Junior Mining Rant

The junior mining industry is for the most part a crooked casino.  I don’t entirely have a problem with people engaging in high-risk and hopefully high-reward activities.  Entrepreneurs do that every day.  If I don’t have a problem with the small business casino, then should I really have a problem with the publicly-traded mining casino?  But where the junior mining industry fails is in allowing insiders to get away with egregious behaviour.

Giving away free money

Junior miners on the Canadian exchanges are sometimes allowed to give away free money by extending the expiration date on options or by lowering the strike price on them.

Insiders usually paid too much

Especially the board of directors.  Their hourly rate is incredible even if you factor in unbillable hours.

Liability insurance

Junior miners often purchase insurance that indemnifies the directors and officers against lawsuits.  Why should shareholders be paying for this?  The directors and officers shouldn’t be doing unethical things in the first place.

To be somewhat more fair to the junior companies, the officers will sometimes get sued for things that may not be their fault.  In the case of Bear Lake Gold, the geologist decided to commit fraud knowing that he would get caught (as far as I can tell… he falsified assay data entry as he entered the results into the database).  Insiders were sued and I am guessing that the insurance company settled out of court to avoid a costly legal battle.  Even if the insiders committed no wrongdoing (I believe this… but who knows), they could lose the court battle because the other legal team may make some emotional arguments (e.g. junior mining companies are a huge scam, this is like bre-X, etc.) that the judge would go for.

But I would still rather see the company provide legal indemnity to its officers and directors… they do not have to pay an insurance company for this.

White Pine Resources / Northfield Capital

Robert Cudney is the CEO of both companies.  Apparently it is allowed for Northfield Capital to buy shares of White Pine in a private placement deal.  In my opinion, there is a potential conflict of interest here because it can be in Mr. Cudney’s interest to dilute White Pine’s shareholders in favour of Northfield’s shareholders. And this is not the first time that Mr. Cudney has done something that is potentially unfair to shareholders… several years ago, Northfield’s book value was understated (its stocks were not marked to market) and Mr. Cudney was buying fistfuls of Northfield stock selling below liquidation value.  Now that he isn’t buying Northfield stock, transparency has gone up a lot (e.g. the financials are easier to figure out).

To be fair… Northfield right now is one of the most honest companies on the TSX Venture exchange.  Insider compensation is very low (Mr. Cudney could be charging 2% of AUM and 20% of profits especially given his track record), there are no egregious related party transactions, the company doesn’t waste money on promotion, and the company does not pay liability insurance.

(*Disclosure: I own shares in both companies, though I own more of Northfield.  I’m not sure why I own White Pine shares though.)

Value creation

In an idealized world, junior miners could create value by finding really good exploration geologists / prospectors and giving them capital.  Most of the value in the resource extraction industry is created by the explorationists.  It is one of the riskiest parts of the resource extraction industry and it is an area where there is a huge range in talent.  Some explorationists are superstars while many of them will never find an economic deposit in their entire professional careers.  They may not have opportunities to make more money than with their current employer… an exploration company could step in and give them equity and give them an opportunity to make more money and to leverage their talents.  (What I’m describing here is maybe what White Pine is doing now under Robert Cudney.  It is exactly what Contango Oil and Gas did in its early days and what Altius Resources does.)

But that isn’t what actually happens in practice.  Juniors will often explore outside their home country, exposing them to political risks because they are foreigners (all countries in the world discriminate against “evil” foreigners more than non-foreigners).  In politically sketchy countries, it is easier to find more gold and higher grades of gold… which makes the junior mining company easier to promote… but such gold is less economic due to the political risk.

And what happens if a junior miner has marginal drill results?  There is an incentive to continue drilling and to pretend that the drill results are a lot better than they are.  Then there is an excuse to raise more money and insiders will have high-paying jobs for a longer period of time.

For various reasons, junior miners will do all sorts of dumb and crazy things.

Fraud

There is the outright Bre-X style fraud where people just make stuff up.  Still happens.

And then there are various forms of exaggeration.  Mine engineering and geology is not a precise science.  Small errors (often intentional) can be cumulative because the economics of a mine is based on a series of assumptions.  This makes early-stage plays very, very, very difficult to evaluate.  Companies will spend millions of dollars on feasibility studies before building a mine, and even then the feasibility studies may be wrong.  Within all this is the opportunity to exaggerate the economics of a deposit.

Under capitalized

Almost all junior miners put themselves in a position where they HAVE to raise money.  They often have to sell shareholders out at a low price to raise money to continue drilling and to continue paying insiders’ inflated salaries.

Advertisements

Marriot Vacations (VAC)

Some very quick observations… it looks like the main goals in the spinoff were:

1. Financial engineering to boost profits.  By adding leverage to the spinoff company, the debtholders (ok, they actually own preferred shares) shoulder taxes that the shareholders would otherwise have to pay.  There is a tax arbitrage here in that the debtholders probably have preferential tax treatment compared to the shareholders.
2. The parent company wanted to get rid of a company that may have negative growth and/or lumpy earnings.  This allows them to make their company easier to understand and hopefully it will attract a better share price (buyers tend to pay more for situations that are easy to understand and have steady profits).

So if you look at the spinoff carefully, the spinoff has issued preferred shares with a ludicrously high interest rate.  This, in a way, overstates book value at the spinoff.  The spinoff is also obligated to pay royalty payments to the parent… I am guessing that this liability is recorded with a book value of 0.  Again, book value of the spinoff is overstated.

Economically, leveraging the spinoff isn’t necessarily the greatest move since the timeshare business may get killed in a recession and the debt levels may become dangerous.  On the other hand, it could very well be a safe level of leverage.

I like to see spinoff situations where management is actively trying to get investors to sell the spinoff too cheap.  This can create the potential for some very nice gains and I think it will happen to MFC Industial Ltd (NYSE:MIL).  However in the case of Marriot Vacations, management is trying to dump the toxic waste into the spinoff much like the Seahawk/Pride spinoff (Seahawk is now in bankruptcy… though this has a lot to do with the Deepwater Horizon disaster, low natural gas prices, and the low cost of shale gas compared to offshore gas).

Disclosure: I used to own Marriot pre-distribution and sold after the spinoff.  I own neither the parent nor the spinoff.

Fortuna Mining

Let’s take a look at their latest MD&A:

I call bullshit.  If you look at the breakdown above, you can see that management expects a ramp in Tonnes milled and a ramp in Au and Ag grades.  Sane mine engineers do not make plans like this.  First off, it is optimal to mine the highest grade ores first to maximize the net present value (NPV) of the mine.  In some mines lower grade ore has to be mined first to get to the highest grade ore.  But generally speaking, you should pretty much see the highest grade ore get mined first.  Mining the highest grade ore 2 years before mine closure makes absolutely no sense at all.

Secondly, the breakdown above calls for production to ramp up to more than four times over four years.  This is a dopey way of building a mine.  It makes more sense to build to a specific capacity by year 1/2 of commercial production as this would maximize the NPV.

What’s probably happening here is that management is making stuff up.  It is highly, highly likely that grades will go down over time according to the mine engineer’s plans.  And my personal opinion is that this company will likely miss its production targets and that this will be blamed on external factors.

Is it any wonder that commodity futures outperform commodity-producing companies by three times?

NI 43-101 techical report red flags

When I read NI 43-101 reports, here are some of the red flags I look for.  If I see these, it means that the rest of the technical report probably uses overly aggressive assumptions.

1. Future commodity prices.  It is reasonable to use the 3-yr historical average.  Now if you are bullish on a commodity then obviously you are going to use your prediction of future prices in trying to value a mining asset.  However, it is a bad sign if the report’s author is using some number that is higher than the 3-yr historical average.  The author is trying to stretch the numbers to make the mining asset look more attractive.  If the author is using commodity prices provided by the mining company’s management… run away.  And if the commodity price is supposed to go up due to inflation… run away.
2. Exchange rates.  If it’s not the exchange rate at the time the report was written… run away.  This is a bogus method for inflating commodity prices or deflating costs.
3. NPV at a discount rate of 5% or lower.  A discount rate like that is stretching.  If the resource is clearly economic, the author would probably start with a base case of 7.5-10%.
4. Geological interpretation.  The size of a deposit could be exaggerated by using an extremely large search size.  Deposit size can also be inflated by interpolating between drill intersections that are incredibly far apart.
5. Untested metallurgical process.  What works on a bench-scale may not necessarily work in a full-scale production environment.  Granted, this isn’t necessarily a red flag as it can make sense to try newer and better recovery techniques.  However, there are technological risks involved that may lead to cost overruns.
6. Were previous technical reports bogus?  Go on SEDAR.ca and look at the technical reports for previous deposits.  In the case of Canada Lithium, they released a bogus report for one of their gold properties claiming several hundred thousand ounces of (Inferred) resources.  Then they raised capital.  Then this property was written down to almost 0 in the same quarter.

Unfortunately, there are also subtle ways to manipulate reserves and NPV that are very difficult to spot.

1. Aggressive engineering assumptions.  A devious author could feign ignorance to engineering complications and leave costs out.  For example, KWG thought that a railroad to its deposit would cost $900M.  Now it is saying that it would cost almost $2B.
2. Grade interpolation method.  This can make a difference of 20% depending on whether nearest neighbour, ID², ID³, etc. are used.  It is a good sign if the report shows the results for many interpolation methods.
3. Mine engineering inherently involves a number of moving parts.  Subtle adjustments to the various factors can have a huge impact on mine economics.  For example, a 5% adjustment to deposit size, mining recovery and metal recovery can lead to a ~15.7% increase in revenue.  A 5% change to operating+capital costs for a mine with a 80% margin would lead to a 20% increase in profit.  It is actually slightly higher than that if lower-grade ore becomes economic due to the lower operating costs.  The bottom line is that a series of very small changes can have a cumulative effect on mine economics.

Contango Oil and Gas (MCF)

History

The CEO, Ken Peak, took his life savings of $400k and started the company, which was traded on the OTCBB.

One of the original strategies was to focus on oil and gas exploration as it is an area where a lot of value can be created.  Exploration skill tends to follow an uneven distribution where a minority of people will account for almost all of the oil and gas discovered.  (Much like the 80/20 rule, how sports superstars command most of the pay, how superstar actors make almost all the money, etc. etc.)  I believe the explorationists came from Xilka Energy, which had a very good exploration track record.

When Contango started out, it couldn’t afford to drill the wells itself.  Its business model hinged on generating good exploration ideas and then convincing other people that they are good ideas.  Other companies would drill the well and give Contango a cut of the profits.

Over time, Contango has been selling its prospect generation business to the explorationists who run it.  Remember that the explorationists can simply walk away and restart the business with their own capital.  The current situation is that Juneau Exploration (“JEX”) is pretty much owned by its explorationists and acts as Contango’s partner.  JEX generates ideas for Contango and Contango pays for much of the drilling costs (they don’t farm a lot out anymore as Contango is a much bigger company).

Venture Capital

This was Contango’s other big idea when Contango first started out.  Unfortunately it did not work out so well and Contango only recovered about half of its capital.

Alta Resources / Unconventional gas

Contango entered into a joint venture with Alta Resources, which did research into extracting natural gas from shale.  Once they started understanding the process, they knew what types of shale/land are good for shale gas production.  The joint venture bought a lot of land rights before other people really knew its value for shale gas.  Ultimately the joint venture hired investment bankers to help flip all the properties to other companies.

Nowadays Ken Peak isn’t that keen on shale gas.  While wells do vary in production, there isn’t a lot of exploration risk when many wells are drilled.  And it doesn’t take a lot of capital to drill a lot of wells compared to drilling in the Gulf of Mexico.  Ken Peak characterizes shale gas as ‘factory’ production.  As the process is more understood now, there isn’t a lot of room for value creation (this is why Ken Peak notes that landowners are getting much smarter now).  He is also worried about the environmental movement, as developing shale gas involves injecting fracturing fluids into the ground with the potential of contaminating groundwater aquifers.  Companies do not currently have to disclose the composition of fracturing fluids(!).  There may be regulations in the future and/or NIMBY protests that will lower profits for shale gas companies.

Contango’s current partnership with Alta Resources is to look at extracting shale gas from offshore reserves.  This is partially a speculative bet on much higher natural gas prices in the future.  With natural gas prices so low right now, a lot of onshore shale gas is not economic.  There is potential opportunity as landowners may not realize the value of offshore shale rights, which seem pretty worthless right now.

Liquid natural gas imports

Back in the day, it was thought that the US would have to import natural gas to meet its energy needs.  Contango made a private investment in Cheniere Energy (symbol LNG) when its stock price was extremely depressed and things look bleak for the company in getting a LNG facility fully permitted and built (a de-gasification facility can only import liquid natural gas, not export it).  Cheniere actually managed to pull it off.  Unfortunately, the industry started to figure out shale gas technology and the US was flooded with cheap natural gas.  Contango is very fortunate is having sold its investment in time, as it looks like the US should be exporting natural gas rather than importing it.  Cheniere is in the process of trying to convert its facility to export LNG (they might succeed).

Hedging

Ken Peak used to be a proponent of hedging.  The problem with fluctuating natural gas prices is that losing money can seriously affect the rate of return.  If the company were to lose half its value, it would have to double its value just to break even.  And if the company has a small chance of going to 0, then it eventually will go to 0.  This is also why Ken Peak does not like leverage, as he has seen too many E&P companies go bankrupt throughout his investment banking career. 

By hedging its output, Contango is able to avoid huge drawdowns in its value.  It does give away some upside but over time the rate of return is arguably superior.  Ken Peak is also well aware that it is dangerous to short futures (and to take short positions via swaps).  If there is a hurricane, Contango may be forced to shut production.  Lower production across producers will raise natural gas prices.  Contango would have zero production while it is obligated to deliver natural gas, which is now at very high prices!  This is why Contango bought call options to protect itself from its swap positions / natural gas shorts.  The overall position is very similar to buying put options and being long volatility*.

(*On the other hand, it may not be a perfect hedge as one set of risks was traded for another.  There are likely differences in delivery location, sulfur content/penalties, mix of natural gas liquids in the natural gas, etc.  Buying put options outright has fewer of these risks… though there may be a spread in price between delivery locations.)

Contango currently does not hedge.  And it probably will not hedge unless gas prices are much higher and volatility is cheap.

Contango’s current strategy (as I understand it)

Other than the onshare shale partnership, Contango is going to stick to its bread and butter: wildcat exploration.  In the wake of the Deepwater Horizon accident, there has been significantly less drilling activity in the Gulf of Mexico because it is harder to get permits, the environmental liabilities are higher, and because gas prices have stayed stubbornly low (most companies cannot economically drill).  Ken Peak is incredibly excited about the GOM as drilling costs have come down significantly and the economics for Contango are extremely attractive.  It has always been able to find gas cheaply and should be able to continue to do so.

In an ideal world, he would probably sell all of Contango’s producing assets and invest it all into wildcat drilling.  Contango should be able to achieve a higher rate of return on wildcat drilling than sitting on its developed assets.  Presumably there are reasons why this hasn’t happened (presumably the private market for gas assets is not very good right now with stubbornly low gas prices).

Contango seems to be having a lot of delays in getting its drilling permit as they were supposed to spud one of their prospects in Sept/October and they still haven’t done so.  In the meantime, they are buying back shares.  Contango should be able to acquire natural gas (or oil) assets cheaper by drilling than through share repurchases.  Its rate of return is being hampered by its inability to drill drill drill.

Outlook

I’m pretty bullish about natural gas.  The current prices are unsustainable as few sources of natural gas are economic at these levels.  Also, Fukushima was a very good thing for natural gas as power generation will shift away from nuclear.  China is starting to recognize its pollution problems and this should reduce its reliance on coal.  This points towards natural gas as being the fuel of choice for baseload power generation.

What I’m actually doing

Trading in and out of Contango.  I recently sold all my shares and am trying to buy them back at $59.  Is this a great idea compared to buy and hold?  Maybe not.

My quick take on PRXI (Premier Exhibitions)

I just don’t think it’s deeply undervalued.  (VIC writeups here and here.)

1- In theory, its Titanic assets are worth a lot.  However, you should read the court filings for yourself.  If Premier Exhibitions wants to sell the Titanic artifacts, it has to sell all of them together.  It cannot sell them separately.  This will make them difficult to sell.  On top of that, Premier will want to lease/rent back the artifacts that it is using for its successful Titanic exhibition.

Premier for a long time has been trying to get permission to sell the artifacts piece by piece.  The judge is NOT happy with them for trying to do this.  I suspect that the judge’s emotions will rule the day and Premier will not get what it wants.

From the buyer’s point of view, the demand may be questionable.  You have to pay ~$200M to buy the artifacts and you are obligated to maintain them (if you cannot maintain the artifacts, you will not be allowed to buy them).  And what is their utility?  I only see somebody buying them for the same reason they buy a piece of artwork.  However, to exhibit these artifacts in your house… you will have to rotate the artifacts in/out to prevent damage associated with exhibiting them (as is the case with the Titanic exhibit).  Is there a market for this?  Maybe.  But figuring out the market for this asset is too hard for me.

2- Management: The old management was very good at running an exhibitions… the new one not so much.  That is why Premier will not be able to maintain its historically high returns on equity.  This is a business where Premier doesn’t have any special advantage or economic moat.

Why I’m shorting TLT (Long-term treasuries ETF)

Basically, the US has very high debt and spending is out of control.  Bondholders are not going paid enough interest to compensate them for the risk that they are taking.

Congressional Budget Office

They issue reports on the projected US deficit.  Read them for yourself!  The issues I have with the reports is that:

1. They don’t even predict an elimination of the budget deficit.
2. Their predictions are based on assumptions that will likely turn out to be false.  (Such is the nature of the prediction game.)  If they were smarter, they would provide a range in their estimates.
3. Historically, politicians always say that they are going to slowly eliminate the deficit.  But they never do.  Why do you think the US has so much debt in the first place?
   Or look at Greece.  The politicians have been hiding their problems for a long time and understating inflation.  But eventually the proverbial excrement will hit the fan and everybody will be panic selling their debt.

Obama’s advisors

Warren Buffet used to be one of Obama’s economic advisors.  His shareholder’s letters at Berkshire Hathaway outlines his thoughts on what the administration should do (lower health care costs / make the system more efficient, cut greenback emissions, etc.).  Needless to say, Obama does not listen to him.

So who is still one of Obama’s economic advisors?  Lawrence Summers.  Nothing against him as a human being, but he has a track record of failure.  At Harvard, he presided over Harvard’s failed gamble on interest rates.  As US treasury secretary, he helped to repeal the Glass-Stegal laws.  It turns out that wasn’t such a good idea as investment banks became “too big to fail” and did all sorts of crazy things.

Wasteful spending

The US military is funding the Taliban and Afghan warlords.  The US military outsources the trucking/delivery of its supplies to a select list of approved companies.  It is cheaper for these companies to pay off the Taliban and local warlords than to protect trucking convoys with troops.  (They also aren’t allowed to use heavier weaponry so they may find themselves outgunned.)

Now all governments and organizations are going to have wasteful spending to some degree.  But as far as I can tell, the politicians are aware of this counter-productive spending and are doing little about it.  It is going to be a little difficult for the US to pay off its debts when you have a system that doesn’t care about correcting its mistakes.

Some of the numbers

10-yr treasury yield: 2.125%
30-yr treasury coupon: 3.750%

Gross debt to GDP: ~98.60%
Revenue to GDP: ~30.83%
Spending to GDP: ~46.41%

Let’s suppose that the US government turns around and starts saving 30% of what it makes (this is the average household savings rates among some Asian countries).  The US will be in some incredible pain as government spending will have to drop from ~46% of GDP to ~21% of GDP.  The US would have to cut slightly more than half its spending (I am guessing that there would be riots in the street).  Then it would take a painful decade to get out of debt.  If the US government only saves 10%, spending will still have to drop drastically and it will take three painful decades to get out of debt.

Of course it will never happen.  It will probably end up like Greece, where the politicians keep running up the deficit while the citizens and media do not hold their governments accountable.  And there will be rioting, much like in Britain.  Historically this is the pattern and it does not look like the US will be the exception.

Disclosure: I am also long US stocks like Microsoft and Apple and a lot of commodity stocks (PG.TO, CLQ.TO, NOT.TO, NFD.A, MCF).