There are many pump and dump penny stocks on the OTCBB… many of these are simply outright scams.
Some “companies” issue misleading press releases that try to trick investors into thinking that there will be an actual producing asset. A mining “company” may buy ore concentrate (this part will be divulged somewhere in their many pages of financial statements) and simply resell the ore concentrate. They will try to make people think that the ore concentrate sales were a result of mine production. I believe that this is what is currently occurring at Gold Resource Corporation (GORO)… of course the short sellers know this and the borrow on the stock is incredibly tight (I am not shorting it because I fear the buy-in).
Sometimes mining companies will purchase mining assets with some kind of subtle flaw. Typically investors are not very savvy (e.g. look at the market cap of GORO, Uranium One) and don’t spot the outright scams. In less outrageous examples, there is actually a mine but some subtle kind of flaw to it.
Political risk is a big one. Foreign companies rarely get treated as well as domestic companies. Even in politically safe jurisdictions like Canada, foreign companies aren’t treated as well (e.g. evil foreigners weren’t allowed to buy Potash Corporation of Saskatchewan). And of course there are many countries where there is corruption and where mining assets are stolen/nationalized. Many of the most successful resource companies like Contango Oil & Gas and Altius Resources do not invest in foreign countries.
Some mines have veins that are extremely high grade. However, the company won’t be so quick to point out that the high grades are in extremely narrow veins. To actually mine the vein, you have to also mine and process significant amounts of waste rock around the vein. This dramatically reduces the economics of the deposit. Excellon Resources is an example of a mine with high grades that aren’t as economically attractive as one would hope.
Some mines are marginally (un)economic. In that situation, everything matters. There are many factors that determine whether or not a mine may be profitable. Political risk, size of the deposit, grade, mining dilution, recovery, processing costs, cost of the proposed mining method, infrastructure, impurities, quality of final product (e.g. fines in iron ore), etc. etc. Subtle changes in key assumptions can have a cumulative effect and make the deposit look way more attractive than it really is. And I don’t believe that anybody will suffer serious consequences for making aggressive engineering assumptions and overstating the mine’s economic viability. (You don’t even get thrown into jail for running an outright scam like Uranium One or Gold Resources.) It’s simply way too hard to evaluate these deposits and these companies are almost certainly fudging the numbers.
“Production is going to follow this parabolic curve”
The proper way to build a mine is to do a lot of exploration upfront so that the engineers can build an appropriately-sized mine for the deposit. And then you build your mine to a specific capacity that maximizes the net present value of the deposit (perhaps taking into account a reasonable internal rate of return). Higher capacity mines benefit from economies of scale. It rarely makes sense to build a mine and then realize that you should have built a higher-capacity mine in the first place (which is expensive and makes you less money than doing it right in the first place).
Also: In any mine, the highest grade ore will almost always be mined first so you can expect grades and production to fall in the future.
There are exceptions. Many iron ore and potash deposits have huge reserves. The mine operator may not even bother exploring the entire property if they know that there is already at least 15-30 years of reserves. But because the price of both iron ore and potash has gone up so much, it can make sense to expand mine capacity.
The other situation is that very deep drilling may not be performed as it is very expensive. The cost per ft increases the deeper you go. Not only that, drillholes go more and more off course the longer it is. There comes a point where it does not make sense to waste money on drilling. But when the mine is built, it is possible to perform exploration from within the mine (and it’s cheaper to drill deep when the drill rig is located deep in the mine). The mine operator may discover more ore. A larger reserve and higher commodity prices could warrant a mine expansion.
But generally speaking, most mining companies that say that production at a mine will increase are making stuff up.
“We have all these reserves in the ground”
It’s so common for an oil & gas company to claim that they have a lot of reserves that they haven’t drilled yet. Guess what? Exploration is risky because it’s highly uncertain what’s in the ground. A lot of oil & gas companies overstate their reserves. When the property is drilled, there is much less uncertainty as the property will produce oil/gas. However, it isn’t clear what the decline in production will look like in the future. The engineers have to make an educated guess. And of course there is room here to make extremely aggressive assumptions to fudge the numbers.
Related party transactions
Chesapeake Energy Corporation (CHK) would be an example of a larger capitalization stock with shady management. Manual of Ideas has a good writeup on Aubrey McClendon’s shenanigans and how he has been lining his own pockets at shareholders’ expense. I’m surprised that many value investors have gotten suckered into this stock (e.g. Longleaf, various VIC writeups like this one, etc.). I’m sure some people have made money in this stock but you are better off holding something else in my opinion.
I would listen to Warren Buffett:
- Stick to what you understand.
- Look for the “one foot hurdle”. Stocks that are wildly mispriced with a large margin of safety.
If you can’t be bothered to read a mine engineering textbook, then why bother investing in mining stocks? Just go to the mall instead and invest in Apple and McDonald’s (their founders also have biographies that are easier to read than some engineering textbook!).
Personally I think that resource stocks aren’t a great sector in general. There are a lot of shenanigans going on and investors don’t always make as much money as they should.