VIRGINIA MINES in the field in Quebec.

VIRGINIA MINES in the field in Quebec.

Apportioning Risk in the Exploration Industry

Issue 63, November 2013

The value of shares traded each month on Toronto’s Venture Exchange, a proxy for exploration stocks globally, has dropped from $6bn in 2011 to $1.2bn in October this year. The total market cap of all mining stocks listed on the exchange has meanwhile dropped from $37bn in 2011 to $11bn currently, shrinking the sector beyond its 2009 lows of $13.9bn.

Of the one hundred largest mining companies on the exchange, only three paid a dividend this year and one of those, Midway Gold, only to holders of preference shares. The data reflects a monumental failing by the exploration industry to deliver shareholder returns, with capital losses far exceeding any metal price decline. Gold and copper are both only 30 per cent from their all time highs.

The volatility of exploration stocks reflects the uncertainties of exploration itself and the long odds of converting an outcrop into a cash generative mine, but it also betrays the inadequacy of the market’s mechanism for absorbing those odds in a way that fosters exploration capital. A buy and hold approach is rendered impossible, repelling long term minded investors and exacerbating the cycle.

“The starting point for me,” says US-based investor Adrian Day, “is that mining at any stage is extremely high risk and exploration is especially high risk. To get from an initial anomaly to an actual mine obviously takes a lot of money, so the question is, how do you mitigate that risk?”

Vancouver’s answer has been simply to pool it: repeatedly raising money for drilling, the exploration industry becomes a rolling dilution machine. Investors are invited to absorb the risk themselves by holding a portfolio of dicey stocks, in turn diluting the upside.

Alongside Sprott’s Rick Rule, Day is the leading investor in prospect generators, companies that limit themselves to prospecting, using cash rich partners to fund high cost drilling. “It’s a good way to participate in exploration while mitigating the risks,” he says. “It enables a company to withstand failure and I think we have to recognise that failure is part of the process.”

In Labrador and Quebec, the model has been pioneered by Altius Minerals and Virginia Mines, two of Day’s largest holdings. Both are pure exploration stocks, but by apportioning risk differently to the bulk of the industry and by stripping the capital intensity out of exploration, both have emerged with cash and royalties in excess of their market caps and both have risen year to date.

Under a listed corporate umbrella, the model echoes an earlier approach to prospecting, whereby lone geologists would wander off into Canada’s snow, turning up gold camps like Hemlo. Without capital for drilling, they would stake ground and option it on, retaining a royalty or minority stake.

In helicopters and high-viz jackets, Altius has the same approach, spending $13m on exploration in five years, vs. $60m in cash receipts and $91m in partner funded drilling. Retaining royalties and spinning discoveries into the market, Altius’ market cap of C$301m ($289m) conceals cash of C$135m, equities trading at C$111m and a portfolio of royalties including 0.3 per cent of Vale’s Voisey’s Bay and 3 per cent of the giant Kami iron ore deposit.

“The beauty of Voisey’s Bay,” Day explains, “is that it pays their overhead, but the Kami royalty is more valuable.” Backed by China’s largest steel mill, Kami is expected to produce 8m tonnes per annum for 30 years from 2016.

At current prices, the figures imply royalty payments of $31m per annum, or as Day conservatively says, “$25m a year for 25 years.” If the payments are paid out in dividends, Altius trades at an 11 per cent forward yield. “The revenue Altius will get from Kami will be far in excess of their needs,” says Day. “That’s also true of Eleonore.”

Having discovered Eleonore on Quebec’s James Bay frontier, Virginia sold the deposit to Goldcorp in 2006, retaining a 2.2 to 3.5 per cent royalty. From 2014, Goldcorp expects Eleonore to produce 600,000 ounces per annum for at least 15 years. Six diamond drill rigs are turning at 7,000m per month from its Andre Gaumond exploration shaft, named after Virginia’s chief executive. “If he wanted,” Day says, “he could pick up the phone and sell the Eleonore royalty within 20 minutes.”

The biggest value in Virginia and Altius however is less in their royalties than in their low cost model and its potential for future discoveries. Fully funded for several decades, exploration success becomes more a question of time than chance or money. “For me,” Day concludes, “when the hard assets add up to the market value and when the overhead is covered by a royalty, it’s just a matter of being patient.”

“The revenue Altius will get from Kami will be far in excess of their needs. That’s also true of Eleonore.”
“When the hard assets add up to the market value and when the overhead is covered by a royalty, it’s just a matter of being patient.”
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