My July 8 post “Mine economics explained” explains why I think capitalization of stripping expenses is bullshit. The current trend is for miners to make more aggressive assumptions in that department to boost their earnings. This is contrary to reality. Lower commodity prices means that mines will close earlier. It would make sense to take impairments on previously capitalized expenses. (Or better yet, accounting rules should be overhauled to reduce accounting shenanigans, investor transparency should be improved, and the accounting burden on public companies should be reduced. Simpler rules would benefit investors. The problem is that the system has been co-opted by public companies that want to play games with their accounting and rulemakers who enjoy lucrative consulting gigs helping companies game the complex rules that they created.)
So right now I am going through the miners in the Labrador trough area:
- Alderon (Altius Minerals owns a large stake in Alderon)
- MFC Industrial (MIL) owns a royalty on Cliffs’ Wabush mine
- Cliffs (CLF)
- Champion Minerals (CHM.TO)
- Labrador Iron Ore Royalty Corporation (LIF.UN)
- New Millennium Iron Corp (NML)
- Adriana Resources
- Zone Resources
- Oceanic Iron Ore Corp.
Oftentimes metallurgical recovery may be (intentionally) overstated. Actual recoveries when mining commences is often lower than figures given by management.
A mining company will always run tests to determine the optimal amount of mineral processing. More expensive mineral processing techniques will yield higher recoveries. However, the higher recovery may not be economically justified.
Company management may quote the highest recovery achieved in initial testing. However, this may not have anything to do with actual recoveries as the additional mineral processing may not be economically justified. Also, the recovery figure may only be applicable to the high grade ore in a mine. The recovery for high grade ore may be higher for lower grade ore.
How mining companies guess future recoveries
#1- Compare the ore to similar ores in other mines.
There are obvious methods of cheating here. It is possible to cherry pick higher numbers from mines with higher recoveries.
The author of a preliminary economic assessment may also conveniently “forget” that the ore has problems that make it difficult to process (these ores are usually referred to as refractory ores).
I would not take this method very seriously in any type of economic assessment.
#2- Run tests on drill core
One method is to take drill core and to form 2 samples: one from high-grade ore and one from low-grade ore. High-grade ore may have higher recoveries than low-grade ore.
Tests may look at:
- Energy needed to grind the ore to particular sizes.
- Grind size versus recovery
- Usefulness of different mineral processing techniques
#3- Take a bulk sample
The problem with small scale tests is that they may not necessarily extrapolate to a full-scale operation. For example, milling equipment in a lab scale behaves very differently than a production-scale model. You can run tests using a production-scale mill, but it requires a lot of ore. If it is not possible to obtain that much ore (or production-scale equipment does not exist because it uses new processing techniques), then an engineer can run tests at various scales and build a model to predict how a full-scale operation would behave. These models are never perfect.
Mining companies may obtain a bulk sample by digging a trench and mining a small amount of ore for testing purposes. Or they may sink an exploration shaft if the ore is not close to the surface.
The bottom line is that larger scale tests are usually more accurate. However, they are not necessarily economically justified for a given stage in mine development.
The things to watch out for
- As previously mentioned, economic assessments should include information from more reliable methods of metallurgical testing.
- Refractory ores and ores that are difficult to process. A simple check is to skim through the technical report and look for the word refractory. Unfortunately this may not be enough. Ideally, you should know potential problems for that particular mineral or that type of ore.
- Marginal low-grade deposits. In these deposits, mineral processing will likely be critical to the economics of the project. This information depends on a number of different factors and information that may not be available without expensive testing. Mining companies will perform such testing in feasibility studies before building a mine. However, they may not necessarily release such information to shareholders. (Personally I don’t think that these types of projects are good investments because insiders can have such a huge information advantage and usually have incentives to promote the stock.)
- New cutting-edge mineral processing techniques. You don’t really know what exactly will happen unless the company runs a large-scale test. Bench-scale/lab-scale tests may be wrong. It is rare for mining companies to emphasize the risk involved. Sometimes this is because a mining company badly needs to raise capital and to promote itself. Sometimes it is simply a matter of professional pride or ego. Some people may not like to say: “Actually we don’t really know if our science project will work on a production scale.”
Does focusing on the recovery figure really make sense?
In my opinion, not really. There is always a balance between higher recovery and lower mineral processing costs. This balance isn’t well known until a feasibility study is run. A lower recovery may be a good thing. However, management may prematurely cite recovery figures and these are usually overly optimistic.
What investors want to know is the predicted future cash flow of a particular project. And these predictions are heavily dependent on engineering data such as grind size versus recovery, energy costs for particular grind sizes, mineral processing costs, and a large number of other factors. “Knowing” the expected metallurgical recovery (which may change or be totally inaccurate) doesn’t necessarily help an investor predict the future cash flow of a given project.
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.
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.
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.)
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.
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.
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.
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?
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.
- 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.
- 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.
- 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%.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
Trading/investing in/speculating on stocks
In my opinion, much of the return on commodities stocks will come from ‘speculating’ on commodity prices. The underlying companies are usually leveraged to the price of commodities. A 2X increase in the price of a commodity will usually lead to more than a 2X increase in operating profits of a mine. If the costs of a mine are 50% of the current commodity price, then a doubling in prices will increase mine profits three times.
A small part of the return will come from buying the dips and selling the rallies. (Because let’s face it- this is how most value investors make money. They aren’t always good at picking stocks.)
And a small part of the return will come from stock picking. But very few people are actually good at it. You know, there are hedge fund managers out there who don’t bother reading 10-Ks. And many of them invest in mining stocks without bothering to read some university textbooks on mine exploration and mine engineering. Some people think that it’s a good idea to go long ATPG, without understanding how PUDs can be manipulated.
There are two reasons why royalties can be very, very profitable. (But only by people who really, really know what they’re doing.)
Firstly, they are a way to rip off companies which are badly in need of financing. Companies in distress. Or junior mining companies where the CEOs do things that don’t make a lot of sense for its investors. And royalties offer the chance for due diligence, so it’s not as risky as investing in a stock where it’s really difficult to do due diligence. NI 43-101 is not perfect as geologists can do subtle things as using a favorable interpolation method (this can make a 20% difference).
And when dealing with junior miners, royalties offer added protection from the CEO doing awful things to its shareholders. The royalty holder is not affected by share dilution, overpaid CEOs, CEOs wasting money on promotion, excess overhead (e.g. liability insurance for insiders), takeunders, etc.
Secondly, they are leveraged to big increases in commodity prices. If a commodity price skyrockets, then naturally the mining company will want to do more exploration on its property and to expand production. The royalty holder benefits from all this without having to put up any capital. (Though not all royalties have this feature.) This is kind of like an out-of-the-money call option and sometimes people seriously underestimate its value.
On the other hand, sometimes there are downsides to mineral royalties. The mining company may try to underpay its royalties. (This happened to Terra Nova, which went to court.)
If a royalty is too large, it discourages mine expansion whereas a smaller one would not.
Examples of successful royalty strategies
Pierre Lassonde + Seymour Schulich / Franco-Nevada
Altius Minerals (ALS.TO)
Labrador Iron Ore Royalty Corporation (LIF.UN) – They don’t even do anything fancy. Most of the asset value is in their royalty, plus an equity stake in the mine covered by the royalty. On the other hand, this company was rather lucky as iron ore prices have skyrocketed.
Kevin McArthur / “Tip of the iceberg”
Kevin McArthur is the ex-CEO of Goldcorp and now runs Tahoe. He is interviewed by The Globe and Mail here. He seems to attribute his success to finding tip-of-iceberg opportunities. As I understand it, this means buying properties that have a lot of exploration potential. This probably comes in the form of extensions to the existing deposit.
How the resource exploitation process works
First you have to find an economic ore deposit. Exploration geologists look at all the previous mines and look at any patterns that exist (e.g. a lot of deposits are found near existing mines). They also utilize scientific knowledge about how ore deposits form (e.g. diamonds can only form under high heat and high pressure; they only end up near the surface if stuff from deep down is ejected upwards, e.g. in kimberlites).
In addition to drilling, geologists may look for things associated with ore deposits. They may go looking for anomalies in gravity, induced polarization, etc. While ore deposits can cause such anomalies, all sorts of other rock configurations can also cause anomalies. So the geologists will drill a lot of holes and find a lot of duds. They most basic method is old school prospecting. You walk around the surface looking for rocks. Certain types of rocks are likely to host valuable minerals. Some rocks obviously contain ore just by looking at it if you are familiar with the different types of rocks. Nowadays geologists will sample surface rock and get the samples assayed for minerals that aren’t visible to the eye (e.g. economic amounts of gold). They may also look for “indicator” materials- stuff that correlates to certain types of ore deposits. And they may look for boulder trains that may lead to a deposit elsewhere.
Most of the really obvious ore has been found. Finding future deposits will only get harder and harder. On the other hand, technology may introduce new technologies that make low-grade deposits economic. We may also discover new technologies to help in exploration.
One thing to note about mineral exploration is that the chance of finding an economic deposit is very, very low. Many geologists will never find a deposit in their entire professional careers.
Pre-feasibility and feasibility studies
In this stage, a mine engineer will evaluate the various technical parameters that determine whether or not a deposit is economic. The more important ones are:
- Size of the deposit.
- Mining method. Underground mining typically costs three times that of open-pit. However, various underground mining methods differ in their cost (the cheaper ones sometimes cannot be used).
- Mining dilution. If the ore deposit is very narrow (only a few meters), mining machines will have to move a lot of waste rock.
- Ore processing / metallurgy. For some ores, the metals cannot be easily (cost-effectively) recovered. Some ores have impurities that cost money to remove (e.g. arsenic, sulphur, etc.).
- Infrastructure. Mines need roads, access to ports (sometimes), power, water, etc.
- Royalties, taxes, etc. Sometimes prospectors and former joint venture partners will have royalties on the property and these need to be factored in.
Other parameters (that are mostly the investor’s job) are:
- Political risk. Some mines may have difficulty due to NIMBY groups. For example, in Australia a lead mine was shutdown after it started production due to residents’ pressure on their politicians.
Some foreign countries are run by corrupt regimes that demand high payments from mining companies. They may escalate these requests in the future (a deal is not a deal). Leaders (sometimes socialist, sometimes not) may appropriate foreign assets. Even in the US and Canada (considered to be the lowest-risk countries), foreign takeovers are often blocked while domestic ones are ok. It doesn’t even make sense because a country can appropriate the assets of foreign countries; it is a good idea for them to follow the host countries’ rules and regulations (though some do not).
- Future commodity prices and exchange rates.
More exploration drilling usually occurs during this stage. If even more ore is discovered (this is a good thing), the mining plan may be changed. Mine construction may be intentionally delayed to avoid building a mine and processing facilities that is not ideal for the deposit.
The feasibility study may determine that the ideal level of investment is higher than what the mining company can afford. So the mining company can sell the asset to another company with more money. Or they can raise money through selling equity, rights offerings, selling royalties on the property, raising debt, etc.
Sometimes there are government-related/government-sponsored entities that will make dumb loans to mining companies (e.g. they don’t charge enough interest relative to the risk). Their mandate may be to help economies develop. In practice, government workers who do their job poorly tend to get to keep their jobs.
Hopefully there are no cost overruns. A companies’ management may have incentives to understate the cost of mine construction to make the economics appear more attractive.
It usually takes 5-10 years (sometimes more!) for a mine to actually start operating. Mining companies are usually very overoptimistic about when a mine will actually start operating.
By this time, commodity prices may be very different and this will affect the economics of a mine.
As the end if a mine’s life comes closer, there is an incentive to find more ore near the processing plant since all the infrastructure is in place and paid for.
Exploration drilling may occur when a mine is operating. Some exploration drilling may be deferred until an underground shaft is built. Drilling very deep is expensive and drills will slowly start going off target the further the drilling gets. Starting underground lowers the exploration cost.
All these things mean that the plan for a mine will likely change several times over the course of its life.