mine, thus reducing the internal rate of return on the invested capital.
 
Let’s look at an example of depletion and discovery. Worldwide copper consumption is about 33 billion pounds per year. To put that in perspective, the biggest copper mines in the world contain in the order of 20 to 30 billion pounds of copper, which means that our annual consumption depletes the equivalent of one major copper deposit a year. Large copper resources do exist, but many of them are in politically unstable parts of the world like the Democratic Republic of Congo, or are expensive to extract, usually due to low grade. I am not necessarily a big fan of copper, but it illustrates the dilemma that a mining company faces. Every year a mining company has to add new reserves to its inventory equal to, or greater than, its production. Otherwise the company gets smaller as time goes by.

 

For personal reasons I am much more interested in gold, although I would not hesitate to invest in a good exploration company that has expertise in a different area. But let’s look at the depleting dilemma from a gold mining perspective. Worldwide gold production from mining is approximately 80 million ounces per year. A few years ago, a world-class gold discovery, which rarely occurs, would have been anything over a million ounces. Perhaps a few such deposits are discovered in a decade yet we mine the equivalent of 80 such deposits a year. Due to recent mergers and acquisition in the mining industry, the bar has been raised and the major mining companies now require deposits to be in excess of 5 million ounces before they become excited. Perhaps only one or two such discoveries are made in a decade.
 
Anglogold mines over 6 million ounces of gold a year. Newmont mines roughly 4 million ounces of gold a year, Barrick 3, Harmony almost 3, Normandy 2, you get the picture. Each of these companies need to make a world-class discovery every year, and some of them need several, just to prevent the natural depletion of their mineral reserves from retiring the entire business. Note that mergers and acquisitions do not add any new resources to the mining industry, it merely changes the ownership of mines. The gold mining industry needs to discover 80 million ounces of gold every year just to prevent it from shrinking and it is highly unlikely that we will ever discover 80 million ounces in any given year, never mind do so on a continuous basis.
 
Gold is extremely scarce
By weight, gold makes up roughly 0.00000006% of the Universe. Fortunately, gold is more abundant in earth crust, contributing 0.00000031% to the mass of crustal rocks. Strangely, gold is 32 times more abundant in human beings but thankfully that doesn’t qualify any of us as economic gold deposits.
 
The abundance of gold in the earth’s crust is more conveniently expressed as 3.1 parts per billion, by weight. That equates to 0.0031 grams per tonne, or 0.00001 ounce per tonne. In order to find a low-grade gold deposit, the gold would have to be concentrated by a factor of at least 1,000 and in order to actually make money, one would hope for a concentration factor in the order of 2,000 to 3,000 times its average. The circumstances that would lead to such a concentration of gold, especially of sufficient size to become economically important, are extremely rare. Which is why gold deposits are so rare and so hard to come by.
 
Consider that to mine the 80 million ounces of gold that is produced each year, assuming that the average worldwide grade is 10 grams per tonne (it is probably less), would require moving, crushing and processing 250 million tonnes of rock. That would make a 3.4 billion cubic feet hole and the gold produced would be only 4,500 cubic feet. No wonder it’s tough making money mining gold.
 
Exploration expenditures are decreasing
One would think that in light of all this, the major mining companies are increasing their exploration efforts to find more mineral deposits. Not so. According to the Metals Economics Group, total worldwide nonferrous exploration was $5.2 billion in 1997. But mineral exploration expenditures declined by 29% in 1998, 24% in 1999 and another 7% in 2000. That brings the total exploration expenditure for 2000 to only $2.6 billion, 50% of what it was only three years prior. Not only is mineral production proceeding unabated and at such a pace that historical exploration has not kept up, current exploration is only half of what it was in 1997.
 
The tide may be turning
It does appear though, as if the tide is turning for the exploration industry. Exploration budgets for the year 2001 should be fairly similar to that of 2000, perhaps only slightly less. Canada, which is the source of almost 60% of all equity capital for global mineral exploration and as a country is among the largest recipients of exploration expenditures, attracting 15% of total worldwide exploration budgets, (Department of Natural Resources, Canada)
has enacted new legislation that provides very attractive tax incentives for investors in exploration companies. Because of that Canadian exploration budgets are bucking the trend and were in fact 12% higher in 2000 than in 1999. Many key figures in the exploration industry, such as Robert Friedland and Frank Giustra are also refocusing their attention on mineral exploration.

 

Junior exploration companies and senior mining companies
When the senior mining companies slashed their exploration budgets, the result was more than just a reduction in exploration activity. Many of the large mining companies reduced their exploration staff, some even closing down entire exploration departments. This is a structural change. The people are gone, many projects have been relinquished and it can take years to regain that lost exposure.
 
Another problem that major mining companies face is that they cannot efficiently compete with small, aggressive and entrepreneurial junior exploration companies for good projects. The bureaucracy pervasive in major mining companies puts them at a disadvantage. For this reason, many majors have publicly announced that they are going to try and enter into joint venture agreements with junior exploration companies that have good projects but may lack the capital to fully develop them.
 
It looks as if the division of labor is such that small exploration companies, working on shoestring budgets, are going to be doing most of the grass-roots generative exploration work. If they come up with good ideas, the major mining companies could enter into exploration joint ventures with them and once a discovery is made, the bigger companies are often better at developing a deposit because of the substantial capital involved.
 
Grass-roots exploration is arguably the most risky business in the world
Anyone who has speculated on exploration companies in the past knows that exploration is fraught with risk and usually leads to disappointment. A fast-talking promoter raises some cash, drills a few holes, finds nothing and the investors lose essentially all their money. It doesn’t have to be that way.
 
What if someone came up to you and proposed a deal whereby you could pick a series of lottery numbers, he will pay for the lottery tickets and you share the profits, would you do it?
 
Taking the risk out of exploration
The best way to take the financial risk out of exploration is to use someone else’s money. In practice that can be accomplished by finding a joint venture partner to fund the exploration costs associated with a project in return for an equity interest in the project. An important point here is that the funding partner should participate at the property level, not at the corporate level. As speculators we would want to be diluted at the property level, where our risk is the highest, and protect the corporate structure of the company that we are investing in, where our risk is drastically reduced and our exposure to multiple exploration projects can be maximized. Making use of joint venture partners, a small exploration company can gain exposure to many promising projects for very little financial risk.

 

The junior exploration company can therefore focus its efforts on project generation. This part of the exploration process requires imagination, an ability to conceptualize and understand geological events that lead to ore deposition, extraordinary skill and hard work. This is where an entrepreneurial geologist working in a small company, in which he owns a substantial equity position, can really excel.
 
In the end it all comes down to the three basic principles of investment. Just like real estate, there are three things that are crucial for success: management, management and management.
 
On the same side of the table
In order for us as shareholders to be successful, we have to have our interests aligned with those of the management team. The best way to achieve this is to invest in exploration companies in which the management themselves are large shareholders. But being a shareholder is not enough. They need to have bought their shares with cold, hard cash, just like we have to, and not just take handouts in the form of stock options. Stock options in lieu of cash are a great way to compensate management and employees, but management must have their own capital on the line as well.
 
Technical competence
Economic mineral discoveries are extremely rare. Luck certainly plays a role but as Rick Rule often says: “Luck favors the trained observer.” The management team should have a very high level of practical and theoretical geological competence. It is not easy to figure out how a mineral deposit formed, what the controls on ore deposition were, what may have happened to the rocks subsequently and how to follow obscure clues towards the always-elusive prize. It is important that the management team have experience and a track record of successful exploration.
 
Among the skills required is the ability to efficiently manage an exploration program without undue expenses, to be able to work in remote parts of the world under difficult circumstances as well as an in-depth knowledge of geology and ore deposition models. But that is not enough.
 
Understand public capital markets
It doesn’t help us one iota if the company is successful in making a discovery and we cannot make any money as shareholders. The management needs to understand how public markets work, have the skill to navigate the regulatory framework of a publicly listed company and the skill to raise capital when it is necessary without any excessive dilution to existing shareholders. A critical issue for us as shareholders is dilution of the share capital of our companies. Management has to be able obtain the funds required with the absolute minimum dilution necessary.
 
Keep the overhead to a minimum
They also need to be able to run a very, very tight ship. Because an exploration business in general doesn’t have any revenues or cash flow, all the expenses have to be paid for by shareholders. This is why it is imperative that management, who spend the money, are also large shareholders and hopefully that ensures they keep a keen eye on expenses and maintain the overhead costs at a bare minimum.

 

How much money should they have?
An exploration company with too much money can become problematic, since the temptation to spend the money instead of getting joint venture partners to spend their money can become irresistible. Of course, a company with too little money is worse because it could run out of cash completely and become worthless. It is important that the management team ensures that the company’s treasury never runs so low that they have to finance the company at unattractive prices, unless of course we are the financiers in which case we can sometimes make an exception. But then they should not let it happen again!
 
Stick to the business plan
The business plan I like most is one that almost no one adheres to. Whenever I discover a company that has all the qualities I look for and adheres to this business plan, I usually become a shareholder.
 
The plan is simple: Use your geological expertise and regional experience to acquire early-stage projects as cheaply as possible. Then apply that geological knowledge to come up with conceptual models that could lead to the discovery of a major ore deposit. If the project fails at this level, abandon it. Very little money would have been lost thus far. If the project passed this stage and a credible exploration program can be devised, sell that idea to a joint venture partner and let them spend the money to test the hypothesis.
 
This does two important things. First of all, someone else is spending their money on our behalf and second of all, they will critically examine the ideas and the project, since they are going to spend their money. If the project stands up to that kind of peer review, it becomes a legitimate exploration target, assuming of course that a competent joint venture partner is selected. The most desirable joint venture partners are the major mining companies since they have the expertise to evaluate projects thoroughly and the capital to develop the project should it be successful. A joint venture partner that runs out of money half way through a project can become more of a liability than an asset.
 
High quality assets
It is hard to evaluate the merit of an exploration project and often it is not the first owner of a property that eventually makes an economic discovery. Nonetheless, each and every project has to be critically evaluated to ensure that it is worth spending any money on it at all. A company that builds up a reputation of consistently finding high quality projects should never have any trouble attracting joint venture partners. The converse is also true. Every project should have the potential to host a world-class ore body. Otherwise valuable time and capital can be wasted with little or no return for shareholders.
 
Do not overpay for an exploration stock, even if everything else is in place
This is where many investors go wrong. The promise of instant riches often clouds an investor’s judgment. It is essential that you do not overpay for a stock. What good would it do if the company is ultimately successful in making a world-class discovery and the stock price doesn’t respond? Or worse yet, the stock price goes down.
 
We have to be able to understand what the economic impact of a discovery on the company’s project can have on its share price. For that we need to know what kind of mineral deposit the company hopes to discover. If the management doesn’t have a clear idea of what they are trying to find, and a strategy with which to accomplish it, then we cannot evaluate the risk/reward profile of the investment and hence we should not invest.
 
Exploration stocks often surge in anticipation of exploration results or sometimes as a result of exploration results. Numerous times it has happened that the market capitalization of the company exceeds the potential value of what they hope to discover. This situation usually leads to disappointment for investors and yet it can be readily avoided by paying attention to the relative value of the stock in relation to the mineral target of the company.
 
Accumulate high quality exploration stocks when no one else is looking
Investing is at once the simplest and most difficult thing to do. Buy low and sell high. Nothing is simpler than that. However, it requires knowledge, patience and above all the ability to be contrarian. You have to buy stocks when no one else is buying them and you have to sell stocks when everyone else is buying them. Right now appears to be an excellent time to accumulate exploration stocks. There are many high quality companies doing extremely good work out there and no one cares.
 
Be patient
Doing exploration is a long-term endeavor. It may appear as if exploration speculators become instant millionaires when their penny stocks skyrocket. But in order to own the stock for pennies, you have to buy it long before the mineral potential becomes evident and you have to hold the stock, sometimes for many years, while the management team tries to solve one of mother nature’s most intricate puzzles.
 
Be merciless
Many, many investors have long lists of penny stocks that have essentially lost all of their value. It is absolutely imperative to sell a speculative stock if the reason why it was purchased is no longer valid. This means that you have to closely monitor the progress of the company and if the potential value diminishes, the stock should be sold. The nature of mineral speculation is that it often results in substantial losses. It doesn’t matter. Even if an investment loses 50% or 75% of its value, it is better to get something back rather than nothing, which is usually the alternative.
 
But markets are not always efficient, especially not in the junior exploration industry. Sometimes high quality exploration stocks decline for no other reason than that nobody is paying attention to them. When that happens investors have a rare opportunity to average down, or take new positions, in excellent companies at bargain discount prices. Although again, it will require a contrarian attitude.
 
The time to act is now
Asset allocation has been shown to be the single most important criteria determining investment success. There is a very strong argument that can be made in favor of investing in the resource sector, especially in the exploration industry.
 
Exploration is undoubtedly one of the riskiest businesses around, but is possible to mitigate that risk by careful selection of the exploration companies that you invest in and continuous monitoring of your investments. Certain criteria for selecting exploration stocks have been listed and many more exist.
 
Currently the resource sector appears to be recovering from a brutal bear market and many excellent opportunities are available to astute investors. Now is the time to invest in high quality exploration companies that have the skill to generate world-class targets and the financial ability to ensure their survival. These companies are out there, themselves waiting to be discovered.