Major precious and base metal mining companies are having a difficult time replacing their metal production with new reserves. For instance, current global mine production is in the order of 85 million ounces per annum, whereas the last time the industry found that many ounces in a year was 1999. This dearth of new discoveries is despite the significant increase in exploration spending since 2002. Particularly disconcerting (to the larger mining companies at least) is the serious decline in discoveries since 2006 notwithstanding exploration spending that has more than doubled from $2.5 billion to over $5 billion.
Recognizing the difficulty the gold miners face in finding and developing new deposits, our brief here at Exploration Insights then becomes pretty straightforward: identify true high margin economic deposits and differentiate them from marginal or uneconomic deposits and geochemical anomalies. Wild-ass guessing may work in a super bull junior market, but my sense is that the high risk flying turkey trade is off for now and investors had better apply economic parameters to anything they consider.
Let's run through an example
I spend most of my time reviewing projects, looking for obviously undervalued assets or potential big discoveries. In the following example we will walk through the very basics of that process using two hypothetical projects that are based on real-life examples. All the usual caveats, warnings and forward-looking statements apply. I will be conducting a workshop titled "Interpreting Exploration Company News Releases" at the upcoming Hard Assets Investment Conference in San Francisco on Nov. 28th for anyone interested in going into much more detail.
Today we will compare two high sulfidation (refer to Epithermal Deposits, page 7, Geo-Insights located under the Geo-Insights tab on my website) projects from the same region of the world. The first has a feasibility study and is being built, the other has an inferred resource with no economic study. We will lay out the basic geology, grade and cost parameters followed by a rough economic assessment of the projects.
Deposit #1 hosts proven and probable reserves of approximately 2.2 million ounces grading about 2 grams per tonne gold. The mineralization occurs in a high sulfidation system comprised of silicified and altered volcanics. It is predominantly un-oxidized, and associated with sulfides. Recovery is approximately 75% and will require crushing and grinding before running the ore through a Carbon in Leach (CIL) circuit. The plant will process 4 million tonnes per annum, and the strip ratio (waste to ore) is 1 to 1. The project is near infrastructure but will require power lines, diesel generators, a tailings pond, and some new roads. The community is onboard so far and the acid mine drainage issue seems to have been addressed. [Acid mine drainage can be a serious environmental problem caused by the oxidation of sulfide bearing rock by surface waters that makes the water very acidic. In old mining camps you can sometimes see this as a brown-red stain on rocks in a river that is barren of fish.]
Mining costs as per the feasibility study are $2.66 per tonne mined, which, at a 1:1 strip ratio, comes to $5.32 per tonne of ore (one tonne of ore plus one tonne of waste). Process costs are $12 per tonne of ore, and general and administrative (G&A) comes to $2 per tonne, processed. This mining and processing cost of roughly $20 per tonne of ore now has to be subtracted from the value of the ore.
Applying a 75% recovery to the average grade of 2 grams per tonne gold leaves us with a recovered grade of 1.5 grams per tonne gold. Assuming a $1,500 gold price we get an average per tonne value of ~$72. Subtracting the $20 per tonne production costs nets an approximate operating margin of $52 per tonne ($72-$20). On a per tonne basis, that is a good margin and beats my general rule of thumb that a mine's average grade should be at least twice the cutoff grade. In this case, the economic cutoff is about 0.4 grams per tonne, although there is a lot more that really goes into determining ore versus waste - we are just trying to get close here.
The capital costs to build any operation are often the key factors in a production decision. For Deposit #1, capital costs are just under $400 million, which equates to mining approximately 8 million tonnes of ore assuming a $52 per tonne operating margin or, two years of production at a $1,500 gold price (8 x $52=$416). This is a reasonable amount of time to recover capital costs and, in reality, Deposit #1 has a higher grade zone that can be mined early on; hence, capital payback will actually be quicker. Thereafter, if all goes well the company is theoretically making good money on their deposit.
Deposit #2 is a much earlier stage project, and our evaluation requires that we make many generalizations regarding all aspects of the geology, metallurgy, and costs. The deposit contains an inferred 3 million ounces grading 1 gram per tonne gold, hosted by an altered high sulfidation system similar to Deposit #1. About 75% of the deposit is mixed oxide and sulfide material, with the remaining resource basically sulfidic.
Detailed metallurgical work has not been completed, but some very basic work suggests that gold is possibly recoverable using cyanide. [In high sulfidation systems metallurgy is key if the material is un-oxidized (see page 38, Geo-Insights). These systems tend to carry other metals that hinder recovery and they can be refractory, meaning it is even more costly to recover the gold. Metallurgical test work should be initiated as soon as a company thinks they may have a deposit.] Given the location and sulfide nature of the ore, it is unlikely that the deposit can be heap leached, so a low cost process option is out of the question for now. Our first big leap of faith then is that the ore is not refractory so can be recovered via CIL as in Deposit #1. We will therefore put gold recovery at 75%.
From the available information (basically photos) it appears the strip ratio could be quite low (at least initially) consequently, we will use 0.5 to 1. Mining, processing, and G&A costs should be close to those of Deposit #1: $2.66 per tonne mined, equating to $4 per tonne at a 0.5:1 strip ratio ($2.66+(.5 x $2.66)); $12 per tonne processed; and $2 per tonne in G&A; for a total of $18 per tonne of ore processed.
Assuming 75% recovery of the 1 gram per tonne deposit nets a recovered grade of 0.75 g/t Au, or $36 per tonne of ore at a $1,500 gold price. Subtracting the production cost of $18 leaves an $18 per tonne operating margin for Deposit #2. If capital costs are $400 million (a reasonable guess given the overall similarities to Deposit #1) it will require about 20 million tonnes of ore to recover the capital cost (at $1,500 gold; $18 x 20Mt=$360mil) or about five years of production at 4 million tonnes per annum. As with Deposit #1, there is a higher grade portion of the deposit that could probably be mined early, with a resultant decreased capital payback time, but we don't have the details to factor that into our assessment and probably shouldn't push for a better scenario given the early stage of this deposit.
Now it gets tricky
I tend to not play the dollar per ounce in the ground game in valuing deposits because, as the above example illustrates, all ounces are not created equal. For our investment purposes at EI, I prefer to consider a deposit as best I can from a mining company perspective. What makes money, what are the headaches, and what could be the fatal flaw? In our valuations it is worth keeping in mind that mining companies are often provided with considerably more information than the public, through confidentiality agreements. They also have a full time staff that is capable of going into much more engineering, mining, and financial detail than we can; hence, we are still at a disadvantage and only speculating.
In performing this assessment it is essential to recognize that we have made some very broad assumptions for a deposit about which we know very little. These assumptions are risks to the project that need to be sorted out through extensive work, which means time and money. The ore could be refractory, a fatal flaw that would make a 1 gram per tonne deposit uneconomic. Alternatively, recovery could be in the 90% range, thereby adding another $10 per tonne to the operating margin. Also, every $100 change in the gold price adds or subtracts about $2.50 per tonne to the operating margin - what gold price is appropriate? At $2,000 rather than $1,500 gold, Deposit #2 starts to look much better, but then what operating and capital cost escalation should be built into our assumptions?
Furthermore, we haven't touched on the volatile topics of political, social, and environmental issues that are becoming more and more relevant in the decision of whether or not to build a mine. Deposit #1 has been permitted and is going ahead, while Deposit #2 has some permitting issues and years of environmental and social work to complete before being issued a mining permit. What is the appropriate cost (or discount rate) to account for the time it takes to get a mining permit and/or the risk that none will be issued?
How much is Deposit #2 worth? How much would the market be willing to pay on a per ounce basis for the company? How much would a mining company pay for the privilege of building this deposit?
Concluding
From my perspective, the higher the risks and the more unknowns, the higher an operating margin we need to see. The company that owns Deposit #2 does not appear to offer a high enough operating margin to justify the risks we have mentioned (or those of which we remain unaware.)
The company trades for about $25 per ounce in the ground based on their market capitalization. This is at the lower end of the dollar per ounce curve for undeveloped deposits, and there is little doubt that the case will be made by others that the company is undervalued, and that a simple doubling of the dollar per ounce in the ground value is warranted. (I would guess the odds of that happening are about 50/50.)
Although tempted, I am unwilling to take that gamble - that someone else will be either more foolish or smarter than us and pay double the current share price. Our assessment suggests that there are too many issues to resolve to take the risk on a marginal deposit. If more data becomes available that answers some basic technical questions and resolves the socio-political issues, then in hindsight perhaps we should have bought the company. Unfortunately, the answers to the questions we seek are outside of our control and I prefer to invest in situations where we have more of an edge over the competition.
Brent Cook brings more than 25 years of experience to his role as a geologist, consultant and investment adviser. Cook's weekly Exploration Insights newsletter focuses on early-discovery, high-reward opportunities primarily among junior mining and exploration companies. He will talk about "Turning Rocks into Money" on Monday, May 9, and on "Interpreting Exploration Company New Releases" on Monday, May 10, during the San Francisco Hard Assets Investment Conference.
