LONDON () - There were many presentations at last week's Mines and Money Conference in London on challenges facing the mining sector. Topics covered included the rising costs of labour, equipment and energy, increasing political risk as the industry shifts to new frontiers, rising social and environmental requirements and the skills shortage and war for talent (for example Australia is projected to need another 70,000 mining workers in the next 10 years while the Canadian tar sands industry alone will need 100,000). There was talk too about potential stumbling blocks in the short to medium term if, for example, growth slows in U.S. and/or China, if interest rates rise further, or if hedge funds exit the market.
But the overwhelming sentiment was one of optimism. The industry is in sound shape and, as the keynote speaker, Professor Ian Plimer of Adelaide University concluded, the future for the sector is bright. Demand for resources will soar as China and India ("Chindia") open up their economies and progress along the development S-curve. Mark Sawyer, General Manager for Business Development of Xstrata [LSE:XTA], claimed that there is no mystery or miracle about this. It has happened before, most recently in Japan from 1960-1980 and in the tiger economies from 1960-1995. Only this time the populations involved and hence the impact on the resources sector will be far greater.
Several of the presentations included commodity price forecasts and all predicted the same basic pattern. Prices are expected to moderate from today's levels, but the floor level will be higher than in the past. Sawyer's chart, further below, based on JP Morgan's projections was typical of those shown.
However even though average prices will be higher there will be still be considerable volatility. Frank Holmes, the Managing Director of U.S. Global Investors, and winner of the Mining Journal Outstanding Achievement Award for Mining Fund Management identified a number of cycles which drive volatility, including, for example, the 20 year 'Kuznets' cycle, the U.S. presidential cycle, seasonal factors and the life cycle of major infrastucture. Commodity price and share price volatility will be further exacerbated by the dollar, by hedge funds and by the low inventories/market tightness which means that prices are highly leveraged to relatively small scale disruptions. As Holmes said, the commodities boom is not over but investors must be able to live with volatility and see downturns as buying opportunities. They must anticipate bad hair days!
The diversification of the majors will afford them some protection from the effects of volatility. Xstrata's Sawyer presented an analysis of the battlefield for the majors based on the number of commodities and regions that each operated in.
However for the juniors, particularly single asset companies, volatility will be magnified. There will be spectacular successes and failures. For example the share price performance over the last year of the gold mining companies on AIM has ranged from Aurum Mining's [AIM:AUR] increase of +202% to GoldStone Resources' [AIM:GRL] fall of 68%. The following table represents AIM gold mining company's percentage change in share price for a one year period to November 24, 2006.
For investors therefore choosing the right share, and at the right price, will be crucial. Dr Fiona Perrot-Humphreys, who worked as an investment mining analyst for 15 years prior to setting up AIM Mining Research, gave a talk at the conference on the issue of share valuation. Her main theses ran thus.
1. There have been a huge number of new mining listings over the last 3 years. This has been driven by the commodity price upswing, the opening up of new frontier regions previously considered 'no go' areas such as the Former Soviet Union and parts of Africa such as the Democratic Republic of Congo, and the delayed impact of the drastic slashing of exploration budgets by the majors between 1997 and 2002.
2. Many of the new listings are young companies and most are at the early stages of exploration and mining. For example, according to Ernst and Young there are 198 mining companies on AIM. The recent PriceWaterhouseCoopers report on AIM which analysed the largest 50 of these concluded that 22 of the top 50 had producing mines last year while 28 were earlier stage. The majority of the companies not in the top 50 are almost certainly early stage.
3. There has been a huge variation in the share price performance of these companies. It has not been in line with the mainboard mining sector nor has it been a geared proxy for the underlying commodity. This is because junior mining shares are driven by a different set of factors from the mainstream miners with drivers including the flow of information on the development of an asset, liquidity levels, political risk shocks and investment interest by a major.
4. A key issue in theory in the valuation of junior depends on where it is in its lifecycle. In the chart the investment risk, shown in red, should fall over time while project value (in green) should increase, though of course at any stage it could fall to zero!
Key aspects to the information flow thus include:
- The discovery of a deposit.
- Proving it up under relevant definitions. Upgrades to early estimates cause share prices to rise, and vice versa.
- The progress in taking a resource into production.
- News on environmental permitting and social issues.
- Financial issues as the accuracy of cost and revenue projections improves.
- Political risk issues, as, for example, Oxus Gold [AIM:OXS] and Asia Energy [AIM:AEN] have discovered to their cost this year.
5. In practice the risk of mispricing of equities can be considerable particularly in illiquid and poorly researched markets. One of the most sensitive times for share price is when junior companies, whose still sets tend to lie in finding prospective assets try to turn the asset into a producing mine.
A wide set of factors determine success or failure at this stage. These are listed on the AIM Mining Research website as:
- Security of tenure.
- Key characteristics of the ore body especially the grade.
- Operating parameters of open pit vs. underground mine development.
- Plant and metallurgy efficiencies, particularly in commodities that need to be separated out from by-products found in the same ore body e.g. PGE.
- Logistics, particularly when a mine is located in a remote region.
- Management record in developing projects to production stage.
- Environmental issues that demand increasing amounts of company time and resource, covering not only the physical environment (where actual legislation will govern company requirements) but also the socio-cultural component (where local communities are capable of stalling potentially viable ventures if their concerns are not addressed).
In his presentation Frank Holmes of U.S. Global Investors illustrated below what can typically happen to a mining share at the stage.
He cited also the typical impact on a share price of various types of delays and disappointments in the project.
6. All of these factors are made more complex when the company is operating in an unfamiliar emerging market region. Of course the overwhelming attraction of many emerging markets is the potential for the discovery of rich ore deposits which have remained untapped so far for political reasons. Risks are correspondingly higher with key issues in these regions including security of tenure, access to data, the availability and reliability of local infrastructure, the reliability of assaying, transport costs and operational logistics in far flung terrains which can be heightened by remoteness or extreme weather. The experience of the management team in operating in the region and their language skills can be a vital ingredient in mitigating some of the risk.
7. Estimates of profitability of a mine depend on cost and revenue projections but there are huge uncertainties associated with both of these. Currency movements further complicate the picture.
8. There are a number of approaches to valuing a mining company but each has drawbacks. For example comparison between companies of ounces in the ground depends totally on what kind of ounces they are and how much they will cost to extract. Similarly comparison of "comparable transactions" depends crucially on the transactions being comparable - often they fail to take into account differences in the resource or in political risk. Net Asset Value can be almost meaningless, while Net Present Value calculations depend on having an accurate estimate of the operational variables and an appropriate determination of the risk-free rate. Approaches by the major mining groups can gave an indication but even these can be distorted by the major's strategic imperatives if, say it is adopting a portfolio approach to a particular location or if acquisition offers synergies.
The bottom line is that there is a high need for sensitivity analysis. Each deposit is unique, the data is often uncertain and there are enormous challenges to be overcome in turning ounces into real resources. Dr. Perrot-Humphrey's conclusion is that there is no holy grail to valuation. Potential investors should:
- Check the track record of the company and board members.
- Decide whether the medium term aim of the company is actually to mine or sell the company.
- Visit the site (in an ideal world).
- Understand the major risks associated with the project.
- Monitor the company's progress tracking actual performance against promises made.
- Know the right questions to ask.
AIM market research published a book "Understanding Junior Miners" in June 2006 targeted at fund managers and investors to help understand the specialist geological and mining issues facing early stage junior miners. Details are on their website.
As Frank Holmes cautioned, investors should consider the wholesale price and the retail price but beware the fairytale price!
