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March 19, 2005

The Business Case for Buying Junior Mineral Exploration Companies Part II
by Bill McWilliam

Introduction

Our thesis is that a convergence of conditions exists in the mining industry that provides an ideal environment in which to speculate on the exploration success of Junior Companies. Importantly, the current situation offers a lower than normal risk profile for Junior Exploration Companies, while providing exceptional discovery leverage. Caution, however, is required as these companies are micro-to-mini-caps and are typically illiquid. The "lower than normal risk profile" is a relative term and should be viewed within the context of very risky securities. Part II will focus on how to recognize Junior Companies that address this environment, while providing an acceptable risk in this market segment.

In Part I, (http://www.safehaven.com/showarticle.cfm?id=2443) we discussed several of the macro-trend issues that created large-scale demand for metals and minerals, which demand could be long lasting. Minerals such as iron ore and various metal additives required to make steel (such as molybdenum, manganese, nickel and vanadium), crude oil, coal, copper and zinc used for basic infrastructure projects and lead and cobalt required for batteries, have all experienced significant demand and price pressures. There are also important emerging technologies, such as fuel cells and related hybrid vehicles, that will change the long term demand for certain metals and minerals but it is too early to predict any major trends. In addition, there are new applications and uses for metals that currently have small markets in addition to broad-based new demand for an important suite of rare metals. All of these factors are positive for Junior Companies.

Mega-Trends

The correlation between metal demand, urbanization and related industrialization is not a new phenomenon. The fact is that urbanization significantly impacts the demand for metals and minerals, resulting in higher commodity prices and, most importantly for Junior Companies, provide a stimulus for exploration spending. The urbanization underway in China today is unprecedented in human history. Prior to this, the largest immigration occurred as 60 to 70 million Europeans migrated to various parts of North America. Those immigrants were politically motivated and inclined to seize opportunities afforded in a fledgling democracy with a fertile and innovative, but nascent, industrial culture. This combination of conditions and events provided the foundation and population density necessary to create the world's dominant and most dynamic economy, that of the United States.

The China story is, however, a much larger migration event and its importance should not be underestimated. This transition is occurring within a totalitarian political framework and, as a result, it is not understood how this version of a communist "control economy" will evolve. What is clear is that the Chinese version of urbanization is also driven by money - money provided by Offshore Chinese conglomerates and American distribution companies such as Wal-Mart that finances the manufacturing capacity of China. The desire for a higher standard of living for a large portion of China's population - in fact, the transition from poverty for many-is as powerful a force as it was in past urban events such as Japan in the 1960s and 70s. China's current growth trajectory and its sheer size suggest that it could be the world's dominant economy at some point. One important caveat: can China's political fusion of Leninist ideology and power with its dynastic history be maintained in a modern economy?

Industrial and infrastructure growth in China have absorbed world excess production capacity of many commodities. Furthermore, there is a very good chance that capacity can not be increased fast enough to satisfy the demand, especially in the base metal mining sector. Over the next 15 years, China expects that 10 to 12 million people per year will leave lower paying agricultural jobs for urban centres. If this occurs, by 2020 the percentage of Chinese in urban settings will be just above 50%. In other major urban migrations metal demand peaked when urban populations reached 65%. This massive movement of people and the resulting demand probably translates into higher prices or at least high-relative prices for many metals for many years to come. This will in turn trigger significantly increased exploration expenditures worldwide. The exploration component is the important part for us and is the fundamental basis for speculating in Junior Companies at this time.

The impact on copper is especially instructive. China currently consumes about 20% of the worlds copper, or about 3.4 million tonnes. China's consumption of copper has doubled in the last ten years. Given reasonable assumptions about the known relationship between industrialization, urbanization and copper consumption, it is estimated that in 2020 China will consume 36% of world copper, which will amount to 13.3 million tonnes of world production, which is forecast at 37 million tonnes. To put this into perspective, BHP's Spence Mine in northern Chile, being prepared for production, will produce 200,000 tonnes of copper per year. The capex is estimated at US$980 million. The 13.3 million tonnes required for the Chinese consumption forecast, if correct, will require the mining industry to find and produce from 66 Spence deposits. Alternatively, the gap could be filled with 375 deposits similar in size to Northgate's Kemess South mine. Those of us in the exploration community are simultaneously numbed and sobered by the magnitude of these numbers.

Convergence

Over the past ten years several important trends have converged, which have created a much stronger and more attractive Junior Company. The mining industry has experienced an extended period of consolidation. As companies merged, they tended to reduce the exploration budget for the new company to a level less than the combined budgets of the merged companies. This meant that experienced people were retired or got the pink slip, and many highly qualified individuals, including seasoned exploration geologists, became available as consultants to or officers of Junior Companies.

At the same time, due to low metal prices, companies not only neglected grassroots exploration but spent most of the exploration budget on minesite exploration. The shift of the exploration budgets to "minesite exploration", where the objective is to find metal close to existing mining and milling infrastructure, moved the major companies further from their roots. Grassroots exploration was neglected as it was considered discretionary and perceived to have very low present value. Today, the property generation strategy of the major companies is essentially a cheque writing exercise as the industry giants are buying developed assets from governments in a variety of jurisdictions or by seeking joint venture properties after the discovery hole is drilled. This new reality essentially cements the role of the Junior Company within the industry, whereby it is no longer a nuisance to the majors but plays a fundamental role in the exploration and discovery of the earth's metals. The economic discoveries made have a clear exit path for the juniors and development by the majors is virtually assured.

The availability of cash to the Junior Company is also vastly improved as they no longer have to rely on the major companies for early stage joint venture financing. There has been significant growth and diversity in several types of financial intermediaries who are prepared to provide risk capital to companies operating in a variety of jurisdictions. The result is a less fragile Junior Company with much deeper management, which is accepted as a fundamental part of the mining industry worldwide.

Exploration Trends

Over the past 10 years metal demand has been steadily increasing and has recently exploded. World production, currently at capacity, must expand to meet demand driven primarily by Asian urbanization.

As a result of the macro and industry conditions discussed above, the property generation segment of the business was neglected for an extended time. The past ten years was also a period of low real metal prices and negative returns for the industry. The resulting attitude towards new exploration spending, seen as discretionary in this economic environment, and the difficulty in getting funding, worsened the situation. At this stage of the cycle, there exists a shortage of quality prospects, especially new large-scale prospects, and this shortage may soon become critical. If the forecast is correct that the Asian countries will experience an extended period of rapid growth, there soon will be a shortage of new mines to fill world metal demand.

It typically takes from 8 to 10 years to find, develop and mine a deposit. Additionally, most of the world's big mines have been in production for several years and are experiencing declining grade, declining reserves and rising operating costs. Thus, the search by the world's mining companies for new deposit-scale mineral properties is gaining momentum as each needs to find and replace its resource base. Because the discovery and development of new resources and lead time to production has many uncertainties, the search for large-scale deposits will be urgent in the near future. The fact that majors must do so with reduced exploration personnel whose knowledge and experience are irreplaceable adds a further layer of complexity to the situation. The Junior Companies have a lot of that talent, which allows them to compete with major companies in the exploration segment of the business.

Junior Company Profile

Clearly, the Junior Companies have a valuable role to play in the new economic scenario. But which companies? The answer appears simple: It is the combination of people, business models, property selection and their various exploration philosophies. But it involves a far more complex analysis and a measured approach to the fundamental components of the mineral exploration business, those being cash and its origin, how innovative is the geological talent, what are quality properties and creative ideas? The business model is another complex issue. It is difficult to say what factor is most important; however, nothing but dreaming results with no cash, a reality which holds true for both major and Junior Companies.

For our purposes, the combination of the cash-generating idea and the people to execute the program is most important. Exploration is a systematic process that requires a lot of time, money and patience. We are looking for companies with cash, a great property, the right people and a management regime that takes a disciplined approach to exploration. If there is a deposit to be found, this approach is what we are looking for.

The idea is essentially that money can find the talent or the talent can find the money, which then finds the rocks. What we do know is that rocks don't find the cash. Someone has to put up the initial cash to get things rolling. A good idea with geological talent but without cash only frustrates all involved.

While most mineral discoveries are made by major companies, Junior Companies have a respectable record of discovering major mineral deposits. Even Junior Companies who do not have blue ribbon management teams or a lot of cash make important discoveries and there are many examples of serendipitous discoveries. A deposit, of course, does not care who discovers it, owns it or mines it.

What differentiates the discovery made by the Junior Company is the leverage provided, albeit with a greater risk ratio. In the last ten years, the risk profile of Junior Companies is vastly improved because the newly-acquired geological talent and expertise provides a far greater selection of sound geologic ideas. As a result, investor confidence has risen rapidly, thereby attracting significant investment in Junior Companies, and the fundamental differences between the junior and major companies are becoming fewer. The main difference remains that major companies, with their focus on production, generate cash flows from metal production. Junior Companies must sell shares to get cash to maintain the exploration effort. Given favourable metal price trends and greater availability of cash, we are betting that the discovery rate for the juniors is going to accelerate. This provides significant comfort for the speculator. So, we are going to focus on this equation: does the discovery leverage provided by the Junior Company compensate for the discovery risk?

Business Models

There are essentially only two business models to consider and they are quite different. The most common involves a Junior Company optioning a property from a third party, usually another mining company but sometimes a private land owner. It is important to know the history of the property as many joint venture properties in the system are recycled ideas. The main problem with this business plan is that the junior company normally incurs a stream of payments that go to the vendor and not into the ground. Additionally, the junior's shelf life is based on one property that has to be drilled, so in each joint venture the junior is faced with potential extinction. The one property companies add considerable risk to the equation. Good mineral properties are scarce and, because of the availability of cash and the continual search for new resources to extend production life, most are controlled by major companies. The life of a junior company that cannot generate properties can be very short and high-risk.

Dilution is always a factor in the property business. The junior company always has to choose which type to take: sell stock and assume equity dilution or joint venture a property and assume property dilution. Many junior companies are often faced with both types of dilution on the same joint venture.

Where and How to Compete

The business plan of most major companies, with respect to exploration, essentially involves purchase or option agreements to joint venture properties, especially ones with large-scale indicated mineralization. Junior Companies, in most cases, simply do not have the resources to compete in this arena. This suggests that the best positioning for junior operations is in areas where majors do not participate. Again, this seems simple enough but is more complex to initiate. Working in a foreign jurisdiction is not a simple matter and it always involves a lot of time, money and a steep learning curve. Language, law, property title issues, local customs and work ethic are all real problems that have to be resolved before any money can be committed to exploration.

Major companies have historically controlled the majority of mines and for good reasons. They have the cash flow and a lot of expertise in mine finding matters. The majors also have several mines that are shut down as they no longer may be considered geologically prospective or the property no longer fits with their business and property portfolio strategy. One of the best places to look for a mineral deposit is near an old mine or a producing mine, as mineral deposits tend to occur in clusters for several good geological reasons. Since a lot of the geological talent is from major companies, one must believe they have specific knowledge of these mining areas and, true to creative exploration geologists, they have an idea where more mineralization can be found related to a known system.

The giant companies, such as Rio Tinto and BHP, have looked at large segments of the world's most prospective geology at least on a first pass basis, as they have the resources to do so. Junior Companies lack these resources but they are able to choose windows of opportunity within the broader context of world exploration. So, if a Junior Company options or purchases a property from a major company it is a good idea to look very closely at the transaction and the people involved. If a Junior Company options a former producing mine, the geological talent has probably looked at all the data and built a new geological model that may predict a new opportunity in an area known for hosting economic deposits. These are also worth paying attention to.

A less common model involves a Junior Company identifying a geologically attractive area and accumulating a large land position. This has been executed successfully in Canadian diamond plays where Junior Companies acquired large tracts of land and subsequently entered into to lucrative agreements with major companies. It is uncommon for a Junior Company to acquire control of a mineral district, let alone discover a brand new showing. If a junior is able to identify and locate by staking prospective mineral showings, its cost structure will be very low as it eliminates the property payments to a vendor and is only faced with the payments to the jurisdiction.

The most sustainable business model is one whereby a company generates prospects and enters into joint ventures, retaining interests through the high-risk but high-leverage portion of the exploration phase. However, few companies are able to assemble the necessary high-caliber team of prospectors capable of executing such a plan. In addition, this strategy requires a lot of seed capital and great quantities of time and systematic ground based prospecting to find good mineral prospects.

Leverage

Our definition of leverage is the additional value a discovery drill hole adds to the market capitalization of a Junior Company. A 300 million tonne economic bulk tonnage copper discovery could have a present value in excess of US$100 million. The companies we are following typically have market caps below US$15 million and some as low as US$8 million, so there is plenty of discovery leverage. The operating formulae for success is judging whether the current market cap when compared to the potential of the project provides enough leverage to mitigate the risk. Forget about concepts like "what's the float?" The truth is, with bad news the float is unlimited and goods news restricts its size-for awhile.

Liquidity

The profile Junior Companies are micro-to-mini-caps and are typically very thinly traded. They are difficult to buy in quantity and that may be a good thing. They are difficult to sell, which is a problem. One of the advantages of owning discovery-driven companies, however, results from the ability to define term of ownership. Once a geological target is defined and the exploration plan for a prospect has been formulated, there is a timeline to discovery, which always involves drilling. The drill program starts on a certain date and it ends on a certain date and both can be known within a few days. Geologists can prospect, sample and map until blue in the face but value creation is nominal. Value is only created by drilling, pure and simple. Somebody has to drill to create value. And subsequent, real market liquidity is only created by the drill hole and liquidity is always created in discovery situations.

The Downside

If the exploration program fails, the share price is likely to suffer by an amount at least as large as the anticipatory rise of a positive result. And the decline will happen quickly, usually after the stock resumes trading after a "trading halt" for dissemination of (bad) news. The best thing to do is to sell and accept the loss and either move on to the next movie or sell and wait until the victimized settles down and a new plan is hatched. Sharp drops in price, with volume, usually means the stock will have negative momentum for awhile.

The important thing to monitor while the drilling program is underway is the trading volume. If the volume increases significantly with an increase in price it probably means good news is forthcoming. Trading volume on a discovery hole will explode and could reach many millions of shares per day while the average volume pre-discovery may have been only in the thousands. And, if an anomalously high volume period occurs with a weakish share price, the news forthcoming is likely to be bad.

Another curious anomaly is the fact that the results of the drilling are sensed by the market before they are published. I'm not sure exactly how this happens but the market always seems to know "value" or "lack of value" in advance of its announcement. For these two reasons, it is particularly important to pay attention to trading volume as the drill program proceeds. You should avoid stocks that rise sharply on low or average volume during a drill program no matter what type of tip you are getting.

Finally, if the exploration program is a bust expect to lose at least half your money. If, however, you have chosen the correct management group who can generate another idea, odds are that the share price will recover. The well run juniors have the ability to regenerate and don't stay down for long.

Recommended Strategy

There is money to be made in the Junior Company arena. It is not easy but what is? It is a situation of assessing the probabilities and the result is always uncertain. All of the trends are positive for speculating in this sector. The amount of geological talent working for these small companies is astonishing and they are working for themselves as they have stock options and a clear self-interest in the discovery process. We believe that the exploration business and its ability to generate new discoveries is a matter of fact. It takes money - lots of money. It also requires patience on the speculators part - sometimes lots of patience. Picking the right management team with the right project at the right time is the key. This takes work - lots of work.

Summary

Over the next few months we intend to bring some of these Junior Companies to your attention. We will describe the company and its prospects, using the analysis and tools discussed herein. Our experience will be tested often but never wasted. The profiles are not "Buy" recommendations: they are information articles about a business that very little is known about, and outline certain speculative possibilities and rationales for certain situations with potential. In some cases, we may own shares of the security that is the subject of the article and we will disclose that fact as well.

As a primer for those who are interested in this market segment, you should read "Gold Rush" written by Michael Caldwell. It contains 25 stories on the management of junior exploration companies, their prospects and exploration philosophies. It is difficult to get information on how these companies are actually managed and even more difficult to get personal information on the people. This book touches on both.

Bill McWilliam
SafeHaven.com

Bill has been involved in virtually all aspects of the investment business as a pension fund manager, broker, analyst and underwriter for the past 30 years. He has also founded, co-founded and financed successful start-ups in the technology and mineral exploration sectors.

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