Resource companies – especially junior resource companies – are sometimes considered "speculative investments" because they can be higher risk than businesses in other industries.
So how do investors navigate their way around these speculative investments to find resource companies that provide a higher likelihood of a promising return?
At the recent Hard Assets show in Chicago, Brent Cook spoke about exactly that topic. Brent Cook is an exploration analyst with 30 years of industry experience. He has worked in over 60 countries on all facets of mining of exploration.
We've summarized his speech below. Where possible, he is quoted directly.
Mr. Cook spoke at length about one of the biggest challenges in mining, which he then translated into a problem (and an opportunity) for junior resource investors.
One of the biggest challenges in mining, he explained, is the high cost of operation, and this has an impact on the amount of minerals being produced: "The CAPEX and the costs are going so high that we're not able to drill new deposits to replace those being mined." Then he showed some graphics that highlighted his position, pointing out that the trend of production is declining and there's a growing gap between current production and deposits coming online.
Next, he gave the audience some very dramatic numbers that might surprise investors: "There are, on average, about 10,000 prospects being explored globally right now," he said. "The odds of finding an economic gold deposit are about 1 in 1,000. And the odds of actually producing an economic deposit of 4 million ounces or more are about 1 in 10,000." Then he added: "Those are really bad odds."
So why is it so hard to find a deposit? There are two reasons, asserted Mr. Cook. The first reason is geology and the second reason is finance.
First, he explained the geology by providing a "geology 101" lesson on how deposits occur: "As the magma rises from the ocean floor, it makes volcanoes. Volcanoes form, the magma forms, and each one of those events creates a geochemical or geophysical anomaly. There are anomalies everywhere."
When those anomalies are discovered, geologists look at them to try and find promising opportunities. "That's what is happening with the 10,000 projects around the world," Mr. Cook said. "As explorationists, our job is to interpret these geochemical anomalies to see what forms an economic deposit. We use geologic mineral models to understand what is happening."
With the process so well know, one might wonder why only 1 in 10,000 deposits become major deposits. Mr. Cook explained: "These [geochemical] events are widespread globally but that doesn't necessarily mean that it's easy for a geologist to find and interpret the data. All we have to see is a bit of rock here or there – in a creek or on the side of a cliff, and it's mostly jungle. That's why the odds are so bad. There's so little data."
Mr. Cook concluded the geology part of his explanation with this summary: "The science of exploration is an inexact science because we are dealing with so little data and projecting it to depth when we can't see anything."
Then Mr. Cook turned his attention to the second reason that the odds of success in resource mining are so low: Finance. "All a junior resource company needs is a good story and a map to go out and get a broker and raise money."
And for investors, Mr. Cook said that the venture exchange is "initially your money and their dreams. And at the end of the story, it's your dreams and their money."
Next, Mr. Cook outlined what companies do to help them raise money – something that investors can watch for by doing their due diligence. They put out news releases to pump up excitement and their share price but those news releases aren't necessarily based on meaningful information. Then Mr. Cook provided a few examples:
He showed a picture of one company that put out results but they were based on a sample that could never be mined – the sample was drawn from the side of a hill and a nearby river floods regularly.
He showed another example of a company that raised some money to drill a target almost 3.5 kilometers down, looking for a vein that is about the size of a sidewalk. Mr. Cook asked: "What are the production costs if they are successful?"
Then he showed another company's stock price: The stock jumped on anticipation of upcoming results. "[The company] filed a 43-101 report, which is available on SEDAR. When you look at the data, you'll see that a dozen holes have been drilled around the area so they knew the size of the potential deposit." However the company drilled in the middle of the area, twinning a hole that had already been drilled. "What we needed to see was not what was in the middle," explained Mr. Cook, "we needed to see if they could extend the deposit outside of the area."
So investors need to look carefully at companies and determine whether the information they are producing is as meaningful as the company suggests it is. Mr. Cook said: "Our job as investors is to interpret the drill results and look at the news results as they come out and make decisions about whether it's working or not working. I spend all my time looking for fatal flaws because I know that 95% aren't going to work. I need to find that fatal flaw before the crowd does."
Next, Mr. Cook talked about the state of the junior mining industry.
"It's not in good shape," he reported. "70% of juniors at the end of August 2012 were trading at under twenty cents per share and had less than $800,000 in the bank. You can't survive on $800,000 for one year. So they're going under… And a large percentage of companies are trading under a dime and have $100,000 in the bank. They're not going to make it." But then Mr. Cook gave a new perspective on these numbers: "In my view, this is a positive development. We're looking for the cream, which floats to the top."
With just a few minutes left in his talk, Mr. Cook wrapped up with a description of a business model that he believes strongly in – the prospect generator model. He said: "There are a number of companies out there that are following [this model]. Doesn't it make sense for a company to generate an idea and then bring somebody else in to spend money on development? The more projects you work your way through, the more likely you are to achieve success.
He gave some examples of companies using the prospect generator model:
Eurasian Minerals (TSX-V: EMX): "They're a great company. They have some of the best projects and best geologists that I know of, working all over the world. They have $34 million in the bank; they get about $6 million from a royalty."
Miranda Gold (TSX-V: MAD) "They have very smart geologists doing very smart work in Nevada, Alaska, and Colombia. Again, their partners are doing the exploration while they go out and generate ideas for us, the shareholders."
Altius Minerals (TSX: ALS) "Great company doing great work. You can buy that one for cash plus shares of other companies. Then you get the royalties almost free."
Mr. Cook encouraged investors that production is outstripping supply yet only a few resource companies will find economic deposits worth taking to production. For investors who understand how to do due diligence, finding those few good companies will provide the biggest return.
Brent Cook, Exploration Insights: http://www.explorationinsights.com
Hard Assets Chicago: http://www.hardassetschi.com/