“The prerequisite to selling high is buying low,” Brent Cook told the audience at the California Resource Investment Conference 2013 in late February. “These are the times when you can select quality deposits and quality companies at reasonable, if not dirt cheap, prices,” he said.
Cook is an exploration analyst and an investor. His decades of experience include serving as a consultant to mining companies and acting as an adviser to investors. He also writes a newsletter, Exploration Insights.
He believes there are opportunities in the gold space, but willingly admits that the market is tough and mining companies have gotten themselves into trouble.
Headaches for the majors
Over the past few years, it appears that too many people have been too focused on rising gold prices.
Many investors jumped into gold mining equities thinking they would be able to leverage gold prices, which have increased at an annualized rate of 20 percent since 2002. There has been wide-scale disappointment because the mega margins they expected simply did not materialize.
Cook said in his presentation that margins have increased by only about 8 percent annually. And, he explained, funnily enough, as the gold price rises, so does the price of fuel, tires and other materials.
At the beginning of the millennium, the average per ounce cost to mine gold was $300. Now, the average cost is about $1,500 an ounce.
Still, it has been often stated that gold miners have the ability to amass large sums of money. Cook wiped some of the allure off of that cash by explaining that much of it is consumed by capital expenditures (capex).
Current global production is about 80 million ounces annually. Just to sustain what is being produced right now will cost over $400 billion in additional capex, Cook stressed.
“Over the past six years, 40 percent of the major mining companies’ market capitalization has been plowed back into new projects — capex.”
“In order to keep up the current production, it’s estimated that 60 percent of their total market valuation is going to have to go back into the ground to build these things. That’s a real problem,” said Cook.
“Not only is it getting more expensive to find these things and build them, but on average, the grade of the deposits, the quality of the deposits is lowering.”
The average gold mine grade has decreased to under 1 gram per ton, he said.
Majors have spent a lot of money snapping up projects without properly weighing quality against the economics. The outcome has often been disappointing. As an example, Cook pointed to Barrick Gold (TSX:ABX,NYSE:ABX). He said the company wrote 36 million ounces off the books, stating that the discarded resources do not meet investment criteria; in other words, Barrick could not make money on them.
Meanwhile, the industry is burning through one Carlin Trend per year, Cook explained. Production needs to be replaced. But discoveries are down, both in terms of ounces and number of discoveries.
“There are about 10,000 properties being explored on a global basis,” Cook explained. “On average, one in a thousand of those — or ten of those — will result in the discovery of an economic deposit. And one in 10,000 — or one of those prospects — will actually turn into a major gold deposit of more than 4 million ounces. Those are just the statistical averages that show how tough it is,” he said.
To put that into perspective, Cook said that in 2011, $8 billion was spent on gold exploration, but there were only about three significant gold discoveries.
Opportunity for the juniors
“The bottom line is that the majors are going to have to acquire and develop new mines. That’s a fact,” Cook emphasized.
“This gap between current production, 80 million ounces, and discoveries, about 10 million ounces, is our opportunity. That is where we stand to make money in this market — regardless of market sentiment — because that gap has to be filled,” Cook said.
But juniors have to realize that the majors are not in the market for just anything. These companies need quality deposits, which is something most juniors do not have to offer.
Cook explained that junior miners have also made a lot of bad decisions. In addition to chasing low-grade trends, some have undertaken nonsensical tasks such as drilling in mountains and looking too deep.
“My biggest issue that I see out there is that a lot of companies are drilling targets for deposits that in the end, even if they’re successful, it doesn’t matter,” he said, explaining that the projects are unlikely to ever become mines.
Considerations for equity investors
Frankly, Cook said, it’s not going to be a good year for juniors.
There is a growing sense of skepticism about the longevity of many of these companies. Based on data from analyst John Kaiser, there are about 1,800 junior companies listed in Vancouver, 70 percent of which are selling are under $0.20. They’ve got a median working capital that has now probably dropped to about $600,000.
“About 600 companies have less than $200,000. You cannot run a company on that,” Cook insisted.
“It takes about $400,000 just for the mining fees and to keep things going. And to assume that you have a secretary and geologist running around. It takes $2,000 just to fly into Mexico to take samples and stay in a hotel.”
The fact that many juniors barely have enough money to stay alive raises serious questions about the future of their projects.
“A lot of these companies have picked up properties and they have property payments. These property payments increase over time. That’s increasing as their working cap is decreasing. Big problem,” warned Cook.
Investors must also consider drilling costs. Just the first look in the ground costs between $1 and $3 million dollars, said Cook.
He advised investors to make sure companies can keep their projects. Investors also need to review these companies’ finances.
“Start off with the market cap versus cash, versus spending,” he said. “That’s really important right now because there is no money coming into these things for the most part.”
Investors also need to be fully aware that their fate is not tied to the fate of these companies. Considering the fact that about 95 percent of juniors will not find anything economic, investors should recognize they can make money regardless.
“If we can interpret that data ahead of the crowd, we can even make money on not finding a discovery,” Cook said. The key is to find the “fatal flaw” and sell when you recognize something is going on.
If you recognize that things are going to continue to get better, add to that position. If you find a company and you can’t find a fatal flaw, that’s when you buy. Remember, Cook urged, real discoveries are very rare. He emphasized that it is also important to consider value as a lot of quality assets are on sale right now.
Securities Disclosure: I, Michelle Smith, do not hold equity interests in any companies in this article.