Why Exploration? June 1, 2003 It’s no news that gold has been through a terrible bear market. Even when we ignore its spike beyond $800 an ounce in January 1980, the gold price declined by more than 63% from around $690 an ounce in 1980 to $252 on August 25th , 1999.
A 63%, nineteen-year bear market is nothing short of a crisis for the gold industry, and Crisis, in Chinese characters, is comprised of Danger and Opportunity. We are now happily in the Opportunity part of the Crisis.
Depleting reserves
The decline in the gold price led to a contraction in cash flow from gold mining, forcing gold mining companies to curtail exploration since the lawyers and accountants that often rise to the top of these companies find it hard to justify exploration expenditures when they don’t see immediate, tangible results to offset their cost.
But mining is a depleting business; every year a mine is in production is a year off its life. So without exploration, mining will cease. Mergers and acquisitions don’t produce new mineral deposits, they merely change the ownership of existing reserve inventory. The spate of mergers and acquisitions we have seen over the past two years has therefore done nothing to alleviate the lack of new projects in the development pipeline.
Without exploration, mining companies will ultimately have to shut down and there is nothing, not even a hostile takeover, that mining executives would rather avoid. Shutting down the business means no more salaries, no more pension plans, no more stock options, no more club fees, etc. Never mind what’s best for the shareholders, who mining executives almost never think of anyway.
Declining exploration
Non-ferrous mineral exploration expenditures declined roughly 50% from 1997 to 2000 as the brunt of the bear market took its toll. Now, with the gold price up over 45% from the low it reached in 1999, we are seeing gold mining cash flows increase and these cash flows will continue to get bigger as the bull market matures, loosening the purse strings that, for the past six years, have been kept very tight. Exploration budgets have already started increasing. For the gold mining industry this is not a choice, it is a necessity.
In addition to the rising gold price, more oxygen has been given to the exploration sector by virtue of tax incentives to investors, especially in Canada, which, by the way, is the target of almost 20% of worldwide exploration expenditures. And don’t believe for a second that Canada has no more mineral wealth to surrender. The last time Canada was this aggressive with tax incentives, in the late 1980s, it resulted in the discovery of the Snip Mine, Eskay Creek, Milligan and Kemess South. Then Canada reduced the tax incentives, funding dried up, and there hasn’t been a major, grass roots discovery in that country since.
With renewed interest in exploration, demand for exploration companies is increasing in the capital markets and their share prices are rising. In addition, nothing drives investor interest towards exploration faster than an increase in the gold price. As well as mineral exploration companies performed in the last two years, we are likely to see a meteoric rise in their share prices as additional capital comes their way.
Making a discovery
Of course, the reason we buy these stocks is not just because the tide is rising. We hope to benefit from a bona fide, economic discovery. The thing is, as interest in mineral exploration increases, and more money flows into the sector, more money gets spent looking for new gold deposits and hence the probability of making a discovery increases. What we have to figure out is how to get in front of as many of these discoveries as possible.
Knock knock
Here is the twist, and herein lies the opportunity: most of the true leaders in mineral exploration are geologists that don’t necessarily fit into corporate culture. These are men and women who like to walk outside, kick rocks, sleep under the stars and swear when they feel like it. They do not want to sit behind desks, stare at computer monitors and talk on the phone. Desk geologists rarely make any discoveries, for the obvious reason that they have to go and find the gold, the gold is not going to find them.
During the bear market most gold mining companies so severely curtailed their exploration expenditures that they closed regional offices, retrenched geologists and relinquished many of their exploration projects. These are structural changes that cannot be undone with a memo from management.
In a major mining company, a successful exploration geologist who made a significant discovery might get a pat on the back and a new credenza, if he’s lucky. An entrepreneur in a small company might get a $10 million, $20 million, or $100 million capital gain, or more. Since many geologists were shown exactly how much they were appreciated by the mining industry when they received their pink slips and handshakes during the lean years, where do you think the talent went?
Some of the best exploration geologists in the world have been organizing themselves into junior companies, with projects, with regional contacts, with regional expertise and with perhaps the greatest advantage over the mining companies: an incentive to succeed.
The lack of exploration and the resultant shortage of large, economic, undeveloped gold deposits are going to cause a noticeable increase in the premium that mining companies will have to pay for new discoveries. Due to the reorganization of talent in the mining industry, and the demand for new deposits, we can expect to see more deals done between mining companies and junior exploration companies. And, while for the past six years the major mining companies have been calling the shots when it came to deal making, the shoe is now shifting to the other foot.
Add to that the leverage we get from an increase in the gold price and the overall leverage becomes astonishing. I almost feel guilty just thinking of it.
Leverage
The increase in the gold price not only focuses more attention on the sector, and causes more money to be spent on exploration thereby increasing the probability of finding new deposits, it also increases the value of any potential discovery through leverage.
Mineral deposits are gauged by the net present value of future cash flow should the deposit be mined. Say for example we found a million ounce deposit and an engineering study suggested it could be mined over ten years at a cost of $250 an ounce, including capital. Assume gold is $350 an ounce, more or less the current price. At a 10% discount rate that deposit would be worth roughly $70 million.
However, if the gold price increases to $400 an ounce (a 15% increase) the value of the same gold deposit increases to $100 million (almost by 50%). That is over 300% leverage to the gold price (50/15). And I firmly believe that a gold price of $700 an ounce is not out of the question.
Reduce the risk
Now what if we could drastically reduce the risk of exploration? After all, exploration is just about the riskiest business in the world and, given how risky it is, we want someone else to pay for it while we retain some of the upside. Well, here’s how to do it.
Invest in junior exploration companies with the geological and technical expertise to identify and acquire high impact, early stage exploration projects. Projects with big enough scope to make an impression on major mining companies.
The exploration company can then enter into a joint venture with one of the mining companies. The mining company will critically examine the ideas and the project, since it will foot the bill. 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 joint venture partner would then put up the capital for exploration while the exploration company we own retains a minority interest in the project. If the project doesn’t bear fruit we would have lost some time, but not much money, if any.
This business model also allows the junior exploration company to focus its resources on project identification and acquisition, instead of the systematic and expensive delineation of a potential deposit, which means that a competent junior should always have many irons in the fire. This way we, the shareholders, get exposed to the upside of a major discovery on multiple projects, all developed with capital supplied from joint venture partners. It reduces the capital drain on the companies we own and it increases the probability that we will participate in a major discovery because our junior exploration company exposes us to multiple, high impact projects.
This sounds good, you say, but where do we find these companies? And how do we know that they can deliver the projects, attract joint venture financing and not squander their treasuries?
I have been looking for such companies for many years now. Investing in these juniors is what I do with my own money and I have found several, high-quality exploration companies that demonstrated their ability to execute this business model.
(This article was written for Doug Casey's International Speculator Volume XXIV No. 6)
Paul van Eeden
Disclaimer This letter/article is not intended to meet your specific individual investment needs and it is not tailored to your personal financial situation. Nothing contained herein constitutes, is intended, or deemed to be -- either implied or otherwise -- investment advice. This letter/article reflects the personal views and opinions of Paul van Eeden and that is all it purports to be. While the information herein is believed to be accurate and reliable it is not guaranteed or implied to be so. The information herein may not be complete or correct; it is provided in good faith but without any legal responsibility or obligation to provide future updates. Neither Paul van Eeden, nor anyone else, accepts any responsibility, or assumes any liability, whatsoever, for any direct, indirect or consequential loss arising from the use of the information in this letter/article. The information contained herein is subject to change without notice, may become outdated and will not be updated. Paul van Eeden, entities that he controls, family, friends, employees, associates, and others may have positions in securities mentioned, or discussed, in this letter/article. While every attempt is made to avoid conflicts of interest, such conflicts do arise from time to time. Whenever a conflict of interest arises, every attempt is made to resolve such conflict in the best possible interest of all parties, but you should not assume that your interest would be placed ahead of anyone else’s interest in the event of a conflict of interest. No part of this letter/article may be reproduced, copied, emailed, faxed, or distributed (in any form) without the express written permission of Paul van Eeden. Everything contained herein is subject to international copyright protection. |
|
