Prospecting for Mining Companies
Investing in mining companies is a very risky yet potentially rewarding endeavour as few properties that are explored ultimately develop into productive mining operations.
Mines do not appear overnight. They take years to develop as they progress through a series of different stages that can be broadly categorized as: explorer, developer, and producer.
Companies closer to production are more highly valued that those just starting the process and market participants should value each stage differently according to the relevant data and issues present.
Explorers and New Discoveries
Any mineral deposit first begins with an initial discovery of an economical resource. Early exploration companies are involved with new discoveries and the subsequent drilling required to further define both the size and grade of the deposit. Some early-stage explorers are concerned only with the discovery of new deposits and have no intention of going into production. Instead, by accumulating enough of these prospective properties they can make a handsome profit by merely selling them to existing mining developers and producers.
Before any mineral deposit can go ahead it must have a preliminary feasibility study completed by a qualified person. A qualified person as defined by the Canadian Institute of Mining, Metallurgy and Petroleum (CIM) is an individual (engineer or geoscientist) with at least five years of relevant experience that is a member in good standing of a Self-Regulating Organization.
This study, also known as a "prefeasibility" study, is concerned with the economic viability of a project and outlines the inferred, indicated and measured resources of the mineral deposit and the economically mineable probable and proven reserves of the deposit.
It must include adequate information on the method of mining (open-pit or underground), determination of an effective method of mineral processing, metallurgical, economic, and other relevant factors that demonstrate, at the time of reporting, that economic extraction can be justified.
The inferred resource estimates have a great deal of uncertainty as to their existence, and great uncertainty as to their economic and legal feasibility. It cannot be assumed that all or any part of an inferred mineral resource will ever be upgraded to a higher category. Under Canadian law, estimates of inferred mineral resources may not form the basis of a feasibility study.
A measured resource has a higher degree of confidence than an indicated resource. More drilling and analysis is required before upgrading an indicated resource to the status of a measured resource. Measured & indicated resources are useful when considering the future potential of a mining project.
Just because a measured mineral resource determines how much of the mineral is in the ground does not necessarily mean that all of it is currently economically viable to extract.
The proven and probable mineral reserves are the economically mineable portions of the measured and indicated mineral resources respectively as demonstrated by at least a preliminary feasibility study. Proven & probable reserves should be used when considering the current economic viability of a mining project.
Developers and Realization of the Project
Developers are concerned primarily with three things: (1) securing the necessary financing to bring the project into existence, (2) acquiring the permitting and licences required under the local jurisdiction in order to begin operations, and (3) construction of the project in a timely manner.
To complete these objectives, detailed engineering and environmental studies are conducted. All geological, operating, economic, political and environmental factors are considered in sufficient detail that it can reasonably serve as the basis for a final decision by a financial institution to finance the development of the deposit.
The permitting process can often be a source of unexpected delays and is perhaps the most frustrating of the stages due to the fact that it lies outside of the control of the mining company and depends on government officials to process and approve.
An estimate of the payback period, cash cost per unit of mineral being mined, internal rate of return (IRR), net present value (NPV) and a timeline of the project should be made available during this stage. These figures are of great concern for an investor to consider. Additional factors to take into account are:
1. Will the company have sufficient funding? Mines require large upfront capital costs followed by years of little or no return. The company may issue additional stock in the form of private placements that have the effect of diluting the stock price in order to raise capital. An investor needs to be prepared for these occurrences.
2. Challenges associated with working in remote locations. What infrastructure is available in terms of access and power generation? Will the ore be milled onsite or does it need to be transported to another location?
3. When is the anticipated production start date? Typically, mining exploration and development accelerates during times of high commodity prices. Those mines that first get into production will be able to sell their product at a higher price than those that follow as the supply increases. Therefore, it is paramount to be able to select high quality mines that are scheduled to go into production near the peak of a commodity cycle in order to maximize profits.
Mining Company Producers
Mining companies that are in the production stage can be valuated more similarly to traditional businesses. Like any other industry, producing mining companies face traditional risks associated with business but the following factors need to also be carefully considered:
1. Political instability and/or threats of nationalization in developing nations such as we see in Venezuela, Zimbabwe and Bolivia.
2. Labour disputes over wages and safety issues concerned with operational hazards.
3. Fluctuating metal prices and foreign currency exchange rates that can greatly affect profitability in a short time.
4. A mine is what's termed a wasting asset in that it loses value over time. Producing mining companies need to allocated some spending to the acquisition of future properties or further development of existing ones.
There are no magic numbers by which to valuate a mining company. Whether the company is an explorer, developer or producer should have a great impact on how much the market capitalization should be relative to the size and quality of the deposit. A useful endeavour is to complete a comparative analysis between different companies at a similar stage of development. Both quantitative and qualitative criteria need to be considered.
Comparing P/E ratios between producers is useful. For developers consider the debt and payback period of the mining operation and consider the value of the proven & probable reserves against market capitalization. Explorers only have the quality and quantity of their deposits available for comparison.
A mining operation with a shorter payback period is obviously preferable to one with a longer one. A larger deposit is superior to a smaller one. But how does a mining operation with a small deposit and short payback compare to one with a large deposit and longer payback period?
Well, that is like comparing apples to oranges and I suppose it depends on whether you prefer the apple to the orange.