The Odds and Opportunities in the Junior Miners

Mining Industry Insights

By Brent Cook

The discovery of an economic mineral deposit is an extremely rare occurrence that involves a very difficult, costly and determined effort. For the few people or companies that do succeed it is an extremely profitable occurrence as well. Recent success stories include Aurelian Resources, which was bought by Kinross for $32 per share (pre-split); AuEx Ventures, which was bought by Fronteer for $6.00 per share (Fronteer was in turn purchased by Newmont for $14 per share); and, Ventana Gold, which was acquired for $13 per share. All of these junior explorers were trading at sub-$1 prices in the early stages of the discovery. That potential, to make five, ten to one hundred times your investment in short order, has attracted over $10 billion of new speculative capital (by way of more than 4,000 financings) over the past two years into the Canadian junior mining sector alone.

But before jumping head first into this high-risk venture a word of caution to the uninitiated: it is exceedingly tough to stumble across Mother Nature’s buried treasures before going broke.

How tough is it? 

Barrick Gold included some telling slides as part of their recent Investor Day presentation. Figure 1, below, illustrates the increasing difficulty the mining industry is having in finding new gold and gold/copper deposits. Current global mine production is in the order of 85 million ounces per annum; whereas, as the chart illustrates, the last time the industry found that many ounces in a year was 1999. For reference, consider that 85 million ounces is approximately the total gold produced from Nevada’s world class Carlin Trend over its 30-year history. For those not keeping track, that’s one Carlin Trend a year the gold mining industry has to prove up just to stay even!

(Fig. 1-Discoveries, spending, and total ounces discovered. Source- Barrick Gold, w/ minor edits by Exploration Insights)

The dearth of new discoveries noted above comes despite the significant increase in exploration spending since 2002. Particularly disconcerting (to the larger mining companies at least) is the decline in discoveries since 2006, notwithstanding that exploration spending has more than doubled from $2.5 billion to over $5 billion. The bottom line is that more and more money is finding less and less gold! The upshot of that fact is that the very few gold discoveries that are legitimately economic are going to be exceptionally valuable. That “gap” in production versus discovery virtually guarantees that the few successful junior exploration companies will command a premium takeout price—hence our focus here at Exploration Insights on the junior end of the spectrum

Fortunately for the gold mining industry, the increase in the gold price has provided a “grace period” for the mining companies in which they can forestall the production deficit. They have managed this discovery versus production deficit by expanding existing operations at their mines and/or lowering the cutoff grade (value per tonne of rock). This is documented by a recent BMO Research report detailing the decline in mined grade from 1997 to 2009 (Fig. 2 below). The average mined grade over that time period decreased about 35%, which, when combined with the increase in material, labor, and power costs, resulted in industry wide gold production costs more than doubling over that same time frame. This lowering of the cutoff grade is only made possible by the higher gold prices that effectively turn previously uneconomic rock (waste), into economic rock (ore). There is a limit to how far mining companies can push the waste to ore strategy before their operations turn marginal or begin to lose money.

(Fig. 2- Change in average gold grade since 1997 in underground, open pit, and dump leach deposits)

On a more positive note for the major mining companies, the steady ten-year rise in the gold price means the miners are flush with cash. This excess cash flow situation can’t go on indefinitely because of the problems discussed above: declining discoveries and declining gold grade equal declining margins. Major gold miners now have a relatively short window of opportunity in which to act. The share prices of most of the junior explorers (the good and bad) have seen substantial declines in share prices over the past 8 months. The share price decline means the good can be acquired at reasonable prices. The bad I am afraid are still worthless.

The results is that the opportunity for speculators in the junior mining sector is the best I have seen in quite some time. Mining companies are making good money, and the confluence of these two macro-themes: declining discoveries and increasing earnings, bodes well for those of us willing to speculate intelligently in this sector. All we have to do is buy the right penny-stock company and wait for the buyout. Problem is, the odds of discovery are extremely low.

How low?

There are in the order of 2,000 junior companies listed on the Canadian exchange and maybe 1,000 more listed in Australia, London, and elsewhere. In round numbers they are exploring 10,000 mineral properties of which only 1 in 1,000, on an annual basis, will produce an economic discovery. Worse, only 1 in 10,000 will result in the delineation of a gold deposit of greater than 4 million ounces (Stephen Enders, Society of Economic Geologists Newsletter, July 2011).

The obvious question for reasoned speculators now becomes, “How is it possible that 3,000 publicly listed companies are able to raise billions of dollars given that the odds of success are 1 in 1,000 for an OK deposit or 1 in 10,000 for the big deposit?” The simplistic answer is that Mother Nature has been very generous to exploration geologists and by association, the brokers that make their living selling the dreams of buried treasure to the public by playing to human nature: greed and the susceptibility to an easy getting rich quick story.

What is exploration and why are the odds so low?

The scientific basis of minerals exploration is pursuit and understanding of anomalies (variations) within the Earth. A mineral deposit is a special type of anomaly in which enough metal has been concentrated under the right geologic conditions to make it economically feasible to extract. The problem is that for every economic metallic anomaly (ore deposit) there are thousands of uneconomic ones that, for any number of reasons, don't cut it. The reasons for failing could include grade, size, metallurgy, depth, strip ratio, location, politics, community, environmental concerns, etc, etc. Referring back to the opening sentence in this paragraph, explorationists evaluate anomalies and an anomaly is little more than some variance from background in the geochemical, geophysical, or geological characteristics of a piece of Earth. There are literally billions of these anomalies that merely reflect and are a function of the Earth’s evolution over billions of years.

So what’s an investor to do?

1.    Of the roughly 3,000 junior exploration companies combing Earth chasing down anomalies, maybe half can be thrown out because of incompetent or unfocused management: management is key in the junior sector—get to know them.

2.    Of the remaining half, about half again can be easily screened out based on the type of mineral target they are exploring. I see way too many exploration groups raising and spending money on targets that, even if successful, are not really valuable—most are too small and marginal at best. Therefore in such a high risk investment sector it only pays to focus on companies that are exploring for game changing discoveries-- ones that can increase the share price tenfold or more. Know what type of deposit the company is looking for and what it sells for in the open market.

3.    The other major issue investors face in this sector is shareholder dilution at the company level. Of what value is a tenfold increase in market capitalization if it is accompanied by a tenfold increase is shares issued? In minerals exploration, money only goes one way: out. This is a capital-intensive business-- no capital means no business. A company must have a very clear vision of the progress they need to see and demonstrate in order to raise money at the next level. Make sure company management is not only technically competent but financially literate as well.

4.    Since we know that most exploration projects are going to eventually fail despite the early excitement, it is critical to recognize the fatal flaw ahead of the crowd. Junior companies thrive on news releases, so an investor’s job is to interpret the drilling, metallurgical, and sample results in the context of the target being explored. When things start going wrong, get out and get out fast. I have found hope and unfounded belief to be very poor investment theses.

Finally, the money you invest in this sector should be money you can afford to lose; but the object is not to lose it but to win big. Take your time and wait for the right pitch. There are no called strikes in this game and there is no shortage of new hot stories that will be touted by the brokerage industry. By spending the time to research a company, via talking to management, following results, and getting sound advice from someone in the industry, you are way ahead of the crowd. In the end, that is what seems to work best.

Brent Cook
Economic Geologist and editor Exploration Insights