Hints on Due Diligence in Rare Earth Mining
Source: Anthony Alfidi, Resource Investor (12/23/11)
"Professional investors prefer projects whose production costs are in the bottom quartile of their peer group. The problem with rare earths is that there are too few operating mines worldwide to construct statistically valid cost curves, so other factors must be considered."
Investment banks and resource industry sources regularly publish information on the cost production curves for specific mining sectors. Professional investors and analysts prefer to invest in projects whose cash costs of production are in the bottom quartile of their peer group. I'm not sure how 25% became the threshold or whether it's been academically validated as a useful cutoff, but it's become an industry truism. This business rule holds true for minerals, oil, natural gas, coal, potash, and any other resource that must be extracted from the earth's crust. That's why junior miners whose executives have good business sense will tell you whether their cash costs place them in the cheapest 25% of their peer group.
The problem with rare earths and other critical metals is that there are too few operating mines worldwide to construct statistically valid cost curves. The rare earth sector is currently dominated by Chinese mines whose financial reporting may not be transparent. The important point to remember is that investors must use factors besides the cost of production to evaluate new resource projects, especially those in the exploratory stage. I recap some of those factors below.
Management Experienced in the Sector
I get impatient whenever I sit through investment conferences and roadshow presentations and listen to a mining company CEO whose background was in investment banking, management consulting, financial brokerage or something else unrelated to mining. That tells me the insiders and founders are just looking to dress up a bad property and quickly flip it to the next round of suckers and bagholders. Yes, folks, there really is some of that from time to time in resource investing. Effective mining CEOs need to be operating geologists, without exception. They should ideally have a career history encompassing an entire project lifecycle, from exploration to shut-down. It's also nice to see other geologists and mining engineers on a junior resource company's management team.
National Instrument 43-101 Compliant Report
The SEC's rules for companies disclosing resource reserves are much more restrictive than Canadian securities rules. The SEC requires disclosure of a company's resources that can be economically extracted. Canada, with a more liberal bent to encourage development of its resource sector, requires companies preparing for production to publish what's commonly known as a 43-101 report. The importance of the report for investors is its disclosure of a company's proven and probable reserves, aka "2P reserves." This reserve category is the most useful estimate of what a company can economically extract, and does not include inferred or implied resources that may later be added to the 2P category after production begins. The 2P number can be plugged into a valuation model to determine the company's worth.
This is the amount of money a junior company is spending monthly to operate. Divide its annual net losses by twelve, then divide that monthly loss into its cash on the balance sheet. I also like to subtract short-term liabilities from the cash on hand just to see if the company will survive for a year. Companies that run out of cash before their exploratory results are complete will need to return to investors hat in hand. Raising more capital will dilute shareholders immediately (through common stock issuance) or eventually (through warrants and PIPEs).
I've said it before and I'll say it again. Water is for heap leaching a mineral deposit, which will also require plans for treatment and disposal of tailings (either in a pond or dry-stacked after baking) that retain traces of toxicity. Electric power is for the equipment and base camp; the company must either be a mile or two away from a transmission line and have planned capex for a step-down transformer, or must have large volume diesel tanks on site. Roads to the project site can be of the gravel and unimproved variety but they must at some point lead to a metals refinery by linking to other hardball roads or a port.
There you have it, critical elements investors. Please do your own homework while researching investment opportunities. I can't do investors' homework for them because nobody pays me anything to do so.
Anthony Alfidi, Resource Investor
Anthony J. Alfidi is founder and CEO of San Francisco-based Alfidi Capital LLC. His Alfidi Capital Blog publishes periodic commentary on anything and everything related to investing.